Financial Analysis for Profit-Driven Pricing

Internal financial considerations and external market considerations are, at most companies, antagonistic forces in pricing decisions. Financial people allocate costs to determine how high prices must be to cover costs and achieve their profit objectives. Marketing and salespeople analyze buyers to determine how low prices must be to achieve their sales objectives. The pricing decisions that result are politically charged compromises, not thoughtful implementations of a coherent strategy. Although common, this situation is neither necessary nor desirable. An effective pricing decision should involve an optimal blending of, not a compromise between, internal financial constraints and external market conditions.

Unfortunately, few managers have any idea how to facilitate such a cross-functional blending of these legitimate concerns. From traditional cost accounting, they learn to take sales objectives as “given” before allocating costs, thus precluding the ability to incorporate market forces into pricing decisions. From marketing, they are told that effective pricing should be entirely “customer driven,” ignoring costs except as a minimum constraint below which the sale would become unprofitable. Perhaps, along the way, these managers study economics and learn that, in theory, optimal pricing is a blending of cost and demand considerations. In practice, however, they find the economists’ assumption of a known demand curve hopelessly unrealistic.

Consequently, pricing at most companies remains stuck between cost-driven and customer-driven procedures that are inherently incompatible. The result is tactical pricing focused on short-term objectives. For example, when planning for the forthcoming fiscal year, companies often set unrealistically high “list” prices to cover costs, only to discount them near the end of the year to make sales. No company can have a real pricing strategy, a plan to maximize long-term profitability, until management has learned how to balance these opposing forces strategically. Thus one purpose of this article is to suggest how managers can break the tactical pricing deadlock and make the pricing decision process more strategic. A second purpose is to develop contribution-based pricing procedures that allow managers to determine “optimal” pricing without using highly technical formulas and without having to precisely define a demand function.

An Integrated Approach to Pricing

As representatives of their respective stakeholders, the finance-accounting and marketing-sales functions have legitimate concerns with regard to pricing policy. The problem is that these concerns are often addressed in functional isolation, and they are decided by whichever functional group wields the most political control. Cost-driven pricing focuses on an individual sale’s profit margin, ignoring effects on volume, while customer-driven pricing focuses on achieving volume, ignoring the effect on overall profitability. We propose an integrative framework that addresses the concerns of these functions simultaneously and that establishes standards for making tradeoffs between them. First, we discuss the objectives and philosophies of both cost-driven and customer-driven pricing. Then we present profit-driven pricing as an alternative that incorporates the strengths of both functional approaches.

Cost-Driven Pricing

In cost-driven pricing, primary responsibility for the pricing decision rests with the finance and accounting functions (see Table 1). They often oversee the financial evaluation of multiple products and services, and their objective is to reduce performance evaluation for all products and services to a common measure: a reasonable return over the product’s “full cost.” Key inputs into the pricing decision include an assessment of unit variable costs, unit fixed costs (stated as “burdens” for sales expenses, factory overhead, administration, etc.), and a forecast of expected sales volume, used to calculate overhead burden rates. Performance of pricing policy is measured in terms of total profit per unit, often described as variances from budgeted revenues, costs, and profits. The pricing decision focuses on price levels relative to full unit costs.

The financial accountants’ concern about covering costs is legitimate; only the cost-plus logic by which they often attempt to do so is flawed. By allocating fixed costs as “burdens” over a given number of sales, they fail to take account of the fact that price affects the level of unit sales and, therefore, the size of the burden that each sale must carry. Since making fewer sales means that the same fixed costs must be allocated over fewer units, a price increase may actually reduce unit profits. Similarly, a price cut that increases sales may actually increase unit profit by spreading fixed costs. Effective financial analysis of a price change must account both for the effect of price on sales volume and for the effect of sales volume on costs.1

Customer-Driven Pricing

In customer-driven pricing, finance and accounting still provide relevant cost information, but the final pricing decision is driven by marketing and sales. Once variable costs are covered, according to this philosophy, pricing should be driven totally by what is necessary to close a sale or achieve a sales objective. Key inputs into the customer-driven pricing process are market factors such as prices of competitive products, prices customers indicate they are willing to pay, and comments from customers about price sensitivity. Performance of the pricing policy is measured in terms of company sales volume or market share. The fundamental focus of the pricing decision is on current sales levels relative to sales objectives.

