Pricing Tactics

Discounting

Discounts and allowances are reductions to a basic price of goods or services and can occur anywhere in the distribution channel.

Learning Objectives

Analyze the use and types of discounts as part of pricing tactics

Key Takeaways

Key Points

  • Seasonal discounts are price reductions given for out-of-season merchandise.
  • Cash discounts are reductions on base price given to customers for paying cash or within some short time period.
  • Senior discounts are discounts offered to customers who are above a certain age, typically a round number such as 50, 55, 60, 65, 70, and 75.
  • Educational or student discounts are price reductions given to members of educational institutions, usually students but possibly also to educators and to other institution staff.
  • Quantity discounts are reductions in base price given as the result of a buyer purchasing some predetermined quantity of merchandise. A noncumulative quantity discount applies to each purchase and is intended to encourage buyers to make larger purchases.

Key Terms

  • List Price: The manufacturer’s suggested retail price (MSRP), list price or recommended retail price (RRP) of a product is the price which the manufacturer recommends that the retailer sell the product.
  • quantity discount: price reductions given for large purchases
  • functional discount: payments to distribution channel members for performing some service

Discounts and allowances are reductions to a basic price of goods or services. There are many different types of price reduction, each designed to accomplish a specific purpose. They can occur anywhere in the distribution channel, modifying either the manufacturer’s list price (determined by the manufacturer and often printed on the package), the retail price (set by the retailer and often attached to the product with a sticker), or the list price (which is quoted to a potential buyer, usually in written form).

Quantity discounts are reductions in base price given as the result of a buyer purchasing some predetermined quantity of merchandise. A noncumulative quantity discount applies to each purchase and is intended to encourage buyers to make larger purchases. This means that the buyer holds the excess merchandise until it is used, possibly cutting the inventory cost of the seller and preventing the buyer from switching to a competitor at least until the stock is used. A cumulative quantity discount applies to the total bought over a period of time. The buyer adds to the potential discount with each additional purchase. Such a policy helps to build repeat purchases. Building material dealers, for example, find such a policy quite useful in encouraging builders to concentrate their purchase with one dealer and to continue with the same dealer over time.

Seasonal discounts are price reductions given for out-of-season merchandise. An example would be a discount on snowmobiles during the summer. The intention of such discounts is to spread demand over the year. This can allow fuller use of production facilities and improved cash flow during the year. Electric power companies use the logic of seasonal discounts to encourage customers to shift consumption to off-peak periods. Since these companies must have production capacity to meet peak demands, the lowering of the peak can lessen the generating capacity required.

Cash discounts are reductions on base price given to customers for paying cash or within some short time period. For example, a 2% discount on bills paid within 10 days is a cash discount. The purpose is generally to accelerate the cash flow of the organization.

Trade discounts, also called functional discounts, are payments to distribution channel members for performing some function. Examples of these functions are warehousing and shelf stocking. Trade discounts are often combined to include a series of functions, for example 20/12/5 could indicate a 20% discount for warehousing the product, an additional 12% discount for shipping the product, and an additional 5% discount for keeping the shelves stocked. Trade discounts are most frequent in industries where retailers hold the majority of the power in the distribution channel (referred to as channel captains). Trade discounts are given to try to increase the volume of sales being made by the supplier.

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Discounts: Discounts, such as 75% off, are used to draw customers to purchase items.

Educational or student discounts are price reductions given to members of educational institutions, usually students but possibly also to educators and to other institution staff. The provider’s purpose is to build brand awareness early in a buyer’s life, or build product familiarity so that after graduation the holder is likely to buy the same product, for own use or for an employer, at its normal price. Educational discounts may be given by merchants directly, or via a student discount program, such as CollegeBudget in the United States or NUS and Studentdiscounts.co.uk in the United Kingdom.

Senior discounts are discounts offered to customers who are above a certain relatively advanced age, typically a round number such as 50, 55, 60, 65, 70, and 75; the exact age varies in different cases. The rationale for a senior discount offered by companies is that the customer is assumed to be retired and living on a limited income, and unlikely to be willing to pay full price; sales at reduced price are better than no sales. Non-commercial organizations may offer concessionary prices as a matter of social policy.

