Determining price is one of the most important marketing-mix decisions. The limiting factors are demand and costs. Demand factors, such as buyer-perceived value, set the price ceiling. The company’s costs set the price floor. In between these two factors, marketers must consider competitors’ prices and other factors such as reseller requirements, government regulations, and company objectives.

Most current competing internet streaming products sell at retail prices between $100 and $500. We first consider HD’s pricing decision from a cost perspective. Then, we consider consumer value, the competitive environment, and reseller requirements.

HD starts with the cost-based approach to pricing discussed in Chapter 10. Recall that the simplest method, cost-plus pricing (or markup pricing), simply adds a standard markup to the cost of the product. To use this method, however, HD must specify expected unit sales so that total unit costs can be determined. Unit variable costs will remain constant regardless of the output, but average unit fixed costs will decrease as output increases.

To illustrate this method, suppose HD has fixed costs of $20 million, and variable costs of $125 per unit and expects unit sales of 1 million players. Thus, the cost per unit is given by:

Note that we do not include the initial investment of $10 million in the total fixed cost figure. It is not considered a fixed cost because it is not a relevant cost. Relevant costs are those that will occur in the future and that will vary across the alternatives being considered. HD’s investment to refurbish the manufacturing facility was a one-time cost that will not reoccur in the future. Such past costs are sunk costs and should not be considered in future analyses.

Also notice that if HD sells its product for $145, the price is equal to the total cost per unit. This is the break-even price—the price at which unit revenue (price) equals unit cost and profit is zero.

Suppose HD does not want to merely break even but rather wants to earn a 25% markup on sales. HD’s markup price is:ⁱ

This is the price at which HD would sell the product to resellers such as wholesalers or retailers to earn a 25% profit on sales.

Another approach HD could use is called return on investment (ROI) pricing (or target-return pricing). In this case, the company would consider the initial $10 million investment, but only to determine the dollar profit goal. Suppose the company wants a 30% return on its investment. The price necessary to satisfy this requirement can be determined by:

That is, if HD sells its product for $148, it will realize a 30% return on its initial investment of $10 million.

In these pricing calculations, unit cost is a function of the expected sales, which were estimated to be 1 million units. But what if actual sales were lower? Then the unit cost would be higher because the fixed costs would be spread over fewer units, and the realized percentage markup on sales or ROI would be lower. Alternatively, if sales are higher than the estimated 1 million units, unit cost would be lower than $145, so a lower price would produce the desired markup on sales or ROI. It’s important to note that these cost-based pricing methods are internally focused and do not consider demand, competitors’ prices, or reseller requirements. Because HD will be selling this product to consumers through wholesalers and retailers offering competing brands, the company must consider markup pricing from this perspective.

Whereas costs determine the price floor, HD also must consider external factors when setting price. HD does not have the final say concerning the final price of its product to consumers—retailers do. So it must start with its suggested retail price and work back. In doing so, HD must consider the markups required by resellers that sell the product to consumers.

In general, a dollar markup is the difference between a company’s selling price for a product and its cost to manufacture or purchase it. For a retailer, then, the markup is the difference between the price it charges consumers and the cost the retailer must pay for the product. Thus, for any level of reseller:

Markups are usually expressed as a percentage, and there are two different ways to compute markups—on cost or on selling price:

To apply reseller margin analysis, HD must first set the suggested retail price and then work back to the price at which it must sell the product to a wholesaler. Suppose retailers expect a 30% margin and wholesalers want a 20% margin based on their respective selling prices. And suppose that HD sets a manufacturer’s suggested retail price (MSRP) of $299.99 for its product.

HD selected the $299.99 MSRP because it is lower than most competitors’ prices but is not so low that consumers might perceive it to be of poor quality. And the company’s research shows that it is below the threshold at which more consumers are willing to purchase the product. By using buyers’ perceptions of value and not the seller’s cost to determine the MSRP, HD is using value-based pricing. For simplicity, we will use an MSRP of $300 in further analyses.

To determine the price HD will charge wholesalers, we must first subtract the retailer’s margin from the retail price to determine the retailer’s cost $(\text{\$}300–(\text{\$}300\times 0.30)=\text{\$}210)$. The retailer’s cost is the wholesaler’s price, so HD next subtracts the wholesaler’s margin $(\text{\$}210–(\text{\$}210\times 0.20)=\text{\$}168)$. Thus, the markup chain representing the sequence of markups used by firms at each level in a channel for HD’s new product is:

By deducting the markups for each level in the markup chain, HD arrives at a price for the product to wholesalers of $168.

The previous analyses derived a value-based price of $168 for HD’s product. Although this price is higher than the break-even price of $145 and covers costs, that price assumed a demand of 1 million units. But how many units and what level of dollar sales must HD achieve to break even at the $168 price? And what level of sales must be achieved to realize various profit goals? These questions can be answered through break-even and margin analysis.

Although it is useful to know the break-even point, most companies are more interested in making a profit. Assume HD would like to realize a $5 million profit in the first year. How many must it sell at the $168 price to cover fixed costs and produce this profit? To determine this, HD can simply add the profit figure to fixed costs and again divide by the unit contribution to determine unit sales:

Thus, to earn a $5 million profit, HD must sell 581,396 units. Multiply by price to determine dollar sales needed to achieve a $5 million profit:

Or use the contribution margin:

Again, note that the difference between the two break-even sales calculations is due to rounding.

As we saw previously, a profit goal can also be stated as a return on investment goal. For example, recall that HD wants a 30% return on its $10 million investment. Thus, its absolute profit goal is $3 million $(\text{\$}10,000,000\times 0.30)$. This profit goal is treated the same way as in the previous example:ⁱⁱ

Or

Finally, HD can express its profit goal as a percentage of sales, which we also saw in previous pricing analyses. Assume HD desires a 25% return on sales. To determine the unit and sales volume necessary to achieve this goal, the calculation is a little different from the previous two examples. In this case, we incorporate the profit goal into the unit contribution as an additional variable cost. Look at it this way: If 25% of each sale must go toward profits, that leaves only 75% of the selling price to cover fixed costs. Thus, the equation becomes:

So,

Thus, HD would need more than $3 billion in sales to realize a 25% return on sales given its current price and cost structure! Could it possibly achieve this level of sales? The major point is this: Although break-even analysis can be useful in determining the level of sales needed to cover costs or to achieve a stated profit goal, it does not tell the company whether it is possible to achieve that level of sales at the specified price. To address this issue, HD needs to estimate demand for this product.

Before moving on, however, let’s stop here and practice applying the concepts covered so far. Now that you have seen pricing and break-even concepts in action as they relate to HD’s new product, here are several exercises for you to apply what you have learned in other contexts.

Now that you’ve studied pricing, break-even, and margin analysis as they relate to HD’s new product launch, use the following exercises to apply these concepts in other contexts.