This approach may work as long as every customer can be charged a unique price. However, communication between customers and their incentive to manipulate sellers to get the lowest price tend to push prices toward the lowest common denominator. At least within a segment that buys the same product, one cannot charge all customers different prices for long. Consequently, one cannot maximize total profits by making every sale that might be individually profitable. Moreover, a customer’s willingness to pay is often a poor guide to pricing even when prices can be individually negotiated. Often willingness to pay falls short of economic value because the customer doubts a product’s promised performance or is uncertain of its benefits. The salesperson’s and product manager’s job is to overcome these problems, raising customers’ willingness to pay to reflect a product’s value.

Profit-Driven Pricing

We propose to replace these two antagonistic approaches with a procedure to facilitate making profitable tradeoffs between higher margins and higher sales. We call the approach profit-driven pricing. Imagine a meeting called to deal with the inadequate profitability of a product recently introduced. Finance and sales managers attend, as well as others in general management. The meeting begins with the financial manager’s report on the product’s dismal profitability. Because the product is not achieving its targeted sales, revenues are not covering the fixed costs of manufacturing, marketing, and overhead, resulting in unfavorable cost variances. Since this product line should “stand on its own” financially, the financial manager proposes a price increase to cover these costs. The sales manager is visibly annoyed. He agrees that the market is tougher than originally predicted, but he argues convincingly that if he can’t meet the sales objective at the current price, how can he possibly meet it at a higher price? The difficult market, he argues, calls for discounting current prices, not increasing them.

Fortunately, this meeting is chaired by a general manager with a financial background who has recently learned how to resolve such conflicts productively. She dispenses with the tactical, inconsistent, counterproductive questions that initially motivated the meeting: “What price do we need to cover our unit costs?” “What price do we need to meet our sales objective?” Instead she focuses the discussion on a more general question: “What changes in price, and in the marketing program, could make this product more profitable?” First, she makes it clear to the sales manager that failing to reach sales goals is not by itself a justification for cutting price. A price cut is justified only if it can generate enough additional sales to make up for the profit lost on sales that could have been made at a higher price.

She then asks the finance manager what portion of the product’s costs are variable. “In the long run, all costs are variable,” he reports smugly.

“Then, in the long run,” she retorts, “I would hope that our finance department would not let us invest in businesses like this one where we are losing money. In the short run, however, we have to cover our fixed costs whether or not we make sales.”

The general manager looks at her copies of the financial statements. She turns to the financial manager: “Materials are all variable; direct labor and shipping expenses are largely variable as well. Other allocated expenses have some variable component.” Together, they conservatively estimate that variable costs represent about half of the current price. “That’s great,” the sales manager breaks in. “I always thought we had more room to cut price than we were led to believe.” The financial manager scowls.

The general manager turns to the sales manager: “Well, not exactly. You have some flexibility to cut price. But it’s not quite that simple.” Using the just-revealed information on cost, she pencils a brief calculation in the margin of her financial statement and turns to the sales manager. “You know this market better than anyone else here. You have talked to the customers, and you understand how competitors will react. I will trust your judgment on this issue. If you decide to discount the price by 10 percent,” she pauses to look at her calculation, “your sales must rise by at least 25 percent to make the price change a profitable one. Consequently, the sales objective, by which your division will be evaluated and compensated, must rise by that amount. You be the judge. If it is easier to reach a 25 percent higher sales objective at lower prices than to reach your current objective at current prices, you should discount the price. We are counting on you to make the right decision.”

In contrast to cost-based pricing, where the finance people can avoid responsibility for effects on sales volume, and customer-driven pricing, where the salespeople can avoid responsibility for profitability, this approach forces the decision maker to confront the tradeoffs. After some time for reflection, the sales manager asks for more information. In particular, he is concerned that there may not be enough additional demand generated by a 10 percent price cut to reach a higher sales objective.

On the other hand, with a stronger sales effort, he wonders if he may be able to get many current buyers to accept a higher price, enhancing the company’s efforts to maintain a premium price positioning and avoiding the possibility of competitive retaliation. “Would a higher price justify lowering the sales objective?” he asks. The general manager again does a brief calculation and reports that, if prices could be increased by 10 percent, she could cut the sales objective by 17 percent and still achieve current levels of profitability.

The final decision: prices will be increased 10 percent. The sales objective will be reduced 17 percent. The sales manager is satisfied, since he has what he thinks is a more achievable sales objective. The finance manager is satisfied because, to the extent that the sales manager succeeds, his profitability objective will also be achieved. The general manager is satisfied because the change in pricing policy integrated the unique knowledge of both the financial and sales functions. The pricing decision was driven by the market, while rationally constrained by the financial tradeoffs involved.

