Answer Finance questions by reading articles and chapters

138

Marketing Management at Lexus Since its inception in 1989, Lexus has emphasized top-notch product quality and customer care, as reflected by its long-time slogan, “The Relentless Pursuit of Perfection.” As part of its “Lexus Covenant,” it has vowed to “have the finest dealer network in the industry, and treat each customer as we would a guest in our own home.” To this end, Lexus built its dealership framework from the ground up, hand-picking dealers committed to providing exceptional experience to customers, a system competitors acknowledge is the industry ideal. With its average buyer in his or her mid-50s, Lexus has set its sights on attracting younger buyers by emphasizing more aggressive styling, han- dling dynamics, and driver engagement. Social media and other promotions and events also create novel customer experiences around food, fashion, entertainment, and travel.1

In this chapter, we will address the following questions:

1. What are the characteristics of products, and how do marketers classify products? (Page 139)

2. How can companies differentiate products? (Page 140)

3. How can a company build and manage its product mix and product lines? (Page 142)

4. How can companies use packaging, labeling, warranties, and guarantees as marketing tools? (Page 145)

5. What strategies are appropriate for introducing new offerings and influencing adoption? (Page 146)

6. What strategies are appropriate in different stages of the product life cycle? (Page 152)

Setting Product Strategy and Introducing New Offerings

Chapter 9

Part 4: Creating Value

Chapter 9 Setting Product Strategy and Introducing New Offerings 139

At the heart of a great brand is a great product offering, which customers judge on three basic elements: product features and quality, service mix and quality, and price. In this chapter we examine product strategy, new product development, and the product life cycle. Chapter 10 explores services, and Chapter 11 discusses price.

Product Characteristics and Classifications A product is anything that can be offered to a market to satisfy a want or need, including physi- cal goods, services, experiences, events, persons, places, properties, organizations, information, and ideas.

Product Levels: The Customer-Value Hierarchy In planning its market offering, the marketer needs to address five product levels (see Figure 9.1).2 Each level adds more customer value, and together the five constitute a customer-value hierarchy. The fundamental level is the core benefit: the service or benefit the customer is really buying. A ho- tel guest is buying rest and sleep. Marketers must see themselves as benefit providers. At the second level, the marketer must turn the core benefit into a basic product. Thus, a hotel room includes a bed, bathroom, and towels. At the third level, the marketer prepares an expected product, a set of attributes and conditions buyers normally expect when they purchase this product. Hotel guests expect a clean bed, fresh towels, and so on.

At the fourth level, the marketer prepares an augmented product that exceeds customer expec- tations. In developed countries, brand positioning and competition take place at this level. At the fifth level stands the potential product, with all the possible augmentations and transformations the product or offering might undergo in the future. Here companies search for new ways to sat- isfy customers and distinguish their offering.

Differentiation arises and competition increasingly occurs on the basis of product augmen- tation. Each augmentation adds cost, however, and augmented benefits soon become expected benefits in the category. As some companies raise the price of their augmented product, others

Figure 9.1 Five Product Levels

Potenti al product

Aug mented product

Exp ected product

Core benefit

Ba sic product

140 Part 4 Creating Value

offer a stripped-down version for less. Marketers must be sure, however, that consumers not see lower quality or limited capability versions as unfair.3

Product Classifications Marketers classify products on the basis of durability, tangibility, and use (consumer or indus- trial). Each type has an appropriate marketing-mix strategy.4

• Durability and tangibility. Nondurable goods are tangible goods (such as shampoo) normally consumed in one or a few uses. Because these are purchased frequently, the appropriate strategy is to make them available in many locations, charge a small markup, and advertise to induce trial and build preference. Durable goods are tangible goods (such as refrigerators) that survive many uses, require more personal selling and service, command a higher margin, and require more seller guarantees. Services are intangible, inseparable, variable, and perishable products (such as haircuts) that normally require more quality control, supplier credibility, and adaptability.

• Consumer-goods classification. Classified on the basis of shopping habits, these include convenience goods (such as soft drinks) that are purchased frequently, immediately, and with minimal effort; shopping goods (such as furniture) that consumers compare on such bases as suitability, quality, price, and style; specialty goods (such as cars) with unique characteristics or brand identification for which enough buyers are willing to make a spe- cial purchasing effort; and unsought goods (such as smoke detectors) that the consumer does not know about or normally think of buying.

• Industrial-goods classification. Materials and parts are goods that enter the manufac- turer’s product completely. Raw materials can be either farm products (wheat) or natural products (iron ore). Manufactured materials and parts fall into two categories: component materials (wires) and component parts (small motors). Capital items are long-lasting goods that facilitate developing or managing the finished product, including installations (factories) and equipment (tools). Supplies and business services are short-term goods and services that facilitate developing or managing the finished product.

Differentiation To be branded, product offerings must be differentiated. At one extreme are products that allow little variation: chicken and steel. Yet even here some differentiation is possible: Perdue chickens and India’s Tata Steel have carved out distinct identities in their categories. At the other extreme are products capable of high differentiation, such as automobiles, commercial buildings, and furniture.

Product Differentiation Means for differentiation include form, features, performance quality, conformance quality, durability, reliability, repairability, style, and customization.5 As discussed below, design is also a means for differentiation.

• Form. Form refers to the size, shape, or physical structure of a product. For example, aspirin can be differentiated by dosage size, shape, color, coating, or action time.

• Features. Most products can be offered with varying features that supplement their basic function. A company can identify and select new features by surveying recent buyers and then calculating customer value versus company cost for each potential feature. Marketers

Chapter 9 Setting Product Strategy and Introducing New Offerings 141

should consider how many people want each feature, how long it would take to introduce it, and whether competitors could easily copy it.6

• Performance quality. Performance quality is the level at which the product’s primary characteristics operate. Firms should design a performance level appropriate to the target market and competition (not necessarily the highest level possible) and manage perfor- mance quality through time.

• Conformance quality. Buyers expect a high conformance quality, the degree to which all produced units are identical and meet promised specifications. A product with low conformance quality will disappoint some buyers.

• Durability. Durability, a measure of the product’s expected operating life under natural or stressful conditions, is a valued attribute for durable goods. The extra price for durability must not be excessive, and the product must not be subject to rapid technological obsolescence.

• Reliability. Buyers normally will pay a premium for reliability, a measure of the probability that a product will not malfunction or fail within a specified period.

• Repairability. Repairability measures the ease of fixing a product when it malfunctions or fails. Ideal repairability would exist if users could fix the product themselves with little cost in money or time.

• Style. Style describes the product’s look and feel to the buyer and creates distinctiveness that is hard to copy, although strong style does not always mean high performance. Style plays a key role in the marketing of many brands, such as Apple’s tablets.

• Customization. Customized products and marketing allow firms to be highly relevant and differentiating by finding out exactly what a person wants and delivering on that. Customized products include M&M’s with specialized messages and Burberry coats with customer-selected fabric and accessories.7

Services Differentiation When the physical product cannot easily be differentiated, the key to competitive success may lie in adding valued services and improving their quality. The main service differentiators are:

• Ordering ease. How easy is it for the customer to place an order with the company? • Delivery. How well is the product or service brought to the customer, including speed,

accuracy, and care throughout the process? • Installation. How is the product made operational in its planned location? This is a true

selling point for buyers of complex products like heavy equipment. • Customer training. How does the supplier teach a customer’s employees to use new

equipment properly and efficiently? • Customer consulting. What data, information systems, and advice services can companies

sell to buyers? • Maintenance and repair. How can companies help customers keep purchased products

in good working order? These services are critical in business-to-business settings and with luxury products.

Design Differentiation As competition intensifies, design offers a potent way to differentiate and position a company’s products and services. Design is the totality of features that affect the way a product looks, feels, and functions to a consumer. It offers functional and aesthetic benefits and appeals to both our

142 Part 4 Creating Value

rational and emotional sides.8 As holistic marketers recognize the emotional power of design and the importance to consumers of look and feel as well as function, design is exerting a stronger in- fluence in categories where it once played a small role. To the company, a well-designed product is easy to manufacture and distribute. To the customer, it is pleasant to look at and easy to open, install, use, repair, and dispose of.

Product and Brand Relationships Each product can be related to other products to ensure that a firm is offering and marketing the optimal set of products.

The Product Hierarchy The product hierarchy stretches from basic needs to particular items that satisfy those needs. A product system is a group of diverse but related items that function in a compatible manner.9 A product mix (also called a product assortment) is the set of all products and items a particu- lar firm offers for sale. A product mix consists of various product lines. As shown in Table 9.1, a company’s product mix has a certain width, length, depth, and consistency. The table shows these concepts for selected Procter & Gamble products.

The width of a product mix refers to how many different product lines the company carries. Table 9.1 shows a product mix width of five lines (only a portion of what Procter & Gamble of- fers). The length of a product mix refers to the total number of items in the mix. The depth of a product mix refers to how many variants are offered of each product in the line. The consistency of the product mix describes how closely related the various product lines are in end use, produc- tion requirements, distribution channels, or some other way.

These product mix dimensions permit the company to expand its business in four ways. It can add new product lines, thus widening its product mix; lengthen each product line; add more

Table 9.1 Product Mix Width and Product Line Length for Procter & Gamble Products (including year of introduction)

Product Mix Width

Detergents Toothpaste Bar Soap Disposable Diapers Paper Products

Ivory Snow (1930) Gleem (1952) Ivory (1879) Pampers (1961) Charmin (1928)

Dreft (1933) Crest (1955) Camay (1926) Luvs (1976) Puffs (1960)

Product line length

Tide (1946) Zest (1952) Bounty (1965)

Cheer (1950) Safeguard (1963)

Dash (1954) Oil of Olay (1993)

Bold (1965)

Gain (1966)

Era (1972)

Chapter 9 Setting Product Strategy and Introducing New Offerings 143

product variants to deepen its product mix; and pursue more product line consistency. To make these product decisions, marketers conduct product line analysis.

Product Line Analysis In offering a product line, companies normally develop a basic platform and modules that can be added to meet different customer requirements, the way car manufacturers build vehicles around a basic platform. Product line managers need to know the sales and profits of each item in each line to determine which ones to build, maintain, harvest, or divest.10 They also need to understand each line’s market profile and image.11 Marketers can use a product map to see which competitors’ items are competing against their own items and to identify market segments so they can gauge how well their items are positioned to serve the needs of each segment.

Product Line Length Companies seeking high market share and market growth will generally carry longer product lines. Those emphasizing high profitability will carry shorter lines of carefully chosen items. However, consumers are increasingly weary of dense product lines, overextended brands, and feature-laden products (see “Marketing Insight: When Less Is More”).12

When Less Is More

With thousands of new products introduced each year, consumers find it ever harder to navigate store aisles. One study found the average shopper spent 40 seconds or more in the super- market soda aisle, compared with 25 seconds six or seven years ago. Although consumers may think greater product variety increases their likelihood of finding the right product for them, the reality is often different. According to research, when presented with too many options, people “choose not to choose,” even if it may not be in their best interests.

Similarly, if product quality in an assortment is high, consumers actually prefer fewer choices. Those with well-defined preferences may benefit from more-differentiated products that offer spe- cific benefits, but others may experience frustra- tion, confusion, and regret. Also, constant product changes and introductions may nudge custom- ers into reconsidering their choices and perhaps switching to a competitor’s product. It’s not just

product lines making consumer heads spin— many products themselves are too complicated. Technology marketers need to be especially sensi- tive to the problems of information overload.

Sources: John Davidson, “One Classic Example of When Less Is More,” Financial Review, April 9, 2013; Carolyn Cutrone, “Cutting Down on Choice Is the Best Way to Make Better Decisions,” Business Insider, January 10, 2013; Dimitri Kuksov and J. Miguel Villas-Boas, “When More Alternatives Lead to Less Choice,” Marketing Science, 29 (May/June 2010), pp. 507–24; Kristin Diehl and Cait Poynor, “Great Expectations?! Assortment Size, Expectations, and Satisfaction,” Journal of Marketing Research 46 (April 2009), pp. 312–22; Joseph P. Redden and Stephen J. Hoch, “The Presence of Variety Reduces Perceived Quantity,” Journal of Consumer Research 36 (October 2009), pp. 406–17; Alexander Chernev and Ryan Hamilton, “Assortment Size and Option Attractiveness in Consumer Choice Among Retailers,” Journal of Marketing Research 46 (June 2009), pp. 410–20; Richard A. Briesch, Pradeep K. Chintagunta, and Edward J. Fox, “How Does Assortment Affect Grocery Store Choice,” Journal of Marketing Research 46 (April 2009), pp. 176–89; Susan M. Broniarczyk, “Product Assortment,” Curt P. Haugtvedt, Paul M. Herr, and Frank R. Kardes, eds., Handbook of Consumer Psychology (New York: Taylor & Francis, 2008), pp. 755–79.

marketing insight

144 Part 4 Creating Value

A company lengthens its product line in two ways: line stretching and line filling. Line stretching occurs when a company lengthens its product line beyond its current range. A firm may choose a down-market stretch—introducing a lower-priced line—to attract shoppers who want value-priced goods, battle low-end competitors, or avoid a stagnating middle market. With an up-market stretch, the firm aims to achieve more growth, realize higher margins, or simply position itself as a full-line manufacturer. Companies serving the middle market might stretch their line in both directions.

With line filling, a firm lengthens its product line by adding more items within the present range. The goals are to reach for incremental profits, satisfy dealers who complain about lost sales because of items missing from the line, utilize excess capacity, try to become the leading full-line company, and plug holes to keep out competitors.

Line Modernization, Featuring, and Pruning Product lines need to be modernized. In rapidly changing markets, modernization is continuous. Companies plan improvements to encourage customer migration to higher-value, higher-price items. Marketers want to time improvements so they do not appear too early (damaging sales of the current line) or too late (giving the competition time to establish a strong reputation).13 The firm typically selects one or a few items in the line to feature, possibly a low-priced item to attract cus- tomers or a high-end item for prestige. Multi-brand companies all over the world try to optimize their brand portfolios, ensuring that every product in a line plays a role. This often means focusing on core brand growth and concentrating resources on the biggest and most established brands.

Product Mix Pricing Marketers must modify their price-setting logic when the product is part of a product mix. In product mix pricing, the firm searches for a set of prices that maximizes profits on the total mix. The process is challenging because the various products have demand and cost interrelationships and are subject to different degrees of competition. We can distinguish six situations calling for product mix pricing, as shown in Table 9.2.

Table 9.2 Product Mix Pricing Situations

1. Product line pricing. The seller introduces price steps within a product line and strives to establish perceived quality differences that justify the price differences.

2. Optional-feature pricing. The seller offers optional products, features, and services with the main product, the way automakers offer different trim levels. The challenge is which options to include in the standard price and which to offer separately.

3. Captive-product pricing. Some products require the use of ancillary or captive products. Manufacturers of razors often price them low and set high markups on razor blades, the captive product. If the captive product is priced too high, however, counterfeiting and substitutions can erode sales.

4. Two-part pricing. Many service firms charge a fixed fee plus a variable usage fee. Cell phone users often pay a monthly fee plus charges for calls that exceed their allotted minutes. The challenge is deciding how much to charge for basic service and variable usage.

5. By-product pricing. The production of certain goods (such as meats) often yields by-products that should be priced on their value. Income from the by-products will make it easier for the company to charge less for its main product if competition forces it to do so.

6. Product-bundling pricing. Pure bundling occurs when a firm offers its products only as a bundle. In mixed bundling, the seller offers goods both individually and in bundles, normally charging less for the bundle than for the items purchased separately. Savings on the price bundle must be enough to induce customers to buy it.

Chapter 9 Setting Product Strategy and Introducing New Offerings 145

Co-Branding and Ingredient Branding Marketers often combine their products with products from other companies in various ways. In co-branding—also called dual branding or brand bundling—two or more well-known brands are combined into a joint product or marketed together in some fashion. One form of co-branding is same-company co-branding, as when General Mills advertises Trix cereal and Yoplait yogurt. Other forms are joint-venture co-branding, multiple-sponsor co-branding, and retail co-branding. For co-branding to succeed, the brands must separately have brand equity—adequate brand awareness and a sufficiently positive brand image.

The main advantage of co-branding is that a product can be convincingly positioned by virtue of the multiple brands, generating greater sales from the existing market and opening opportunities for new consumers and channels. It can also reduce the cost of product introduc- tion because it combines two well-known images and speeds adoption. And co-branding may be a valuable means to learn about consumers and how other companies approach them. The potential disadvantages are the risks and lack of control in becoming aligned with another brand. Consumer expectations of co-brands are likely to be high, so unsatisfactory performance could have negative repercussions for both brands. Also, consumers may feel less sure of what they know about the brand.14

Ingredient branding is a special case of co-branding.15 It creates brand equity for materi- als, components, or parts that are necessarily contained within other branded products. For host products whose brands are not that strong, ingredient brands can provide differentiation and important signals of quality.16 An interesting take on ingredient branding is self-branded ingredi- ents that companies advertise and even trademark.17 Westin Hotels advertises its own “Heavenly Bed”—an important ingredient for a guest’s good night’s sleep. Ingredient brands try to create enough awareness and preference so consumers will not buy a host product that doesn’t contain it.

What are the requirements for successful ingredient branding?18

1. Consumers must believe the ingredient matters to the performance and success of the end prod- uct. Ideally, this intrinsic value is easily seen or experienced.

