Firms utilize strategies such as price and promotional reduction to minimize cost, maximize revenue, and thereby optimize profits.
Explain managerial methods of profit optimization
- Firms can employ a number of methods to optimize profit including employing yield management and revenue optimization strategies.
- Yield optimization is the practice of using models to analyze data and information to forecast the best quantity of output a firm should produce to meet the total demand, thereby optimizing revenue.
- Optimization attempts to take information on a firm’s operating constraints, market demand, and factors influencing these to find the optimal selling prices and optimal production quantities for a firm’s goods.
- Revenue optimization is the mathematical process of finding the highest possible revenue a firm can make, using quadratic equations.
- Revenue optimization: A method of finding the best possible combination of output and price level to give the most possible revenue.
- revenue: the total income received from a given source
- yield management: The analysis of qualitative and quantitative information on factors driving demand for a good in order to forecast the most profitable production decisions for a firm.
Traditional profit optimization includes methods for reduction of pricing, promotional, and markdown losses.
Yield management can help firms optimize profits. Firms that engage in yield management usually do so via computer yield management systems, and periodically review transactions for goods or services already supplied as well as those being supplied in the future. They may also review information (including statistics) about events (known future events such as holidays, or unexpected past events such as terrorist attacks), competitive information (including prices), seasonal patterns, and other pertinent factors affecting sales. The models use market segment and price point to forecast total demand for all products or services they provide. Since total demand normally exceeds what the particular firm can produce in that period, the models attempt to optimize the firm’s outputs to maximize revenue. This optimization seeks to address key questions, such as: “Given our operating constraints, what is the best mix of products and/or services for us to produce and sell in the period; and at what prices do we sell those products and/or services to generate the highest expected revenue? ” Optimization can help the firm adjust prices and allocate capacity among market segments to maximize expected revenues. This can be done at different levels:
- By goods (such as a seat on a flight or a seat at an opera production)
- By group of goods (such as the entire opera house or all seats on a flight)
- By market (such as sales from Seattle and Minneapolis for a flight via Seattle-Minneapolis-Boston)
- Overall (such as on all routes of an airline, or on all seats during an opera production season)
Revenue optimization is a method of determining ‘optimal’ profits or expenditures, and can be related to quadratics, as the vertex of a parabola can illustrate the point where the ‘maximum’ revenue can be attained. Revenue optimization requires finding the x-intercepts and vertex, which can be done utilizing the quadratic formula (x-intercepts), and completing the square (vertex/ maximum). By finding these, one can then determine the highest or lowest cost and where the costs and quantities must lie in accordance to the vertex. This method is effective for maximizing profits for companies and families, as it can ensure the highest profit for sales and the lowest amounts for expenditures.
Return on Investment
Return on investment (ROI) is one way of considering profits in relation to capital invested.
Explain the effect of marketing on return on investment (ROI)
- Marketing not only influences net profits but also can affect investment levels, too. New plants and equipment, inventories, and accounts receivable are three of the main categories of investments that can be affected by marketing decisions.
- The purpose of the ” return on investment ” metric is to measure per-period rates of return on dollars invested in an economic entity.
- Return on investment (%) = Net profit ($) / Investment ($) × 100; or: Return on investment = (gain from investment – cost of investment) / cost of investment.
- Interest on a second (or refinanced) loan may increase, and loan fees may be charged, both of which can reduce the ROI when the new numbers are used in the ROI equation.
- return on investment: One way of considering profits in relation to capital invested.
- profits: Collective form of profit.
Return on Investment
Return on investment (ROI) is one way of considering profits in relation to capital invested. Return on assets (ROA), return on net assets (RONA), return on capital (ROC) and return on invested capital (ROIC) are similar measures with variations on how ‘investment’ is defined.
Marketing not only influences net profits but also can affect investment levels too. New plants and equipment, inventories, and accounts receivable are three of the main categories of investments that can be affected by marketing decisions.
In a survey of nearly 200 senior marketing managers, 77 percent responded that they found the “return on investment” metric very useful.