Defining Profit-Driven Pricing

Profit-driven pricing is a systematic procedure for maximizing profitability by making tradeoffs between price changes and changes in sales volume. The focus on overall profitability avoids the distortions that result from tactical pricing to achieve functional objectives. It is consistent with economic theory, but, unlike economic theory, it is simple and intuitive, and it permits managers to make decisions based on judgments about uncertain and unquantified market response.

With profit-driven pricing, performance is measured in terms of changes in sales volume and changes in profitability. These measures simplify and clarify the analysis of a price change by including only those variables that will be affected by the price change (price, variable costs, incremental fixed costs, and sales volume) and excluding variables that are irrelevant to the price change (administrative overhead and other sunk or fixed costs). As a result, the decision is always focused on the potential change in profitability caused by the price change, that is, current contribution relative to potential contribution.

An Integrative Framework

We propose a framework for making strategic, profit-driven pricing decisions that integrates input from three centers of strategic assessment (see Figure 1). Financial sensitivity analysis examines the effects of internal costs. Customer and competitive assessments consider the impact of external market forces. Strategic assessment addresses the impact of the price decision on corporate or product line strategy. In the past two decades, marketing theorists and practitioners have made enormous strides in incorporating the external considerations into marketing strategy. But the appropriate role of financial analysis in marketing has been less well explained and understood. The framework uses quantitative information first to assess the financial sensitivity of the product’s profitability to changes in price. Qualitative and subjective market information then must be considered to assess the likelihood that customer and competitor response will enable the firm to achieve the breakeven sales level and to ensure that the price change is consonant with managerial strategy.

Internal Costs

Financial sensitivity analysis determines the possible effects of price changes on the firm’s profitability. It involves two steps: cost structure analysis and breakeven sales analysis.

Cost Structure Analysis

Cost structure analysis asks two important questions relating to the firm’s cost structure: What portion of price affects profitability? How great is the leverage between volume and profitability? The portion of price that affects profitability is the contribution margin, calculated as unit price minus unit variable costs. The goal is to cover variable costs and to find price changes that will add incrementally to the total “contribution” available to recover fixed costs and achieve profitability. Whether that contribution vastly exceeds what is necessary to achieve our profit objective or falls dismally short is not a pricing issue. Pricing cannot be expected to fix bad investment decisions. It can only be expected to fully capture the contribution available.

The ratio of contribution to price, called the percent contribution margin, is an important measure of the leverage between a firm’s sales volume and its profit. It indicates the importance of sales volume as a marketing objective. Consider two companies whose revenues and costs are shown in Table 2. Each is currently earning the same net profit (10 percent) on sales, but they have substantially different percent contribution margins because different portions of their costs are variable.

Product A has high variable costs, equal to 70 percent of its product price. Its percent contribution margin is therefore 30 percent; a small portion of price affects profitability. Product B has low variable costs, equal to 20 percent of its product’s price. Its percent contribution margin is therefore 80 percent; a large portion of price affects profitability. Although, at current sales volume, each firm earns the same net profit, the effect on each of a change in sales volume is dramatically different. For Product A, only $.30 of every additional sales dollar increases profit or reduces losses. For Product B, that figure is $.80. Product B has greater price leverage on profitability and will have greater incentive to stimulate sales volume to achieve profitability.

For example, in order for Product A to profit from a 5 percent price cut, its sales must increase by more than 20 percent, compared with only 6.7 percent for Product B. Similarly, for larger price cuts, Product A must gain more sales than Product B to make them profitable. Price leverage cuts both ways, however. For price increases, Product A can afford to lose more sales before any increase becomes unprofitable.

Breakeven Sales Analysis

A cost structure analysis provides a general sense of the firm’s financial sensitivity. A breakeven sales analysis calculates precisely the change in sales required for a given price change to yield incremental profit contribution, that is, the change in sales for the price change to at least “break even.” The key inputs to this calculation include the product’s contribution margin, anticipated changes in variable costs arising from the price change (e.g., quantity discounts for materials purchasing), incremental fixed costs, and, of course, the proposed change in price. For a price cut, the breakeven sales change is the minimum increase in sales volume necessary for the price cut to yield an increase in profit contribution. For a price increase, it is the maximum reduction in sales volume that can be absorbed for the price increase to yield an increase in contribution.

