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ESSAY #3 – Pricing Strategies

By Lena Bucatariu ID95389

MBA, Australian Institute of Business, 2013

BA, Cuza University, Romania, 2004

Submitted in Partial Fulfillment of the International Marketing Management Course

To

George Babu

SMC University, Switzerland

March 2016

Abstract

Pricing is a major decision for international businesses since it affects a firm’s positioning,

profitability, and shareholder value. Irrespective of the context, companies need to set their

pricing strategy to recoup capital investment, make a profit margin above fixed and variable

costs, limit the negative effects of elasticity of demand, match the right stage in the product

lifecycle, fulfill company objectives, and differentiate themselves from competitors. In

international markets, firms will also have to consider local market conditions, avoid being

charged with dumping, mitigate currency risks, engage in transfer pricing between subsidiaries,

transact with other governments through countertrade, and minimize the effects of price

escalation.

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Introduction

With the increase in globalization, there is more pressure on businesses to reengineer their

logistics and distribution system (Hill & Hernandez-Roquejo, 2011) for the world, adapt marketing

communications to cultural realities (De Mooij, 2010), and consider global and localized pricing

strategies (Narayandas, Quelch, & Swartz, 2000). This paper will start with an analysis of general

factors affecting price such costs, demand, competitors, and company objectives (Kotler &

Armstrong, 2010), then move on to issues that are of higher concern in international markets,

including price escalation, price corridors, foreign exchange, risk of customer default,

countertrade, and transfer pricing (Johansson, 2009).

1. Generic Factors affecting Price

Be it a family-run agri-business in a developing economy or an innovative software

provider born global, all for-profit firms share cost, demand, competition, and company objectives

as challenges when setting prices. Covering fixed and variable costs and making a margin is an

ongoing concern (Kotler & Armstrong, 2010) as the business starts with major capital investments

and incurs current operational expenses. Examples of industries where capital intensive industries

include aviation, telecommunications, oil and gas, computers, and pharma (Maverick, 2016).

Initial investments are building, facilities, and production equipment, recurrent major costs include

salaries of full-time employees or long-term lease or rent, costs of R&D, while variable costs

change with the quantity of output, such as raw materials, packaging, or delivery charges (Kotler

& Armstrong, 2010). Demand for the company’s offering is a composite of estimating market size

(e.g. total number of potential consumers or B2B buyers), factoring in fluctuations (e.g. seasonal

demand for Easter chocolate eggs) and the economic principle of elasticity (Mankiw, 2009). To

illustrate, a logistics firm may see its orders drop as gas prices go up. Examples of businesses for

which demand is near inelastic tend to be necessities with few or no substitutes, such as gasoline

or utilities (Johnson, 2011) for consumers, or compliance (e.g. auditing) for all firms listed on the

stock exchange. In contrast, demand can be highly volatile in the hospitality industry as leisure

travel is a non-essential expense and the inventory cycle for a hotel is only 24 hours (Wood, 2016).

Nature and intensity of competition can also push prices down (Porter, 2008) if rivals offer

discounts, have a more active sales force or better reputation. The airline industry, long-distance

telephone operators, and online insurance brokers are examples of firms where price wars are

common. Managers may employ price cuts with predatory intent or simply because they are

perceived as easy, reversible actions to gain market share (Rao, Bergen, & Davis, 2000), but such

initiatives may erode long-term profits and brand image. To win a price war, Rao, Bergen and

Davis (2000) recommend competing on quality, forming partnerships, launching innovative

products or using complex pricing decisions such as bundle pricing or loyalty schemes. The

lifecycle stage of the product also influences how much the business can charge. A breakthrough

medical device in the growth stage may command a premium skimming price (Kotler &

Armstrong, 2010) while a DVD manufacturer may have to be content with minimum margins in a

saturated market. Common for high-tech, designer fashion, hardcover books, or luxury cars

(Maguire, 2015), skimming brings in high return on investment, maintains brand prestige, and

gathers useful feedback from early adopters (Dawson, 2014). However, price skimming is best

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suited for highly differentiated, superior products, and it usually cannot be maintained for a long

time without continuous innovation, which leaves most firms with the option of penetration

pricing. Kokemuller (2016) identifies Netflix mail order movies, Frito-Lay’s Stax chips, and

Econo Lodge budget hotels as successful examples of businesses that used low introductory prices

as a strategy to capture market share and gradually rose prices after securing a loyal customer base.