2. Consumers must be convinced that not all ingredient brands are the same and that the ingredi- ent is superior.

3. A distinctive symbol or logo must clearly signal that the host product contains the ingredient. Ideally, this symbol or logo functions like a “seal” and is simple and versatile, credibly communi- cating quality and confidence.

4. A coordinated “pull” and “push” program must help consumers understand the advantages of the branded ingredient. Channel members must offer full support such as consumer advertising and promotions and—sometimes in collaboration with manufacturers—retail merchandising and promotion programs.

Packaging, Labeling, Warranties, and Guarantees Many marketers have called packaging a fifth P, along with price, product, place, and promotion. Most, however, treat packaging and labeling as an element of product strategy. Warranties and guarantees can also be an important part of the product strategy.

Packaging Packaging includes all the activities of designing and producing the container for a product. Packages might have up to three layers: a primary package inside a secondary package, with one or more packaged units sent in a shipping package. Packaging is important because it is the

146 Part 4 Creating Value

buyer’s first encounter with the product. A good package draws the consumer in and encour- ages product choice. Distinctive packaging like that for Altoids mints is an important part of a brand’s equity.

Packaging must achieve a number of objectives: (1) identify the brand, (2) convey descrip- tive and persuasive information, (3) facilitate product transportation and protection, (4) assist at-home storage, and (5) aid at-home consumption. Functionally, structural design is crucial. Aesthetic considerations relate to a package’s size and shape, material, color, text, and graphics. The packaging elements must harmonize with each other and with pricing, advertising, and other parts of the marketing program. Color can define a brand, from Tiffany’s blue box to UPS’s brown trucks. Packaging updates and redesigns can keep the brand contemporary, relevant, or practi- cal, but they can also have a downside if consumers dislike the new package or confuse it with other brands. Companies must also consider environmental and safety concerns about excess and wasteful packaging.

Labeling The label can be a simple attached tag or an elaborately designed graphic that is part of the package. A label performs several functions. First, it identifies the product or brand—for in- stance, the name Sunkist stamped on oranges. It might also grade the product; canned peaches are grade-labeled A, B, and C. The label might describe the product: who made it, where and when, what it contains, how it is to be used, and how to use it safely. Finally, the label might promote the product through attractive graphics.

Labels eventually need freshening up. The label on Ivory soap has been redone at least 18 times since the 1890s, with gradual changes in the size and design of the letters. Legal and regula- tory requirements must also be considered. For example, processed foods must carry nutritional labeling that clearly states the amounts of protein, fat, carbohydrates, and calories as well as vita- min and mineral content as a percentage of the recommended daily allowance.19

Warranties and Guarantees All sellers are legally responsible for fulfilling a buyer’s normal or reasonable expectations. Warranties are formal statements of expected product performance by the manufacturer. Products under warranty can be returned to the manufacturer or designated repair center for repair, replace- ment, or refund. Whether expressed or implied, warranties are legally enforceable. Guarantees reduce the buyer’s perceived risk. They suggest that the product is of high quality and the company and its service performance are dependable. They can be especially helpful when the company or product is not well known or when the product’s quality is superior to that of competitors.

Managing New Products A company can add new products through acquisition (buying another firm, buying patents from other firms, licensing or franchising from another firm) or organically through development from within (in its own laboratories, contracting with independent researchers, or hiring a new- product development firm).20 New products range from new-to-the-world items that create an entirely new market to minor improvements or revisions of existing products. Most new-product activity is devoted to improving existing products. In contrast, new-to-the-world products incur the greatest cost and risk. And while radical innovations can hurt the company’s bottom line in the short run, if they succeed they can improve the corporate image, create a greater sustainable competitive advantage than ordinary products, and produce significant rewards.21

Chapter 9 Setting Product Strategy and Introducing New Offerings 147

The Innovation Imperative and New Product Success In an economy of rapid change, continuous innovation is a necessity. Companies that fail to de- velop new products leave themselves vulnerable to changing customer needs and tastes, shortened product life cycles, increased domestic and foreign competition, and especially new technologies. Most established companies focus on incremental innovation, entering new markets by tweaking products for new customers, using variations on a core product to stay one step ahead of the mar- ket, and creating interim solutions for industry-wide problems. Newer companies create disruptive technologies that are cheaper and more likely to alter the competitive space.

New-product specialists Robert Cooper and Elko Kleinschmidt found that unique, superior products succeed 98 percent of the time, compared with products that have a moderate advantage (58 percent success) or minimal advantage (18 percent success). Other factors include a well- defined product concept, well-defined target market and benefits, technological and marketing synergy, quality of execution, and market attractiveness.22

New products continue to fail at rates estimated as high as 50 percent or even 95 percent in the United States and 90 percent in Europe.23 The reasons are many: ignored or misinterpreted market research; overestimates of market size; high development costs; poor design or ineffectual performance; incorrect positioning, advertising, or price; insufficient distribution support; com- petitors who fight back hard; and inadequate ROI or payback.

New Product Development The stages in new product development are shown in Figure 9.2 and discussed next.

Idea Generation The new-product development process starts with the search for ideas. Some marketing experts believe we find the greatest opportunities and highest leverage for new

Figure 9.2 The New-Product Development Decision Process

No

NoNoNoNoNo

No

No No

Yes Yes Yes Yes Yes Yes

Yes

Yes

Yes

Yes

No

Send the idea back for product development?

7. Market testing

6. Product development

Have we got a technically and commercially

sound product?

5. Business analysis

Will this product meet

our profit goal?

4. Marketing strategy

development

1. Idea generation

Is the idea worth

considering?

Modify the product or marketing

program?

2. Idea screening

Is the product idea compatible with company

objectives, strategies, and

resources?

Make future plans

Drop

8. Commercialization

Are product sales meeting

expectations?

3. Concept development and testing

Can we find a good concept

consumers say they would try?

Can we find a cost-effective,

affordable marketing strategy?

Have product sales met

expectations?

148 Part 4 Creating Value

products by uncovering the best possible set of unmet customer needs or technological innova- tion.24 Ideas can come from interacting with customers, employees, scientists, and other groups; from using creativity techniques; and from studying competitors. Through Internet-based crowdsourcing, paid or unpaid outsiders can offer needed expertise or a different perspective on a new-product project that might otherwise be overlooked. The traditional company-centric approach to product innovation is giving way to a world in which companies cocreate products with consumers. Besides producing new and better ideas, cocreation can help customers feel closer to the company and create favorable word of mouth.25

Idea Screening The purpose of screening is to drop poor ideas as early as possible because product-development costs rise substantially at each successive development stage. Most com- panies require new-product ideas to be described on a standard form for a committee’s review. The description states the product idea, the target market, and the competition and estimates market size, product price, development time and costs, manufacturing costs, and rate of return. The executive committee then reviews each idea against a set of criteria. Does the product meet a need? Would it offer superior value? Can it be distinctively advertised or promoted? Does the company have the necessary know-how and capital? Will the new product deliver the expected sales volume, sales growth, and profit? The committee estimates whether the probability of suc- cess is high enough to warrant continued development.

Concept Development and Testing A product idea is a possible product the company might offer to the market. A product concept is an elaborated version of the idea expressed in consumer terms. A product idea can be turned into several concepts by asking: Who will use this product? What primary benefit should this product provide? When will people consume or use it? By answering these questions, a company can form several concepts, select the most promis- ing, and create a product-positioning map for it. Figure 9.3(a) shows the positioning of a product concept, a low-cost instant breakfast drink, based on the two dimensions of cost and preparation time and compared with other breakfast foods. These contrasts can be useful in communicating and promoting a concept to the market.

Figure 9.3 (b) is a brand-positioning map, a perceptual map showing the current positions of three existing brands of instant breakfast drinks (Brands A–C) as seen by consumers in four seg- ments, whose preferences are clustered around the points on the map. The brand-positioning map helps the company decide how much to charge and how calorific to make its drink. As shown on this map, the new brand would be distinctive in the medium-price, medium-calorie market or in the high-price, high-calorie market. There is also a segment of consumers (4) clustered fairly near the medium-price, medium-calorie market, suggesting this may offer the greatest opportunity.

Concept testing means presenting the product concept to target consumers, physically or sym- bolically, and getting their reactions. The more the tested concepts resemble the final product or ex- perience, the more dependable concept testing is. In the past, creating physical prototypes was costly and time consuming, but today firms can use rapid prototyping to design products on a computer and then produce rough models to show potential consumers for their reactions. Companies are also using virtual reality to test product concepts. Consumer reactions indicate whether the concept has a broad and strong consumer appeal, what products it competes against, and which consumers are the best targets. The need-gap levels and purchase-intention levels can be checked against norms for the product category to determine whether the concept appears to be a winner, a long shot, or a loser.

Marketing Strategy Development Following a successful concept test, the firm develops a preliminary three-part strategy for introducing the new product. The first part describes the target market’s size, structure, and behavior; the planned brand positioning; and the sales, market share,

Chapter 9 Setting Product Strategy and Introducing New Offerings 149

and profit goals sought in the first few years. The second part outlines the planned price, distribu- tion strategy, and marketing budget for the first year. The third part describes the long-run sales and profit goals and marketing-mix strategy over time. This strategy lays a foundation for the business analysis.

Business Analysis Here the firm evaluates the proposed product’s business attractiveness. Management needs to prepare sales, cost, and profit projections to determine whether they satisfy company objectives. If they do, the concept can move to the development stage. As new information comes in, the business analysis will undergo revision and expansion. Sales- estimation methods depend on whether the product is purchased once (such as an engage- ment ring), infrequently, or often.

For one-time products, sales rise at the beginning, peak, and approach zero as the number of potential buyers becomes exhausted; if new buyers keep entering the market, the curve will not drop to zero. Infrequently purchased products such as automobiles exhibit replacement cycles dictated by physical wear or obsolescence associated with changing styles, features, and performance. Therefore, sales forecasts must estimate first-time sales and replacement sales separately. With frequently pur- chased products, such as consumer and industrial nondurables, the number of first-time buyers initially increases and then decreases as fewer buyers are left (assuming a fixed population). Repeat purchases occur soon, providing the product satisfies some buyers. The sales curve eventually falls to a plateau of steady repeat-purchase volume; by this time, the product is no longer a new product.

Figure 9.3 Product and Brand Positioning

Slow Pancakes

Quick

Expensive

Inexpensive

Bacon and eggs

Cold cereal

Hot cereal

Instant breakfast

Lo w

in c

al or

ie s

Hi gh

in c

al or

ie s

High price per ounce

Low price per ounce

Brand C

Brand A Brand B

(a) Product-positioning Map (Breakfast Market)

(b) Brand-positioning Map (Instant Breakfast Market)

Segment 3 Segment 4

Segment 2Segment 1

150 Part 4 Creating Value

Product Development Up to now, the product has existed only as a description, drawing, or prototype. The next step represents a jump in investment that dwarfs the costs incurred so far. The company will determine whether the product idea can translate into a technically and com- mercially feasible product.

The job of translating target customer requirements into a working prototype is helped by a set of methods known as quality function deployment (QFD). The methodology takes the list of desired customer attributes (CAs) generated by market research and turns them into a list of engineering attributes (EAs) that engineers can use. For example, customers of a proposed truck may want a certain acceleration rate (CA). Engineers can turn this into the required horsepower and other engineering equivalents (EAs). QFD improves communication between marketers, engineers, and manufacturing people.26

The R&D department develops a prototype that embodies the key attributes in the product- concept statement, performs safely under normal use and conditions, and can be produced within budgeted manufacturing costs, speeded by virtual reality technology and the Internet. Prototypes must be put through rigorous functional and customer tests before they enter the marketplace. Alpha testing tests the product within the firm to see how it performs in different applications. After refining the prototype, the company moves to beta testing with customers, bringing consumers into a laboratory or giving them samples to use at home.

Market Testing After management is satisfied with functional and psychological perfor- mance, the product is ready to be branded with a name, logo, and packaging and go into a market test. Not all companies undertake market testing. The amount of testing is influenced by the investment cost and risk on the one hand and time pressure and research cost on the other. High- investment–high-risk products, whose chance of failure is high, must be market tested; the cost will be an insignificant percentage of total project cost. Consumer-products tests seek to estimate four variables: trial, first repeat, adoption, and purchase frequency. Table 9.3 shows four methods of consumer-goods testing, from the least costly to the most costly.

Expensive industrial goods and new technologies will normally undergo alpha and beta test- ing. During beta testing, the company’s technical people observe how customers use the product,

Table 9.3 Methods of Market Testing Consumer Goods

Method Description

Sales-wave research Consumers who initially try the product at no cost are reoffered it, or a competitor’s product, at slightly reduced prices. The offer may be made as many as five times (sales waves), while the company notes how many customers select it again and their reported level of satisfaction.

Simulated test marketing Thirty to 40 qualified shoppers are asked about brand familiarity and preferences in a specific product category and attend a brief screening of advertising. Consumers receive a small amount of money and are invited into a store to shop. The company notes how many consumers buy the new brand and competing brands and asks consumers why they bought or did not buy. Those who did not buy the new brand are given a free sample and are reinterviewed later to determine attitudes, usage, satisfaction, and repurchase intention.

Controlled test marketing A research firm delivers the product to a panel of participating stores and controls shelf position, pricing, and number of facings, displays, and point-of-purchase promotions. The company can evaluate sales, the impact of local advertising and promotions, and customers’ impressions of the product.

Test markets The company chooses a few representative cities, implements a full marketing communications campaign, and sells the trade on carrying the product. Marketers must decide how many test cities to use, how long the test will last, and what data will be collected. At the conclusion, they must decide what action to take. Many companies today skip test marketing and rely on faster and more economical testing methods.

Chapter 9 Setting Product Strategy and Introducing New Offerings 151

a practice that often exposes unanticipated problems of safety and servicing and alerts the com- pany to customer training and servicing requirements. At trade shows the company can observe how much interest buyers show in the new product, how they react to features and terms, and how many express purchase intentions or place orders. In distributor and dealer display rooms, products may stand next to the manufacturer’s other products and possibly competitors’ prod- ucts, yielding preference and pricing information in the product’s normal selling atmosphere. However, customers who come in might not represent the target market, or they might want to place early orders that cannot be filled.

Commercialization Commercialization is the costliest stage in the process because the firm will need to contract for manufacture, or it may build or rent a full-scale manufacturing facility. Most new-product campaigns also require a sequenced mix of market communication tools to build awareness and ultimately preference, choice, and loyalty.27 Market timing is critical.

If a firm learns that a competitor is readying a new product, one choice is first entry (for “first mover advantages” of locking up key distributors and customers and gaining leadership). However, this can backfire if the product has not been thoroughly debugged. A second choice is parallel entry (timing its entry to coincide with the competitor’s entry to gain both products more attention). A third choice is late entry (delaying its launch until after the competitor has borne the cost of educating the market). This might reveal flaws the late entrant can avoid and also show the size of the market.

Most companies will develop a planned market rollout over time. In choosing rollout mar- kets, the major criteria are market potential, the company’s local reputation, the cost of filling the pipeline, the cost of communication media, the influence of the area on other areas, and competitive penetration. With the Internet connecting far-flung parts of the globe, competition is more likely to cross national borders. Companies are increasingly rolling out new products simultaneously across the globe.

The Consumer-Adoption Process Adoption is an individual’s decision to become a regular user of a product and is followed by the consumer-loyalty process. New-product marketers typically aim at early adopters and use the theory of innovation diffusion and consumer adoption to identify them.

Stages in the Adoption Process An innovation is any good, service, or idea that someone perceives as new, no matter how long its history. Everett Rogers defines the innovation diffusion process as “the spread of a new idea from its source of invention or creation to its ultimate users or adopters.”28 The consumer-adoption process is the mental steps through which an individual passes from first hearing about an innovation to final adoption.29 These five steps are: (1) awareness (consumer becomes aware of the innovation but lacks information about it), (2) interest (consumer is stimulated to seek information about the inno- vation), (3) evaluation (consumer considers whether to try the innovation), (4) trial (consumer tries the innovation to estimate its value), and (5) adoption (consumer decides to make full and regular use of the innovation).

Factors Influencing the Adoption Process Rogers defines a person’s level of innovativeness as “the degree to which an individual is rela- tively earlier in adopting new ideas than the other members of his social system.” As Figure 9.4 shows, innovators are the first to adopt something new. After a slow start, an increasing number

152 Part 4 Creating Value

of people adopt the innovation, the number reaches a peak, and then it diminishes as fewer non- adopters remain. The five adopter groups (innovators, early adopters, early majority, late major- ity, and laggards) differ in their value orientations and their motives for adopting or resisting the new product.30

Personal influence, the effect one person has on another’s attitude or purchase probability, has greater significance in some situations and for some individuals than others, and it is more important in evaluation than in the other stages. It has more power over late than early adopters and in risky situations.

Five characteristics influence an innovation’s rate of adoption. The first is relative advantage, the degree to which the innovation appears superior to existing products. The second is compat- ibility, the degree to which the innovation matches consumers’ values and experiences. The third is complexity, the degree to which the innovation is difficult to understand or use. The fourth is divisibility, the degree to which the innovation can be tried on a limited basis. The fifth is com- municability, the degree to which the benefits of use are observable or describable to others. Other characteristics that influence the rate of adoption are cost, risk and uncertainty, scientific credibility, and social approval.

