Pricing Calcula�onsWeek 6
PRICING CALCULATIONS
In order to teach different pricing methods and to do a really cool and thorough example of the valuepricing framework, in this section I go over the HBS case, Atlantic Computer. Please read the case beforeproceeding.
Fou r p r i c i ng me thods
On page 6 of the case, Jason Jowers delineates the four pricing methods he can go for. Expand each tab below for a detailed explanationof each of these four choices.
Status Quo Pricing
Price just the hardware (Tronn servers) and give the software (PESA) free, as AC has done so far. Based on exhibit 3, the price wouldbe $2,000 per server, so the total would be $4,000.
1. Pros: This method doesn’t rock the boat: it is easy for the sales people to sell it to consumers because they understand itand are used to it (i.e. that’s their reference price scheme). In addition, since the price itself is pretty low in comparison to
what consumers are getting (the power of 4 servers in 2 servers) and in comparison to what they can get from competitors,it should be easy to capture the market for basic servers, which is roughly 200,000 units over the next two years (exhibit 1).
2. Cons: price is too low and doesn’t capture the amazing value customers get from the software.
Compe��on Based Pricing
In this pricing strategy, the company is pricing based on what consumers would pay had they bought the closest competitor. In this caseit would be Ontario Zink servers, and they would need 4 of them. The price Ontario charges is $1700, so for 4 servers, they’d charge$6,800. In competition based pricing we aim for the final price to be the same, but the break down can take different forms. In this case,it can be:
2 Tronn servers 2 × $2,000 = $4,000
2 PESA software (one per server) ??
Total $6,800
Which means that the price of 2 PESAs should be $2,800 (i.e. each one is $1,400).
1. Pros: easy for the sales people to sell this price because it is equivalent to what customers would pay if they choose thecompetitor’s product—i.e. that’s their reference price. In this scheme, AC is getting compensated for the software, which is greatfor capturing its value.
2. Cons: Sales people will need to explain why AC is deviating from its traditional method of not pricing the software. It is possiblethat this price doesn’t capture all of customer value, and hence may still be too low.
Cost Plus Pricing
In this pricing strategy, the company is pricing based on its costs and sale volume, so some assumptions need to be made as well asthoroughly thought through (i.e., better err on the side of caution and make conservative assumptions). To follow the calculations below,
read footnote 5 on page 6 and check out exhibit 1:
2001 2002 2003 Total
Servervolume
Market share = 4% of the basic segment = 0.04 ×50,000 = 2,000
9% × 70,000 = 6,300 14% × 92,000 =12,880
21,180 servers
PESAvolume 50% attachment rate = 1,000 3,150 6,440
10,590 servers w/PESA
Next we calculate the cost of PESA:
R&D costs for Atlantic to develop PESA = $2,000,000 (see bottom of page 10). In the near future, it is expected that 10,590 units willbe sold, hence the average cost per unit = $2,000,000/10,590 = $188.86Based on footnote 5, the target margin is 30%. Hence the target price is $188.86 × 1.3 = $245.51
Therefore the price for two servers with PESA based on cost plus is 2×($2,000 + $245.51) = $4,491, which is much lower than the pricebased on competitor’s prices.
Value Pricing
In this pricing strategy, the company is pricing based on the value the product’s benefits provide customers, including whatever saving itcreates. But the savings have to be concrete and tangible, otherwise they are just a slogan (as the case suggested on page 7).
To do value pricing, let’s examine exhibits 2-3 carefully and compare the new product (Tronn+PESA) to the old product. Since we’reworking in multiples of 4, we will compare 4 “old” servers with 2 new servers that have PESA loaded on.
The table below calculates the cost of each of the old options (i.e. what can be saved by not using these options):
4 Atlantic Tronn servers 4 Ontario Zink servers
Hardware 4 × $2,000 = $8,000 4 × $1,700 = $6,800
Labor (annual) 4 × ($80,000 / 40) = $8,000 4 × ($80,000 / 40) = $8,000
Electricity (annual) 4 × $250 = $1,000 4 × $250 = $1,000
App license (annual) 4 × $750 = $3,000 4 × $750 = $3,000
Total $20,000 $18,800
However, now we should add the cost of the new option, 2 Tronn servers loaded with PESA:
2 Atlantic tronn + PESA SAVINGS
Hardware 2 × $2,000 = $4,000 $6,800 – $4,000 = $2,800
Labor (annual) 2 × ($80,000 / 40) = $4,000 $8,000 – $4,000 = $4,000
Electricity (annual) 2 × $250 = $500 $1,000 – $500 = $500
App license (annual) 2 × $750 = $1,500 $3,000 – $1,500 = $1,500
What i s t he revenue f o r each op t i on?
2 Atlantic tronn + PESA SAVINGS
Total saving $8,800
So in total the new PESA software can save customers $8,800 (after they pay $4,000 for the two servers). The question is how to pricePESA?
If AC wants to capture the entire customer value, then the price should be $8,800 / 2 = $4,400 per PESA (one PESA per machine).That would make the whole deal price $12,800.But based on footnote 6 on page 6, we should assume that the cost saving would split 50-50 between AC and customers.Therefore, the price of 2 PESA can be at most $8,800/2 = $4,400, and the whole deal (including the two Tronn servers) would be$8,400.
ssuming that AC sells 10,590 servers with PESA over the next three years (based on the cost plus calculations above), then this tableelow illustrates how much money it will bring in in each option. Consider your thoughts, then click to reveal the table
Click to reveal the revenue from each option
Price Total
Status quo $4,000 $42,360,000
Price Total
Competition $6,800 $72,012,000
Cost plus $4,491 $47,559,690
Max value $12,800 $135,552,000
Shared value $8,400 $88,956,000
Therefore, compared with the status quo pricing, in which PESA is given for free, competition pricing, and value pricing can createsignificant additional revenues for AC.