• Proactive Change in Price. In the scenario described earlier, a 10 percent price cut required a 25 percent sales increase and a 10 percent price increase required that sales volume fall by no more than 17 percent. How did the general manager arrive at those figures? Recall that she and the financial manager determined that unit variable costs were about 50 percent of the product’s $60 wholesale price. At this price, the company sells 400,000 units for total sales revenue of $24 million. Fixed costs are $9 million. The general manager determined the breakeven sales change using a simple “back-of-the-envelope” formula involving two inputs: the proposed price change and the contribution margin (see Table 3, Proactive Price Change). The proposed change in price (ΔP) is -$6; the product’s contribution margin (CM) is $30 ($60 price – $30 variable costs). Inserting these values into the formula for a proactive price change yields .25 or 25 percent. The price cut will be profitable only if it leads to an increase in sales volume of more than 25 percent. Relative to current sales volume of 400,000 units, the sales manager would have to sell at least 100,000 units more (.25 x 400,000) for the price change to be profitable. A similar calculation for a 10 percent price increase, that is, a +$6 change in price (ΔP), yields a breakeven sales change of -17 percent. The sales objective could be reduced 68,000 units (.17 x 400,000) before the price increase would become unprofitable.

• Change in Variable Costs. Some changes in price lead to changes in variable cost structure. Perhaps the sales manager believes that an important element in getting customers to accept a 10 percent price increase is improved packaging to make the product appear more attractive. The financial manager quickly determines that such packaging will add $1 per unit to variable cost. How would that affect the earlier breakeven calculation, which indicated that a 10 percent price increase could be profitable only if sales declined less than 17 percent? Here, the unit change in price (+$6) and the unit change in variable cost (+$1) result in a unit change in contribution margin of +$5 (6 minus 1). Inserting these values into the formula for a price change with a change in variable cost (Table 3) yields a breakeven sales change of –14.3 percent. Thus, the planned 10 percent increase in price, accompanied by a consequent change in unit variable costs, could lead to a 14.3 percent reduction in the sales objective before it would be unprofitable.
• Change in Fixed Costs. Strategic pricing focuses on the profitability of alternative price change scenarios, some of which may involve investments in fixed costs to implement the price change. While sunk fixed costs are irrelevant to a pricing decision, these incremental fixed costs are not. These might include the costs of additional advertising, package redesign, or administrative costs associated with repricing. In such cases, the breakeven sales change must also account for these incremental investments in fixed costs, which must be subtracted from the change in contribution resulting from the price change.

In the case discussed earlier, the sales manager determined that, with additional sales support, he could convince many buyers to accept a higher price. Such support would include money for training the salesforce in “selling value” and for additional advertising. After reviewing these needs, the general manager gives him the result of one more calculation: the added sales required to pay for these additional marketing resources. This surprises the sales manager, for whom marketing resources were always charged simply as part of “administrative overhead burden.” She points out to him, however, that spending money on these resources can only be justified if they generate a sufficient addition to sales, in excess of what otherwise would be needed.

They agree that he will need an additional $500,000 for increased sales support. The general manager calculates that, at the new contribution margin of $35, he will need to sell at least 14,286 units more, about 3.6 percent of original sales, just to cover this expenditure. This was calculated as $500,000 in incremental fixed costs, divided by the $35 profit contribution generated by each unit sold at the new price. This means that his sales goal at higher prices can be cut by only 10.7 percent rather than by 14.3 percent.

While back-of-the-envelope formulas are handy for quick price change-profitability calculations, most managers have access to personal computers and spreadsheets that significantly enhance their ability to assess the impact of a pending price change. A manager may, for instance, want to simulate different scenarios of market response to assess their relative impact on the profitability of the price change.

Suppose that the general manager asks the financial manager to calculate a series of “what if” scenarios. At worst, how would profitability be affected if the price change caused sales to fall by 40 percent? Or, more optimistically, how would profitability be affected if sales were unaffected by the price change or unexpectedly increased by 10 percent? Table 4 shows a simple spreadsheet simulating the impact on profitability of the price change.

In the worst case scenario, sales fall by 40 percent or 160,000 units, causing a loss in profit contribution of almost $3.6 million. From this, the incremental fixed costs ($500,000) required to implement the price change must be subtracted. Thus, under this pessimistic scenario, the price change would cause a net loss of almost $4.1 million. By contrast, suppose sales fell by only 5 percent (Scenario 8) or 20,000 units. Contribution would increase by $1.3 million and net profit by $802,000. It is clear that scenarios 7 through 11 are profitable scenarios. Scenarios 1 through 6 are unprofitable.