Finally, adoption is associated with variables in the organization’s environment (com- munity progressiveness, community income), the organization itself (size, profits, pressure to change), and the administrators (education level, age, sophistication). Other forces come into play in trying to get a product adopted into organizations that are mostly government-funded, such as public schools. A controversial or innovative product can be squelched by negative public opinion.

Product Life-Cycle Marketing Strategies A company’s positioning and differentiation strategy must change as its product, market, and competitors change over the product life cycle (PLC). To say a product has a life cycle is to as- sert four things: (1) products have a limited life, (2) product sales pass through distinct stages, each posing different marketing challenges and opportunities, (3) profits rise and fall at different

Figure 9.4 Adopter Categorization on the Basis of Relative Time of Adoption of Innovations

Source: Tungsten, http://en.wikipedia.ord/wiki/Everett_Rogers. Based on E. Rogers, Diffusion of Innovations (London: Free Press, 1962).

16% Laggards

34% Late majority

34% Early majority

13 % Early adopters

2 % Innovators

Time of Adoption of Innovations

Chapter 9 Setting Product Strategy and Introducing New Offerings 153

stages, and (4) products require different marketing, financial, manufacturing, purchasing, and human resource strategies in each stage.

Product Life Cycles Most product life cycles are portrayed as bell-shaped curves (see Figure 9.5), typically divided into four stages: introduction, growth, maturity, and decline. In introduction, sales grow slowly as the product is introduced; profits are nonexistent because of the heavy introductory expenses. Growth is a period of rapid market acceptance and substantial profit improvement. In maturity, sales growth slows because the product has achieved acceptance by most potential buyers, and profits stabilize or decline because of increased competition. In decline, sales drift downward and profits erode.

Marketing Strategies: Introduction Stage and the Pioneer Advantage Because it takes time to roll out a new product, work out technical problems, fill dealer pipelines, and gain consumer acceptance, sales growth tends to be slow in the introduction stage. Profits are negative or low, and promotional expenditures are at their highest ratio to sales because of the need to (1) inform potential consumers, (2) induce product trial, and (3) secure distribution.31

To be the first to introduce a product can be rewarding, but risky and expensive. Steven Schnaars studied 28 industries in which imitators surpassed the innovators and found several weaknesses among the failing pioneers.32 These included new products that were too crude, im- properly positioned, or launched before strong demand existed; exhaustive product-development costs; a lack of resources to compete against larger entrants; and managerial incompetence or un- healthy complacency. Successful imitators thrived by offering lower prices, continuously improv- ing the product, or using brute market power to overtake the pioneer.

Gerald Tellis and Peter Golder have identified five factors underpinning long-term market leadership: vision of a mass market, persistence, relentless innovation, financial commitment, and asset leverage.33 One study found Internet companies that realized benefits from moving fast (1) were first movers in large markets, (2) erected barriers of entry against competitors, and (3) directly controlled critical elements necessary for starting a company.34

Figure 9.5 Sales and Profit Life Cycles

Profit

Sales

Sa le

s an

d Pr

ofi ts

( $)

Time

Introduction Growth Maturity Decline

154 Part 4 Creating Value

Marketing Strategies: Growth Stage The growth stage is marked by a rapid climb in sales. Early adopters like the product, and addi- tional consumers start buying it. New competitors enter, introducing new features and expand- ing distribution, and prices stabilize or fall slightly, depending on how fast demand increases. Companies maintain marketing expenditures or raise them slightly to meet competition, but sales rise much faster than marketing expenditures. Profits increase as marketing costs are spread over a larger volume, and unit manufacturing costs fall faster than price declines. Firms must watch for a change to a decelerating rate of growth in order to prepare new strategies.

To sustain rapid market share growth now, the firm must improve product quality, add new features, and improve styling; add new models and flanker products to protect the main product; enter new segments; increase distribution coverage and enter new channels; shift from awareness and trial communications to preference and loyalty communications; and cut price to attract price-conscious buyers. By spending money on product improvement, promotion, and distri- bution, the firm can capture a dominant position, trading off maximum current profit for high market share and the hope of greater profits in the next stage.

Marketing Strategies: Maturity Stage At some point, the rate of sales growth slows. Most products are in this stage of the life cycle, which normally lasts longer than the preceding ones. Three ways to change the course for a brand in the maturity stage are market, product, and marketing program modifications. A firm might try to expand the market by increasing the number of users (converting nonusers, enter- ing new segments, or attracting rivals’ customers) and increasing usage rates among users (get- ting current customers to use the product on more occasions, use more on each occasion, or use the product in new ways). The firm can also try to stimulate sales by improving quality, features, or style. Finally, it might try to stimulate sales by modifying non-product elements—price, distri- bution, and communications in particular.

Marketing Strategies: Decline Stage Sales decline for a number of reasons, including technological advances, shifts in consumer tastes, and increased foreign competition. All can lead to overcapacity, increased price cutting, and profit erosion. As sales and profits decline, some firms withdraw. Those remaining may reduce the number of products they offer, exiting smaller segments and weaker trade channels, cutting marketing budgets, and reducing prices further. Unless strong reasons for retention exist, carrying a weak product is often very costly.

A company in an unattractive industry that possesses competitive strength should consider shrinking selectively. A strong competitor in an attractive industry should consider strengthen- ing its investment. Companies that successfully restage or rejuvenate a mature product often do so by adding value to it. Two other options are harvesting and divesting. Harvesting calls for gradually reducing a product or business’s costs while trying to maintain sales. When a company decides to divest a product with strong distribution and residual goodwill, it can probably sell it to another firm. If the company can’t find any buyers, it must decide whether to liquidate the brand quickly or slowly.

Critique of the Product Life-Cycle Concept Table 9.4 summarizes the characteristics, marketing objectives, and marketing strategies in each stage in the product life cycle. The PLC concept helps marketers interpret product and market dynamics, conduct planning and control, and do forecasting. However, critics say that life-cycle

Chapter 9 Setting Product Strategy and Introducing New Offerings 155

patterns are too variable to be generalized and that marketers can seldom tell what stage their product is in. A product that appears mature may actually be at a plateau prior to another up- surge. Critics also say that the PLC pattern is the self-fulfilling result of marketing strategies and that skillful marketing can in fact lead to continued growth.35 Firms also need to visualize a market’s evolutionary path as it is affected by new needs, competitors, technology, channels, and other developments and change product and brand positioning to keep pace.36

Executive Summary A product is anything that can be offered to a market to satisfy a want or need. The marketer needs to think through the five levels of the product: the core benefit, the basic product, the expected product, the augmented product, and the potential product. Marketers classify products on the basis of durability, tangibility, and use (consumer or industrial). Products may be differentiated by form, features, performance quality, conformance quality, durability, reliability, repairability, style, customization, and design. Service differentiators include ordering ease, delivery, installation, cus- tomer training, customer consulting, and maintenance and repair.

Table 9.4 Summary of Product Life-Cycle Characteristics, Objectives, and Strategies

Introduction Growth Maturity Decline

Characteristics

Sales Low sales Rapidly rising sales Peak sales Declining sales

Costs High cost per customer Average cost per customer Low cost per customer Low cost per customer

Profits Negative Rising profits High profits Declining profits

Customers Innovators Early adopters Middle majority Laggards

Competitors Few Growing number Stable number beginning to decline

Declining number

Marketing Objectives

Create product awareness and trial

Maximize market share Maximize profit while defending market share

Reduce expenditure and milk the brand

Strategies

Product Offer a basic product Offer product extensions, service, warranty

Diversify brands and items Phase out weak products

Price Charge cost-plus Price to penetrate market Price to match or best competitors’

Cut price

Distribution Build selective distribution Build intensive distribution Build more intensive distribution

Go selective: phase out unprofitable outlets

Communications Build product awareness and trial among early adopters and dealers

Build awareness and interest in the mass market

Stress brand differences and benefits and encourage brand switching

Reduce to minimal level needed to retain hard-core loyals

Sources: Chester R. Wasson, Dynamic Competitive Strategy and Product Life Cycles (Austin, TX: Austin Press, 1978); John A. Weber, “Planning Corporate Growth with Inverted Product Life Cycles,” Long Range Planning (October 1976), pp. 12–29; Peter Doyle, “The Realities of the Product Life Cycle,” Quarterly Review of Marketing (Summer 1976).

156 Part 4 Creating Value

A product mix can be classified according to width, length, depth, and consistency, four dimensions for developing the marketing strategy and deciding which product lines to grow, maintain, harvest, and divest. Physical products must be packaged and labeled, may have well-designed packages, and may come with warranties and guarantees. The new-product de- velopment process consists of: idea generation, screening, concept development and testing, marketing strategy development, business analysis, product development, market testing, and commercialization. The adoption process—by which customers learn about new products, try them, and adopt or reject them—is influenced by multiple factors. Each product life-cycle stage (introduction, growth, maturity, and decline) calls for different marketing strategies.

Notes

1. Michael McCarthy, “Lexus Makes Big ‘Move’ to Regain Crown,” Advertising Age, June 24, 2013; Cheryl Jensen, “Cars More Dependable than Ever, Lexus Tops the Chart while Land Rover Is Least Reliable,” New York Daily News, April 16, 2013; Matthew de Paula, “Lexus Pursues Hipper Crowd with New Ads for Its LS Sedan,” Forbes, October 31, 2012; Craig Trudell and Yuki Hagiwara, “Lexus Beating Mercedes Shows U.S. Luxury a 3-Brand Race,” Bloomberg News, June 6, 2014.

2. This discussion is adapted from a classic article: Theodore Levitt, “Marketing Success through Differentiation: Of Anything,” Harvard Business Review, January–February 1980, pp. 83–91. The first level, core benefit, has been added to Levitt’s discussion.

3. Andrew D. Gershoff, Ran Kivetz, and Anat Keinan, “Consumer Response to Versioning: How Brands’ Production Methods Affect Perceptions of Unfairness,” Journal of Consumer Research 39 (August 2012), pp. 382–98.

4. For some definitions, see AMA Dictionary from the American Marketing Association, www.ama.org /resources/Pages/Dictionary.aspx.

5. Some of these bases are discussed in David A. Garvin, “Competing on the Eight Dimensions of Quality,” Harvard Business Review, November–December 1987, pp. 101–9.

6. Marco Bertini, Elie Ofek, and Dan Ariely, “The Impact of Add-On Features on Product Evaluations,” Journal of Consumer Research 36 (June 2009), pp. 17–28; Tripat Gill, “Convergent Products: What Functionalities Add More Value to the Base,” Journal of Marketing 72 (March 2008), pp. 46–62; Robert J. Meyer, Sheghui Zhao, and Jin K. Han, “Biases in Valuation vs. Usage of Innovative Product Features,” Marketing Science 27 (November–December 2008), pp. 1083–96.

7. Rupal Parekh, “Personalized Products Please but Can They Create Profit,” Advertising Age, May 20, 2012; www.us.burberry.com/store/bespoke; Paul Sonne,

“Mink or Fox? The Trench Gets Complicated,” Wall Street Journal, November 3, 2011.

8. Ravindra Chitturi, Rajagopal Raghunathan, and Vijay Mahajan, “Delight by Design: The Role of Hedonic versus Utilitarian Benefits,” Journal of Marketing 72 (May 2008), pp. 48–63.

9. For branding advantages of a product system, see Ryan Rahinel and Joseph P. Redden, “Brands as Product Coordinators: Matching Brands Make Joint Consumption Experiences More Enjoyable,” Journal of Consumer Research 39 (April 2013), pp. 1290–99.

10. A. Yesim Orhun, “Optimal Product Line Design when Consumers Exhibit Choice Set-Dependent Preferences,” Marketing Science 28 (September–October 2009), pp. 868–86; Robert Bordley, “Determining the Appropriate Depth and Breadth of a Firm’s Product Portfolio,” Journal of Marketing Research 40 (February 2003), pp. 39–53; Peter Boatwright and Joseph C. Nunes, “Reducing Assortment: An Attribute-Based Approach,” Journal of Marketing 65 (July 2001), pp. 50–63.

11. Ryan Hamilton and Alexander Chernev, “The Impact of Product Line Extensions and Consumer Goals on the Formation of Price Image,” Journal of Marketing Research 47 (February 2010), pp. 51–62.

12. Aner Sela, Jonah Berger, and Wendy Liu, “Variety, Vice and Virtue: How Assortment Size Influences Option Choice,” Journal of Consumer Research 35 (April 2009), pp. 941–51; Cassie Mogilner, Tamar Rudnick, and Sheena S. Iyengar, “The Mere Categorization Effect: How the Presence of Categories Increases Choosers’ Perceptions of Assortment Variety and Outcome Satisfaction,” Journal of Consumer Research 35 (August 2008), pp. 202–15; John Gourville and Dilip Soman, “Overchoice and Assortment Type: When and Why Variety Backfires,” Marketing Science 24 (Summer 2005), pp. 382–95.

13. Brett R. Gordon, “A Dynamic Model of Consumer Replacement Cycles in the PC Processor Industry,”

Chapter 9 Setting Product Strategy and Introducing New Offerings 157

Marketing Science 28 (September–October 2009), pp. 846–67; Raghunath Singh Rao, Om Narasimhan, and George John, “Understanding the Role of Trade-Ins in Durable Goods Markets: Theory and Evidence,” Marketing Science 28 (September–October 2009), pp. 950–67.

14. Tansev Geylani, J. Jeffrey Inman, and Frenkel Ter Hofstede, “Image Reinforcement or Impairment: The Effects of Co-Branding on Attribute Uncertainty,” Marketing Science 27 (July–August 2008), pp. 730–44; Ed Lebar, Phil Buehler, Kevin Lane Keller, Monika Sawicka, Zeynep Aksehirli, and Keith Richey, “Brand Equity Implications of Joint Branding Programs,” Journal of Advertising Research 45 (December 2005).

15. Philip Kotler and Waldermar Pfoertsch, Ingredient Branding: Making the Invisible Visible (Heidelberg, Germany: Springer-Verlag, 2011).

16. Simon Graj, “Intel, Gore-Tex and Eastman: The Provenance of Ingredient Branding,” Forbes, July 10, 2013; Anil Jayaraj, “Solving Ingredient Branding Puzzle,” Business Standard, August 13, 2012.

17. Kalpesh Kaushik Desai and Kevin Lane Keller, “The Effects of Brand Expansions and Ingredient Branding Strategies on Host Brand Extendibility,” Journal of Marketing 66 (January 2002), pp. 73–93.

18. Kevin Lane Keller, Strategic Brand Management, 4th ed. (Upper Saddle River, NJ: Prentice Hall, 2013). See also Philip Kotler and Waldemar Pfoertsch, B2B Brand Management (New York: Springer, 2006).

19. John C. Kozup, Elizabeth H. Creyer, and Scot Burton, “Making Healthful Food Choices,” Journal of Marketing 67 (April 2003), pp. 19–34; Siva K. Balasubramanian and Catherine Cole, “Consumers’ Search and Use of Nutrition Information,” Journal of Marketing 66 (July 2002), pp. 112–27.

20. Stephen J. Carson, “When to Give Up Control of Outsourced New-Product Development,” Journal of Marketing 71 (January 2007), pp. 49–66.

21. Thomas Dotzel, Venkatesh Shankar, and Leonard L. Berry, “Service Innovativeness and Firm Value,” Journal of Marketing Research 50 (April 2013), pp. 259–76; Michael J. Barone and Robert D. Jewell, “The Innovator’s License: A Latitude to Deviate from Category Norms,” Journal of Marketing 77 (January 2013), pp. 120–34; Christine Moorman, Simone Wies, Natalie Mizik, and Fredrika J. Spencer, “Firm Innovation and the Ratchet Effect among Consumer Packaged Goods Firms,” Marketing Science 31 (November/December 2012), pp. 934–51; Katrijn Gielens, “New Products: The Antidote to Private Label Growth?,” Journal of Marketing Research 49 (June 2012), pp. 408–23; Gaia Rubera and Ahmet H. Kirca,

“Firm Innovativeness and Its Performance Outcomes: A Meta-Analytic Review and Theoretical Integration,” Journal of Marketing 76 (May 2012), pp. 130–47; Shuba Srinivasan, Koen Pauwels, Jorge Silva-Risso, and Dominique M. Hanssens, “Product Innovations, Advertising and Stock Returns,” Journal of Marketing 73 (January 2009), pp. 24–43; Alina B. Sorescu and Jelena Spanjol, “Innovation’s Effect on Firm Value and Risk: Insights from Consumer Packaged Goods,” Journal of Marketing 72 (March 2008), pp. 114–32; Sungwook Min, Manohar U. Kalwani, and William T. Robinson, “Market Pioneer and Early Follower Survival Risks,” Journal of Marketing 70 (January 2006), pp. 15–33.

22. Robert G. Cooper and Elko J. Kleinschmidt, New Products: The Key Factors in Success (Chicago: American Marketing Association, 1990).

23. Elaine Wong, “The Most Memorable Product Launches of 2010,” Forbes, December 3, 2010; Susumu Ogama and Frank T. Piller, “Reducing the Risks of New- Product Development,” MIT Sloan Management Review 47 (Winter 2006), pp. 65–71.

24. John Hauser, Gerard J. Tellis, and Abbie Griffin, “Research on Innovation: A Review and Agenda for Marketing Science,” Marketing Science 25 (November– December 2006), pp. 687–717.