The purpose of the “return on investment” metric is to measure per-period rates of return on dollars invested in an economic entity. ROI and related metrics (ROA, ROC, RONA and ROIC) provide a snapshot of profitability adjusted for the size of the investment assets tied up in the enterprise. Marketing decisions have obvious potential connection to the numerator of ROI (profits), but these same decisions often influence asset usage and capital requirements (for example, receivables and inventories). Marketers should understand the position of their company and the returns expected. ROI is often compared to expected (or required) rates of return on dollars invested.
For a single-period review, just divide the return (net profit) by the resources that were committed (investment):
Return on investment (%) = Net profit ($) / Investment ($) × 100
Return on investment = (gain from investment – cost of investment) / cost of investment
Problems in Calculating ROI
Complications in calculating ROI can occur when a real estate property is refinanced, or a second mortgage is taken out. For example, interest on a second (or refinanced) loan may increase or loan fees may be charged. Both of these factors can reduce the ROI when the new numbers are used in the ROI equation. There may also be an increase in maintenance costs and property taxes, or an increase in utility rates if the owner of a residential rental or commercial property pays these expenses.
Complex calculations may also be required for property bought with an adjustable rate mortgage (ARM) with a variable escalating rate charged annually through the duration of the loan. (To know more about ARM, check out: Mortgages: Fixed-Rate Versus Adjustable-Rate. )
Market share is an indicator of how well a firm is doing against its competitors and can often be influenced through pricing.
Explain the importance of market share
- Market share, usually measured as a percentage of a market’s total revenue captured by a single entity, is a key indicator of market competitiveness.
- Managers can use market share data to evaluate a firm’s overall performance, market demand, market growth, and customer preference trends.
- Market share is measured by looking at a firm’s sales revenue as a percentage of the total market revenue.
- Market Share: The percentage amount of a market captured by a single firm
Market share is the percentage of a market (defined in terms of either units or revenue) accounted for by a specific entity.
Market share is a key indicator of market competitiveness—that is, how well a firm is doing in terms of its competition. This metric, supplemented by changes in sales revenue, helps managers evaluate both primary and selective demand in their market. It enables them to judge not only total market growth or decline, but also trends in customers’ selections among competitors. Generally, sales growth resulting from primary demand (total market growth) is less costly and more profitable than that achieved by capturing share from competitors. Conversely, losses in market share can signal serious long-term problems that require strategic adjustments. Firms with market shares below a certain level may not be viable. Similarly, within a firm’s product line, market share trends for individual products are considered early indicators of future opportunities or problems.
Increasing market share is one of the most important objectives of business. The main advantage of using market share as a measure of business performance is that it is less dependent upon macroenvironmental variables, such as the state of the economy or changes in tax policy. However, increasing market share may be dangerous for makers of fungible hazardous products, particularly products sold into the United States market, where they may be subject to market share liability.
Although market share is likely the single most important marketing metric, there is no generally acknowledged best method for calculating it. This is unfortunate as different methods may yield not only different computations of market share at a given moment but also widely divergent trends over time. The reasons for these disparities include variations in the lenses through which share is viewed (units versus dollars), where in the channel the measurements are taken (shipments from manufacturers versus consumer purchases), market definition (scope of the competitive universe), and measurement error.
Demanding a Premium
Firms can engage in premium pricing by keeping the price of their good artificially higher than the benchmark price.
Explain why business owners sometimes price at a premium
- Premium pricing is used to maximize profit in areas where customers are happy to pay more, where there are no substitutes for the product, where there are barriers to entering the market, or when the seller cannot save on costs by producing at a high volume.
- More expensive items are perceived to be of better quality or have a better reputation by virtue of their price.
- Luxury has a psychological association with price premium pricing.
- prestige: The quality of how good the reputation of something or someone is.
- Price premium: The percentage by which a product’s selling price exceeds a benchmark price.
Pricing strategies for products or services encompass three main ways to improve profits. The business owner can cut costs or sell more, or find more profit with a better pricing strategy. When costs are already at their lowest and sales are hard to find, adopting a better pricing strategy is a key option to stay viable.
Premium pricing is the practice of keeping the price of a product or service artificially high in order to encourage favorable perceptions among buyers, based solely on the price. The practice is intended to exploit the (not necessarily justifiable) tendency for buyers to assume that expensive items enjoy an exceptional reputation or represent exceptional quality and distinction. A premium pricing strategy involves setting the price of a product higher than similar products. This strategy is sometimes also called skim pricing because it is an attempt to “skim the cream” off the top of the market. It is used to maximize profit in areas where customers are happy to pay more, where there are no substitutes for the product, where there are barriers to entering the market, or when the seller cannot save on costs by producing at a high volume. It is also called image pricing or prestige pricing.
