/ What's Ahead
Factors to Consider When Setting Prices
Internal Factors Affecting Pricing Decision
External Factors Affecting Pricing Decisions
General Pricing Approaches
Cost-Based Pricing
Value-Based Pricing
Competition-Based Pricing
Chapter Wrap-Up
What's Ahead
For decades preceding 1995, Kellogg was beloved on Wall Street—it was a virtual money machine. The cereal giant's 1995 sales of $7 billion represented its fifty-first straight year of rising revenues. Over the previous 30 years, Kellogg's sales had grown at one and a half times the industry growth rate and its share of the U.S. cereal market had consistently exceeded 40 percent. Over the preceding decade, annual returns to shareholders had averaged 19 percent, with gross margins running as high as 55 percent. In 1995, Kellogg held a 42 percent worldwide market share, with a 48 percent share in Asia and Europe and a mind-blowing 69 percent share in Latin America. Things, it seemed, could only get better for Kellogg.
Behind these dazzling numbers, however, Kellogg's cereal empire had begun to lose its luster. Much of its recent success, it now appears, had come at the expense of cereal customers. Kellogg's recent gains—and those of major competitors General Mills, Post, and Quaker—had come not from innovative new products, creative marketing programs, and operational improvements that added value for customers. Instead, these gains had come almost entirely from price increases that padded the sales and profits of the cereal makers.
Throughout most of the 1980s and early 1990s, Kellogg had boosted profit margins by steadily raising prices on its Rice Krispies, Special K, Raisin Bran, and Frosted Flakes—often twice a year. For example, by early 1996, a 14-ounce box of Raisin Bran that sold for $2.39 in 1985 was going for as much as $4.00 to $5.00, but with little or no change in the costs of the materials making up the cereal or its packaging. Since World War II, no food category had had more price increases than cereal. The price increases were very profitable for Kellogg and the other cereal companies—on average, the cereal makers were reaping more than twice the operating margins of the food industry as a whole. However, the relentless price increases became increasingly difficult for customers to swallow.
So, not surprisingly, in 1994 the cereal industry's pricing policies began to backfire as frustrated consumers retaliated with a quiet fury. Cereal buyers began shifting away from branded cereals toward cheaper private-label brands; by 1995, private labels were devouring 10 percent of the American cereal market, up from a little more than 5 percent only five years earlier. Worse, many Americans switched to less expensive, more portable handheld breakfast foods, such as bagels, muffins, and breakfast bars. As a result, total American cereal sales began falling off by 3 to 4 percent a year. Kellogg's sales and profits sagged and its U.S. market share dropped to 36 percent. By early 1996, after what most industry analysts viewed as years of outrageous and self-serving pricing policies, Kellogg and the other cereal makers faced a full-blown crisis.
Post Cereals was the first competitor to break away. Belated research showed that exorbitant pricing was indeed the cause of the industry's doldrums. "Every statistic, every survey we took only showed that our customers were becoming more and more dissatisfied," said Mark Leckie, then general manager of Post Cereals. "You can see them walking down cereal aisles, clutching fistfuls of coupons and looking all over the shelves, trying to match them with a specific brand." To boost its soggy sales, in April 1996 Post slashed the prices on its 22 cereal brands an average of 20 percent—a surprise move that rocked the industry.
At first, Kellogg, General Mills, and Quaker held stubbornly to their premium prices. However, cereal buyers began switching in droves to Post's lower-priced brands—Post quickly stole 4 points from Kellogg's market share alone. Kellogg and the others had little choice but to follow Post's lead. Kellogg announced price cuts averaging 19 percent on two-thirds of all brands sold in the United States, marking the start of what would become a long and costly industry price war. In recanting their previous pricing excesses, the cereal makers swung wildly in the opposite direction, caught up in layoffs, plant closings, and other cost-cutting measures and fresh rounds of price cutting. "It reminds me of one of those World War I battles where there's all this firing but when the smoke clears you can't tell who won," noted an industry analyst. In fact, it appears that nobody won, as the fortunes of all competitors suffered.