25. Martin Schreier, Christoph Fuchs, and Darren W. Dahl, “The Innovation Effect of User Design: Exploring Consumers’ Innovation Perceptions of Firms Selling Products Designed by Users,” Journal of Marketing 76 (September 2012), pp. 18–32; Patricia Seybold, Outside Innovation: How Your Customers Will Codesign Your Company’s Future (New York: Collins, 2006).

26. John Hauser, “House of Quality,” Harvard Business Review, May–June 1988, pp. 63–73; customer- driven engineering is also called “quality function deployment.”

27. Alicia Barroso and Gerard Llobet, “Advertising and Consumer Awareness of New, Differentiated Products,” Journal of Marketing Research 49 (December 2012), pp. 773–92; Norris I. Bruce, Natasha Zhang Foutz, and Ceren Kolsarici, “Dynamic Effectiveness of Advertising and Word of Mouth in Sequential Distribution of New Products,” Journal of Marketing Research 49 (August 2012), pp. 469–86.

28. The following discussion leans heavily on Everett M. Rogers, Diffusion of Innovations (New York: Free Press, 1962). Also see his third edition, published in 1983.

29. Karthik Sridhar, Ram Bezawada, and Minakshi Trivedi, “Investigating the Drivers of Consumer Cross-Category Learning for New Products Using Multiple Data Sets,” Marketing Science 31 (July/August 2012), pp. 668–88; C. Page Moreau, Donald R. Lehmann, and Arthur B. Markman, “Entrenched Knowledge Structures and

158 Part 4 Creating Value

Consumer Response to New Products,” Journal of Marketing Research 38 (February 2001), pp. 14–29.

30. Everett M. Rogers, Diffusion of Innovations (New York: Free Press, 1962), p. 192; Geoffrey A. Moore, Crossing the Chasm (New York: HarperBusiness, 1999); for an interesting application with services, see Barak Libai, Eitan Muller, and Renana Peres, “The Diffusion of Services,” Journal of Marketing Research 46 (April 2009), pp. 163–75.

31. Rajesh J. Chandy, Gerard J. Tellis, Deborah J. MacInnis, and Pattana Thaivanich, “What to Say When: Advertising Appeals in Evolving Markets,” Journal of Marketing Research 38 (November 2001), pp. 399–414.

32. Steven P. Schnaars, Managing Imitation Strategies (New York: Free Press, 1994). See also Jin K. Han, Namwoon Kim, and Hony-Bom Kin, “Entry Barriers: A Dull-, One-, or Two-Edged Sword for Incumbents?,” Journal of Marketing 65 (January 2001), pp. 1–14.

33. Gerald Tellis and Peter Golder, Will and Vision: How Latecomers Can Grow to Dominate Markets (New York:

McGraw-Hill, 2001); Rajesh K. Chandy and Gerald J. Tellis, “The Incumbent’s Curse? Incumbency, Size, and Radical Product Innovation,” Journal of Marketing Research 64 (July 2000), pp. 1–17. See also Dave Ulrich and Norm Smallwood, “Building a Leadership Brand,” Harvard Business Review, July–August 2007, pp. 93–100.

34. Marty Bates, Syed S. H. Rizvi, Prashant Tewari, and Dev Vardhan, “How Fast Is Too Fast?,” McKinsey Quarterly no. 3 (2001); see also Stephen Wunker, “Better Growth Decisions: Early Mover, Fast Follower or Late Follower?,” Strategy & Leadership 40, no. 2 (2012).

35. Youngme Moon, “Break Free from the Product Life Cycle,” Harvard Business Review, May 2005, pp. 87–94.

36. Hubert Gatignon and David Soberman, “Competitive Response and Market Evolution,” Barton A. Weitz and Robin Wensley, eds., Handbook of Marketing (London, UK: Sage Publications, 2002), pp. 126–47; Robert D. Buzzell, “Market Functions and Market Evolution,” Journal of Marketing 63 (Special Issue 1999), pp. 61–63.

159

In this chapter, we will address the following questions:

1. How can services be defined and classified, and how do they differ from goods? (Page 160)

2. What are the new services realities? (Page 162)

3. How can companies manage service quality and achieve excellence in services marketing? (Page 166)

4. How can goods marketers improve customer-support services? (Page 169)

Designing and Managing Services

Marketing Management at USaa USAA Insurance sells auto and other insurance products to current and former members of the military and their families. The company has increased its share of each customer’s business by launch- ing a consumer bank, issuing credit cards, opening a discount brokerage, and offering no-load mutual funds. Its legendary service quality has led to the highest customer satisfaction in the industry, result- ing in high customer loyalty and significant cross-selling opportunities. It trains its call center reps to answer investment queries as well as insurance-related calls, increasing productivity and reducing the need to transfer customers between agents. A technological leader, USAA was the first bank to allow iPhone deposits for its military customers and to conduct face-to-face video chats with soldiers in the field. Whether a customer is using a tablet, smartphone, or computer or visiting one of its financial centers—located mostly near military bases—USAA is committed to meeting needs by providing ex- emplary service.1

As companies find it harder to differentiate their physical products, they turn to service dif-ferentiation, whether that means on-time delivery, better and faster response to inquiries, or quicker resolution of complaints. Because it is critical to understand the special nature of

Chapter 10

160 Part 4 Creating Value

services and what that means to marketers, in this chapter we analyze services and how to mar- ket them most effectively.

The Nature of Services The government sector, with its courts, hospitals, military services, police and fire departments, postal service, regulatory agencies, and schools, is in the service business. The private nonprofit sector—museums, charities, churches, colleges, and hospitals—is in the service business. A good part of the business sector, with its airlines, banks, hotels, insurance companies, law firms, medical practices, and real estate firms, is in the service business. Many workers in the manufacturing sec- tor, such as accountants and legal staff, are really service providers, making up a “service factory” providing services to the “goods factory.” And those in the retail sector, such as cashiers, salespeople, and customer service representatives, are also providing a service.

A service is any act or performance one party can offer to another that is essentially intangible and does not result in the ownership of anything. Its production may or may not be tied to a physi- cal product. Increasingly, manufacturers, distributors, and retailers are providing value-added ser- vices, or simply excellent customer service, to differentiate themselves. Many pure service firms are now using the Internet to reach customers; some operate purely online.

Categories of Service Mix The service component can be a minor or a major part of the total offering. We distinguish five categories of offerings:

1. A pure tangible good such as soap, toothpaste, or salt with no accompanying services. 2. A tangible good with accompanying services, like a car, computer, or cell phone, with a warranty

or customer service contract. Typically, the more technologically advanced the product, the greater the need for high-quality supporting services.

3. A hybrid offering, like a restaurant meal, of equal parts goods and services. 4. A major service with accompanying minor goods and services, like air travel with supporting

goods such as snacks and drinks. 5. A pure service, primarily an intangible service, such as babysitting, psychotherapy, or massage.

Customers typically cannot judge the technical quality of some services even after they have received them, as shown in Figure 10.1.2 At the left are goods high in search qualities—that is, characteristics the buyer can evaluate before purchase. In the middle are goods and services high in experience qualities—characteristics the buyer can evaluate after purchase. At the right are goods and services high in credence qualities—characteristics the buyer normally finds hard to evaluate even after consumption.3

Because services are generally high in experience and credence qualities, there is more risk in their purchase, with several consequences. First, service consumers generally rely on word of mouth rather than advertising. Second, they rely heavily on price, provider, and physical cues to judge quality. Third, they are highly loyal to service providers who satisfy them. Fourth, because switching costs are high, consumer inertia can make it challenging to entice business away from a competitor.

Distinctive Characteristics of Services Four distinctive service characteristics greatly affect the design of marketing programs: intangi- bility, inseparability, variability, and perishability.

Chapter 10 Designing and Managing Services 161

Intangibility Unlike physical products, services cannot be seen, tasted, felt, heard, or smelled before they are bought. A person getting cosmetic surgery cannot see the results before the purchase, for instance. To reduce uncertainty, buyers will look for evidence of quality by draw- ing inferences from the place, people, equipment, communication material, symbols, and price. Therefore, the service provider’s task is to “manage the evidence,” to “tangibilize the intangible.”4 Service companies can try to demonstrate their service quality through physical evidence and pre- sentation.5 Table 10.1 measures brand experiences in general along sensory, affective, behavioral, and intellectual dimensions; applications to services are clear.

Inseparability Whereas physical goods are manufactured, then inventoried, then distributed, and later consumed, services are typically produced and consumed simultaneously. Because the client is also often present, provider–client interaction is a special feature of services marketing. Several strategies exist for getting around the limitations of inseparability. When clients have strong provider preferences, the provider can raise its price to ration its limited time. The service provider can also work with larger groups, work faster, or train more providers and build up cli- ent confidence.

Variability Because the quality of services depends on who provides them, when and where, and to whom, services are highly variable. Service buyers are aware of potential variability and often talk to others or go online to collect information before selecting a specific service provider. To reassure customers, some firms offer service guarantees that may reduce consumer percep- tions of risk.6 Three steps to increase quality control of services are to (1) invest in good hiring and training procedures, (2) standardize the service-performance process, and (3) monitor

Figure 10.1 Continuum of Evaluation for Different Types of Products

C lo

th in

g

Easy to Evaluate

Most goods

High in Search Qualities

Difficult to Evaluate

Je w

el ry

Fu rn

itu re

H ou

se s

Au to

m ob

ile s

R es

ta ur

an t m

ea ls

Va ca

tio n

H ai

rc ut

s

C hi

ld c

ar e

Te le

vi si

on r

ep ai

r

Le ga

l s er

vi ce

s

R oo

t c an

al

Au to

r ep

ai r

M ed

ic al

d ia

gn os

is

High in Credence Qualities

High in Experience Qualities

Most services

Source: Valarie A. Zeithaml, “How Consumer Evaluation Processes Differ between Goods and Services,” James H. Donnelly and William R. George, eds., Marketing of Services (Chicago: American Marketing Association, 1981). Reprinted with permission of the American Marketing Association.

162 Part 4 Creating Value

customer satisfaction. Service firms can also design marketing communication and information programs so consumers learn more about the brand than what their subjective experience alone tells them.

Perishability Services cannot be stored, so their perishability can be a problem when demand fluctuates. To accommodate rush-hour demand, public transportation companies must own more equipment than if demand was even throughout the day. Demand or yield management is critical—the right services must be available to the right customers at the right places at the right times and right prices to maximize profitability.

Several strategies can produce a better match between service demand and supply.7 On the demand (customer) side, these include differential pricing to shift some demand to off-peak pe- riods (such as pricing matinee movies lower), cultivating nonpeak demand (the way McDonald’s promotes breakfast), offering complementary services as alternatives (the way banks offer ATMs), and using reservation systems to manage demand (airlines do this). On the supply side, strategies include adding part-time employees to serve peak demand, having employees perform only essential tasks during peak periods, increasing consumer participation (shoppers bag their own groceries), sharing services (hospitals can share medical-equipment purchases), and having facilities for future expansion.

The New Services Realities Although service firms once lagged behind manufacturers in their use of marketing, service firms are now some of the most skilled marketers. However, because U.S. consumers generally have high expectations about service delivery, they often feel their needs are not being adequately met. A 2013 Forrester study asked consumers to rate 154 companies on how well they met their needs and how easy and enjoyable they were to do business with. Almost two-thirds of the companies

Table 10.1 Dimensions of Brand Experience

Sensory

• This brand makes a strong impression on my visual sense or other senses. • I find this brand interesting in a sensory way. • This brand does not appeal to my senses. affective

• This brand induces feelings and sentiments. • I do not have strong emotions for this brand. • This brand is an emotional brand. behavioral

• I engage in physical actions and behaviors when I use this brand. • This brand results in bodily experiences. • This brand is not action-oriented. intellectual

• I engage in a lot of thinking when I encounter this brand. • This brand does not make me think. • This brand stimulates my curiosity and problem solving.

Source: Joško Brakus, Bernd H. Schmitt, and Lia Zarantonello, “Brand Experience: What Is It? How Is It Measured? Does It Affect Loyalty?,” Journal of Marketing 73 (May 2009), pp. 52–68. Reprinted with permission from the Journal of Marketing, published by the American Marketing Association.

Chapter 10 Designing and Managing Services 163

were rated only “OK,” “poor,” or “very poor.” Retail and hotel companies were rated the highest on average, and Internet, health service, and television service providers were rated the worst.8 This is just one indicator of the shifting relationship between customers and service providers.

A Shifting Customer Relationship Savvy services marketers are recognizing the new services realities, such as the importance of the newly empowered customer, customer coproduction, and the need to engage employees as well as customers.

Customer Empowerment Customers are becoming more sophisticated about buying product-support services and are pressing for “unbundled services” so they can select the ele- ments they want. They increasingly dislike having to deal with a multitude of service providers handling different types of products or equipment. Most importantly, the Internet has empow- ered customers by letting them send their comments around the world with a mouse click. A person who has a good customer experience is more likely to talk about it, but someone who has a bad experience will talk to more people.9 When a customer complains, most companies are responsive because solving a customer’s problem quickly and easily goes a long way toward win- ning long-term loyal customers.10

Customer Coproduction The reality is that customers do not merely purchase and use a service; they play an active role in its delivery. Their words and actions affect the quality of their service experiences and those of others as well as the productivity of frontline employees.11 This coproduction can put stress on employees, however, and reduce their satisfaction, especially if they differ from customers culturally or in other ways.12 Moreover, one study estimated that one- third of all service problems are caused by the customer.13

Preventing service failures is crucial because recovery is always challenging. One of the big- gest problems is attribution—customers often feel the firm is at fault or, even if not, that it is still responsible for righting any wrongs. Unfortunately, although many firms have well-designed and executed procedures to deal with their own failures, they find managing customer failures—when a service problem arises from a customer’s mistake or lack of understanding—much more diffi- cult. Solutions include: redesigning processes and customer roles to simplify service encounters; using technology to aid customers and employees; enhancing customer role clarity, motivation, and ability; and encouraging customers to help each other.14

Satisfying Employees as Well as Customers Excellent service companies know that positive employee attitudes will strengthen customer loyalty.15 Instilling a strong customer orientation in employees can also increase their job satisfaction and commitment, especially if they have high customer contact. Employees thrive in customer-contact positions when they have an internal drive to (1) pamper customers, (2) accurately read their needs, (3) develop a personal relationship with them, and (4) deliver high-quality service to solve customers’ prob- lems.16 Given the importance of positive employee attitudes to customer satisfaction, service companies must attract the best employees they can find, marketing a career rather than just a job. They must design a sound training program, provide support and rewards for good per- formance, and reinforce customer-centered attitudes. Finally, they must audit employee job satisfaction regularly.

Achieving Excellence in Services Marketing The increased importance of the service industry and the new realities have sharpened the focus on what it takes to excel in the marketing of services.17 In the service sector, excellence

164 Part 4 Creating Value

must cover broad areas of marketing: external, internal, and interactive (see Figure 10.2).18 External marketing describes the normal work of preparing, pricing, distributing, and promot- ing the service to customers. Internal marketing describes training and motivating employees to serve customers well. The most important contribution the marketing department can make is to be “exceptionally clever in getting everyone else in the organization to practice marketing.”19

Interactive marketing describes the employees’ skill in serving the client. Clients judge service not only by its technical quality (Was the surgery successful?), but also by its functional quality (Did the surgeon show concern and inspire confidence?).20 In interactive marketing, teamwork is often key. Delegating authority to frontline employees can allow for greater service flexibility and adaptability because it promotes better problem solving, closer employee coopera- tion, and more efficient knowledge transfer.21

Companies must avoid pushing technological efficiency so hard, however, that they reduce perceived quality.22 Some methods lead to too much standardization, but service providers must deliver “high touch” as well as “high tech.”23 Amazon has some of the most innovative technol- ogy in online retailing, but it also keeps customers extremely satisfied when a problem arises even if they don’t actually talk to an Amazon employee.24

Well-managed service companies that achieve marketing excellence have in common a stra- tegic concept, a history of top-management commitment to quality, high standards, profit tiers, and systems for monitoring service performance and resolving customer complaints.

Strategic Concept Top service companies are “customer obsessed.” They have a clear sense of their target customers and their needs and have developed a distinctive strategy for satisfying them.

Figure 10.2 Three Types of Marketing in Service Industries

Company

External Marketing

Internal Marketing

CustomersEmployees Interactive Marketing

Cleaning/ maintenance

services

Restaurant industry

Financial/ banking services

$

Chapter 10 Designing and Managing Services 165

Top-Management Commitment Companies such as USAA and Marriott have a thorough commitment to service quality. Their managers look monthly not only at financial performance but also at service performance. USAA, Allstate, Dunkin’ Brands, and Oracle have high-level senior executives with titles such as Chief Customer Officer, Chief Client Officer, or Chief Experience Officer, giving these executives the power to improve customer service across every customer interaction.25

High Standards The best service providers set high quality standards. Standards must be set appropriately high. A 98 percent accuracy standard may sound good, but it would result in 400,000 incorrectly filled prescriptions daily, 3 million lost pieces of mail each day, and no phone, Internet, or electricity for eight days per year.

Profit Tiers Firms have decided to coddle big spenders to retain their patronage as long as possible. Customers in high-profit tiers get special discounts, promotional offers, and lots of special service; those in lower-profit tiers who barely pay their way may get more fees, stripped-down service, and voice messages to process their inquiries. Companies that provide differentiated levels of service must be careful about claiming superior service, however— customers who receive lesser treatment will bad-mouth the company and injure its reputa- tion. Delivering services that maximize both customer satisfaction and company profitability can be challenging.

