How to value Price

A product always comes at a price. Price and product are inseparable. You cannot imagine marketing a product unless you have a price for it. Even more weird, you cannot imagine a price unless it is for a certain product. Imagine a conversation that starts with, “Hey, would you like to buy something from me? I’m not quite sure yet what it is, but the price is two hundred dollars.” Sounds like a line from the theater of the absurd, doesn’t it?

Needless to say, price is imperative to insure profitability. For without profits, the whole exercise of manufacturing and marketing becomes pointless. It is profit (and lots of it) that makes everything else possible. Budgets for salaries of the staff, rent for the office, advertising and other expenses… even Christmas parties and charitable donations are all made possible because profits exist. Profits can sometimes be seen as the be-all and end-all of all economic activity, and because of this, it has gotten some rather bad press in the past. But there is nothing evil about profits. It is simply a necessary part of the entire commercial enterprise – whether we speak of a single product, a company, or an entire nation. A necessary evil, if you must, but necessary is the operative word, not evil. For nothing can happen without it. Without profits as a motivating factor, why would an entrepreneur go into business? Why would a bank set up shop? Why would a farmer grow more produce than his family can consume?

Profit is the great enabler. This fact probably lies at the heart of its harshest criticism as a necessary evil. Because profits do enable all other activities – good and bad. A businessman who makes excess profits may be tempted to spend his money at a casino, and subsequently develop an addiction to gambling. Excess money can easily tempt its owner to spend on unwise luxuries, or worse, experiment with drugs and other evil substances. But to be completely accurate about it, it is not money per se that is the root of all evil, but the love of it. In other words, money by itself does not cause sin, instead, it is the condition of being much too desirous of it that often leads to sin – and crime. But enough moralizing about money and profits. For the purposes of this treatise, the focus is on Price, not Profit.

So, what else can Price do? Apart from ensuring profitability, price can also be used to support some of the brand’s claims. One good illustration is supporting a brand’s claim of superiority. A premium brand will always be expected to cost more than a lower quality competitor. Once a premium brand’s price goes below that of its competitor’s, consumers immediately begin to doubt its authenticity. Price is usually used as a reference by the consumer as a validation of the brand’s perceived value. In the consumer’s mind, a certain stratification exists – competing products are always categorized as either high-end or low-end, or something in between. Higher quality brands are expected to be priced higher. When they are not, consumers are happy with the pleasant surprise. But it also makes them wonder why. Maybe the product is a fake? Or defective? A reject by the Quality Control department? Whatever it is, a disparity between what a brand’s perceived value is and the price at which it is being offered raises questions in the consumer’s mind.

Conversely, a not-so-great product may use price as a tool to artificially enhance its image by precisely leveraging this well-known consumer behavior. This normally does not end well for the brand because sooner or later the consumer will recognize the trick and consequently drop the brand. If somehow the brand survives, it is usually because the consumer has found some other justification for the higher price he is paying, such as attributing some kind of psychological, sentimental, or emotional reason for staying with the brand. One loyal consumer of an expensive yet ordinary product once justified her purchase by saying, “My husband used to buy me these expensive chocolates.” For most other consumers, these brands will simply be remembered as overpriced.

At the other end of the spectrum, low-end brands thrive on low prices, and are usually able to build up good sales volumes, making their overall operations profitable in spite of slim margins from the low prices that they charge per unit. Low-value, high-volume products are the main drivers of most commercial activity in the world today. Most of these products are well-recognized brands. They can be so familiar that they have become part of our environment, or even part of our daily lives. To illustrate: Coca-Cola sells one million bottles of soda every minute of every hour, 24 hours a day, seven days a week, 365 days a year. That means even a mere $0.01 profit on each bottle translates into billions of dollars in gross profits at the end of the year. In truth, the company makes more than $20 billion every year. The numbers can be mind-boggling.

Most products fall under either of these two categories, price-wise: they are either high-volume, low value items, or they are low volume, high value items. Most consumer products are described as “FMCG” – fast-moving consumer goods. This covers most items that you find in grocery stores – everything from beverages (like soft drinks and bottled water) to shampoo and pet food. These are typically the high volume, low-value products. Manufacturers produce them by the billions and it is this huge volume that allows them to keep prices very low. Compare that to products like perfumes and automobiles. Sure, the US produces cars in the millions every year, and you could say that these are high enough numbers to qualify them as “high-volume” products. Not quite. Total volume of vehicles sold in the US has not reached 18 million in a year. How many bottles of soda does the Coca-Cola company sell? Over 1.8 billion per day – that’s 18 million times 100 times 365 days. Understandably, Coca-Cola is a far more valuable brand than either Ford, GM, or Toyota.

A product without a competitor is rare. However, any product that enjoys a monopoly, or at least some semblance of it, will also be expected to be premium-priced. Why? Common sense says, when you have no competition, you can name your price. But can you, really? Yes and no. Yes, you should be able to extract maximum profitability if your product has no competition. This is the situation seen every time a pharmaceutical company introduces a new drug that treats a medical condition for which there were no treatments previously available. The most memorable example is Viagra. In fact, not only was Pfizer able to generate enormous profits from Viagra, but they were able to do so with hardly any advertising at all. Instead, Viagra became a household word through the news media – the very first viral brand (even before “viral” as a media phenomenon existed). You could say Pfizer had a virtual monopoly over the erectile dysfunction market. In fact, the phrase “erectile dysfunction” became a household word because of Viagra. Before Viagra, most people did not know there was a term for that condition.