Reactive Price Change.

Not all price changes are proactive. Some are reactive or defensive. How can one calculate the breakeven sales change required before a reactive price change is profitable? Continuing with our illustration, several days after the last price policy meeting, the sales manager learns from a major buyer that a competitor has just announced a 10 percent price cut, effective immediately. This changes the situation significantly. “Clearly it no longer makes sense to raise price,” notes the sales manager. “In fact, the word I’m getting from the field reps is that, if we want to be competitive, we had better think about cutting price to match the competition. Otherwise, we will continue to fall short of our sales objectives.”

The general manager responds, “Let’s set aside the sales support expenditure program for a moment and focus on your proposed reactive price cut. How many sales would we have to lose before the cost of lost sales exceeded the cost of matching the price cut?” Using the proposed price cut of $6, and the original contribution margin of $30, she inserts these values into the formula for a reactive price change (Table 3), yielding a break-even sales change of -20 percent.

The general manager turns to the sales manager. “In your judgment, do we stand to lose more than 20 percent of our sales volume if we don’t match the price cut? If not, we will be more profitable by focusing on customers who are less price sensitive, more loyal, and more profitable.” The sales manager looks through a printout of his accounts and notes that it is unlikely that 20 percent of sales volume would be lost. Just in case, however, he suggests that “given the changing market situation, the sales support expenditure program should be implemented nonetheless to convince current customers that the price premium relative to the competition is worth it.”

“That’s fine,” replies the general manager, “but remember that you will still have to sell more units just to cover the cost of that investment. If we don’t change our price, our contribution margin will remain at $30. This means you will have to sell an additional 16,670 units (500,000 divided by 30) or 4 percent of current sales just to cover the incremental investment. In this case, we should expect that the sales support program will ensure that our sales losses are no greater than 16 percent.”

Constant Profit Curves.

So far we have discussed breakeven sales analysis in terms of a single change in price. However, what if the company wants to consider a range of potential price changes? How can breakeven sales analysis be applied to consider more than just one price change at a time? The answer is by charting a constant profit curve, which summarizes the results of a series of breakeven sales analyses on different prices.

Constant profit curves also involve doing a series of“what if ” analyses, similar to the spreadsheet simulations discussed in the last section. The difference is that we now simulate different levels of price change, using the breakeven sales formulas, to determine breakeven sales volume levels that are associated with each price level. Table 5 shows spreadsheet calculations for eleven potential price changes, ranging from +25 percent to -25 percent. The calculations are particularly interesting when plotted, since they define a boundary of market response required for a price change to break even (see Figure 2).

Note that the vertical axis consists of different price levels for the product; the horizontal axis presents a sales volume level that is associated with each price level. Each point on the constant profit curve represents the sales volume necessary to achieve at least as much profit as could be earned without changing the price. For example, the baseline price is $60 per unit and baseline sales volume is 400,000 units. If, however, price were to decrease 10 percent to $54, sales volume would have to increase 25 percent to 500,000 units to achieve breakeven sales. Conversely, if price were to increase 10 percent to $66, sales volume could decrease 17 percent to approximately 338,000 units and still achieve breakeven sales.

The constant profit curve is a simple yet powerful way to synthesize and evaluate the dynamics behind the profitability of potential price changes. It presents succinctly and visually the dividing line that separates profitable price decisions from unprofitable price decisions: profitable price decisions are those that result in sales volumes in the area to the right of the curve; unprofitable price decisions are those that result in sales volumes in the area to the left of the curve.

What is the logic behind this? Recall our earlier discussion of what happens before and after a price change. The constant profit curve represents those sales volume levels, associated with their respective price levels, where the company will make just as much contribution after the price change as it made before the price change. If the company’s sales volume after the price change is greater than the breakeven sales volume (i.e., actual sales volume is to the right of the curve), then the price change will add to contribution. If the company’s sales volume after the price change is less than the breakeven sales volume (i.e., the area to the left of the curve), then the price change will be unprofitable.

Constant Profit Curves and Price Elasticity.

Note that the shape of the breakeven sales curve looks similar to a traditional downward-sloping demand curve in economic theory, where different levels of price (on thevertical axis) are associated with different levels of quantity demanded (on the horizontal axis). The similarity between the constant profit curve and the demand curve is no coincidence.