Monitoring Systems Top firms audit service performance, both their own and competitors’, on a regular basis. They collect voice of the customer (VOC) measurements to probe customer satisfiers and dissatisfiers and use comparison shopping, mystery or ghost shopping, customer surveys, suggestion and complaint forms, service-audit teams, and customers’ letters.

Satisfying Customer Complaints On average, 40 percent of customers who suffer through a bad service experience stop doing business with the company.26 Companies that encourage dis- appointed customers to complain—and also empower employees to remedy the situation on the spot—have been shown to achieve higher revenues and greater profits than companies without a systematic approach for addressing service failures.27 Customers evaluate complaint incidents in terms of the outcomes they receive, the procedures used to arrive at those outcomes, and the nature of interpersonal treatment during the process.28 Companies also are increasing the quality of their call centers and their customer service representatives (see “Marketing Insight: Improving Company Call Centers”).

Differentiating Services Marketing excellence requires service marketers to continually differentiate their brands so they are not seen as a commodity. What the customer expects is called the primary service package. The provider can also add secondary service features to the package. In the hotel industry, various chains have introduced such secondary service features as merchandise for sale, free breakfast buffets, and loyalty programs.

Innovation is as vital in services as in any industry.29 And it can have big payoffs. When Ticketmaster introduced interactive seat maps that allowed customers to pick their own seats instead of being given one by a “best seat available” function, the conversion rate from potential to actual buyers increased by 25 percent to 30 percent. Persuading a ticket buyer to add an “I’m going …” message to Facebook adds an extra $5 in ticket sales on average; adding reviews of a show on the site doubles the conversion rate.30

166 Part 4 Creating Value

Managing Service Quality The service quality of a firm is tested at each service encounter. One study identified more than 800 critical behaviors that cause customers to switch services; see the eight categories of those behaviors in Table 10.2.31 A more recent study honed in on the service dimensions custom- ers would most like companies to measure. Knowledgeable frontline workers and the ability to achieve one-call-and-done rose to the top.32 Two important considerations in service quality are managing customer expectations and incorporating self-service technologies.

Managing Customer Expectations Customers form service expectations from many sources, such as past experiences, word of mouth, and advertising. In general, they compare perceived service and expected service. If the perceived service falls below the expected service, customers are disappointed. Successful com- panies add benefits to their offering that not only satisfy customers but surprise and delight them by exceeding expectations.33 The service-quality model in Figure 10.3 on page 168 highlights five gaps that can prevent successful service delivery:34

1. Gap between consumer expectation and management perception—Management does not al- ways correctly perceive what customers want. Hospital administrators may think patients want better food, but patients may be more concerned with nurse responsiveness.

Improving Company Call Centers

Many firms have learned the hard way that empowered customers will not put up with poor service. After Sprint and Nextel merged, they ran their call centers as cost centers rather than as a means to enhance customer loyalty. Employee rewards were for keeping customer calls short, and when management started to monitor even bath- room trips, morale sank. With customer churn spinning out of control, Sprint Nextel appointed its first chief service officer and started rewarding operators for solving problems on a customer’s first call.

Some firms, such as AT&T, JPMorgan Chase, and Expedia, have call centers in the Philippines rather than India because Filipinos speak lightly accented English and are more steeped in U.S. culture. Others are getting smarter about the calls they send to off-shore call centers, homeshoring by directing complex calls to highly trained do- mestic service reps. Some firms are using Big Data to match individual customers with the

call center agent best suited to meet their needs. Using something like the methods of online dating sites, advanced analytics technology mines cus- tomer transaction and demographic information and examines call center agents’ average call han- dling time and sales efficiency to identify optimal matches in real time.

Sources: Claudia Jasmand, Vera Blazevic, and Ko de Ruyter, “Generating Sales while Providing Service: A Study of Customer Service Representatives’ Ambidextrous Behavior,” Journal of Marketing 76 (January 2012), pp. 20–37; Kimmy Wa Chan and Echo Wen Wan, “How Can Stressed Employees Deliver Better Customer Service?,” Journal of Marketing 76 (January 2012), pp. 119–37; Joseph Walker, “Meet the New Boss: Big Data,” Wall Street Journal, September 20, 2012; Vikas Bajaj, “A New Capital of Call Centers,” New York Times, November 25, 2011; Michael Shroeck, “Why the Customer Call Center Isn’t Dead,” Forbes, March 15, 2011; Michael Sanserino and Cari Tuna, “Companies Strive Harder to Please Customers,” Wall Street Journal, July 27, 2009, p. B4; Spencer E. Ante, “Sprint’s Wake-Up Call,” BusinessWeek, March 3, 2008, pp. 54–57; Jena McGregor, “Customer Service Champs,” BusinessWeek, March 5, 2007.

marketing insight

Chapter 10 Designing and Managing Services 167

2. Gap between management perception and service-quality specification—Management might correctly perceive customers’ wants but not set a performance standard. Hospital administrators may tell the nurses to give “fast” service without specifying speed in minutes.

3. Gap between service-quality specifications and service delivery—Employees might be poorly trained or incapable of or unwilling to meet the standard; they may be held to conflicting stan- dards, such as taking time to listen to customers and serving them fast.

4. Gap between service delivery and external communications—Consumer expectations are af- fected by statements made by company representatives and ads. If a hospital brochure shows a beautiful room but the patient finds it cheap and tacky-looking, external communications have distorted the customer’s expectations.

5. Gap between perceived service and expected service—The consumer may misperceive the service quality. The physician may keep visiting the patient to show care, but the patient may interpret this as an indication that something is really wrong.

Based on this service-quality model, researchers identified five determinants of service quality. In descending order of importance, they are reliability, responsiveness, assurance, em- pathy, and tangibles.35 The researchers also note there is a zone of tolerance, or a range in which a service dimension would be deemed satisfactory, anchored by the minimum level consumers are willing to accept and the level they believe can and should be delivered.

Much work has validated the role of expectations in consumers’ interpretations and evaluations of the service encounter and in the relationship they adopt with a firm over time.36 Consumers are often forward-looking with respect to their decision to keep or drop a service relationship in terms of their likely behavior and interactions with a firm. Any marketing activity that affects current or expected future usage can help to solidify a service relationship.

Table 10.2 Factors Leading to Customer Switching Behavior

Pricing

• High price • Price increases • Unfair pricing • Deceptive pricing

inconvenience

• Location/hours • Wait for appointment • Wait for service

Core Service Failure

• Service mistakes • Billing errors • Service catastrophe

Service encounter Failures

• Uncaring • Impolite • Unresponsive • Unknowledgeable

response to Service Failure

• Negative response • No response • Reluctant response

Competition

• Found better service

ethical Problems

• Cheat • Hard sell • Unsafe • Conflict of interest

involuntary Switching

• Customer moved • Provider closed

Source: Susan M. Keaveney, “Customer Switching Behavior in Service Industries: An Exploratory Study,” Journal of Marketing (April 1995): 71–82. Reprinted with permission from the Journal of Marketing, published by the American Marketing Association.

168 Part 4 Creating Value

Incorporating Self-Service Technologies Consumers value convenience in services,37 and many person-to-person service interactions are being replaced by self-service technologies (SSTs) intended to provide that convenience. To traditional vending machines we can add automated teller machines (ATMs), self-pumping at gas stations, self-checkout at hotels, and a variety of activities on the Internet, such as ticket purchasing. Not all SSTs improve service quality, but they can make service transactions more accurate, convenient, and faster. Obviously, they can also reduce costs. One technology firm, Comverse, estimates the cost to answer a query through a call center at $7, but online at only 10 cents.38

Successfully integrating technology into the workforce thus requires a comprehensive reengi- neering of the front office to identify what people do best, what machines do best, and how to de- ploy them separately and together.39 Customers must have a clear sense of their roles in the process.

Figure 10.3 Service-Quality Model

Sources: A. Parasuraman, Valarie A. Zeithaml, and Leonard L. Berry, “A Conceptual Model of Service Quality and Its Implications for Future Research,” Journal of Marketing (Fall 1985), p. 44. The model is more fully discussed or elaborated in Valarie Zeithaml, Mary Jo Bitner, and Dwayne D. Gremler, Services Marketing: Integrating Customer Focus across the Firm, 6th ed. (New York: McGraw-Hill/Irwin, 2013).

GAP 5

GAP 3GAP 1

GAP 4

GAP 2

Word-of-mouth communications

Past experiencePersonal needs

Expected service

Perceived service

Service delivery (including pre-

and post-contacts)

External communications

to consumers

Translation of perceptions into service-quality specifications

Management perceptions of

consumer expectations

CONSUMER

MARKETER

Chapter 10 Designing and Managing Services 169

Managing Product-Support Services Manufacturers of equipment—small appliances, office machines, tractors, mainframes, air- planes—all must provide product-support services, now a battleground for competitive advantage. Some equipment companies, such as Caterpillar Tractor and John Deere, make a significant per- centage of their profits from these services.40 In the global marketplace, companies that make a good product but provide poor local service support are seriously disadvantaged.

Identifying and Satisfying Customer Needs Traditionally, customers have had three specific worries about product service.41 First, they worry about reliability and failure frequency. A farmer may tolerate a combine that will break down once a year, but not one that goes down two or three times a year. Second, they worry about downtime. The longer the downtime, the higher the cost, which is why the customer counts on the seller’s service dependability—the ability to fix the machine quickly or at least pro- vide a loaner. The third issue is out-of-pocket costs. How much does the customer have to spend on regular maintenance and repair costs?

A buyer takes all these factors into consideration and tries to estimate the life-cycle cost, which is the product’s purchase cost plus the discounted cost of maintenance and repair less the discounted salvage value. To provide the best support, a manufacturer must identify the services customers value most and their relative importance. For expensive equipment, manufacturers offer facilitating services such as installation, staff training, maintenance and repair services, and financing. They may also add value-augmenting services that extend beyond the product’s func- tioning and performance.

A manufacturer can offer, and charge for, product-support services in different ways. One chemical company provides a standard offering plus a basic level of services. If the business cus- tomer wants additional services, it can pay extra or increase its annual purchases to a higher level. Many companies offer service contracts (also called extended warranties), agreeing to provide maintenance and repair services for a specified period at a specified contract price.

Product companies must understand their strategic intent and competitive advantage in de- veloping services. Are service units supposed to support and protect existing product businesses or grow as an independent platform? Are the sources of competitive advantage based on economies of scale (size) or economies of skill (smarts)?42

Postsale Service Strategy The quality of customer service departments varies greatly. At one extreme are those that simply transfer customer calls to the appropriate person for action with little follow-up. At the other ex- treme are departments eager to receive customer requests, suggestions, and even complaints and handle them expeditiously. Some firms even proactively contact customers to provide service after the sale is complete.43

Manufacturers usually start by running their own parts-and-service departments. They want to stay close to the equipment and know its problems. They also find it expensive and time consuming to train others and discover they can make good money from parts and service if they are the only supplier and can charge a premium price. In fact, many equipment manufactur- ers price their equipment low and compensate by charging high prices for parts and service.

Over time, manufacturers switch more maintenance and repair service to authorized dis- tributors and dealers. These intermediaries are closer to customers, operate in more locations, and can offer quicker service. Still later, independent service firms emerge and offer a lower price or faster service. A significant percentage of auto-service work is now done outside franchised

170 Part 4 Creating Value

automobile dealerships by independent garages and chains such as Midas Muffler and Sears. Independent service organizations handle mainframes, telecommunications equipment, and a variety of other equipment lines.

Customer-service choices are increasing rapidly, however, and equipment manufacturers increasingly must figure out how to make money on their equipment, independent of service contracts. Some new-car warranties now cover 100,000 miles before customers have to pay for servicing. The increase in disposable or never-fail equipment makes customers less inclined to pay 2 percent to 10 percent of the purchase price every year for service. Some business customers may find it cheaper to have their own service people on-site.

Executive Summary A service is any act or performance that one party can offer to another that is essentially intangible and does not result in the ownership of anything. It may or may not be tied to a physical product. Five categories of offerings are: (1) pure tangible good, (2) tangible good with accompanying ser- vices, (3) hybrid offering of equal parts goods and services, (4) major service with accompanying minor goods and services, and (5) pure service. Services are intangible, inseparable, variable, and perishable. Marketers must find ways to give tangibility to intangibles, to increase service provid- ers’ productivity, to increase and standardize the service quality, and to match the supply of ser- vices with market demand.

Marketing of services faces new realities due to customer empowerment, customer copro- duction, and the need to satisfy employees as well as customers. Achieving excellence in service marketing calls for external marketing, internal marketing, and interactive marketing. Top service companies adopt a strategic concept, have top-management commitment to quality, commit to high standards, establish profit tiers, and monitor service performance and customer complaints. They also differentiate their brands through primary and secondary service features and continual innovation. Superior service delivery requires managing customer expectations and incorporating self-service technologies. Manufacturers of tangible products should identify and satisfy customer needs for service and provide postpurchase service.

Notes

1. John Adams, “How USAA Innovates Online Banking,” American Banker, September 1, 2012; David Rohde, “In the Era of Greed, Meet America’s Good Bank: USAA,” The Atlantic, January 27, 2012; Jena McGregor, “USAA’s Battle Plan,” Bloomberg BusinessWeek, March 1, 2010; “Customer Service Champs,” BusinessWeek, March 5, 2007; Allison Enright, “Serve Them Right,” Marketing News, May 1, 2006; Mike W. Thomas, “USAA Reports Mid-Year Growth,” San Antonio Business Journal, July 28, 2014, www.bizjournals.com.

2. Valarie A. Zeithaml, “How Consumer Evaluation Processes Differ between Goods and Services,” J. Donnelly and W. R. George, eds., Marketing of Services (Chicago: American Marketing Association, 1981), pp. 186–90.

3. Jin Sun, Hean Tat Keh, and Angela Y. Lee, “The Effect of Attribute Alignability on Service Evaluation: The Moderating Role of Uncertainty,” Journal of Consumer Research 39 (December 2012), pp. 831–47.

4. Theodore Levitt, “Marketing Intangible Products and Product Intangibles,” Harvard Business Review, May–June 1981, pp. 94–102; Leonard L. Berry, “Services Marketing Is Different,” Business, May–June 1980, pp. 24–29.

5. B. H. Booms and M. J. Bitner, “Marketing Strategies and Organizational Structures for Service Firms,” J. Donnelly and W. R. George, eds., Marketing of Services (Chicago: American Marketing Association, 1981), pp. 47–51.

6. Rebecca J. Slotegraaf and J. Jeffrey Inman, “Longitudinal Shifts in the Drivers of Satisfaction with

Chapter 10 Designing and Managing Services 171

Product Quality: The Role of Attribute Resolvability,” Journal of Marketing Research 41 (August 2004), pp. 269–80.

7. W. Earl Sasser, “Match Supply and Demand in Service Industries,” Harvard Business Review, November– December 1976, pp. 133–40.

8. David Roe, “Forrester’s Customer Experience Index: The Good, The Bad and the Poor,” www.cmswire .com, January 17, 2013; “The Emerging Role of Social Customer Experience in Customer Care,” www.lithium .com, May 2013; “The State of Customer Experience, 2012,” white paper, Forrester Research, Inc., April 24, 2012; Josh Bernoff, “Numbers Show Marketing Value in Sustaining Good Customer Service,” Advertising Age, January 17, 2011.

9. Elisabeth Sullivan, “Happy Endings Lead to Happy Returns,” Marketing News, October 30, 2009, p. 20.

10. Matthew Dixon, Karen Freeman, and Nicholas Toman, “Stop Trying to Delight Your Customers,” Harvard Business Review, July–August 2010, pp. 116–22.

11. Chi Kin (Bennett) Yim, Kimmy Wa Chan, and Simon S. K. Lam, “Do Customers and Employees Enjoy Service Participation? Synergistic Effects of Self- and Other-Efficacy,” Journal of Marketing 76 (November 2012), pp. 121–40; Zhenfeng Ma & Laurette Dubé, “Process and Outcome Interdependency in Frontline Service Encounters,” Journal of Marketing 75 (May 2011), pp. 83–98; Stephen S. Tax, Mark Colgate, and David Bowen, “How to Prevent Your Customers from Failing,” MIT Sloan Management Review (Spring 2006), pp. 30–38.

12. Kimmy Wa Chan, Chi Kin (Bennett) Yim, and Simon S. K. Lam, “Is Customer Participation in Value Creation a Double-Edged Sword? Evidence from Professional Financial Services Across Cultures,” Journal of Marketing 74 (May 2010), pp. 48–64.

13. Valarie Zeithaml, Mary Jo Bitner, and Dwayne D. Gremler, Services Marketing: Integrating Customer Focus across the Firm, 6th ed. (New York: McGraw-Hill, 2013).

14. Rachel R. Chen, Eitan Gerstner, and Yinghui (Catherine) Yang, “Customer Bill of Rights Under No- Fault Service Failure: Confinement and Compensation,” Marketing Science 31 (January/February 2012), pp. 157–71; Michael Sanserino and Cari Tuna, “Companies Strive Harder to Please Customers,” Wall Street Journal, July 27, 2009, p. B4.

15. James L. Heskett, W, Earl Sasser Jr., and Joe Wheeler, Ownership Quotient: Putting the Service Profit Chain to Work for Unbeatable Competitive Advantage (Boston, MA: Harvard Business School Press, 2008).