However, introductory prices are not always a guarantee of success, as Bhasin (2016) reveals

through the case study of Mokai, a Danish brand of cider drink (see photo). Despite low initial

prices, the product failed to gain momentum among female Tanzanian drinks as Mokai did not

invest sufficiently in brand awareness and partnered with unreliable distributors (Bhasin, 2016).

Figure 1 Mokai Cult, Cider from Denmark. Source: Cult.com 2016

Finally, company objectives will also play a part in the decision, exercising upward or

downward pressure on final retail prices. For instance, manufacturers of popular patented drugs

such as Teva Pharma (developer of Copaxone for multiple sclerosis) and AstraZeneca (Nexium for

acid reflux) will initially price high to meet ROI targets (Target Return, 2016) and thus recoup

significant R&D investments before the patent expires (Staton, 2013). A start-up food delivery

business such as Tummykart Hyderabad kept prices low and focused on reaching break-even

(Choudhury, 2016) within 6 months in order to attract the next round of funding. In sectors plagued

by overcapacity such as chemicals, Rohm and Haas – a Dow Chemical Company affiliate – is

forced to apply survival pricing on commoditized products and hopes to recover some margin from

servicing niche segments (Henrie, 2010).

2. Global Pricing Issues

In addition to the general factors presented above, international firms face a host of other

considerations, some stemming from the complexity of managing multi-country pricing, others

from legal or market constraints. Price escalation may result in a considerably higher final price

overseas compared to the domestic environment (Price Escalation, 2016), to cover tariffs,

insurance, freight, VAT, and intermediary margins. Exporters attempting to control final prices

have several options requiring varying levels of investment and risk. First, importing the product

in a work-in-progress state usually results in a lower tariff classification, for instance Mitsubishi’s

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plant in the Philippines imports knock down kits for local assembly (Assembled Cars vs. Imported

Cars in the Philippines , 2014). Shipping and handling can add several percentages to the cost,

especially in the case of multi-carrier haul of bulky, low-value items. Although most firms would

substitute for cheaper, albeit slower modes of transport such as ocean liner, more creative

businesses have reduced the size of pillows and diapers through air suction (Johansson, 2009). To

limit how many times VAT and intermediary margins are added, the exporter may cut out one or

more middlemen, e.g. by shipping to an importer which is also a distributor, or, if critical mass can

be reached, even replacing the entire channel with the firm’s own representative office in thus save

up to 70% of channel costs and mark-ups (Johansson, 2009). For the B2B market, international

contractors may impose a clause for price escalation to mitigate changes in the cost of labor and

construction materials due to inflation (Keller, Gupta, & Supriyasilp, 1982). Under special

conditions, Forman and Lancioni (2002) recommend a barter strategy to neutralize price escalation

for industrial products in the chemical, transportation, and manufacturing industries.

In their effort to manipulate prices, however, MNCs may be flagged for dumping, that is

selling products in overseas markets below production costs or lower than home-market prices

(Dumping, 2016). To avoid the imposition of countervailing duties (Johansson, 2009), MNCs can

practice partial allocation of fixed costs and full allocation of internationally-incurred costs, thus

assigning sufficient overhead to make a small margin overseas (Ito & Krueger, 1993). An

interesting analysis showed that a firm which is risk-averse, can wait to finalize prices after

exchange rates are realized, has manufacturing facilities in several countries, and faces volatility

of demand can, in fact, engage in below-cost pricing as a viable strategy without any predatory

intentions (Park, Kazaz, & Webster, 2016). To limit dumping, the ‘price adjustment methodology’

is practiced within the EU (Koval & Trofimenko, 2015) though occasionally appealed against by

its major trading partners, such as Russia. On a macro-level, some concerns have arisen as

governments weigh anti-dumping measures against lowering FDI inflows (Sibanda, 2014). To

illustrate, the study argues that the South African government should expect lower FDI

investments in response to its excessive anti-dumping duties on Brazilian chicken imports and

local content rules on the Walmart-Massmart merger.

When faced with multi-country decisions, firms may choose between polycentric,

ethnocentric, and geocentric pricing strategies (Johansson, 2009). Standardized prices may be

easy to manage due to low complexity, but are likely to create opportunity losses as they disregard

differences in shipping costs, local disposable income levels, and competitive intensity (What

Pricing Policy Should a Global Company Pursue?, 2016). Highly adapted prices can make the

most of local conditions, but at the cost of sabotaging price optimization at supra-national levels.

If there are major price differences in relatively close markets, such as UK v. Eurozone for car

imports, manufacturers need to balance financial gains with the threat of parallel imports. Although

gray cars may be priced up to 20% below exclusive channels, authorized dealers should maintain

prices and emphasize buyer risks from gray cars, among which safety issues, lack of financing,

special insurance charges, and lack of warranty (Importing a Car, What to Look out For, 2010).