Luxury has a psychological association with price premium pricing. The implication for marketing is that consumers are willing to pay more for certain goods and not for others. To the marketer, it means creating a brand equity or value for which the consumer is willing to pay extra. Marketers view luxury as the main factor diﬀerentiating a brand in a product category.
Status-Quo Pricing of Existing Products
Status quo pricing is the practice of maintaining current price levels that other firms are charging.
Compare Nagle and Holden’s nine laws of price sensitivity with status-quo pricing
- Pricing strategies for products or services encompass three main ways to improve profits. These are that the business owner can cut costs or sell more, or find more profit with a better pricing strategy.
- Merely raising prices is not always the answer, especially in a poor economy. One strategy does not fit all, so adopting a pricing strategy is a learning curve when studying the needs and behaviors of customers and clients.
- Status-quo pricing advantages: Avoids price competition that can damage the company. Disadvantages: Because the price may not grab the customer’s interest, businesses may have to attract customers in other ways. Also, these prices may barely cover production costs, resulting in low profits.
- status-quo pricing: The practice of pricing goods such that the current market price level is maintained.
Pricing strategies for products or services encompass three main methods of improving profits: the business owner can cut costs, sell more, or implement a better pricing strategy. When costs are already at their lowest and increasing sales becomes difficult, adopting a better pricing strategy may be a key option for staying viable.
However, merely raising prices is not always the best solution, particularly in poorer economies. Many businesses fold because as a result of pricing themselves out of the marketplace. On the other hand, many business and sales staff leave “money on the table”. One strategy does not fit all, so adopting a pricing strategy is a learning curve—studying the needs and behaviors of customers and clients is essential.
Nine Laws of Price Sensitivity and Consumer Psychology
In their book The Strategy and Tactics of Pricing, Thomas Nagle and Reed Holden outline nine “laws”—factors they say influence how a consumer perceives a given price, and how price-sensitive they may be with respect to different purchase decisions.
- Reference Price Effect: Buyer’s price sensitivity for a given product increases the higher the product’s price relative to perceived alternatives. Perceived alternatives can vary by buyer segment, occasion, or other factors.
- Difficult Comparison Effect: Buyers are less sensitive to the price of a known or more reputable product when they have difficulty comparing it to potential alternatives.
- Switching Costs Effect: The higher the product-specific investment a buyer must make to switch suppliers, the less price sensitive that buyer is when choosing between alternatives.
- Price-Quality Effect: Buyers are less sensitive to price the more higher prices signal higher quality. Products for which this effect is particularly relevant include image products, exclusive products, and products with minimal cues for quality.
- Expenditure Effect: Buyers are more price sensitive when the expense accounts for a large percentage of buyers’ available income or budget.
- End- Benefit Effect: This effect refers to the relationship of a given purchase to a larger overall benefit, and is divided into two parts. The first, derived demand, referes to buying sensitivity relative to the price of the end benefit; the more sensitive they will be to the prices of those products that contribute to that benefit. The second, price proportion cost refers to the percent of the total cost of the end benefit accounted for by a given component that helps produce the end benefit (e.g., CPU and PCs). The smaller the given components share of the total cost of the end benefit, the less sensitive buyers will be to the component’s price.
- Shared-cost Effect: The smaller the portion of the purchase price buyers must pay for themselves, the less price sensitive they will be.
- Fairness Effect: Buyers are more sensitive to the price of a product when the price is outside the range they perceive as “fair” or “reasonable” given the purchase context.
- The Framing Effect: Buyers are more price sensitive when they perceive the price as a loss rather than a forgone gain, and they have greater price sensitivity when the price is paid separately rather than as part of a bundle.
Status-quo pricing, also known as competition pricing, involves maintaining existing prices (status quo) or basing prices on the prices of competitor firms.
Advantages: Avoids price competition that can damage the company.
Disadvantages: Because the price will not grab the customer’s interest, businesses must attract customers in other ways. Also, these prices may barley cover production costs, resulting in low profits.