Pricing Methods

Cost-Based Pricing

Cost-based pricing involves calculating the cost of the product, and then adding a percentage mark-up to determine price.

Learning Objectives

Analyze the use of cost-plus pricing as a pricing method

Key Takeaways

Key Points

  • Cost based pricing is the easiest way to calculate what a product should be priced at. This appears in two forms: full cost pricing and direct-cost pricing. Full cost pricing takes into consideration both variable, fixed costs and a % markup. Direct-cost pricing is variable costs plus a % markup.
  • Cost-plus pricing is a pricing method used by companies to maximize their profits. The firms accomplish their objective of profit maximization by increasing their production until marginal revenue equals marginal cost, and then charging a price which is determined by the demand curve.
  • Cost-plus pricing is used primarily because it is easy to calculate and requires little information.

Key Terms

  • markups: Markup is the difference between the cost of a good or service and its selling price. A markup is added on to the total cost incurred by the producer of a good or service in order to create a profit.
  • variable cost: the amount of resources used that changes with the change in volume of activity of an organization
  • rate of return: Rate of return (ROR), also known as return on investment (ROI), rate of profit or sometimes just return, is the ratio of money gained or lost (whether realized or unrealized) on an investment relative to the amount of money invested.

Cost-plus pricing is the simplest pricing method. A firm calculates the cost of producing the product and adds on a percentage (profit) to that price to give the selling price. This appears in two forms: the first, full cost pricing, takes into consideration both variable and fixed costs and adds a % markup. The other is direct cost pricing, which is variable costs plus a % markup. The latter is only used in periods of high competition as this method usually leads to a loss in the long run.This method, although simple, does not take demand into account, and there is no way of determining if potential customers will purchase the product at the calculated price.

Cost-plus pricing is a method used by companies to maximize their profits. There are several varieties, but the common thread is that one first calculates the cost of the product, then adds a proportion of it as markup. Basically, this approach sets prices that cover the cost of production and provide enough profit margin to the firm to earn its target rate of return. It is a way for companies to calculate how much profit they will make.

Cost-plus pricing is used primarily because it is easy to calculate and requires little information, therefore it is useful when information on demand and costs is not easily available. This additional information is necessary to generate accurate estimates of marginal costs and revenues. However, the process of obtaining this additional information is expensive. Therefore, cost-plus pricing is often considered the most rational approach in maximizing profits. This approach relies on arbitrary costs and arbitrary markups.

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Cost-based Pricing: Cost-based pricing model

Demand-Based Pricing

Demand-based pricing uses consumer demand (and therefore perceived value) to set a price of a good or service.

Learning Objectives

Compare various methods of price-setting

Key Takeaways

Key Points

  • Demand -based pricing uses consumer demand (and therefore perceived value ) to set a price of a good or service.
  • Methods of demand-based pricing can include price skimming, price discrimination and yield management, price points, psychological pricing, bundle pricing, penetration pricing, price lining, value-based pricing, geo and premium pricing.
  • Pricing factors include manufacturing cost, market location, competition, market condition, and the quality of the product.

Key Terms

  • Price skimming: Price skimming is a pricing strategy in which a marketer sets a relatively high price for a product or service at first, then lowers the price over time. It is a temporal version of price discrimination/yield management.
  • yield management: The method of analyzing information to forecast market conditions and implications for the firm

Demand-based pricing is any pricing method that uses consumer demand, based on perceived value, as the central element. These include: price skimming, price discrimination and yield management, price points, psychological pricing, bundle pricing, penetration pricing, price lining, value-based pricing, geo and premium pricing. Pricing factors are manufacturing cost, market place, competition, market condition, and quality of product.