Value-Based Pricing

Value-based pricing seeks to set prices primarily on the value perceived by customers rather than on the cost of the product or historical prices.

Learning Objectives

Examine the rationale behind value based pricing as a pricing tactic

Key Takeaways

Key Points

  • 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).
  • Although it would be nice to assume that a business has the freedom to set any price it chooses, this is not always the case. Firms are limited by constraints such as government restrictions.
  • Value-based pricing is predicated upon an understanding of customer value. In many settings, gaining this understanding requires primary research through interviews with customers and various surveys. The results of such surveys often depict a customer’s willingness to pay.

Key Terms

  • willingness to pay: The willingness to pay (WTP) is the maximum amount a person would be willing to pay, sacrifice, or exchange in order to receive a good or to avoid something undesired, such as pollution.
  • consumer buying process: There are 5 stages of a consumer buying process. They are: The problem recognition stage, the search for information, the possibility of alternative options, the choice to purchase the product, and then finally the actual purchase of the product. This shows the complete process that a consumer will most likely, whether recognizably or not, go through when they go to buy a product.

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. This strategy focuses entirely on the customer as a determinant of the total price/value package. Marketers who employ value-based pricing might use the following definition: “It is what you think your product is worth to that customer at that time.” This image shows the process for value based pricing.

A chart that shows what value-based pricing takes into account (customers, value, price, cost, and product).

Value-Based Pricing: Value-based pricing focuses entirely on the customer as a determinant of the total price or value package.

Goods that are very intensely traded (e.g., oil and other commodities) or that are sold to highly sophisticated customers in large markets (e.g., automotive industry) usually are sold based on cost-based pricing. 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).

Many customer-related factors are important in value-based pricing. For example, it is critical to understand the consumer buying process. How important is price? When is it considered? How is it used? Another factor is the cost of switching. Have you ever watched the television program,”The Price is Right”? If you have, you know that most consumers have poor price knowledge. Moreover, their knowledge of comparable prices within a product category (e.g., ketchup is typically worse). So price knowledge is a relevant factor. Finally, the marketer must assess the customers’ price expectations. How much do you expect to pay for a large pizza? Color TV? DVD? Newspaper?Swimming pool? These expectations create a phenomenon called “sticker shock” as exhibited by gasoline, automobiles, and ATM fees.

Value-based pricing is predicated upon an understanding of customer value. In many settings, gaining this understanding requires primary research. This may include evaluation of customer operations and interviews with customer personnel. Survey methods are sometimes used to determine value a customer attributes to a product or a service. The results of such surveys often depict a customer’s willingness to pay. The principal difficulty is that the willingness of the customer to pay a certain price differs between customers, between countries, even for the same customer in different settings (depending on his actual and present needs), so that a true value-based pricing at all times is impossible. Also, extreme focus on value-based pricing might leave customers with a feeling of being exploited which is not helpful for the companies in the long run.

Although it would be nice to assume that a business has the freedom to set any price it chooses, this is not always the case. There are a variety of constraints that prohibit such freedom. Some constraints are formal, such as government restrictions in respect to strategies like collusion and price-fixing. This occurs when two or more companies agree to charge the same or very similar prices. Other constraints tend to be informal. Examples include matching the price of competitors, a traditional price charged for a particular product, and charging a price that covers expected costs.

Geographic Pricing

Geographical pricing is the practice of modifying a basic list price based on the location of the buyer to reflect shipping costs.

Learning Objectives

Describe the different types of geographic pricing from a pricing tactic perspective

Key Takeaways

Key Points

  • Zone pricing is a pricing tactic where prices increase as shipping distances increase. This is sometimes done by drawing concentric circles on a map with the plant or warehouse at the center and each circle defining the boundary of a price zone.
  • FOB origin (Free on Board origin) is a pricing tactic where the shipping cost from the factory or warehouse is paid by the purchaser. Ownership of the goods is transferred to the buyer as soon as it leaves the point of origin.
  • Freight-absorption pricing is where the seller absorbs all or part of the cost of transportation. This amounts to a price discount and is used as a promotional tactic.

