Marc Cosentino’s Case in Point is the old standby of case interviews. Everybodys read it or is at least familiar with the basic concepts. One of the most sticky concepts in Cosentino’s book is the three types of pricing strategies:
1. Cost Based Pricing
2. Competitive Analysis
3. Price Based Costing (aka value based pricing)
Pricing Strategy Cases do come up pretty frequently, so let’s talk about how to use the aforementioned pricing strategies and figure out how to update them for the modern day.
Cost Based Pricing
In cost based pricing you figure out the breakeven price for the product and then add an appropriate margin.
The breakeven price sets a floor for the price of the product. To calculate the breakeven point you need a few pieces of information:
1. The Fixed Investment Cost – Facilities, Equipment, Marketing & Sales, R&D, etc.
2. The Variable Cost per unit – Usually depends on raw material, manufacturing, labor, and transportation costs.
3. The Number of Units sold within the breakeven period – Depends on the estimated number of customers, units sold per customer, and breakeven time period.
Breakeven Price = Fixed Cost / # of units sold + Variable Cost / Unit
Then, you can add to the breakeven price a margin based on either:
1. A Competition’s margin, a margin for similar products or
2. A margin based on the CEO’s preferences.
In competitive analysis you price based upon:
1. Prices of Direct Competitors – In pricing cases we’re often dealing with new products that have no direct competition, so this isn’t always possible.
However, even if a direct competitor exists you need to consider the target customer segment. For example, the competition may be targeting a lower end of the market than we are planning to target. If that’s the case information about their pricing is less useful.
2. Prices of Substitutes – For example, one way to price, say, a diet pill would be to look at the price of a gym membership.
Value Based Pricing
In value based pricing you price the product based on the additional revenue and cost savings the customer gets from using your product.
For example, one of my favorite value based pricing cases is the Maine Apples case found in the Kellogg 2011 casebook. In this case, a biotech company has developed a chemical that makes apples ripen faster and improves yield. As a result:
1. The chemical increases revenues because the apple yield / acre increases.
2. The chemical lowers costs because the ripening time for the apples decreases.
The value of the product in this case is the increased profit / acre and it can be quantified and factored into the chemical’s price, setting a theoretical ceiling for the product’s value.
Also, one important concept to take into account with value based pricing is that value to the end user may not translate to value to the payer. As a result, even a product with high value to the end user may not command a price premium.
One example is health insurance. A specific treatment may provide enormous value to the end customer but the health insurance payer may not be willing to put up the money for it. As a result, it’s also very important to assess willingness to pay for the various stakeholders when using value based pricing.
There are three types of pricing strategies:
1. Cost Based Pricing – You take the breakeven price for the product and then add an appropriate margin. The breakeven price can be used as the absolute minimum or floor for pricing.
2. Competitive Analysis – You take the prices of direct competitors in the same segment or indirect substitutes to help you set price.
3. Value Based Pricing – You price the product based on the additional revenue and cost savings the customer gets from using your product.
It’s often useful to consider all three, though consulting firms prefer to use value based pricing (the clients can probably pretty easily do the first two, after all).
Hope it helps!