General Pricing Strategies

Cost-Based Pricing

Just as it sounds, cost-based pricing identifies the overall fixed, variable, and indirect costs of production and prices that product accordingly.

Learning Objectives

Grasp the concept of pricing based on overall costs, and identify the various cost inputs involved

Key Takeaways

Key Points

  • When all operational fixed and variable costs are measured, and indirect costs are also compensated for, a price point can be determined based on overall price.
  • Often referred to as cost-plus pricing, some firms (excepting non- profits ) will add a margin on top of the overall cost-based pricing to ensure profitability for stakeholders.
  • Differentiating between fixed, variable, and indirect costs is a central consideration for cost-based pricing strategies.
  • This model is best for organizations working to compete on price, and striving for optimal efficiency in the production process.

Key Terms

  • cost-based pricing: This pricing strategy focuses on measuring all of the costs involved in producing a given product, and pricing that product according to those costs.

Pricing on Cost

Cost-based pricing is a fairly straight-forward concept, where the organization understands the operation costs of producing a given good and prices that good as close to this cost level as possible. It is often referred to as cost-plus pricing, as the firm (unless it is a non-profit organization) must retain some value or profit from the sale. This markup can be set at a fixed percentage, such as 5%. If a given good will cost $10 to develop, a perfect cost-based pricing would be to sell it at $10. A cost-plus pricing model at 5% would be to sell the product at $10.50.

Determining Cost

While the concept of cost-based pricing is quite simple, the accurate measurement of cost can sometimes be a bit complex. There are fixed costs, variable costs, and indirect costs that all must be factored into the overall calculation. Each of these costs are impacted differently by volume, and as a result, cost-based pricing may fluctuate over time. This creates some requirements for projecting volume, basing cost off of a certain volume and understanding the potential in variance.

Fixed Cost

Fixed cost changes over time, for the simple reason that each additional unit produced will lower the average cost per unit relative to fixed investments. Take, for example, an investment in a machine for $10,000. The machine can produce 10,000 units in a year. At maximum capacity, this machine will cost $1 per unit. However, the demand is not high enough to produce at this capacity. Instead, it is only producing 5,000 units a year. Now the cost per unit is $2.

Variable Cost

The variable cost is consistent for each new unit, and as a result is not sensitive to overall volume (in most cases). What this means is that producing 1 unit will cost $5, and producing 10 units will cost $50, 100 units $500.

Indeed, sensitivity to volume is often one of economy of scale, which is to say that purchasing inputs for production may even become cheaper the higher the quantity that is produced. As a result, variable costs and quantity have a very different relationship than fixed costs and quantity.

This simple chart underlines the relationship between fixed, variable and total cost compared to quantity produced and/or sold.

Quantity : The chart shows the relationship between fixed costs, variable costs, and total costs compared to the quantity produced and/or sold.

Indirect Cost

Complicating the concept of cost-based pricing is the indirect cost of doing business. Many aspects of an organization are not directly related to production, and are therefore somewhat difficult to factor into the overall equation. Salaries of corporate staff, administration costs, legal costs, office costs, utilities, electricity, and other supports must be accurately projected and built into the cost-based pricing model in order to ensure that the organization is properly pricing the product for profitability.

Conclusion

Overall, when a company decides to price goods based on cost, it is important that the internal mechanisms of measurement for fixed, variable, and indirect inputs are highly accurate and developed. This cost method is often considered a low-cost method, as the firm is attempting to forward as much value as possible to the consumer. This model is best for organizations working to compete on price, and striving for optimal efficiency in the production process.

Demand-Based Pricing

Demand-based pricing is any pricing method that uses consumer demand – based on perceived value – as the central element.

Learning Objectives

Demonstrate the meaning of and the different types of demand-based pricing

Key Takeaways

Key Points

  • 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.
  • Price discrimination exists when sales of identical goods or services are transacted at different prices from the same provider.
  • Psychological pricing is a marketing practice based on the theory that certain prices have a psychological impact.
  • Bundle pricing is a marketing strategy that involves offering several products for sale as one combined product.
  • 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.
  • Value -based pricing sets prices primarily on the value, perceived or estimated, to the customer rather than on the cost of the product or historical prices.