Kellogg was perhaps the hardest hit of the major competitors. Post Cereal's parent company, consumer-foods powerhouse Philip Morris, derived only about 2 percent of its sales and profits from cereals and could easily offset the losses elsewhere. However, Kellogg, which counted on domestic cereal sales for 42 percent of its revenues and 43 percent of its operating profits, suffered enormously. Its operating margins were halved, and even after lowering its prices, Kellogg's revenues and profits continued to decline.
Now, several years after the initial price rollbacks, Kellogg and the cereal industry are still feeling the aftershocks. Entering the new millennium, the total American cereal market is growing at a meager 1 percent a year, private brands now capture an impressive 18 percent market share, and alternative breakfast foods continue their strong growth. Kellogg's market share has slumped to 32 percent, down from 42 percent in 1988, and its sales and profits are flat. During the past several years, Kellogg has watched its stock price languish while the stock market as a whole has more than tripled.
Recently, Kellogg and the other cereal titans have quietly begun pushing ahead with modest price increases. The increases are needed, they argue, to fund the product innovation and marketing support necessary to stimulate growth in the stagnant cereal category. But there's an obvious risk. Consumers have long memories, and if the new products and programs aren't exciting enough, the higher prices may well push consumers further toward less expensive private-label cereals and alternative breakfast foods. "It's almost a no-win situation," says another analyst.
Despite its problems, Kellogg remains the industry leader. The Kellogg brand name is still one of the world's best known and most respected. Kellogg's recent initiatives to cut costs, get reacquainted with its customers, and develop innovative new products and marketing programs—all of which promise to add value for customers rather than simply cutting prices—has Wall Street cautiously optimistic about Kellogg's future. But events of the past five years teach an important lesson. When setting prices, as when making any other marketing decisions, a company can't afford to focus on its own costs and profits. Instead, it must focus on customers' needs and the value they receive from the company's total marketing offer. If a company doesn't give customers full value for the price they're paying, they'll go elsewhere. In this case, Kellogg stole profits by steadily raising prices without also increasing customer value. Customers paid the price in the short run—but Kellogg is paying the price in the long run.1
All profit organizations and many nonprofit organizations must set prices on their products or services. Price goes by many names:
Price is all around us. You pay rent for your apartment, tuition for your education, and a fee to your physician or dentist. The airline, railway, taxi, and bus companies charge you a fare; the local utilities call their price a rate; and the local bank charges you interest for the money you borrow. The price for driving your car on Florida's Sunshine Parkway is a toll, and the company that insures your car charges you a premium. The guest lecturer charges an honorarium to tell you about a government official who took a bribe to help a shady character steal dues collected by a trade association. Clubs or societies to which you belong may make a special assessment to pay unusual expenses. Your regular lawyer may ask for a retainer to cover her services. The "price" of an executive is a salary, the price of a salesperson may be a commission, and the price of a worker is a wage. Finally, although economists would disagree, many of us feel that income taxes are the price we pay for the privilege of making money.2
In the narrowest sense, price is the amount of money charged for a product or service. More broadly, price is the sum of all the values that consumers exchange for the benefits of having or using the product or service. Historically, price has been the major factor affecting buyer choice. This is still true in poorer nations, among poorer groups, and with commodity products. However, nonprice factors have become more important in buyer-choice behavior in recent decades.
Throughout most of history, prices were set by negotiation between buyers and sellers. Fixed price policies—setting one price for all buyers—is a relatively modern idea that arose with the development of large-scale retailing at the end of the nineteenth century. Now, some one hundred years later, the Internet promises to reverse the fixed pricing trend and take us back to an era of dynamic pricing—charging different prices depending on individual customers and situations. The Internet, corporate networks, and wireless setups are connecting sellers and buyers as never before. Web sites like Compare.Net and PriceScan.com allow buyers to quickly and easily compare products and prices. Online auction sites like eBay.com and Amazon.com make it easy for buyers and sellers to negotiate prices on thousands of items—from refurbished computers to antique tin trains. At the same time, new technologies allow sellers to collect detailed data about customers' buying habits, preferences—even spending limits—so they can tailor their products and prices.3
Price is the only element in the marketing mix that produces revenue; all other elements represent costs. Price is also one of the most flexible elements of the marketing mix. Unlike product features and channel commitments, price can be changed quickly. At the same time, pricing and price competition is the number-one problem facing many marketing executives. Yet, as the chapter-opening Kellogg example illustrates, many companies do not handle pricing well. The most common mistakes are pricing that is too cost oriented rather than customer-value oriented; prices that are not revised often enough to reflect market changes; pricing that does not take the rest of the marketing mix into account; and prices that are not varied enough for different products, market segments, and purchase occasions.