16. D. Todd Donovan, Tom J. Brown, and John C. Mowen, “Internal Benefits of Service Worker Customer

Orientation,” Journal of Marketing 68 (January 2004), pp. 128–46.

17. Frances X. Frei, “The Four Things a Service Business Must Get Right,” Harvard Business Review, April 2008, pp. 70–80.

18. Christian Gronroos, “A Service-Quality Model and Its Marketing Implications,” European Journal of Marketing 18 (1984), pp. 36–44.

19. Detelina Marinova, Jun Ye, and Jagdip Singh, “Do Frontline Mechanisms Matter? Impact of Quality and Productivity Orientations on Unit Revenue, Efficiency, and Customer Satisfaction,” Journal of Marketing 72 (March 2008), pp. 28–45.

20. Christian Gronroos, “A Service-Quality Model and Its Marketing Implications,” European Journal of Marketing 18 (1984), pp. 36–44.

21. Ad de Jong, Ko de Ruyter, and Jos Lemmink, “Antecedents and Consequences of the Service Climate in Boundary-Spanning Self-Managing Service Teams,” Journal of Marketing 68 (April 2004), pp. 18–35; Michael D. Hartline and O. C. Ferrell, “The Management of Customer-Contact Service Employees,” Journal of Marketing 60 (October 1996), pp. 52–70; Christian Homburg, Jan Wieseke, and Torsten Bornemann, “Implementing the Marketing Concept at the Employee-Customer Interface,” Journal of Marketing 73 (July 2009), pp. 64–81; Chi Kin (Bennett) Yim, David K. Tse, and Kimmy Wa Chan, “Strengthening Customer Loyalty through Intimacy and Passion,” Journal of Marketing Research 45 (December 2008), pp. 741–56.

22. Roland T. Rust and Ming-Hui Huang, “Optimizing Service Productivity,” Journal of Marketing 76 (March 2012), pp. 47–66.

23. Linda Ferrell and O.C. Ferrell, “Redirecting Direct Selling: High-touch Embraces High-tech,” Business Horizons 55 (May 2012), pp. 273–81.

24. Heather Green, “How Amazon Aims to Keep You Clicking,” BusinessWeek, March 2, 2009, pp. 34–40.

25. Paul Hagen, “The Rise of the Chief Customer Officer,” Forbes, February 16, 2011.

26. Dave Dougherty and Ajay Murthy, “What Service Customers Really Want,” Harvard Business Review, September 2009, p. 22; for a contrarian point of view, see Edward Kasabov, “The Compliant Customer,” MIT Sloan Management Review (Spring 2010), pp. 18–19.

27. Jeffrey G. Blodgett and Ronald D. Anderson, “A Bayesian Network Model of the Customer Complaint Process,” Journal of Service Research 2 (May 2000), pp. 321–38.

28. Stephen S. Tax, Stephen W. Brown, and Murali Chandrashekaran, “Customer Evaluations of Service

172 Part 4 Creating Value

Complaint Experiences: Implications for Relationship Marketing,” Journal of Marketing 62 (April 1998), pp. 60–76.

29. Thomas Dotzel, Venkatesh Shankar, and Leonard L. Berry, “Service Innovativeness and Firm Value,” Journal of Marketing Research 50 (April 2013), pp. 259–76.

30. Eric Savitz, “Can Ticketmaster CEO Nathan Hubbard Fix the Ticket Market,” Forbes, February 18, 2011.

31. Susan M. Keaveney, “Customer Switching Behavior in Service Industries: An Exploratory Study,” Journal of Marketing 59 (April 1995), pp. 71–82.

32. Dave Dougherty and Ajay Murthy, “What Service Customers Really Want,” Harvard Business Review, September 2009, p. 22.

33. Roland T. Rust and Richard L. Oliver, “Should We Delight the Customer?,” Journal of the Academy of Marketing Science 28 (December 2000), pp. 86–94.

34. A. Parasuraman, Valarie A. Zeithaml, and Leonard L. Berry, “A Conceptual Model of Service Quality and Its Implications for Future Research,” Journal of Marketing 49 (Fall 1985), pp. 41–50. See also Michael K. Brady and J. Joseph Cronin Jr., “Some New Thoughts on Conceptualizing Perceived Service Quality,” Journal of Marketing 65 (July 2001), pp. 34–49.

35. Leonard L. Berry and A. Parasuraman, Marketing Services: Competing through Quality (New York: Free Press, 1991), p. 16.

36. Roland T. Rust and Tuck Siong Chung, “Marketing Models of Service and Relationships,” Marketing Science 25 (November–December 2006), pp. 560–80; Katherine

N. Lemon, Tiffany Barnett White, and Russell S. Winer, “Dynamic Customer Relationship Management: Incorporating Future Considerations into the Service Retention Decision,” Journal of Marketing 66 (January 2002), pp. 1–14.

37. Leonard L. Berry, Kathleen Seiders, and Dhruv Grewal, “Understanding Service Convenience,” Journal of Marketing 66 (July 2002), pp. 1–17.

38. “Help Yourself,” Economist, July 2, 2009, pp. 62–63. 39. Jeffrey F. Rayport and Bernard J. Jaworski, Best Face

Forward (Boston: Harvard Business School Press, 2005); Jeffrey F. Rayport, Bernard J. Jaworski, and Ellie J. Kyung, “Best Face Forward,” Journal of Interactive Marketing 19 (Autumn 2005), pp. 67–80; Jeffrey F. Rayport and Bernard J. Jaworski, “Best Face Forward,” Harvard Business Review, December 2004, pp. 47–58.

40. Eric Fang, Robert W. Palmatier, and Jan-Benedict E. M. Steenkamp, “Effect of Service Transition Strategies on Firm Value,” Journal of Marketing 72 (September 2008), pp. 1–14.

41. Mark Vandenbosch and Niraj Dawar, “Beyond Better Products: Capturing Value in Customer Interactions,” MIT Sloan Management Review 43 (Summer 2002), pp. 35–42.

42. Byron G. Auguste, Eric P. Harmon, and Vivek Pandit, “The Right Service Strategies for Product Companies,” McKinsey Quarterly 1 (2006), pp. 41–51.

43. Goutam Challagalla, R. Venkatesh, and Ajay K. Kohli, “Proactive Postsales Service: When and Why Does It Pay Off?,” Journal of Marketing 73 (March 2009), pp. 70–87.

173

In this chapter, we will address the following questions:

1. How do consumers process and evaluate prices? (Page 174)

2. How should a company set prices initially? (Page 176)

3. How should a company adapt prices to meet varying circumstances and opportunities? (Page 184)

4. When and how should a company initiate a price change and respond to a competitor’s price changes? (Page 187)

Developing Pricing Strategies and Programs

Marketing Management at Ryanair Profits for discount European air carrier Ryanair have been sky-high thanks to its revolutionary business model. Founder Michael O’Leary thinks like a retailer, charging passengers for almost everything—except their seat. A quarter of Ryanair’s seats are free, and O’Leary wants to double that within five years, with the ultimate goal of making all seats free. Passengers currently pay only taxes and fees of about $10 to $24, with an average one-way fare of roughly $52. Everything else is extra: checked luggage ($9.50 per bag) and snacks ($5.50 for a hot dog, $3.50 for water). Other strategies cut costs or generate outside revenue. More than 99 percent of tickets are sold online, and its Web site offers travel insurance, hotels, ski packages, and car rentals. This formula works for Ryanair: The airline flies 58 million people to more than 150 airports each year. Ryanair enjoys net margins of 25 percent, more than three times Southwest’s 7 percent. Some industry pundits even refer to Ryanair as “Walmart with wings”!1

Price is the one element of the marketing mix that produces revenue; the other elements pro-duce costs. Price also communicates the company’s intended value positioning of its product or brand. But new economic realities have caused many consumers to reevaluate what they are

Chapter 11

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willing to pay, and companies have had to carefully review their pricing strategies as a result. Pricing decisions must take into account many factors—the company, the customers, the compe- tition, and the marketing environment. In this chapter, we discuss concepts and tools to facilitate the setting of initial prices and adjusting prices over time and markets.

Understanding Pricing Price is not just a number on a tag. It comes in many forms and performs many functions, whether it’s called rent, tuition, fares, fees, rates, tolls, or commissions. Price also has many components. Throughout most of history, prices were set by negotiation between buyers and sellers. Setting one price for all buyers is a relatively modern idea that arose with the develop- ment of large-scale retailing at the end of the nineteenth century. Tiffany & Co. and others advertised a “strictly one-price policy” because they carried so many items and supervised so many employees.

Pricing in a Digital World Traditionally, price has operated as a major determinant of buyer choice. Consumers and pur- chasing agents who have access to price information and price discounters put pressure on retailers to lower their prices. Retailers in turn put pressure on manufacturers to lower their prices. The result can be a marketplace characterized by heavy discounting and sales promotion.

Downward price pressure from a changing economic environment coincided with some longer-term trends in the technological environment. For some years now, the Internet has been changing the way buyers and sellers interact. Buyers can instantly compare prices from thousands of vendors, check prices at the point of purchase, name their own price, and even get products free. Sellers can monitor customer behavior, tailor offers to individual buyers, and give certain customers access to special prices. Both buyers and sellers can negotiate prices in online auctions and exchanges or in person.

A Changing Pricing Environment Pricing practices have changed significantly, thanks in part to a severe recession in 2008–2009, a slow recovery, and rapid technological advances. But the new millennial generation also brings new attitudes and values to consumption. Often burdened by student loans and other financial demands, members of this group (born between about 1977 and 1994) are reconsidering just what they really need to own and often choosing to rent, borrow, and share.

Some say these new behaviors are creating a sharing economy in which consumers share bikes, cars, clothes, couches, apartments, tools, and skills and extracting more value from what they already own. As one sharing-related entrepreneur noted, “We’re moving from a world where we’re organized around ownership to one organized around access to assets.” In a sharing econ- omy, someone can be both a consumer and a producer, reaping the benefits of both roles.2 Trust and a good reputation are crucial in any exchange but imperative in a sharing economy. Most platforms that are part of a sharing-related business have some form of self-policing mechanism such as public profiles and community rating systems, sometimes linked with Facebook.

How Companies Price In small companies, the boss often sets prices. In large companies, division and product line managers do. Even here, top management sets general pricing objectives and policies and often approves lower management’s proposals.

Chapter 11 Developing Pricing Strategies and Programs 175

Where pricing is a key competitive factor (railroads, oil companies), companies often establish a pricing department to set or assist others in setting appropriate prices. This depart- ment reports to the marketing department, finance department, or top management. In B-to-B settings, research suggests that pricing performance improves when pricing authority is spread horizontally across the sales, marketing, and finance units and when there is a balance in cen- tralizing and delegating that authority between individual salespeople and teams and central management.3

Common pricing mistakes include not revising price often enough to capitalize on market changes; setting price independently of the rest of the marketing program rather than as an intrinsic element of market-positioning strategy; and not varying price enough for different product items, market segments, distribution channels, and purchase occasions. For any orga- nization, effectively designing and implementing pricing strategies requires a thorough under- standing of consumer pricing psychology and a systematic approach to setting, adapting, and changing prices.

Consumer Psychology and Pricing Marketers recognize that consumers often actively process price information, interpreting it from the context of prior purchasing experience, formal communications (advertising, sales calls, and brochures), informal communications (friends, colleagues, or family members), point-of-purchase or online resources, and other factors.4 Purchase decisions are based on how consumers perceive prices and what they consider the current actual price to be—not on the marketer’s stated price. Customers may have a lower price threshold, below which prices signal inferior or unacceptable quality, and an upper price threshold, above which prices are prohibitive and the product appears not worth the money.

Three key topics for understanding how consumers arrive at their perceptions of prices are reference prices, price–quality inferences, and price endings.

• Reference prices. Although consumers may have fairly good knowledge of price ranges, surprisingly few can accurately recall specific prices.5 When examining products, they often employ reference prices, comparing an observed price to an internal reference price they remember or an external frame of reference such as a posted “regular retail price.”6 Marketers encourage this thinking by stating a high manufacturer’s suggested price, indi- cating that the price was much higher originally, or pointing to a competitor’s high price.7 Clever marketers try to frame the price to signal the best value possible. For example, a rel- atively expensive item can look less expensive if the price is broken into smaller units, such as a $500 annual membership for “under $50 a month,” even if the totals are the same.8

• Price-quality inferences. Many consumers use price as an indicator of quality. Image pricing is especially effective with ego-sensitive products such as perfumes, expensive cars, and designer clothing. When information about true quality is available, price becomes a less significant indicator of quality. For luxury-goods customers who desire uniqueness, demand may actually increase price because they then believe fewer other customers can afford the product.9

• Price endings. Customers perceive an item priced at $299 to be in the $200 range rather than the $300 range; they tend to process prices “left to right” rather than by rounding.10 Price encoding in this fashion is important if there is a mental price break at the higher, rounded price. Another explanation for the popularity of “9” endings is that they suggest a discount or bargain, so if a company wants a high-price image, it should probably avoid the odd-ending tactic.11

176 Part 4 Creating Value

Setting the Price A firm must set a price for the first time when it develops a new product, when it introduces its regular product into a new distribution channel or geographical area, and when it enters bids on new contract work. The firm must decide where to position its product on quality and price.

Firms devise their branding strategies to help convey the price-quality tiers of their products or services to consumers.12 Having a range of price points allows a firm to cover more of the market and to give any one consumer more choices. “Marketing Insight: Trading Up, Down, and Over” describes how consumers have been shifting their spending in recent years.

The firm must consider many factors in setting its pricing policy.13 Table 11.1 summarizes the six steps in the process.

Step 1: Selecting the Pricing Objective Five major pricing objectives are: survival, maximum current profit, maximum market share, maximum market skimming, and product-quality leadership. Companies pursue survival as their major objective if they are plagued with overcapacity, intense competition, or chang- ing consumer wants. As long as prices cover variable costs and some fixed costs, the com- pany stays in business. To maximize current profits, a firm estimates the demand and costs

Trading Up, Down, and Over

Michael Silverstein and Neil Fiske, the authors of Trading Up, have observed a number of middle-market consumers periodically “trading up” to what they call “New Luxury” products and ser- vices “that possess higher levels of quality, taste, and aspiration than other goods in the category but are not so expensive as to be out of reach.” Three main types of New Luxury products are:

• Accessible super-premium products (such as Kettle gourmet potato chips), which carry a significant price premium but are still relatively low-ticket items in affordable categories.

• Old Luxury brand extensions (such as the Mercedes-Benz C-class), which retain their cachet while extending historically high- priced brands down-market.

• Masstige goods, such as Kiehl’s skin care prod- ucts, which are “based on emotions” and are priced between average middle-market brands and super-premium Old Luxury brands.

To trade up to brands that offer these emo- tional benefits, consumers often “trade down” by shopping at discounters for staple items or goods that deliver quality and functionality. The recent economic downturn increased the prevalence of trading down. As the economy improved and con- sumers tired of putting off discretionary purchases, retail sales picked up. Trading up and down has persisted, however, along with “trading over” or switching spending from one category to another, buying a new home theater system, say, instead of a new car.

Sources: Cotten Timberlake, “U.S. 2 Percenters Trade Down with Post- Recession Angst,” www.bloomberg.com, May 15, 2013; Anna-Louise Jackson and Anthony Feld, “Frugality Fatigue Spurs Americans to Trade Up,” www.bloomberg.com, April 13, 2012; Walker Smith, “Consumer Behavior: From Trading Up to Trading Off,” Branding Strategy Insider, January 26, 2012; Bruce Horovitz, “Sale, Sale, Sale: Today Everyone Wants a Deal,” USA Today, April 21, 2010, pp. 1A–2A; Michael J. Silverstein, Treasure Hunt: Inside the Mind of the New Consumer (New York: Portfolio, 2006); Michael J. Silverstein and Neil Fiske, Trading Up: The New American Luxury (New York: Portfolio, 2003).

marketing insight

Chapter 11 Developing Pricing Strategies and Programs 177

associated with alternative prices and chooses the price that produces maximum current profit, cash flow, or rate of return on investment. However, the company may sacrifice long- run performance by ignoring the effects of other marketing variables, competitors’ reactions, and legal restraints on price.

Some companies want to maximize their market share, believing a higher sales volume will lead to lower unit costs and higher long-run profit. With market-penetration pricing, firms set the lowest price, assuming the market is price sensitive. This strategy is appropriate when (1) the market is highly price sensitive and a low price stimulates market growth; (2) production and distribution costs fall with accumulated production experience; and (3) a low price discourages actual and potential competition.

Companies unveiling a new technology favor setting high prices to maximize market skim- ming. Market-skimming pricing, in which prices start high and slowly drop over time, makes sense when (1) a sufficient number of buyers have a high current demand; (2) the unit costs of producing a small volume are not so high that they cancel the advantage of charging what the traffic will bear; (3) the high initial price does not attract more competitors to the market; and (4) the high price communicates the image of a superior product.

A company might aim to be the product-quality leader in the market.14 Many brands strive to be “affordable luxuries”—products or services characterized by high levels of perceived qual- ity, taste, and status with a price just high enough not to be out of consumers’ reach.

Nonprofit and public organizations may have other pricing objectives. A university aims for partial cost recovery, knowing that it must rely on private gifts and public grants to cover its 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 seats.