Key Terms

  • heterogeneity: This term describes the uniqueness of service offerings.
  • psychological pricing: a marketing practice based on the theory that nominally different prices may be perceived differently

Demand -Based Pricing

Demand-based pricing, also known as customer-based pricing, is any pricing method that uses consumer demand – based on perceived value – as the central element. These include: price skimming, price discrimination, psychological pricing, bundle pricing, penetration pricing, and value-based pricing.

Pricing factors are manufacturing cost, market place, competition, market condition, and quality of the product.

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. In other words, price skimming is when a firm charges the highest initial price that customers will pay. As the demand of the first customers is satisfied, the firm lowers the price to attract another, more price-sensitive segment.

The objective of a price skimming strategy is to capture the consumer surplus. It allows the firm to recover its sunk costs quickly before competition steps in and lowers the market price. 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.

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Price Skimming: These are graphical representations of price skimming. Price skimming is sometimes referred to as riding down the demand curve.

Price Descrimination

Price discrimination exists when sales of identical goods or services are transacted at different prices from the same provider. Product heterogeneity, market frictions, or high fixed costs (which make marginal-cost pricing unsustainable in the long run) can allow for some degree of differential pricing to different consumers, even in fully competitive retail or industrial markets. Price discrimination also occurs when the same price is charged to customers that have different supply costs. Price discrimination requires market segmentation and some means to discourage discount customers from becoming resellers and, by extension, competitors. This usually entails using one or more means of preventing any resale, keeping the different price groups separate, making price comparisons difficult, or restricting pricing information.

Psychological Pricing

Psychological pricing 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. The theory is this drives demand greater than would be expected if consumers were perfectly rational. Bundle pricing is a marketing strategy that involves offering several products for sale as one combined product. This strategy is very common in the software business, in the cable television industry, 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, a compilation, or an anthology.

Penetration Pricing

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. The main disadvantage with penetration pricing is that it establishes long term price expectations for the product as well as image preconceptions for the brand and company. This makes it difficult to eventually raise prices.

Value-based Pricing

Value-based pricing sets prices primarily, but not exclusively, on the value, perceived or estimated, to the customer rather than on the cost of the product or historical prices. Value-based-pricing is most successful when products are sold based on emotions (fashion), in niche markets, in shortages (e.g. drinks at open air festival at a hot summer day), or for indispensable add-ons (e.g. printer cartridges, headsets for cell phones). By definition, long term prices based on value-based pricing are always higher or equal to the prices derived from cost-based pricing.

Competitor-Based Pricing

Organizations that sell products or services may look at what price a product is generally being sold at and set that as a target for the sales price.

Learning Objectives

Understand why matching the price of competitors is important, and how it can be misused (i.e. price fixing)

Key Takeaways

Key Points

  • Determining the price of a product or service can be approached many different ways, from consumer willingness to pay to pursuing the lowest possible cost for the consumer.
  • Competitor -based pricing is the strategic approach in which a company tries to match (or perhaps better) the price point set by key competitors within the industry.
  • Competitor-based pricing is particularly useful for new entrants, who are trying to achieve the efficiency and low price of more mature and established competitors.
  • Competitor-based pricing can be inappropriate in markets with limited competition, as it could essentially lead to price fixing.

Key Terms

  • price fixing: An illegal agreement between participants on the same side in a market to buy or sell a product, service, or commodity only at a fixed price, or maintain the market conditions such that the price is maintained at a given level by controlling supply and demand.

Pricing Overview

Determining the optimal price for a given product or service can be approached in many different ways. Some organizations simply look at what it will cost (on average) to produce a product or service, and sell it at an acceptable profit margin above that expense rate. Other businesses may focus more on what the consumer is willing to pay, and try to capture as much of that potential as possible. Other organizations may be non-profit oriented, and will sell at the lowest possible price while remaining in business.

A fruit market in Israel.

Pricing: Sellers price products in order to obtain a profit margin that is above the expense rate.

