Managing the marketing mix 303
are often striking and not appreciated by
marketers. For example, consider a company
selling 100 million units at a price of £1, with a
contribution margin of 50 per cent and an
operating margin of 5 per cent. A 5 per cent
price increase would double profits if volume
remained unchanged. Even if the volume drop-
ped by 50 000 units, profits would still rise by
45 per cent because of the reduction in variable
costs. Other ways of increasing profits tend to
be less powerful. For example, while a 5 per
cent price increase could double profits, a 5 per
cent volume increase, or a 5 per cent cut in fixed
costs, would have only half that effect.
Effect of a 5 per cent price increase (£ million):
Now Volume
unchanged5 per cent
volume
lossSales 100.00 105.00 99.75
Variable costs 50.00 50.00 47.50
Contribution 50.00 55.00 52.25
Fixed costs 45.00 45.00 45.00
Operating profits 5.00 10.00 7.25
The problem with this approach is that it
ignores long-term effects. Over the long term,
price elasticity tends to be higher as customers
find alternative, cheaper suppliers. Certainly,
repeated price increases are likely to lead to
continuing erosion of market share, ultimately
destroying the value of the business. This can
be illustrated by comparing a skimming versus
a penetration pricing strategy.
Under skimming pricing, the company
introduces a new product with a high price that
captures a substantial proportion of the value
the innovation offers consumers. As Table 11.4
illustrates, this leads to a big positive cash flow
in the early years, but then declines as new
competitors enter the market with substantially
lower prices. By contrast, under the penetration
pricing strategy cash flow is zero in the early
years because of the low prices and high capital
requirements to support the faster volume
growth. But then once a critical market share is
achieved, margins and cash flow improve
rapidly. Note in the example that the cumu-
lative cash flows over the 7-year planning
period are identical. When the cash flows are
discounted, the skimming pricing strategy
value is £10.2 million greater. Nevertheless, the
penetration pricing strategy delivers more than
twice the shareholder value of the skimming
strategy. The real difference lies in the continu-
ing value of the two strategies: at the end of
year 7 the skimmer has lost its market position
and is economically worthless; the penetration
strategy has a strong market position resulting
in a business with a continuing value of £63
million. Confusing short-term profits with
long-term value has been disastrous for many
businesses. The price that maximizes share-
holder value is invariably lower than that
which maximizes short-term profits.Pricing and customer value
Most companies seek to set prices on the basis
of various forms of cost plus (see Chapter 13),
but this can lead to prices that are too high or
too low. What customers are willing to pay
depends upon the value to them of the suppli-
er’s offer; they do not care what it costs to
produce. If customers perceive competitors as
making similar offers, their price will deter-
mine the upper limit. However, if the company
can differentiate its offer and add benefits, then
it should determine how customers value these
new features in setting its price.
Consider this example from the construc-
tion equipment market. The established market
leader sells a bulldozer at a price of £50 000.
Over the product’s economic life, averaging
12 000 operating hours, the customer spends
£20 000 on diesel oil and lubricants, £40 000 on
servicing and parts, and £20 per hour on labour,
making a total lifetime cost of £350 000. A new
competitor with advanced technology enters
the market and estimates the value of these
features as a precursor to setting prices. It
envisages launching two models. The basic