Price skimming is a pricing strategy in which a marketer sets a relatively high price for a product or service at first, then lowers the price over time. It is a temporal version of price discrimination/yield management. It allows the firm to recover its sunk costs quickly before competition steps in and lowers the market price. Price skimming is sometimes referred to as riding down the demand curve. The objective of a price skimming strategy is to capture the consumer surplus. If this is done successfully, then theoretically no customer will pay less for the product than the maximum they are willing to pay. In practice, it is almost impossible for a firm to capture all of this surplus.

Price discrimination or price differentiation exists when sales of identical goods or services are transacted at different prices from the same provider.

Yield management is the process of understanding, anticipating and influencing consumer behavior in order to maximize yield or profits from a fixed, perishable resource, such as airline seats or hotel room reservations. As a specific, inventory-focused means of revenue management, yield management involves strategic control of inventory to sell it to the right customer at the right time for the right price. This process can result in price discrimination, where a firm charges customers consuming otherwise identical goods or services a different price for doing so. Yield management is a large revenue generator for several major industries; Robert Crandall, former Chairman and CEO of American Airlines, gave yield management its name and has called it “the single most important technical development in transportation management since we entered deregulation. ”

Price points are prices at which demand for a given product is supposed to stay relatively high.

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Demand-based Pricing: Illustration of price points, or concave-downward cusps on a demand curve (P is price; Q is quantity demanded; A, B, and C are the price points)

Psychological pricing or price ending is a marketing practice based on the theory that certain prices have a psychological impact. The retail prices are often expressed as “odd prices”: a little less than a round number, e.g. $19.99 or £2.98. The theory is this drives demand greater than would be expected if consumers were perfectly rational. Psychological pricing is one cause of price points.

Product bundling is a marketing strategy that involves offering several products for sale as one combined product. This strategy is very common in the software business (e.g., bundle a word processor, a spreadsheet, and a database into a single office suite), in the cable television industry (e.g., basic cable in the United States generally offers many channels at one price), and in the fast food industry in which multiple items are combined into a complete meal. A bundle of products is sometimes referred to as a package deal or a compilation or an anthology.

Penetration pricing is the pricing technique of setting a relatively low initial entry price, often lower than the eventual market price, to attract new customers. The strategy works on the expectation that customers will switch to the new brand because of the lower price. Penetration pricing is most commonly associated with a marketing objective of increasing market share or sales volume, rather than to make profit in the short term.

Value-based pricing, or value-optimized pricing is a business strategy. It sets prices primarily, but not exclusively, on the value, perceived or estimated, to the customer rather than on the cost of the product, the market price, competitors’ prices, or historical prices. The goal of value-based pricing is to align a price with the value delivered. It is based on the notion that a customer receiving high levels of value will pay a higher price than a customer receiving lower levels of value for the same product or service.

Geo (also called marketing geography or geomarketing) is a discipline within marketing analysis which uses geolocation (geographic information) in the process of planning and implementation of marketing activities. It can be used in any aspect of the marketing mix: the product, price, promotion, or place (geo targeting).

Competition-Based Pricing

Competitive-based pricing occurs when a company sets a price for its good based on what competitors are selling a similar product for.

Learning Objectives

Explain the competitive-based pricing model

Key Takeaways

Key Points

  • If competitors are pricing their products at a lower price, then it’s up to the company to either price their goods at a higher or lower price, all depending on what they want to achieve.
  • One advantage of competitive-based pricing is that it avoids price competition that can damage the company.
  • Potential disadvantages include that businesses may need to engage in other tactics to engage customers (if the price is not enough of an incentive ).
  • Another concern for companies is that this pricing method may barely cover production costs, resulting in low profits.
  • Another concern for companies is that this pricing method may only cover production costs, resulting in low profits.

Key Terms

  • competitive-based pricing: Competitive-based pricing occurs when a company sets a price for its good based on what competitors are selling a similar product for.

