General Pricing Approaches
Category: Marketing
The price the company charges will be between one that is too low to produce a profit and one that is too high to produce any demand. Product costs set a floor to the price; consumer perception of the product’s value sets the ceiling. The company must consider competitors’ prices and other external and internal factors to find the best price between these two extremes.
Companies set prices by selecting a general price approach that includes one or more of these three sets of factors: Cost-based pricing, customer-based pricing, and competition-based pricing.
Cost-based pricing. The simplest pricing method is cost-plus pricing — adding a standard markup to the cost of the product.
To illustrate mark-up pricing, suppose an ice cream manufacturer had the following costs and expected sales:
Variable cost 3
Fixed cost 300,000
Expected unit sales 500,000
The manufacturer’s cost per product is then given by:
Now suppose the manufacturer wants to earn a 20% mark-up on sales. The manufacturer’s markup price is then given by:
The manufacturer would charge dealers 4.5 per ice cream and make a profit of 0.9 a piece. The dealers in turn will mark up the ice cream price. If dealers want to earn 50% on the sales price, they will mark up the ice cream to 9 (4.5 + 50% of 9).
Still, mark-up pricing remains popular for many reasons. First, sellers are more certain about costs than about demand. By tying the price to cost, sellers simplify pricing — they do not have to make frequent adjustments as demand changes. Secondly, when all companies in the industry use this pricing method, prices tend to be similar and price competition is thus minimized. Thirdly, many people believe that cost-plus pricing is more fair to both buyers and sellers. Sellers earn a fair return on their investment, but do not take advantage of buyers when buyers demand increases.
Buyer-based pricing. An increasing number of companies are basing their prices on the product’s perceived value. Perceived-value pricing uses buyers’ perceptions of value, not the seller’s cost, as the key to pricing. The company uses the non-price variables in the marketing mix to build up perceived value in the buyers’ minds. Price is set to match the perceived value.
Consider the various prices different restaurants charge for the same items. A consumer who wants a cup of coffee and a slice of apple pie may pay 10 at a drugstore counter, 12 at a family restaurant, 18 at a hotel coffee shop, 25 for hotel room service, and 30 at an elegant restaurant. Each succeeding restaurant can charge more because of the value added by the atmosphere.
The company using perceived-value pricing must find out the value in the buyer’s minds for different competitive offers.
Sometimes consumers could be asked how much they would pay for each benefit added to the offer. If the seller charges more than the buyers’ perceived value, the company’s sales will suffer. Many companies overprice their products, and their products sell poorly. Other companies under price. Under priced products sell very well, but they produce less revenue than they would if prices were raised to the perceived-value level.
Competition-based pricing. In going-rate pricing, the company bases its price largely on competitors’ prices, with less attention paid to its own costs or demand. The company might charge the same, more, or less than its major competitors. The smaller companies follow the leader: They change their prices when the market leader’s prices change, rather than when their own demand or cost changes. Some companies may charge a bit more or less, but they hold the amount of difference constant.
Going-rate pricing is quite popular. When demand elasticity is hard to measure, companies feel that the going price represents the collective wisdom of the industry concerning the price that will yield a fair return. They also feel that holding to the going price will avoid harmful price wars.
New product pricing. Pricing strategies usually change as the product passes through its life cycle. The introductory stage is especially challenging. We can distinguish between pricing a real product innovation that is patent-protected and pricing a product that imitates existing products.
Companies bringing out an innovative product can choose between market-skimming pricing and market-penetration pricing.
Market-skimming pricing. Many companies that invent new products set high prices initially to «skim» revenues layer by layer from the market.
Market skimming makes sense only under certain conditions. First, the product’s quality and image must support its higher price, and enough buyers must want the product at that price. Secondly, the costs of producing a small volume must not be so high that it eliminates the advantage of charging a high price. Finally, competitors should not be able to enter the market easily and undercut the high price.
Market-penetration pricing. Rather than setting a high initial price to skim small but profitable market segments, other companies set a low initial price in order to penetrate the market quickly and deeply — to quickly attract a large number of buyers and win a large market share.
Several conditions favor setting a low price. The market must be highly price-sensitive so that a low price produces more market growth. Production and distribution costs must fall as sales volume increases. And the low price must help to keep out the competition.
Product-Mix pricing. The strategy for setting a price on a product often has to be changed when the product is part of a product mix. In this case, the company looks for a set of prices to maximise the profits on the total product mix. Pricing is difficult because the various products have related demand and costs and face different degrees of competition. We present four product-mix pricing situations:
Product-line pricing. Companies usually develop product lines rather than single products. For product-line pricing, the management must determine the price steps to set between the various products. The price steps should take into account those cost differences between the products, customer evaluation of their different features, and competitors’ prices. If the price difference between two successive products is small, buyers will usually buy the more advanced product increasing company profits if the cost difference is smaller than the price difference. If the price difference is large, customers will generally buy the less advanced product.
Optional-product pricing. Many companies use optional-product pricing — offering to sell optional or accessory products along with their main product. A car buyer can order electric windows, air conditioning, and cruise control. Pricing these options is a sticky problem.
Captive-product pricing. Companies making products which must be used along with a main product use captive-product pricing. Examples of captive products are razor blades, camera film, and computer software. Producers of the main products (razors, cameras, and computers) often price them low and set high mark-ups on the supplies.