In this chapter and the next, we focus on the problem of setting prices. This chapter looks at the factors marketers must consider when setting prices and at general pricing approaches. In the next chapter, we examine pricing strategies for new-product pricing, product mix pricing, price adjustments for buyer and situational factors, and price changes.
/ Factors to Consider When Setting PricesA company's pricing decisions are affected by both internal company factors and external environmental factors (see Figure 10.1).4
/ Figure 10.1 / Factors affecting price decisionsInternal Factors Affecting Pricing Decision
Internal factors affecting pricing include the company's marketing objectives, marketing mix strategy, costs, and organizational considerations.
Marketing Objectives
Before setting price, the company must decide on its strategy for the product. If the company has selected its target market and positioning carefully, then its marketing mix strategy, including price, will be fairly straightforward. For example, if General Motors decides to produce a new sports car to compete with European sports cars in the high-income segment, this suggests charging a high price. Motel 6, Econo Lodge, and Red Roof Inn have positioned themselves as motels that provide economical rooms for budget-minded travelers; this position requires charging a low price. Thus, pricing strategy is largely determined by decisions on market positioning.
At the same time, the company may seek additional objectives. The clearer a firm is about its objectives, the easier it is to set price. Examples of common objectives are survival,current profit maximization, market share leadership, and product quality leadership.
Product-quality leadership: Maytag targets the higher quality end of the appliance market. Its ads use the long-running slogan "Built to last longer" and feature Ol' Lonely, the Maytag repairman.Companies set survival as their major objective if they are troubled by too much capacity, heavy competition, or changing consumer wants. To keep a plant going, a company may set a low price, hoping to increase demand. In this case, profits are less important than survival. As long as their prices cover variable costs and some fixed costs, they can stay in business. However, survival is only a short-term objective. In the long run, the firm must learn how to add value that consumers will pay for or face extinction.
Many companies use current profit maximization as their pricing goal. They estimate what demand and costs will be at different prices and choose the price that will produce the maximum current profit, cash flow, or return on investment. In all cases, the company wants current financial results rather than long-run performance. Other companies want to obtain market share leadership. They believe that the company with the largest market share will enjoy the lowest costs and highest long-run profit. To become the market share leader, these firms set prices as low as possible.
/ Consider how one major corporation benefited from current profit maximization.A company might decide that it wants to achieve product quality leadership. This normally calls for charging a high price to cover higher performance quality and the high cost of R&D. For example, Hewlett-Packard focuses on the high-quality, high-price end of the hand-held calculator market. Gillette's product superiority lets it price its Mach3 razor cartridges at a 50 percent premium over its own SensorExcel and competitors' cartridges. Maytag has long built high-quality washing machines and priced them higher. Its ads use the long-running Maytag slogan "Built to last longer" and feature the lonely Maytag repairman (who's lonely because no one ever calls him for service). The ads point out that washers are custodians of what is often a $300 to $400 load of clothes, making them worth the higher price tag. For instance, at $1,099, Maytag's new Neptune, a front-loading washer without an agitator, sells for double what most other washers cost because the company's marketers claim that it uses less water and electricity and prolongs the life of clothing by being less abrasive.5
A company might also use price to attain other, more specific objectives. It can set prices low to prevent competition from entering the market or set prices at competitors' levels to stabilize the market. Prices can be set to keep the loyalty and support of resellers or to avoid government intervention. Prices can be reduced temporarily to create excitement for a product or to draw more customers into a retail store. One product may be priced to help the sales of other products in the company's line. Thus, pricing may play an important role in helping to accomplish the company's objectives at many levels.
Nonprofit and public organizations may adopt a number of other pricing objectives. A university aims for partial cost recovery, knowing that it must rely on private gifts and public grants to cover the remaining costs. A nonprofit hospital may aim for full cost recovery in its pricing. A nonprofit theater company may price its productions to fill the maximum number of theater seats. A social service agency may set a social price geared to the varying income situations of different clients.