Economists approach pricing problems by asking, “What is the demand curve?” Unfortunately, since managers almost never “know” the demand curve with any precision, they usually abandon the economic approach in frustration. But managers are not totally ignorant about demand, they are just uncertain. Moreover, good managers are accustomed to making judgments under uncertainty. To make the economics of pricing into a useful managerial tool, we have turned the economic theory on its head. Instead of demanding a precise estimate of actual demand elasticity and proceeding to set the optimal price, we begin with the price changes that managers might choose to make for strategic reasons (e.g., to improve margins or enhance market growth) and use economic theory to calculate the minimum demand elasticity necessary to make those price changes profitable. The calculation of those minimum demand elasticities (what we call the breakeven sales changes) for different price changes produces the points on the constant profit curve. Where management believes that actual sales volume would exceed the volume shown by the curve, then the corresponding price change would be profitable.

Figure 3 plots hypothetical demand curves with the constant profit curve. If demand is more elastic, as in the top figure, then price reductions relative to the baseline price will result in gains in profitability, and price increases will result in losses in profitability. If demand is less elastic, as in the lower figure, then price increases relative to the baseline price will result in gains in profitability, and price reductions will result in losses in profitability. Unfortunately, accurately measuring a demand curve is a little like trying to achieve a perfect vacuum; you can never completely achieve success, and the cost increases exponentially as you try to get closer. Fortunately, by reversing the economic approach to pricing, we can replace the need to forecast demand accurately with the less onerous requirement that we merely test the hypothesis that the demand curve’s elasticity is greater or less than the required level, as illustrated in the constant profit curve.

There are now many formal research techniques, such as conjoint analysis, that are sufficiently reliable when used in the appropriate context to test hypotheses about demand.2 But the approach proposed here more readily lends itself to the use of informal “expert judgment.” We have observed cases where salespeople report a complete inability to estimate demand for the product they sell or even to assign subjective probabilities to alternative demand scenarios. Those same salespeople, however, are quite confident deciding whether they would be willing to accept a specified increase in their sales goals in exchange for offering a deeper discount.

The Long Term

The very nature of price tempts one to treat it tactically to solve short-term problems. It can be changed readily without long lead times. It can generate instant market response, with little immediate pain or consequence. The longer-term consequences of pricing decisions, however, are more ominous and require a strategic assessment of price. Costs, customers, and competition all change over time, affecting our long-term assessment of profitable pricing policies. An astute manager may thus ask: Within what period of time must we achieve a breakeven change in sales volume? What if we fall short?

Some business writers and marketing practitioners disdain financial analysis precisely because it is a constraint on long-term planning. But the problem inherent in financial analysis is not the numbers themselves; it is how those numbers are used and the time horizon over which they are applied. The fact that a pricing decision might not achieve its breakeven sales level in the short term is not by itself a reason to reject it. The long-term benefits of the decision — reducing future costs or competition, for example — may be worth the initial cost. No manager, however, can make such a tradeoff intelligently without first determining the short-term cost and estimating the long-term benefit. Breakeven sales analysis is helpful in doing both.

Falling short of the breakeven sales change in the near term (e.g., the first year), requires that sales volume exceed the breakeven level by even more in later years. Moreover, since future dollars are worth less than current ones, sales in future years must be still higher. There are two ways to incorporate this into our analysis. The first is to calculate the anticipated shortfall in near-term sales, multiply it by the contribution margin, and treat that profit shortfall as an incremental “investment” that we must expect to recover in future periods. The analyst would add to the simple breakeven sales change in future periods the amount of additional sales necessary to recover the initial profit shortfall, with interest. The pattern of future profit recovery (as represented by corresponding breakeven sales levels) could be made uniform, increasing, or whatever amortization scenario seems most appropriate given the expected pattern of future returns. This is illustrated in Figure 4. The problem with this approach is that it requires a good estimate of how much you may sell, and therefore how much you may lose, in the short run.

The alternative approach overcomes this problem but at the expense of requiring another piece of information. The added information is the amount of future sales expected for each additional sale made in the near term. For example, when offering price promotions to induce customers to try new products, packaged goods companies can often anticipate from market research the percent of customers who will purchase the product again and how frequently they will do so. Multiplying those future sales by the contribution margin, appropriately discounted for the time value of money, gives an estimate of the future contribution generated by each current sale. Adding that to the current contribution margin enables one to calculate an adjusted contribution associated with additional current sales. The adjusted contribution can then be used to calculate a breakeven sales change that incorporates the long-term benefits of making near-term sales.