Product-bundle pricing. Using product-bundle pricing, sellers often combine several of their products and offer the bundle at a reduced price. Price bundling can promote the sales of products consumers might not otherwise buy, but the combined price must be low enough to make them buy the bundle.
Discount pricing and allowances. Most companies adjust their basic price to reward customers of certain responses, such as early payment of bills, volume purchases, and buying off-season.
Cash discounts. A cash discount is a price reduction to buyers who pay their bills promptly. Such discounts are customary in many industries; they help improve the sellers’cash situation, reduce bad debts, and lower credit-collection costs.
Quantity discounts. A quantity discount is a price reduction to buyers who buy large volumes.
Seasonal discounts. A seasonal discount is a price reduction to buyers who buy merchandise or services out-of-season.
The problems of different forms of discounts are that they seem to be irreversible by nature and their effect on profits is misjudged.
The following table is an example of how large the elasticity must be for a price reduction (discount) to pay. If the company has a contribution margin of 30%, a discount of 5% has to yield at least 20% increased sale measured in units.
Required increase in volume if unchanged contribution margin is to be maintained after a price reduction
When choosing contribution margin, use the contribution margin before price reduction.
Discriminatory pricing. Companies often adjust their basic prices to allow for differences in customers, products, and locations. In discriminatory pricing, the company sells a product or service at two or more prices, even though the difference in prices is not based on differences in costs. Discriminatory pricing takes several forms:
Customer-segment pricing. Different customers pay different prices for the same product or service. Museums, for example, often charge a lower admission for students and senior citizens.
Product-form pricing. Different versions of the product are priced differently but not according to differences in their costs.
Location pricing. Different locations are priced differently even though the cost of offering each location is the same. For instance, a theatre varies its seat prices because of audience preferences for certain locations. State universities charge higher tuition for out-of-state students.
Time pricing. Prices are varied seasonally, by the month, by the day, and even by the hour. Public utilities vary their prices to commercial users by time of day and weekends versus weekdays. The telephone company offers lower «off-peak» charges, and resorts give seasonal discounts.
For discriminatory pricing to be an effective strategy for the company, certain conditions must exist. It must be possible to segment the market and the segments must show different degrees of demand. Members of the segment paying the lower price should not be able to turn around and resell the product to the segment paying the higher price. Competitors should not be able to undersell the company in the segment being charged the higher price. Nor should the costs of segmenting and watching the market exceed the extra revenue obtained from the price difference. The practice should not lead to customer resentment and ill will. Finally, the discriminatory pricing must be legal.
Psychological pricing. Price indicates something about the product. For example, many consumers use price to judge quality. A bottle of perfume which costs 100 may have a scent which is only worth 3, but some people are willing to pay 100 because this price indicates something special. One explanation could be that this product is linked with high status.
When using psychological pricing, sellers consider the psychology of prices and not simply the economics. When consumers can judge the quality of a product by examining it or by calling upon past experience with it, they use price less to judge quality. But when consumers cannot judge quality because they lack the information or skill, price becomes an important quality signal.
Promotional pricing. Through promotional pricing, companies temporarily price their products below list price, and sometimes even below cost.
Initiating price changes. After developing their price structures and strategies, companies may face occasions when they will want either to cut or to raise prices.
Initiating price cuts. Several situations may lead a company to consider cutting its price. One is
excess capacity.
Initiating price increases. On the other hand, many companies have had to raise prices in recent years. They do this knowing that the price increases may be resented by customers, dealers, and their own sales force. When a company cannot supply all its customers’ needs, it can raise its prices, ration products to customers, or both.
Companies can increase their prices in a number of ways to keep up with rising costs. Prices can be raised almost invisibly by dropping discounts and adding higher-priced units to the line. Or prices can be pushed up openly. In passing on price increases to customers, the company needs to avoid the image of price shark. The price increases should be supported by a company communication programme telling customers why prices are being increased. The company sales force should help customers find ways to economies.
Competitor reactions to price changes. A company considering a price change has to worry about competitor reactions as well as customer reactions. Competitors are most likely to react when the number of companies involved is small, when the product is uniform, and when the buyers are well informed.
How can the company figure out the likely reactions of its competitors? Assume that the company faces one large competitor. If the competitor tends to react in a set way to price changes, that reaction may be anticipated. But if the competitor treats each price change as a fresh challenge and reacts according to his self-interest, the company must analyse the competitor’s self-interest each time.
The problem is complex because the competitor can interpret a company price cut in many ways. It may think that the company is trying to grab a larger market share, that the company is doing poorly and trying to boost its sales, or that the company wants the whole industry to cut prices to increase total demand.
When there are several competitors, the company must guess the likely reaction of each competitor. If all competitors behave alike, this amounts to analysing only a typical competitor. However, if the competitors do not behave alike — perhaps because of differences in size, market shares, or policies — separate analyses are necessary. On the other hand, if some competitors will match the price change, there is good reason to expect that the rest will do the same.
Responding to price changes
Now let us reverse the question and ask how a company should respond to a price change by a competitor. The company needs to consider several issues:
• Why did the competitor change the price?
— Was it to take more market share, to use excess capacity, to meet changing cost conditions, or to lead an industry-wide price change?
• Does the competitor plan to make a temporary or permanent price change?
• What will happen to the company’s market share and profits if it does not respond?
• Are other companies going to respond?
• What are the competitor’s and other companies’ responses likely to be to each possible reaction?
Answers to the above questions will decide how the company responds to price changes.