In economics, competition is the rivalry among sellers trying to achieve such goals as increasing profits, market share, and sales volume by varying the elements of the marketing mix: price, product, distribution, and promotion. Merriam-Webster defines competition in business as “the effort of two or more parties acting independently to secure the business of a third party by offering the most favorable terms. ” It was described by Adam Smith in The Wealth of Nations (1776) and later economists as allocating productive resources to their most highly-valued uses and encouraging efficiency. Smith and other classical economists before Cournot were referring to price and non-price rivalry among producers to sell their goods on best terms by the bidding of buyers, and not necessarily to a large number of sellers or to a market in final equilibrium.

Competitive-based pricing, or market-oriented pricing, involves setting a price based upon analysis and research compiled from the target market. With competition pricing, a firm will base what they charge on what other firms are charging. This means that marketers will set prices depending on the results from their research. For instance, if the competitors are pricing their products at a lower price, then it’s up to them to either price their goods at a higher or lower price, all depending on what the company wants to achieve.

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Competitive Market Pricing: Status-quo pricing, also known as competition pricing, involves maintaining existing prices or basing prices on what other firms are charging.

One advantage of competitive-based pricing is that it avoids price competition that can damage the company. Disadvantages include that businesses have to attract customers in other ways, since the price will not grab the customer’s interest. The price may also barely cover production costs, resulting in low profits.

Break-Even Analysis

The break-even point (BEP) is the point where expenses and revenue intersect.

Learning Objectives

Explain the break-even point (BEP)

Key Takeaways

Key Points

  • At this point there is no loss or gain to the company. On a graph, it appears as the point where the cost and revenue curves intersect.
  • In an instance when costs are linear, the break-even point is equal to the fixed costs divided by the contribution margin per unit.
  • The break-even point is one of the simplest yet least used analytical tools in management. It helps to provide a dynamic view of the relationships between sales, costs and profits.

Key Terms

  • price: The price is the amount a customer pays for the product.
  • expense: A spending or consuming. Often specifically an act of disbursing or spending funds.

In Business Economics, specifically cost accounting, the break-even point (BEP) is the point at which cost (or expenses ) and revenue are equal—there is no net loss or gain, i.e., one can “break even. ” No profit is achieved nor loss incurred, although opportunity costs are reconciled, and capital receives the risk-adjusted, expected return. Shown graphically, it is seen at the point where the total revenue and total cost curves meet. In the linear model, the break-even point is equal to the fixed costs divided by the contribution margin per unit.

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Break-Even Analysis: This graphs depicts an example of a break-even point based on sales and total costs.

Example: Suppose that if a business sells fewer than 200 tables each month it will incur a loss, and if it sells more it will turn a profit. Given this scenario, the company’s business managers will need to compile information to determine if they can reasonably manufacture and sell 200 tables per month.

If they think they cannot sell that many, to ensure continued viability they might:

  • Try reducing their fixed costs (e.g., by renegotiating rent, or by better controlling utility telephone bills or other costs)
  • Try reducing their variable costs (the price paid for the tables by finding a new supplier)
  • Consider increasing the selling price of their tables

Any of these would reduce the break-even point, meaning the business would not need to sell so many tables to ensure it could pay its fixed costs.

By inserting different prices into the formula, you will obtain a number of break-even points, one for each possible price point. If in the above example the firm changes the selling price for its product, say from $2 to $2.30, then it would have to sell only 589 units (1000/(2.3 – 0.6) = 589) to break even rather than 715.

Graphing these results can make them more clear. To do this, draw the total cost curve (TC in the diagram), showing total cost associated with each possible level of output; the fixed cost curve (FC), showing costs that do not vary with output level; and finally, the various total revenue lines (R1, R2, and R3), showing the total amount of revenue received at each output level given the chosen price point.

The break-even point is one of the simplest yet least used analytical tools in management. It helps provide a dynamic view of the relationships between sales, costs and profits. For an even clearer understanding, break-even sales can be expressed as a percentage of actual sales. By linking the percent to a point (during the week or month) that the percent of sales might occur, managers can glean when they might expect to break even.