For example, imagine that a product sells for $4 (wholesale) and has a contribution margin of $2. Now imagine that research shows that of those customers who try the product at a lower promotional price, 20 percent are likely to purchase again. Further, each new customer who tries it is likely to purchase it 3.4 times over a two-year period. The company believes that to effectively induce trial will require offering a promotion costing $.65 per unit (including the price discount and any other costs of promotion, such as fulfillment). (To keep this example simple, we will ignore discounting to reflect the time value of money.)

How many incremental sales over the long term are necessary to justify this short-term promotion? The answer is at least 24 percent. We get this by calculating the adjusted contribution margin for incremental sales — $2 (the original contribution margin) plus a 20 percent probability of realizing another 3.4 purchases, also at $2 each: 2 + .2 x 3.4 x 2. We then use this to calculate the breakeven sales for a $.65 price reduction.

External Market Forces

Many companies simplistically predict market response to a pricing policy by forecasting unit sales volume. This forecast is then formalized into a “budgeted sales volume” to determine budgeted profits. Finally, the sales forecast is institutionalized as a performance standard against which sales and marketing are measured. Unfortunately, this standard presumes an exaggerated level of accuracy, is misleading, and often leads to shortsighted tactical pricing decisions.

We propose a more holistic approach to assessing market response. In addition to analyzing the financial consequences of price, managers should gather, track, and systematically organize data from a variety of sources that can provide early warning signals of how customers or competitors may respond to the price. This process leads to the development of a pricing decision support system, consisting of databases and information files, that may be accessed quickly to assess likely market response to a pricing decision. Some of this data may be quantitative but most will be subjective and qualitative, and it must be sifted and synthesized to obtain a balanced perspective of the market factors that will influence the success or failure of a pricing decision.

Customer Response

Anticipating customer response requires customer information to predict how customers will react to the price change. Which customer segments will be more sensitive to the price change? How will customer expectations be influenced by the price change? Will they perceive an emerging price trend or simply an opportunity for a short-term sale? Will new market segments emerge as a result of the new price? If so, are the costs of serving these new customers different, and how should these costs be integrated into an assessment of financial sensitivity (i.e., as an incremental fixed cost or a change in variable cost)?

Sources of information include the following:

• Customer Buying, Usage, and Well-Being Analysis. Companies have considerable customer information at their disposable. This includes historical patterns of orders and sales, of responses to previous changes in price, and of buyer behavior in anticipation of expected price changes (i.e., building or depleting inventories). This data may be augmented with additional subjective information about the customer. For example, how does the customer use our product? How important is our product to the successful delivery of the customer’s product? What is the cost of our product relative to other product inputs? What is the financial well-being of the customer? This information can be gleaned from publicly available sources, such as annual reports, government filings, reports from financial analysts, credit reports, press clippings, or from customer visits, conversations, and encounters.3
• Field Sales Data. Field salesforces have substantial amounts of information on customers. Are field sales information tracking systems designed, however, to capture the richness of these interpersonal customer interactions? For most firms, the objective of field sales information systems is motivational, to track sales performance and incentives. With incremental effort, these systems can be augmented to track key information on customer willingness to pay, sources of customer price sensitivity, and competitors’ pricing activities and their consequent effect on customer reaction.
• Distribution Channel Data. How will major distributors react to the price change? What is the financial well-being of key distributors? How important are distributors in determining the success of the new price policy? For example, travel agents exercise increasing influence in airline travel. More important, they control travel arrangements for many major industrial corporations whose high-margin business travelers are critical to airline profits. To ignore the impact of an airline’s potential price change on this critical link in the distribution channel would be very short sighted. Agents would simply steer business away to competitive carriers.

• Marketing Research. Companies can do specific marketing research to test market response to new product introductions, advertising programs, or price changes. Techniques for doing so have become more sophisticated and reliable. In addition, however, managers should proactively identify emerging customer segments with differing needs and price sensitivity. In the mid-1970s, sales of Chesebrough-Pond’s Vaseline petroleum jelly stalled due to market saturation. Market research, however, identified one promising use of significant value to a segment of low-quantity users: a moisturizing lip balm. Vaseline Lip Therapy now sells for substantially more per ounce than Vaseline petroleum jelly.

Competitive Response

Managers considering a price change need competitor intelligence to predict how and how quickly competitors will match the price change.4 Which competitors will more likely respond? Are they financially able to sustain a significant threat to the proposed price policy? What market signals have they given regarding their marketing and pricing strategies? Will they interpret our price change as a signal to defend current customers, as an opportunistic threat, or as a longer-term strategic shift in positioning? Will new competitors be encouraged to enter as a result of the new price policy? If so, how will the dynamics of industry competition be affected?5 Which segments are they likely to target? Which segments do we want to protect and defend, and which are we willing to cede? We propose four categories of competitor information to address these questions.