Step 2: Determining Demand Each price will lead to a different level of demand and have a different impact on a company’s marketing objectives. The normally inverse relationship between price and demand is captured in a demand curve. The higher the price, the lower the demand. For prestige goods, the demand curve sometimes slopes upward. Some consumers take the higher price to signify a better prod- uct. However, if the price is too high, demand may fall.

Price Sensitivity The demand curve shows the market’s probable purchase quantity at alter- native prices, summing the reactions of many individuals with different price sensitivities. The first step in estimating demand is to understand what affects price sensitivity. Generally speak- ing, customers are less price sensitive to low-cost items or items they buy infrequently. They are also less price sensitive when (1) there are few or no substitutes or competitors; (2) they do not readily notice the higher price; (3) they are slow to change their buying habits; (4) they think the

Table 11.1 Steps in Setting a Pricing Policy

1. Selecting the Pricing Objective

2. Determining Demand

3. Estimating Costs

4. Analyzing Competitors’ Costs, Prices, and Offers

5. Selecting a Pricing Method

6. Selecting the Final Price

178 Part 4 Creating Value

higher prices are justified; and (5) price is only a small part of the total cost of obtaining, operat- ing, and servicing the product over its lifetime.

A seller can successfully charge a higher price than competitors if it can convince customers that it offers the lowest total cost of ownership (TCO). Marketers often treat the service elements in a product offering as sales incentives rather than as value-enhancing augmentations for which they can charge. In fact, pricing expert Tom Nagle believes the most common mistake manufac- turers make is to offer services to differentiate their products without charging for them.15

Estimating Demand Curves Most companies attempt to measure their demand curves using several different methods. They may use surveys to explore how many units consumers would buy at different proposed prices. Although consumers might understate their purchase intentions at higher prices to discourage the company from pricing high, they also tend to exag- gerate their willingness to pay for new products or services.16 Price experiments can vary the prices of different products in a store or of the same product in similar territories to see how the change affects sales. Also, statistical analyses of past prices, quantities sold, and other factors can reveal their relationships.

In measuring the price-demand relationship, the market researcher must control for vari- ous factors that will influence demand.17 The competitor’s response will make a difference. Also, if the company changes other aspects of the marketing program besides price, the effect of the price change itself will be hard to isolate.

Price Elasticity of Demand Marketers need to know how responsive, or elastic, demand is to a change in price. If demand hardly changes with a small change in price, we say it is inelastic. If demand changes considerably, it is elastic. The higher the elasticity, the greater the volume growth resulting from a 1 percent price reduction. If demand is elastic, sellers will consider low- ering the price to produce more total revenue. This makes sense as long as the costs of producing and selling more units do not increase disproportionately.

Price elasticity depends on the magnitude and direction of the contemplated price change. It may be negligible with a small price change and substantial with a large price change. It may differ for a price cut versus a price increase, and there may be a band within which price changes have little or no effect. Long-run price elasticity may differ from short-run elasticity. Buyers may continue to buy from a current supplier after a price increase but eventually switch suppliers. The distinction between short-run and long-run elasticity means that sellers will not know the total effect of a price change until time passes.

Consumers tend to be more sensitive to prices during tough economic times, but that is not true across all categories.18 One comprehensive review of a 40-year period of academic research on price elasticity yielded interesting findings.19 Price elasticity magnitudes were higher for du- rable goods than for other goods and higher for products in the introduction/growth stages of the product life cycle than in the mature/decline stages. Also, promotional price elasticities were higher than actual price elasticities in the short run (though the reverse was true in the long run).

Step 3: Estimating Costs Whereas demand sets a ceiling on the price the company can charge for its product, costs set the floor. The company wants to charge a price that covers its cost of producing, distributing, and selling the product, including a fair return for its effort and risk. Yet when companies price prod- ucts to cover their full costs, profitability isn’t always the net result.

Types of Costs and Levels of Production A company’s costs take two forms, fixed and variable. Fixed costs, also known as overhead, are costs such as rent and salaries that do not vary

Chapter 11 Developing Pricing Strategies and Programs 179

with production level or sales revenue. Variable costs vary directly with the level of production. For example, each calculator produced by Texas Instruments incurs the cost of plastic, micropro- cessor chips, and packaging. These costs tend to be constant per unit produced, but they’re called variable because their total varies with the number of units produced.

Total costs consist of the sum of the fixed and variable costs for any given level of produc- tion. Average cost is the cost per unit at that level of production; it equals total costs divided by production. Management wants to charge a price that will at least cover the total production costs at a given level of production.

To price intelligently, management needs to know how its costs vary with different levels of production. The cost per unit is high if few units are produced per day. As production increases, the average cost falls because the fixed costs are spread over more units. Short-run average cost increases after a certain point, however, because the plant becomes inefficient (due to problems such as machines breaking down). By calculating costs for plants of different sizes, a firm can identify the optimal size and production level. To estimate the real profitability of selling to dif- ferent types of retailers or customers, the manufacturer needs to use activity-based cost (ABC) accounting instead of standard cost accounting.

Accumulated Production Suppose Samsung runs a plant that produces 3,000 tablet com- puters per day. As the company gains experience producing tablets, its methods improve. Workers learn shortcuts, materials flow more smoothly, and procurement costs fall. The result, as Figure 11.1 shows, is that average cost falls with accumulated production experience. Thus the average cost of producing the first 100,000 tablets is $100 per tablet. When the company has produced the first 200,000 tablets, the average cost has fallen to $90. After its accumulated pro- duction experience doubles again to 400,000, the average cost is $80. This decline in the average cost with accumulated production experience is called the experience curve or learning curve.

Now suppose three firms compete in this particular tablet market, Samsung, A, and B. Samsung is the lowest-cost producer at $80, having produced 400,000 units in the past. If all three firms sell the tablet for $100, Samsung makes $20 profit per unit, A makes $10 per unit, and B breaks even. The smart move for Samsung would be to lower its price to $90. This will drive B out of the market, and even A may consider leaving. Samsung will pick up the business that

Figure 11.1 Cost per Unit as a Function of Accumulated Production: The Experience Curve

200,000 400,000 800,000

$80

$60

$40

$20

$100

C os

t pe

r U

ni t

100,000

Accumulated Production

Current price

Experience curve

B A

Samsung

180 Part 4 Creating Value

would have gone to B (and possibly A). Furthermore, price-sensitive customers will enter the market at the lower price. As production increases beyond 400,000 units, Samsung’s costs will drop still further and faster, more than restoring its profits, even at a price of $90.

Experience-curve pricing nevertheless carries major risks. Aggressive pricing might give the product a cheap image. It also assumes competitors are weak followers. The strategy leads the company to build more plants to meet demand, but a competitor may choose to innovate with a lower-cost technology. The market leader is now stuck with the old technology.

Target Costing Costs change with production scale and experience. They can also change as a result of a concentrated effort by designers, engineers, and purchasing agents to reduce them through target costing. Market research establishes a new product’s desired functions and the price at which it will sell, given its appeal and competitors’ prices. This price less desired profit margin leaves the target cost the marketer must achieve. The firm must examine each cost element—design, engineering, manufacturing, sales—and bring down costs so the final cost projections are in the tar- get range. Cost cutting cannot go so deep as to compromise the brand promise and value delivered.

Step 4: Analyzing Competitors’ Costs, Prices, and Offers Within the range of possible prices identified by market demand and company costs, the firm must take competitors’ costs, prices, and possible reactions into account. If the firm’s offer contains features not offered by the nearest competitor, it should evaluate their worth to the customer and add that value to the competitor’s price. If the competitor’s offer contains some features not offered by the firm, the firm should subtract their value from its own price. Now the firm can decide whether it can charge more, the same, or less than the competitor.20

Step 5: Selecting a Pricing Method The company is now ready to select a price. Figure 11.2 summarizes the three major consider- ations in price setting: Costs set a floor to the price. Competitors’ prices and the price of substi- tutes provide an orienting point. Customers’ assessment of unique features establishes the price ceiling. We will examine seven price-setting methods: markup pricing, target-return pricing, perceived-value pricing, value pricing, EDLP, going-rate pricing, and auction-type pricing.

Markup Pricing The most elementary pricing method is to add a standard markup to the product’s cost. Construction companies submit job bids by estimating the total project cost and adding a standard markup for profit. Suppose a toaster manufacturer has the following costs and sales expectations:

Variable cost per unit $10

Fixed costs $300,000

Expected unit sales 50,000

The manufacturer’s unit cost is given by:

Unit cost = variable cost + fixed cost unit sales

= $10 + $300,000

50,000 = $16

If the manufacturer wants to earn a 20 percent markup on sales, its markup price is given by:

Markup price = unit cost

(1 - desired return on sales) =

$16 1 - 0.2

= $20

Chapter 11 Developing Pricing Strategies and Programs 181

The manufacturer will charge dealers $20 per toaster and make a profit of $4 per unit. If dealers want to earn 50 percent on their selling price, they will mark up the toaster 100 percent to $40.

Generally, the use of standard markups does not make logical sense. Any pricing method that ignores current demand, perceived value, and competition is not likely to lead to the op- timal price. Markup pricing works only if the marked-up price actually brings in the expected level of sales. Still, markup pricing remains popular because sellers can determine costs much more easily than they can estimate demand. By tying the price to cost, sellers simplify the pric- ing task. Also, when all firms in the industry use this pricing method, prices tend to be similar and price competition is minimized. Finally, many people feel cost-plus pricing is fairer to both buyers and sellers.

Target-Return Pricing In target-return pricing, the firm determines the price that yields its target rate of return on investment. Public utilities, which need to make a fair return on in- vestment, often use this method. Suppose the toaster manufacturer has invested $1 million in

Figure 11.2 The Three Cs Model for Price Setting

Low Price

(No possible profit at

this price)

Customers’ assessment of unique product features

Ceiling price

Orienting point

Competitors’ prices and prices of

substitutes

Costs

Floor price

High Price

(No possible demand at this price)

182 Part 4 Creating Value

the business and wants to set a price to earn a 20 percent ROI, specifically $200,000. The target- return price is given by the following formula:

Target@return price = unit cost + desired return * invested capital

unit sales

= $16 + .20 * $1,000,000

50,000 = $20

The manufacturer will realize this 20 percent ROI provided its costs and estimated sales turn out to be accurate. But what if sales don’t reach 50,000 units? The manufacturer can prepare a break-even chart to learn what would happen at other sales levels (see Figure 11.3). Fixed costs are stable, regardless of sales volume. Variable costs, not shown in the figure, rise with volume. Total costs equal the sum of fixed and variable costs. The total revenue curve starts at zero and rises with each unit sold.

The total revenue and total cost curves cross at 30,000 units. This is the break-even volume. We can verify it by the following formula:

Break@even volume = fixed cost

(price - variable cost) =

$300,000 $20 - $10

= 30,000

If the manufacturer sells 50,000 units at $20, it earns $200,000 on its $1 million investment, but much depends on price elasticity and competitors’ prices. Unfortunately, target-return pric- ing tends to ignore these considerations. The manufacturer needs to consider different prices and estimate their probable impacts on sales volume and profits. It should also search for ways to lower its fixed or variable costs because lower costs will decrease its required break-even volume.

Perceived-Value Pricing An increasing number of companies now base their price on the customer’s perceived value. Perceived value is made up of a host of inputs, such as the buyer’s

Figure 11.3 Break-Even Chart for Determining Target-Return Price and Break-Even Volume

40 50

800

1,000

600

400

200

1,200

D ol

la rs

( in

t ho

us an

ds )

3020100 Sales Volume in Units (thousands)

Fixed cost

Total cost

Target profit

Total revenue

Break-even point

Chapter 11 Developing Pricing Strategies and Programs 183

image of product performance, channel deliverables, warranty quality, customer support, and the supplier’s reputation. Companies must deliver the value promised by their value proposition, and the customer must perceive this value. Firms use other marketing program elements, such as advertising, the sales force, and the Internet, to communicate and enhance perceived value in buyers’ minds.

Even when a company claims its offering delivers more total value, not all customers will respond positively. Some care only about price. But there is also typically a segment that cares about quality. The key to perceived-value pricing is to deliver more unique value than competi- tors and to demonstrate this to prospective buyers.

Value Pricing Companies that adopt value pricing win loyal customers by charging a fairly low price for a high-quality offering. This requires reengineering the company’s operations to become a low-cost producer without sacrificing quality to attract a large number of value- conscious customers.

EDLP A retailer using everyday low pricing (EDLP) charges a constant low price with little or no price promotion or special sales. Constant prices eliminate week-to-week price uncer- tainty and the high-low pricing of promotion-oriented competitors. In high-low pricing, the retailer charges higher prices on an everyday basis but runs frequent promotions with prices temporarily lower than the EDLP level.21 The most important reason retailers adopt EDLP is that constant sales and promotions are costly and have eroded consumer confidence in every- day prices. Some consumers also have less time and patience for clipping coupons. Yet promo- tions and sales do create excitement and draw shoppers, so EDLP does not guarantee success and is not for everyone.22

Going-Rate Pricing In going-rate pricing, the firm bases its price largely on competi- tors’ prices. Smaller firms “follow the leader,” changing their prices when the market leader’s prices change. Some may charge a small premium or discount, but they preserve the difference. Going-rate pricing is quite popular. Where costs are difficult to measure or competitive re- sponse is uncertain, firms feel it is a good solution because they believe it reflects the industry’s collective wisdom.

Auction-Type Pricing Auction-type pricing is growing more popular, especially with elec- tronic marketplaces. English auctions, with ascending bids, have one seller and many buyers; bid- ders raise their offers until the highest bidder gets the item. There are two types of Dutch auctions, which feature descending bids. In the first, an auctioneer announces a high price and then slowly decreases the price until a bidder accepts. In the other, the buyer announces something he or she wants to buy, and potential sellers compete to offer the lowest price. In sealed-bid auctions, would- be suppliers submit only one bid; they cannot know the other bids. The U.S. government often uses this method to procure supplies. A supplier will not bid below its cost but cannot bid too high for fear of losing the job. The net effect of these two pulls is the bid’s expected profit.

Step 6: Selecting the Final Price Pricing methods narrow the range from which the company must select its final price. In se- lecting that price, the company must consider additional factors, including the impact of other marketing activities, company pricing policies, gain-and-risk-sharing pricing, and the impact of price on other parties.

Impact of Other Marketing Activities The final price must take into account the brand’s quality and advertising relative to the competition. When Paul Farris and David Reibstein

184 Part 4 Creating Value

examined the relationships among relative price, relative quality, and relative advertising for 227 consumer businesses, they found that brands with average relative quality but high relative ad- vertising budgets could charge premium prices because consumers were willing to pay more for known products.23 Brands with high relative quality and high relative advertising obtained the highest prices. Conversely, brands with low quality and low advertising charged the lowest prices. For market leaders, the positive relationship between high prices and high advertising held most strongly in the later stages of the product life cycle.

Company Pricing Policies The price must be consistent with company pricing policies. Although companies may establish pricing penalties under certain circumstances, they should use them judiciously and try not to alienate customers. Many companies set up a pricing depart- ment to develop policies and establish or approve decisions. The aim is to ensure salespeople quote prices that are reasonable to customers and profitable to the company.

Gain-and-Risk-Sharing Pricing Buyers may resist accepting a seller’s proposal because they perceive a high level of risk, such as in a big computer hardware purchase or a company health plan. The seller then has the option of offering to absorb part or all the risk if it does not deliver the full promised value. An increasing number of companies, especially B-to-B marketers, may have to stand ready to guarantee any promised savings but also participate in the upside if the gains are much greater than expected.

Impact of Price on Other Parties How will distributors and dealers feel about the contem- plated price?24 If they don’t make enough profit, they may choose not to bring the product to market. Will the sales force be willing to sell at that price? How will competitors react? Will sup- pliers raise their prices when they see the company’s price? Will the government intervene and prevent this price from being charged? For example, it is illegal for a company to set artificially high “regular” prices, then announce a “sale” at prices close to previous everyday prices.

Adapting the Price Companies usually do not set a single price but rather develop a pricing structure that reflects variations in geographical demand and costs, market-segment requirements, purchase tim- ing, order levels, delivery frequency, guarantees, service contracts, and other factors. As a result of discounts, allowances, and promotional support, a company rarely realizes the same profit from each unit of a product that it sells. Here we will examine several price-adaptation strategies: geographical pricing, price discounts and allowances, promotional pricing, and differentiated pricing.

Geographical Pricing (Cash, Countertrade, Barter) In geographical pricing, the company decides how to price its products to different customers in different locations and countries. Should the company charge higher prices to distant customers to cover higher shipping costs or a lower price to win additional business? How should it account for exchange rates and the strength of different currencies?

Another question is how to get paid. This issue is critical when buyers lack sufficient hard currency to pay for their purchases. Many want to offer other items in payment, a practice known as countertrade, and U.S. companies are often forced to accept if they want the busi- ness. One form of countertrade is barter, in which the buyer and seller directly exchange goods, with no money and no third party involved. A second form is a compensation deal, in which the

Chapter 11 Developing Pricing Strategies and Programs 185

seller receives some percentage of the payment in cash and the rest in products. A third form is a buyback agreement, as when the firm sells a plant, equipment, or technology to a company in an- other country and agrees to accept as partial payment products manufactured with the supplied equipment. A fourth form of countertrade is offset, where the firm receives full payment in cash for a sale overseas but agrees to spend a substantial amount of the money in that country within a stated time period.