Pricing on Competition

Organizations that sell products or services, usually in mature industries, may look at what price a product is generally being sold at and emulate that sales price. This can be done for a variety of reasons, and firms must be careful of ethical and legal concerns when considering this approach:

  • Customer Expectation – In some industries, competitor-based pricing is the best way to ensure customers pay what they expect to pay. A cup of coffee, for example, is very rarely priced too much differently from the competition. Customers don’t expect to pay $5 for a coffee, and therefore companies that sell at that price point will be quickly beaten by the competition.
  • Competitiveness – Along similar lines, remaining competitive (particularly for goods that are not easily differentiate) often requires matching or beating the price of the competition. Many companies will even match competitor prices as a policy, which is to say that if a consumer finds the same product somewhere else for cheaper, the organization will match that price in order to retain the customer. Competitor-based pricing ensures the organization can remain competitive.
  • Follow the leader – For newer entrants in an industry, keeping pace with the industry standard or industry leader is sometimes useful. This motivates the firm to match (or exceed) the more efficient and mature players in an industry, and sets a benchmark for what is feasibly accomplished in terms of efficiency and low-cost strategies.

Legal Concerns

While competitor-based pricing may be in pursuit of the cheapest possible price for consumers, this is unfortunately not always the case. Price fixing is a risk for organizations that pursue this pricing strategy, as it essentially would allow industries which are oligopolies (with a small number of providers) to remove the competitive aspect of capitalism through establishing a fixed price across all firms.

All this really means is that organizations within certain industries are NOT allowed to agree on a price that each competitor will stick to. If organizations were allowed to do this, competition on a key component of the marketing mix would be lost completely (i.e. price). Without this competitive force, organizations would gain pricing power over consumers through price fixing. As a result, competitor-based pricing is more appropriate for firms trying to grow more efficient and become more competitive, but not as appropriate for firms who are already established.

Markup Pricing

Markup pricing is a strategy in which a company first calculates the cost of the product, then adds a proportion of it as markup.

Learning Objectives

Examine the rationale behind the use of markup pricing as a general pricing strategy

Key Takeaways

Key Points

  • Markup pricing is used primarily because it is easy to calculate and requires little information.
  • The first step to determine markup price involves calculation of the cost of production, and the second step is to determine the markup over costs.
  • In markup pricing, we use quantity to calculate price, but price is the determinant of quantity. To avoid this problem, the quantity is assumed.

Key Terms

  • marginal cost: The increase in cost that accompanies a unit increase in output; the partial derivative of the cost function with respect to output. The additional cost associated with producing one more unit of output.
  • discretion: The freedom to make one’s own judgements.

Markup Pricing

Several varieties of markup pricing – also known as cost-plus pricing – exist, but the common thread is that one first calculates the cost of the product, then adds a proportion of it as markup. The amount to be marked up is decided at the discretion of the company. 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.

Cost-plus pricing is used primarily because it is easy to calculate and requires little information. Information on demand and costs is not easily available; however, this information is necessary to generate accurate estimates of marginal costs and revenues. Moreover, the process of obtaining this additional information is expensive. Therefore, cost-plus pricing is often considered a rational approach to maximizing profits. Cost-plus pricing is especially useful in the following cases:

  • Public utility pricing
  • Finding out the design of the product when the selling price is predetermined, which is also known as product tailoring
  • Pricing products that are designed to the specification of a single buyer
  • “Monopsony Buying” – buyers have enough knowledge about the costs of a supplier. Thus, they may make the product themselves if they do not comply with the offered prices. So the relevant cost would be the cost that a buying company would incur if it made the product itself.

Calculating a Markup Price

There are two steps which form this approach. The first step involves calculation of the cost of production, and the second step is to determine the markup over costs. The total cost has two components: total variable cost and total fixed cost. In both cases, costs are computed on an average basis. In cost-plus pricing, we use quantity to calculate price, but price is the determinant of quantity. To avoid this problem, the quantity is assumed. This rate of output is based on some percentage of the firm’s capacity. The objective of determining markup over costs is to set prices in a manner that a firm earns its targeted rate of return. This return can be considered RsX, where Rs is the ratio of the respective share of total profit. Therefore, the markup over costs on each unit of output will be X/Q. Price will be calculated through the formula in.

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Cost-Plus Price Equation: A cost-plus price is equal to the average variable costs plus average fixed costs plus markup per unit.