• Financial Well-Being Analysis. At a minimum, managers should track and monitor their competitors’ financial health, including sales performance, profitability, stock market performance, and activity in financial markets. Operating information on capacity utilization, cost structure, operating margins, and management changes frequently can be gathered through trade association contacts or other knowledgeable industry members, such as distributors, consultants, or contractors.
• Competitor Signals. Many managers deliberately conceal all information from competitors; others carefully control the flow of selected information to maintain an “information advantage.”6 Carefully tracking these signals can reveal a great deal about a competitor’s intent to respond to a price change. For instance, Chrysler communicated its intent to defend its leading share in the mini-van market by telling the business press of an emergency plan “in the desk drawer” to build a very low-priced minivan were the need to arise.
• Capital Investments. Firms also communicate their strategic intentions by their capital investments.7 In the late 1980s, IBP, Inc., the leading U.S. meat packer, surprisingly increased processing capacity with new, modernized beef-packing plants, even though the industry already operated well below capacity and consumers were turning away from red meat consumption. By 1990, IBP regularly underpriced less efficient competitors in a drive to dominate a declining market segment.
• Competitor Pricing History. Managers should be familiar with the pricing history of competitors, including, for example, patterns of chronological price changes, reactive price changes, and actual deal prices relative to quoted list prices. In the early 1980s, Texas Instruments (TI) determined to establish itself as the market leader in personal computers. Within several years, following a series of reactive price cuts to maintain price leadership, its price had fallen to $100, lowest in the industry, plus a manufacturer’s rebate of $50. In 1983, TI withdrew from the category. This pattern should have been no surprise to seasoned managers familiar with TI’s pricing history in calculators, watches, and semiconductors.

Managerial Strategy

A strategic assessment pulls the pieces together — costs, customers, and competitive dynamics — to determine a viable strategy for future growth and profit. Does the price change lead to market opportunities that are consistent with the firm’s core competencies and with the business unit’s goals and objectives? What are the “ripple effects” of a change in price policy on other dimensions of corporate strategy?

For instance, a firm may decide to cut price to protect its market base from aggressive competitors. To communicate the price cut, it decides on a significant short-term increase in advertising. The ripple effects of these decisions may be significant. First, the company must expand production and sales to maintain profitability. A significant expansion in volume may require the company to enter new higher-volume channels of distribution. The distributors in these new channels, however, are quite different from the firm’s original distributors. They expect manufacturers to “support” their products with substantial advertising to pull the product through the channel. A relatively innocent price cut rather quickly becomes the tail that wags the dog, as the firm is drawn into a market environment that requires very different core competencies than the firm’s original strengths.

Managerial Process

Strategic pricing should involve not only what is evaluated but how it is evaluated. The managerial process is as important as the information it evaluates. Tactical pricing involves isolated decision making by single functional centers within the company. Yet no single function has all the information needed to make a balanced evaluation of a pricing decision. Marketing tracks competitive information. Sales has access to customer response information. Accounting and finance monitor cost information. A strategic pricing approach, by contrast, involves integrated decision making by representatives from each of the functional centers. Profit-driven pricing thus gathers all of the information bearing on the price change, quantitatively frames it in a way that highlights the tradeoffs involved in a pricing decision, and evaluates the information in a managerial forum that collectively weighs alternative scenarios and strives for a consensus about the most prudent pricing policy to achieve a common objective.

Conclusion

Pricing decisions require a balance of competing forces. Internal financial concerns require that price be high enough to yield a profit. Yet external market concerns require that prices be low enough to give buyers sufficient incentive to buy. The trouble with many companies is that they let either of these concerns dominate pricing decisions, resulting in either cost-driven or customer-driven pricing decisions that are tactical and short-term oriented, and abandon the critical role pricing must play in the firm’s marketing strategy.

Strategic pricing requires that managers focus on long-term profitability. We have suggested a profit-driven approach to pricing, which focuses on changes in profit contribution and defines the market response necessary to achieve incremental profitability. In effect, this frames the managerial pricing decision in terms of market response and profitability, and invites managerial evaluation at a strategic level, in an integrated forum, that combines the expertise of all key disciplines relating to the profitability of a pricing decision.