Compare that to the Segway. Here was a product that was also revolutionary, had no competitor either, and best of all, was seen as cool and hip. And yes, it was in fact rather fun to use. But while Pfizer raked in billions from Viagra (and continues to do so), Segway had miserably poor sales figures. Until today, Segway remains a curious oddity, whereas Viagra is practically mainstream. The only plausible explanation? The Segway was overpriced. In other words, the sky is not the limit even when you have a monopoly of a product.

Going back to Price as supporting a brand’s claims, it remains tremendously important for the manufacturer to be critically aware of what the consumer is willing to pay for his product, whatever the product promise may be, and regardless of its actual manufacturing cost. Within reasonable bounds, consumers will put their common sense to good use by figuring out what a reasonable price they should be paying for the product being offered to them. For instance, designer apparel will always be accepted as a premium product and therefore command a higher price than its less fashionable alternatives. House brands are expected to cost much lower than branded equivalents – to illustrate: Tide detergent is always priced higher than the house brand Kirkland at Costco. And the Kirkland brand is recognized as a respectable and not-too-inferior an alternative to the more established brands – but Tide’s sales figures are always so much higher than Kirkland (or any other alternative house brand from any other retailer, such as Target).

So how does a marketer determine the price at which his product should be sold? How does “MSRP” (Manufacturer’s suggested retail price) come into being? Apart from the obvious – tally up all the manufacturing costs: raw materials, equipment, packaging, transport and shipping, labor and other overhead costs, etc., then slap on a desired profit margin, make allowances for taxes, add them all up, and that’s your MSRP. Is there some other method for determining what’s a reasonable and optimally profitable price? There is. Marketers use research companies to ask prospective consumers what price they would be willing to pay for a product given the features and benefits that their product offers. It is a simple enough research test that is most helpful when introducing a new product – i.e., when there is no competitor’s price to use as a  “benchmark” against which one can compare the new brand’s price.

A simple price test asks respondents how much they are willing to pay for a product. It is usually a range of answers graphed as a bell curve where a “sweet spot” emerges that would give the marketer the highest possible price without losing the interest of too many prospective consumers. It would also show how low he can bring his price down to attract the most number of new customers without losing money in the process. This is important when designing promotions that will involve reductions in pricing. This test allows new products to be sold at the optimum price point where the manufacturer can make the most profit without killing the goose that lays the golden eggs. It is understandably a tricky balancing act, for if a certain “tipping point” is reached, then you can expect the product to follow the path of the Segway. Consumers will wise up to the manufacturer’s greed and just completely shun the new product.

Price wars.

This is where price gets more interesting or should we say, exciting. For very established brands, price can have some flexibility. Sometimes a challenger brand will undercut a market leader by cutting prices. This is called a price war. The challenger hopes to gain market share by offering a lower price. Obviously, this is most effective for a new brand trying to break into a market space already dominated by one or more other brands. A new brand has to find a way to break into the space. In marketing warfare terms, the brand needs a beachhead. It can be as major a launch as the invasion of Normandy, with assault troops on the ground transported by a flotilla of assault naval vessels, and air support from above. Translation: an aggressive, mobilized, and highly motivated sales force invading the retail outlets and heavy bombing from the air, a.k.a. on air advertising (i.e., on-air via broadcast media). In a matter of just a few weeks, a new brand can achieve high brand recognition and initiate product trials rapidly, hoping to sustain the initial sales with satisfied consumers wanting to make a repeat purchase after the initial purchase.

It also works for major competing brands that have achieved parity in stature (and therefore also price). A challenger starts the war by lowering his prices to gain higher market share at the expense of the market leader. A marketer does not do this to be more profitable, because lower prices mean less money, not more. But it is an effective tactic for gaining market share. The market leader can meet the challenge head on by also lowering his price. A second round of price cuts can ensue, and then a third, and so on. But he doesn’t have to. The wise brand manager of the market leader will instead offer something else – perhaps launch a promotion that will give the consumer extra product without changing the price. The additional product effectively brings down the cost per unit price, but the sticker price remains the same. For instance, bundling the product with a smaller pack, say a half-liter is offered free on a full liter purchase. That gives the consumer 50% more product at the same price. More value for his or her money. For the marketer, he simply moved 50% more inventory but did not raise his sales revenues.

Price wars are very expensive exercises, and marketers are always warned against going into them because previous exercises usually show no real winner. Except perhaps for the consumer. They can get a really great deal from both of the competing brands, regardless of their brand loyalties.

When is a price war worth waging? Only in instances where the challenger needs to grow sales to a certain volume where the totals can compensate for the lower revenues per unit of product sold. Translation: economies of scale. In most manufacturing operations, larger volumes enable the company to spread fixed costs such that the actual cost to manufacture a single unit of the product becomes lower. In other words, it is usually cheaper by the dozen.