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Total Average Cost Equation: The total average cost for a product is determined by dividing the total fixed costs (TFC) and total variable costs (TVC) by the quantity of the product produced and then adding them together.

Reasons For Widespread Use

The following points explain as to why this approach is widely used:

  • Even if a firm handles many products, this approach provides the means by which fair prices can be easily found.
  • This approach involves calculation of full cost. Prices based on full cost look factual and precise and may be more defensible on moral grounds than prices established by other means.
  • This approach reduces the cost of decision-making. Firms which prefer stability use cost-plus pricing as a guide to price products in an uncertain market where knowledge is incomplete.
  • Firms are never too sure about the shape of their demand curve; neither are they very sure about the probable response to any price change. It thus becomes risky for a firm to move away from cost-plus pricing.
  • The reaction of rivals to the set price is a major uncertainty. When products and production processes are similar, competitive stability is achieved by usage of cost-plus pricing. This competitive stability is achieved by setting a price that is likely to yield acceptable returns to other members of the industry.
  • Management tends to know more about product costs than any other factors which can be used to price a product.
  • Markup pricing ensures a seller against unpredictable or unexpected later costs.
  • Price increases can be justified in terms of cost increases.

Disadvantages Of Markup Pricing

Disadvantages of this strategy include:

  • Provides incentive for inefficiency
  • Tends to ignore the role of consumers
  • Tends to ignore the role of competitors
  • Uses historical rather than replacement value
  • Uses “normal” or “standard” output level to allocate fixed costs
  • Includes sunk costs rather than just using incremental costs
  • Ignores opportunity cost

Profit-Maximization Pricing

Profit maximization analysis is the process by which a firm determines the price and output level that returns the greatest profit.

Learning Objectives

Describe profit maximization pricing relative to general pricing strategies

Key Takeaways

Key Points

  • Fixed costs, which occur only in the short run, are incurred by the business at any level of output, including zero output.
  • Variable costs change with the level of output, increasing as more product is generated.
  • The profit -maximizing output is the one at which the difference between total cost and total revenue reaches its maximum.
  • If a firm is not a perfect competitor in the output market, the price to sell the product at can be read off the demand curve at the firm’s optimal quantity of output.

Key Terms

  • marginal cost: The increase in cost that accompanies a unit increase in output; the partial derivative of the cost function with respect to output. The additional cost associated with producing one more unit of output.

Profit Maximization Pricing

Profit maximization is the short run or long run process by which a firm determines the price and output level that returns the greatest profit. Any costs incurred by a firm may be classed into two groups: fixed costs and variable costs.

Fixed costs, which occur only in the short run, are incurred by the business at any level of output, including zero output. These may include equipment maintenance, rent, wages of employees whose numbers cannot be increased or decreased in the short run, and general upkeep.

Variable costs change with the level of output, increasing as more product is generated. Materials consumed during production often have the largest impact on this category, which also includes the wages of employees who can be hired and laid off in the span of time (long run or short run) under consideration.

Fixed cost and variable cost, combined, equal total cost. Revenue is the amount of money that a company receives from its normal business activities, usually from the sale of goods and services (as opposed to monies from security sales such as equity shares or debt issuances).To obtain the profit maximising output quantity, we start by recognizing that profit is equal to total revenue (TR) minus total cost (TC).

Given a table of costs and revenues at each quantity, we can either compute equations or plot the data directly on a graph.

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Total Profit Maximization: This linear total revenue curve represents the case in which the firm is a perfect competitor in the goods market, and thus cannot set its own selling price.

The profit-maximizing output is the one at which this difference reaches its maximum. In the accompanying diagram, the linear total revenue curve represents the case in which the firm is a perfect competitor in the goods market and thus cannot set its own selling price. The profit-maximizing output level is represented as the one at which total revenue is the height of C and total cost is the height of B; the maximal profit is measured as CB. This output level is also the one at which the total profit curve is at its maximum.

If, contrary to what is assumed in the graph, the firm is not a perfect competitor in the output market, the price to sell the product at can be read off the demand curve at the firm’s optimal quantity of output. The above method takes the perspective of total revenue and total cost. A firm may also take the perspective of marginal revenue and marginal cost, which is based on the fact that total profit reaches its maximum point where marginal revenue equals marginal cost.