Weighing the pros and cons of extreme standardization or adaptation, more experienced

firms may institute pricing corridors (Johansson, 2009) to set predetermined upper and lower

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limits for local managers, or impose a certain percentage distance from competitors’ prices

(Cavusgil, 1996). Such strategies have sufficient flexibility to keep local managers motivated and

to take local issues into account e.g. full-costing in middle income nations or during an economic

boom, lower retail prices when fighting a state-owned monopoly or an aggressive new entrant.

Unlike ethnocentric pricing, market-responsive strategies help to curb gray trade by minimizing

price differentials between neighboring countries (Johansson, 2009). A potentially lucrative tool

against parallel imports is built-in modularity, with the added benefit of closely matching local

preferences and, in the process, charging a premium above undifferentiated imports. Modul System

is a Swedish-based manufacturer of modular racking for vans which customizes ‘rack solutions’

down to the level of the car brand for French-based Citroen, Romanian made Dacia, or Italian Fiat

cars (Racking Proposals, 2016).

Foreign exchange risks constitute another obstacle for global pricing; to counteract

volatility, firms may agree on spot or forward rates to protect both buyer and seller (Forward Rate

Agreement , 2016). Alternatively, they can use hedging or engage in currency swaps, in which one

party exchanges an equal amount of the other currency to become impervious to devaluation

(Currency Swaps , 2016). Depending on the direction in which currencies move, the firm should

adapt its prices to maximize returns. For example, in the case of a weak home currency, the MNC

should emphasize price benefits, add costly features, find new export markets and try to recover

receivables quickly (Cavusgil, 1996). In contrast, when the domestic currency has gained in value,

exporters should emphasize after sales service, employ marginal cost pricing, slow down

repatriation of foreign income, and bill foreign buyers in the domestic currency (Cavusgil, 1996).

Payment terms and the method of payment selected can also help to mitigate risks: for example,

the importer may use a bank-guaranteed financial instrument such as a letter of credit (L/C)

denominated in US dollars, Euro, or another stable international currency (Anjoran, 2011). When

stating prices on a purchase order on an L/C, exporters must pay attention to Incoterms and factor

in the level of responsibility that each entails. To illustrate, an agreed FOB price is lower and the

title shifts to the buyer once the goods are on board the ship; CIF is the landed cost used to calculate

tariffs, and DDP is the highest price as it puts the burden of transport and customs clearance on

the exporter (Transport Obligations, Costs and Risks, 2016). To maximize business opportunities,

a seasoned exporter like Shanghai Coshow Cosmetics China charges $0.10 FOB unit cost for lip

gloss on orders above 5,000 units (2016) and offers a variety of trade terms (CIF, CFR, EXW,

FAS, DDP) and payment methods (L/C, T/T, draft against payment, Paypal, and Money Gram).

Despite the exporter’s best efforts, currency shifts, a sudden economic downturn or actual

intention to deceit may result in the importer defaulting on payment. To minimize such risks, the

seller can institute tighter payment terms and cash flow controls, conduct due diligence to establish

creditworthiness of buyer, or require a direct cash advance (usually done through TT/telegraphic

transfer) for new or unverified clients. For large sums, the seller may ask the buyer to deposit the

cash into an escrow account with a third-party (How Are Escrow Services Used in International

Trade Transactions?, 2015) or require a down payment followed by partial deliveries (exporter can

interrupt or delay deliveries if the installment plan is not met). As such measures may render the

exporter less competitive in the international arena, the seller can avail of, when available, export

insurance and financing, government grants, export credits, and other trade incentives (Export

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Finance and Insurance: International Agreements , 2013). For instance, the Australian government

set up the Export Finance and Insurance Corporation to offer advice and financial assistance for

Australian SMEs wishing to expand overseas. The agency facilitates, among others, direct

investment guarantees, supply chain bonds, and working capital guarantees (Bond in supply chain

contract, 2016).

To secure major orders from countries where inflation is rampant and hard currency scarce,

large-scale exporters may go beyond traditional monetary exchanges and accept a countertrade

deal. Typically, such transactions are handled at the government level e.g. Thailand supplying

fruits to China in exchange for buses or the Philippine government offering coffee to pay for

imports (Tyler, 2010). Depending on the situation or government preference, partners may agree

on a straight barter, offset, counter purchase, or switch trading (What Are the Various Forms of

Counter trade?, 2011). For example, the French government set up Sodimex, an organization

responsible for trading French high-technology products in exchange for coal, phosphates, and

agricultural products in clearing agreements with Algeria, Syria, and Vietnam (Stern, 1985). The

Greek government stipulated offsets sales terms for procurement of a command and control system

for the Greek Air Force, while the Romanian government engaged in counter purchase and set up

special agencies to resell countertrade products to third countries (Stern, 1985).