To illustrate: if it costs say a million dollars a day to run a manufacturing plant to produce one million bags of chocolate chip cookies in a single 8-hour shift, then that means the unit cost of producing the cookies is $1.00 per bag. Most likely, it will not cost another one million dollars to run a second shift to produce a second batch of one million bags of cookies. Typically, the cost for the second shift can be as low as merely 50% of the cost of the first shift. Why? Because the first shift already paid for most, if not all, of the standing overhead costs – the factory and all the equipment inside, the rental for the property and the warehouse, the forklifts and any other vehicles operating within the premises, permits and licenses, insurance premiums, etc., for that day. That means the second shift will only have labor, raw materials, and direct operating costs (such as electric consumption) tallied as its total cost. That means that the overhead costs are now spread over two million bags of cookies instead of just one million. If that overhead cost was $0.50 per bag for the first million, then the new overhead cost becomes $0.25 per bag for two million bags. And production costs for the two million bags is now $0.75 per bag, instead of $1.00 per bag.

To complete the illustration, if the company sees that it can double its sales volume by reducing its price by as much as 25%, then they should do it.

There are also speculative price wars. Let us say two companies are in the business of providing transport services to producers of livestock, and both have a fairly equal share of the market. But the holidays are coming up. Their clients are going to have an increased need for transport services to get their turkeys out before Thanksgiving and their hogs out before Christmas. The smarter company will lease additional trucks from a vendor. This will increase his operating costs but he hopes to make up for it by growing his volume by so much more. He then starts offering discounted rates to the farmers, maybe as much as 40% off on a second truck just for the season. If the farmers bite, this will mean the transport company will double his volume and grow his revenues by 60 percent. If he only increased his operating costs by 30% paying for the additional trucks, then he would have grown his profits by 30%. If his competitor did not do anything to protect his market share, then the smarter company would now likely control two-thirds of the market.

Price brands.

Many times, when market leaders are being challenged, they develop “flanking brands” – these are essentially competitors to their own brands except that they are also owned by the company. How does this make sense? Simple: if your consumer is about to drop your brand in favor of a cheaper alternative, you will want that alternative to be one of your own brands (what we call a “price brand” or “flanking brand”), instead of the real competitor. That way, the consumer’s money will still go to one of your own pockets, instead of to your competitor’s.

This was best demonstrated in the Philippines during the protracted beer wars between San Miguel Corporation and Asia Brewery Inc. (ABI) in the 1970s up to the 1990s. SMC had been the sole beer brewing company in the country for decades. An early competitor, Halili Beer, was bought out and quietly killed. Along came Asia Brewery, owned by tobacco tycoon Lucio Tan. Tan had a robust war chest from the profits of his cigarette company (he was licensed to manufacture Marlboro and Philip Morris, among others). He launched brands one after another to challenge the market supremacy of San Miguel’s Pale Pilsen – the country’s number one beer for many generations. For very many years in fact, San Miguel was the only brand available. None of the challenger brands ever succeeded in making any serious dents into the market dominance of San Miguel. A huge part of SMC’ success in defending its turf was the flanking brand strategy. Before Asia Brewery could launch any of its new brands, SMC would already have launched another brand to compete with the new entrant head on. Typically, the flanking brand would be priced below the challenger brand, and this undercutting tactic would always make it impossibly expensive for ABI to compete. They would be forced to lower their price – to the point where they would be losing more money the more bottles they sold, if they sold any bottles at all.

An interesting “side effect” of this situation was the relationship that evolved between SMC’s Pale Pilsen and the flanking brands. One of these brands was Gold Eagle, a reasonable facsimile of the flagship brand Pale Pilsen but was always priced lower than PP. Gold Eagle was the main flanking brand used to draw buyers away from ABI’s brands. It became quite successful on its own and established its own base of loyal consumers. Gold Eagle created its own market segment, typically previously loyal Pale Pilsen drinkers who didn’t mind taking a slightly watered-down version of their favorite beer if it meant saving some money on every bottle. Another successful flanking brand was Red Horse, the one with a higher alcohol content and was billed as the “Extra strong beer” for consumers with higher testosterone levels (or thought they did) and the alcohol appetite to match. Clearly, with such a lineup of strong brands (there were a couple of other brands, including a non-alcoholic brand for the ladies, Lagerlite), SMC was making sure Asia Brewery would be facing an uphill battle every time they wanted to pick a fight.

Pricing was a key element in their differentiation from one another. It came to a point where if SMC needed to be more profitable, they would simply raise the price of Gold Eagle a little bit. That little trick would not just increase revenues per unit of sales on Gold Eagle, it would also lead some of its consumers to think that, “Hey look, the price difference between Gold Eagle and Pale Pilsen is now only a few centavos!” At this negligible price difference beer drinkers would then switch up back to Pale Pilsen. The small price difference tells them that for just a little bit more money, they can have Pale Pilsen, the benchmark brand, the gold standard for beer in the Philippines. Why settle for a second-rate beer brand if the top brand is only a negligible price difference away? Of course, as more of these consumers switched up to Pale Pilsen, SMC made even more money with every bottle sold.


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