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December 3 2007: 4:16 AM EST
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The black art of auto pricing

As the 2008 Chevy Malibu shows, there are lots of intangibles involved in setting the sticker price.

By Alex Taylor III, Fortune senior editor

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(Fortune) -- So, General Motors: You've invested four years of sweat and tears, along with $1 billion or so, in the new Chevy Malibu, and now you are ready to put it on sale. How much are you going to charge for it?

The simple answer is to figure out what the Malibu costs to make, amortize the development expense, and then add a reasonable profit. But that doesn't take into account the economy, the appeal of the Chevy brand, the strength of the competition, and the vicissitudes of the marketplace.

There's a lot riding on the Malibu. GM vice chairman Bob Lutz told the Detroit News last week that the new model will generate $5,000 more profit per car than the old one. "My bet is that we're going from a car people have to be bribed to take to a car people will actually pay for," Lutz said.

So how did GM actually price the car? We'll get to that in a minute. But first, a primer on the mysterious art of pricing. "Pricing a car can be a notoriously intricate undertaking," say McKinsey's Gianluca Camplone and Jan Wullenweber, in a new study, "Making Sure the Price is Right." They add: "Matching a new car with a price that generates both sales volume and profitability can be one of the toughest tasks that any OEM faces."

Not surprisingly, McKinsey preaches the use of fact-based tools backed by volumes of customer research. First, the manufacturer has to determine how much customers are willing to pay. That means understanding the price at which current owners will buy the same car again, as well as the cost of conquesting new owners from other makes.

Then it must figure out what features customers will pay up for -- those that can capture a big price improvement for relatively little cost. Manufacturers love to fiddle with the design of a car's front and rear end because it inexpensively changes the look of a car. By comparison, increasing the interior space would also draw more customers but would be more expensive.

The last piece, and perhaps the most important one, is optimizing the balance between price and volume. Manufacturers make the most money when plants run at full capacity, and they try to price their vehicles accordingly. But McKinsey cautions against taking a two-dimensional view of the price-volume relationship. The authors argue that it is not always linear; a small price reduction may generate a big increase in volume. "Thus, OEMs should set prices according to the largest positive gap between revenues and total costs."

Independent marketing consultant Susan Jacobs finds the McKinsey approach simplistic. She argues that the relative price position of any new model, along with the strength or weakness of competitive brands, is too fast-moving to be analyzed with traditional research methods. "When pricing is determined from focus group results, the process breaks the link with market reality, which is constantly changing because competitors' products, price positions, and other brand strategies area in flux," she says. "It is an activity dealing with fantasy more than reality." She concludes: "The real issue is not what customers say they 'would do', but what they actually do do - which a researcher can better determine from market data on actual sales and prices."

Take, for example, the dilemma faced by GM (Charts, Fortune 500) in pricing the Malibu. GM is extremely bullish on the car's design, handling, and level of standard equipment. So it priced the car aggressively. It set the entry-level model four-cylinder model at $19,345 -- a fat $2,000 more than last year's model and only $2,000 less than its larger Chevy stablemate, the V-6 powered Chevy Impala.

Then there was the little matter of the rival Honda Accord, also thoroughly redesigned for 2008. The Accord has been an industry standout, whereas the previous generation Malibu made its biggest impression on airport rental car lots. Yet GM decided that the features, slick interior, and overall value proposition of the Malibu made it worth only $1,000 less than the Accord, which has a four-cylinder model starting at $20,360.

Did GM get it right? Market performance alone will determine that. But Edmunds.com senior analyst Jesse Toprak believes the Malibu is well positioned against the Accord. "It is priced pretty accurately, considering the standard equipment and freshly redesigned interior," he says. For instance, the Malibu has a standard automatic transmission, while the base model Accord gets only five-speed manual.

Adds Toprak: "When you sit inside the top-of-the-line Malibu, it is like sitting in a $45,000 Lexus." As for the Impala, GM says it appeals to people who want capacity to carry six people, whereas the Malibu will attract younger, female buyers.

Perhaps, but the Malibu has more interior space than you'd think. Its wheelbase - the distance between the two axles - is actually two inches longer than the Impala's. In any case, Impala will have its day in the sun a few years from now, when it gets a fresh look and the Malibu is beginning to show its age. By then we'll have a clearer idea of how GM's pricing strategy with the Malibu paid off.  To top of page