Lastly, transfer pricing is practiced by MNCs that shift large amounts of product and

currency between highly regulated international markets. Understood as the price that related

companies charge each other for sale of goods and services in another country (Introduction to

Transfer Pricing , 2016), it can be employed strategically to cross-subsidize a newly established

affiliate or one that is fighting a competitive war (Johansson, 2009). As it involves costs and profit

margins, transfer pricing often serves in repatriation of revenue out of a country with a restrictive

financial environment such as China (Hoffmann, 2013) or to manage double taxation (Bond &

Sweigart, 2016). Given their potential for manipulation, calculations of what constitutes arm’s

length are clearly defined in local accounting standards (Batra, 2015) and records audited by

qualified firms (McKinley & Owsley, 2013). Durr and Gox (2013) demonstrated that negotiated

transfer pricing may not result in the most efficient renegotiation of the first contract because the

SBUs need to choose between lowering taxes paid and sharing of gains. Instead, following the

arm’s length rules offers the options of either executing the previous contract or adjusting

quantities without taking tax into account. A corporate governance perspective (Xiaoling Chen,

Shimin, Fei, & Yue, 2015) used agency theory and information asymmetry to explain the level of

a subsidiary’s autonomy in setting transfer pricing, and made it contingent on the amount of foreign

capital (higher foreign investment resulted in less autonomy) and home and host taxes (less

autonomy when tax rate differences are high), among others. The study also showed that division

managers perceived transfer prices to be less fair when transfer pricing autonomy was inconsistent

with organizational characteristics, e.g. in a decentralized organizational structure.

Still on the topic of financial restrictions, governments in developing nations are likely to

impose price controls as minimum and maximum values that can be charged in sensitive

industries, such as food staples, health care, energy, or banking. One recent example is Vietnam’s

cap on milk formula prices which sets ceilings at both wholesale and retail levels, and requires

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resellers to formally register their highest price with the relevant government authorities (Finance

Ministry Steps in to Control Formula Milk Prices, 2014). The Norwegian government

implemented several direct and indirect price control actions to regulate the pharmaceutical market

after EU accession (Hakonsen, Horn, & Toverud, 2009). The main method initially used in

Norway was a direct control strategy called international reference price of prescription drugs,

which resulted in a significant drop in prices. Subsequent indirect initiatives such as reference-

based pricing, generic substitution, and index pricing had only marginal impact as they passed on

cost increases to patients or dis-incentivized pharmaceutical chains. Referring back to the

discussion on parallel imports, price controls – both firm or government imposed – increase the

chances for arbitrage (Grossman & Lai, 2008). The authors acknowledge the general view that

gray trade hurts intellectual property rights and lowers the firms’ appetite for investment in capital-

intensive R&D, but put forward a novel view: innovation will speed up when patents and

intellectual property is infringed at international levels. In support of this perspective, the paper

showed that increased parallel trade in EU pharmaceuticals resulted in lower price controls in

Portugal and Italy, thus bringing local prices closer to the EU average. When compulsory licensing

for foreign entry was added to the mix, price control and the threat of compulsory licensing were

found to be mutually reinforcing (Bond & Saggi, 2014), and could potentially limit a developing

economy’s ability to access patented products.

Conclusion

To conclude, for-profit businesses face difficult pricing decisions as they must cover fixed

and variable costs, match demand, fight against competitors, and meet investment expectations.

When competing overseas, firms may counter the effects of price escalation by cutting out

intermediaries, reclassifying under a lower tariff rate or partially allocating costs. Uniform pricing

may render the company uncompetitive, while a price adaptation strategy is complex to manage

and likely to result in gray trade. Solutions include educating buyers against the risks of parallel

imports, creating modular products with innovative features, and setting price corridors. To

minimize price hikes due to currency risks and customer default, traders should choose safer

payment options such as L/C denominated in stable currencies, and seek government export

assistance or counter trade deals when appropriate. Finally, businesses entering controlled

economies need to be aware of government price controls and use transfer pricing strategies to

manage double taxation or repatriation of profits. By taking into account the factors above,

international firms are more likely to develop an optimum pricing strategy that ensures profitability

and sustained growth.

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