Price Discounts and Allowances Most companies will adjust their list price and give discounts and allowances for early payment, volume purchases, and off-season buying (see Table 11.2). Companies must do this carefully or find their profits much lower than planned.25 Some product categories self-destruct by always being on sale. Manufacturers should consider the implications of supplying retailers at a discount because they may end up losing long-run profits in an effort to meet short-run volume goals. Upper management should conduct a net price analysis to arrive at the “real price” of the offering, which is affected by discounts and other expenses.

Promotional Pricing Companies can use several pricing techniques to stimulate early purchase:

• Loss-leader pricing. Stores often drop the price on well-known brands to stimulate store traffic. This pays if the revenue on the additional sales compensates for the lower loss-leader margins. Manufacturers of loss-leader brands typically object because this practice can dilute the brand image and bring complaints from retailers who charge the list price.

• Special event pricing. Sellers establish special prices in certain seasons to draw in more customers, such as back-to-school sales.

• Special customer pricing. Sellers offer special prices exclusively to certain customers, such as members of a brand community.

Table 11.2 Price Discounts and Allowances

Discount: A price reduction to buyers who pay bills promptly. A typical example is “2/10, net 30,” which means payment is due within 30 days and the buyer can deduct 2 percent by paying within 10 days.

Quantity Discount: A price reduction to those who buy large volumes. A typical example is “$10 per unit for fewer than 100 units; $9 per unit for 100 or more units.” Quantity discounts must be offered equally to all customers and must not exceed the cost savings to the seller. They can be offered on each order placed or on the number of units ordered over a given period.

Functional Discount: Discount (also called trade discount) offered by a manufacturer to trade-channel members if they perform certain functions, such as selling, storing, and record keeping. Manufacturers must offer the same functional discounts within each channel.

Seasonal Discount: A price reduction to those who buy merchandise or services out of season. Hotels and airlines offer seasonal discounts in slow selling periods.

allowance: An extra payment designed to gain reseller participation in special programs. Trade-in allowances are granted for turning in an old item when buying a new one. Promotional allowances reward dealers for participating in advertising and sales support programs.

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• Cash rebates. Auto companies and others offer cash rebates to encourage purchase of the manufacturers’ products within a specified time period, clearing inventories without cut- ting the stated list price.

• Low-interest financing. Instead of cutting its price, the company can offer low-interest financing.

• Longer payment terms. Sellers, especially mortgage banks and auto companies, stretch loans over longer periods and thus lower the monthly payments. Consumers often worry less about the cost (the interest rate) of a loan and more about whether they can afford the monthly payment.

• Warranties and service contracts. Companies can promote sales by adding a free or low-cost warranty or service contract.

• Psychological discounting. This strategy sets an artificially high price and then offers the product at substantial savings; for example, “Was $359, now $299.” The Federal Trade Commission and Better Business Bureau fight illegal discount tactics.

Promotional-pricing strategies are often a zero-sum game. If they work, competitors copy them and they lose their effectiveness. If they don’t work, they waste money that could have been put into other marketing tools, such as building up product quality and service or strengthening product image through advertising.

Differentiated Pricing Companies often adjust their basic price to accommodate differences among customers, prod- ucts, locations, and so on. Price discrimination occurs when a company sells a product or ser- vice at two or more prices that do not reflect a proportional difference in costs. In first-degree price discrimination, the seller charges a separate price to each customer depending on the intensity of his or her demand. In second-degree price discrimination, the seller charges less to buyers of larger volumes. In third-degree price discrimination, the seller charges different amounts to different classes of buyers. Examples include: charging students and senior citizens lower prices; pricing different versions of the product differently; pricing the same product at dif- ferent levels depending on image differences; charging differently for a product sold through dif- ferent channels; pricing a product differently at different locations; and varying prices by season, day, or time of day.

The airline and hospitality industries use yield management systems and yield pricing, offering discounted but limited early purchases, higher-priced late purchases, and the lowest rates on unsold inventory just before it expires. Airlines charge different fares to passengers on the same flight de- pending on the seating class, the time of day, the day of the week, and so on.

The phenomenon of offering different pricing schedules to different consumers and dy- namically adjusting prices is exploding. Online merchants selling their products on Amazon .com are changing their prices on an hourly or even minute-by-minute basis, in part so they can secure the top spot on search results.26 Even sports teams are adjusting ticket prices to reflect the popularity of the competitor and the timing of the game.27

Price discrimination works when (1) the market is segmentable and the segments show dif- ferent intensities of demand; (2) members in the lower-price segment cannot resell the product to the higher-price segment; (3) competitors cannot undersell the firm in the higher-price segment; (4) the cost of segmenting and policing the market does not exceed the extra revenue derived from price discrimination; (5) the practice does not breed customer resentment and ill will; and (6) the particular form of price discrimination is not illegal.28

Chapter 11 Developing Pricing Strategies and Programs 187

Initiating and Responding to Price Changes Companies often need to cut or raise prices.

Initiating Price Cuts Several circumstances might lead a firm to cut prices. One is excess plant capacity: The firm needs additional business and cannot generate it through increased sales effort, product im- provement, or other measures. Companies sometimes initiate price cuts in a drive to dominate the market through lower costs. Either the company starts with lower costs than its competitors, or it initiates price cuts in the hope of gaining market share and lower costs.

Cutting prices to keep customers or beat competitors often encourages customers to demand price concessions, however, and trains salespeople to offer them.29 A price-cutting strategy can lead to other possible traps. Consumers might assume quality is low, or the low price buys market share but not market loyalty—because customers switch to lower-priced firms. Also, higher- priced competitors might match the lower prices but have longer staying power because of deeper cash reserves. Finally, lowering prices might trigger a price war.30

Initiating Price Increases A successful price increase can raise profits considerably. If the company’s profit margin is 3 percent of sales, a 1 percent price increase will increase profits by 33 percent if sales volume is unaffected. A major circumstance provoking price increases is cost inflation. Rising costs unmatched by pro- ductivity gains squeeze profit margins and lead companies to regular rounds of price increases. Companies often raise their prices by more than the cost increase, in anticipation of further infla- tion or government price controls, in a practice called anticipatory pricing.

Another factor leading to price increases is overdemand. When a company cannot supply all its customers, it can raise its prices, ration supplies, or both. Although there is always a chance a price increase can carry some positive meanings to customers—for example, that the item is “hot” and represents an unusually good value—consumers generally dislike higher prices. To avoid sticker shock and a hostile reaction when prices rise, the firm should give customers advance notice so they can do forward buying or shop around. Sharp price increases also need to be ex- plained in understandable terms.

Anticipating Competitive Responses How can a firm anticipate a competitor’s reactions? One way is to assume the competitor reacts in the standard way to a price being set or changed. Another is to assume the competitor treats each price difference or change as a fresh challenge and reacts according to self-interest at the time. Now the company will need to research the competitor’s current financial situation, recent sales, customer loyalty, and corporate objectives. If the competitor has a market share objective, it is likely to match price differences or changes.31 If it has a profit-maximization objective, it may react by increasing its advertising budget or improving product quality.

Responding to Competitors’ Price Changes In responding to competitive price cuts, the company must consider the product’s stage in the life cycle, its importance in the company’s portfolio, the competitor’s intentions and resources, the market’s price and quality sensitivity, the behavior of costs with volume, and the company’s alternative opportunities. In markets characterized by high product homogeneity, the firm can enhance its augmented product or meet the price reduction. If the competitor raises its price in a

188 Part 4 Creating Value

homogeneous product market, other firms might not match it if the increase will not benefit the industry as a whole. Then the leader will need to roll back the increase.

In nonhomogeneous product markets, a firm should consider why the competitor changed the price. Was it to steal the market, to utilize excess capacity, to meet changing cost conditions, or to lead an industry-wide price change? Is the competitor’s price change temporary or perma- nent? What will happen to the company’s market share and profits if it does not respond? Are other companies going to respond? And how are competitors and other firms likely to respond to each possible reaction?

Executive Summary Price is the only marketing element that produces revenue; the others produce costs. Consumers often actively process price information within the context of prior purchasing experience, for- mal and informal communications, point-of-purchase or online resources, and other factors. In setting pricing policy, a company follows six steps: (1) select the pricing objective; (2) determine demand; (3) estimate costs; (4) analyze competitors’ costs, prices, and offers; (5) select a pricing method; and (6) select the final price. Price-adaptation strategies include geographical pricing, price discounts and allowances, promotional pricing, and discriminatory pricing. Price-setting methods include markup pricing, target-return pricing, perceived-value pricing, value pricing, EDLP, going-rate pricing, and auction-type pricing.

A price decrease might be brought about by excess plant capacity, declining market share, a desire to dominate the market through lower costs, or economic recession. A price increase might be brought about by cost inflation or overdemand. Companies must carefully manage customer perceptions when raising prices. Also, they should anticipate competitor price changes and prepare contingent responses, including maintaining or changing price or quality. When fac- ing competitive price changes, the firm should try to understand the competitor’s intent and the likely duration of the change.

Notes

1. “Ryanair Food Costs More than Price of Flight,” The Telegraph, August 28, 2012; Simon Calder, “Ryanair Unveils Its Latest Plan to Save Money: Remove Toilets from the Plane,” The Independent, October 12, 2011; Peter J. Howe, “The Next Pinch: Fees to Check Bags,” Boston Globe, March 8, 2007; Kerry Capel, “‘Wal-Mart with Wings,’” BusinessWeek, November 27, 2006, pp. 44–45; Renee Schultes, “Ryanair Could Hold Altitude in Airline Descent,” Wall Street Journal, July 6, 2014.

2. Tomio Geron, “The Share Economy,” Forbes, February 11, 2013.

3. Christian Homburg, Ove Jensen, and Alexander Hahn, “How to Organize Pricing? Vertical Delegation and Horizontal Dispersion of Pricing Authority,” Journal of Marketing 76 (September 2012), pp. 49–69.

4. For a review of pricing research, see Chezy Ofir and Russell S. Winer, “Pricing: Economic and Behavioral

Models,” Bart Weitz and Robin Wensley, eds., Handbook of Marketing (London: Sage Publications, 2002). For a recent sampling of some research on consumer processing of prices, see Ray Weaver and Shane Frederick, “A Reference Price Theory of the Endowment Effect,” Journal of Marketing Research 49 (October 2012), pp. 696–707; and Kwanho Suk, Jiheon Lee, and Donald R. Lichtenstein, “The Influence of Price Presentation Order on Consumer Choice,” Journal of Marketing Research 49 (October 2012), pp. 708–17.

5. Hooman Estalami, Alfred Holden, and Donald R. Lehmann, “Macro-Economic Determinants of Consumer Price Knowledge: A Meta-Analysis of Four Decades of Research,” International Journal of Research in Marketing 18 (December 2001), pp. 341–55.

Chapter 11 Developing Pricing Strategies and Programs 189

6. For a comprehensive review, see Tridib Mazumdar, S. P. Raj, and Indrajit Sinha, “Reference Price Research: Review and Propositions,” Journal of Marketing 69 (October 2005), pp. 84–102. For a different point of view, see Chris Janiszewski and Donald R. Lichtenstein, “A Range Theory Account of Price Perception,” Journal of Consumer Research 25 (March 1999), pp. 353–68. For business-to-business applications, see Hernan A. Bruno, Hai Che, and Shantanu Dutta, “Role of Reference Price on Price and Quantity: Insights from Business-to-Business Markets,” Journal of Marketing Research 49 (October 2012), pp. 640–54.

7. Ritesh Saini, Raghunath Singh Rao, and Ashwani Monga, “Is the Deal Worth My Time? The Interactive Effect of Relative and Referent Thinking on Willingness to Seek a Bargain,” Journal of Marketing 74 (January 2010), pp. 34–48.

8. John T. Gourville, “Pennies-a-Day: The Effect of Temporal Reframing on Transaction Evaluation,” Journal of Consumer Research 24 (March 1998), pp. 395–408. See also Anja Lambrecht and Catherine Tucker, “Paying with Money or Effort: Pricing when Customers Anticipate Hassle,” Journal of Marketing Research 49 (February 2012), pp. 66–82.

9. Wilfred Amaldoss and Sanjay Jain, “Pricing of Conspicuous Goods: A Competitive Analysis of Social Effects,” Journal of Marketing Research 42 (February 2005), pp. 30–42.

10. Mark Stiving and Russell S. Winer, “An Empirical Analysis of Price Endings with Scanner Data,” Journal of Consumer Research 24 (June 1997), pp. 57–68.

11. Eric T. Anderson and Duncan Simester, “Effects of $9 Price Endings on Retail Sales: Evidence from Field Experiments,” Quantitative Marketing and Economics 1 (March 2003), pp. 93–110.

12. Katherine N. Lemon and Stephen M. Nowlis, “Developing Synergies between Promotions and Brands in Different Price-Quality Tiers,” Journal of Marketing Research 39 (May 2002), pp. 171–85; but see also Serdar Sayman, Stephen J. Hoch, and Jagmohan S. Raju, “Positioning of Store Brands,” Marketing Science 21 (Fall 2002), pp. 378–97.

13. Shantanu Dutta, Mark J. Zbaracki, and Mark Bergen, “Pricing Process as a Capability: A Resource-Based Perspective,” Strategic Management Journal 24 (July 2003), pp. 615–30.

14. Wilfred Amaldoss and Chuan He, “Pricing Prototypical Products,” Marketing Science 32 (September–October 2013), pp. 733–52.

15. Timothy Aeppel, “Seeking Perfect Prices, CEO Tears Up the Rules,” Wall Street Journal, March 27, 2007.

16. Joo Heon Park and Douglas L. MacLachlan, “Estimating Willingness to Pay with Exaggeration Bias- Corrected Contingent Valuation Method,” Marketing Science 27 (July–August 2008), pp. 691–98.

17. Thomas T. Nagle, John E. Hogan, and Joseph Zale, The Strategy and Tactics of Pricing, 5th ed. (Upper Saddle River, NJ: Pearson, 2011)

18. Brett R. Gordon, Avi Goldfarb, and Yang Li, “Does Price Elasticity Vary with Economic Growth? A Cross-Category Analysis,” Journal of Marketing Research 50 (February 2013), pp. 4–23. See also Harald J. Van Heerde, Maarten J. Gijsenberg, Marnik G. Dekimpe, and Jan-Benedict E. M. Steenkamp, “Price and Advertising Effectiveness over the Business Cycle,” Journal of Marketing Research 50 (April 2013), pp. 177–93.

19. Tammo H. A. Bijmolt, Harald J. Van Heerde, and Rik G. M. Pieters, “New Empirical Generalizations on the Determinants of Price Elasticity,” Journal of Marketing Research 42 (May 2005), pp. 141–56.

20. Marco Bertini, Luc Wathieu, and Sheena S. Iyengar, “The Discriminating Consumer: Product Proliferation and Willingness to Pay for Quality,” Journal of Marketing Research 49 (February 2012), pp. 39–49.

21. Michael Tsiros and David M. Hardesty, “Ending a Price Promotion: Retracting It in One Step or Phasing It Out Gradually,” Journal of Marketing 74 (January 2010), pp. 49–64.

22. Paul B. Ellickson, Sanjog Misra, and Harikesh S. Nair, “Repositioning Dynamics and Pricing Strategy,” Journal of Marketing Research 49 (December 2012), pp. 750–72.

23. Paul W. Farris and David J. Reibstein, “How Prices, Expenditures, and Profits Are Linked,” Harvard Business Review, November–December 1979, pp. 173–84.

24. Joel E. Urbany, “Justifying Profitable Pricing,” Journal of Product and Brand Management 10 (2001), pp. 141–57; Charles Fishman, “The Wal-Mart You Don’t Know,” Fast Company, December 2003, pp. 68–80.

25. Kusum L. Ailawadi, Scott A. Neslin, and Karen Gedenk, “Pursuing the Value-Conscious Consumer,” Journal of Marketing 65 (January 2001), pp. 71–89.

26. “Increasing Revenue and Reducing Workload Using Yield Management Software,” Globe Newswire, March 12, 2013; Julia Angwin and Dana Mattioli, “Coming Soon: Toilet Paper Priced Like Airline Tickets,” Wall Street Journal, September 5, 2012.

27. Andrea Rothman, “Greyhound Taps Airline Pricing Models to Boost Profit,” www.bloomberg.com, May 21, 2013; Bill Saporito, “This Offer Won’t Last! Why

190 Part 4 Creating Value

Sellers Are Switching to Dynamic Pricing,” Time, January 21, 2013, p. 56; Patrick Rishe, “Dynamic Pricing: The Future of Ticket Pricing in Sports,” Forbes, January 6, 2012.

28. Felix Salmon, “Why the Internet Is Perfect for Price Discrimination,” Reuters, September 3, 2013. For more information about specific types of price discrimination that are illegal, see Henry Cheeseman, Business Law, 8th ed. (Upper Saddle River, NJ: Pearson, 2013).

29. Bob Donath, “Dispel Major Myths about Pricing,” Marketing News, February 3, 2003, p. 10.

30. Harald J. Van Heerde, Els Gijsbrechts, and Koen Pauwels, “Winners and Losers in a Major Price War,” Journal of Marketing Research 45 (October 2008), pp. 499–518.

31. Kusum L. Ailawadi, Donald R. Lehmann, and Scott A. Neslin, “Market Response to a Major Policy Change in the Marketing Mix,” Journal of Marketing 65 (January 2001), pp. 44–61.