Key Terms

  • list price: The retail selling price of an item, as recommended by the manufacturer or retail distributor, or as listed in a catalog.
  • zone pricing: The practice of modifying a basic list price based on the geographical location of the buyer.

Geographical pricing is the practice of modifying a basic list price based on the geographical location of the buyer. It is intended to reflect the costs of shipping to different locations. There are several types of geographic pricing:

  • FOB origin (Free on Board origin): The shipping cost from the factory or warehouse is paid by the purchaser. Ownership of the goods is transferred to the buyer as soon as it leaves the point of origin. It can be either the buyer or seller that arranges for the transportation.
A container ship loads cargo at a loading dock.

FOB: FOB is used for sea freight. The purchaser is responsible for the shipping costs.

  • Uniform delivery pricing (also called postage stamp pricing): The same price is charged to all.
  • Zone pricing: Prices increase as shipping distances increase. This is sometimes done by drawing concentric circles on a map with the plant or warehouse at the center and each circle defining the boundary of a price zone. Instead of using circles, irregularly shaped price boundaries can be drawn that reflect geography, population density, transportation infrastructure, and shipping cost. (The term “zone pricing” can also refer to the practice of setting prices that reflect local competitive conditions (i.e., the market forces of supply and demand, rather than actual cost of transportation). Zone pricing, as practiced in the gasoline industry in the United States, is the pricing of gasoline based on a complex and secret weighting of factors, such as the number of competing stations, number of vehicles, average traffic flow, population density, and geographic characteristics. This can result in two branded gas stations only a few miles apart selling gasoline at a price differential of as much as $0.50 per gallon. Many business people and economists state that gasoline zone pricing merely reflects the costs of doing business in a complex and volatile marketplace. Critics contend that industry monopoly and the ability to control not only industry-owned “corporate” stations, but locally owned or franchise stations, make zone pricing into an excuse to raise gasoline prices virtually at will. Oil industry representatives contend that while they set wholesale and dealer tank wagon prices, individual dealers are free to see whatever prices they wish and that this practice in itself causes widespread price variations outside industry control. Zone pricing is also used to price fares in certain metro stations.
  • Basing point pricing: Certain cities are designated as basing points. All goods shipped from a given basis point are charged the same amount.
  • Freight-absorption pricing: The seller absorbs all or part of the cost of transportation. This amounts to a price discount and is used as a promotional tactic.

Transfer Pricing

Transfer pricing describes all aspects of intracompany pricing arrangements between business entities for goods and services.

Learning Objectives

Outline the concept and rationale of transfer pricing as a pricing tactic

Key Takeaways

Key Points

  • Transfer pricing refers to the setting, analysis, documentation, and adjustment of charges of goods and services within a multi-divisional organization, particularly in regard to cross-border transactions.
  • Intra-company transactions across borders are growing rapidly and are becoming much more complex. Compliance with the differing requirements of multiple overlapping tax jurisdictions is a complicated and time-consuming task.
  • Division managers are provided incentives to maximize their own division’s profits. The firm must set the optimal transfer prices to maximize company profits or each division will try to maximize their own profits leading to lower overall profits for the firm.

Key Terms

  • marginal revenue: Marginal revenue is the additional revenue that will be generated by increasing product sales by one unit.
  • marginal cost: Marginal cost is the change in total cost that arises when the quantity produced changes by one unit. That is, it is the cost of producing one more unit of a good.

Transfer pricing refers to the setting, analysis, documentation, and adjustment of charges of goods and services within a multi-divisional organization, particularly in regard to cross-border transactions. Transfer pricing describes all aspects of intra company pricing arrangements between related business entities, including transfers of intellectual property, transfers of tangible goods, services and loans, and other financing transactions.

For example, goods from the production division may be sold to the marketing division, or goods from a parent company may be sold to a foreign subsidiary, with the choice of the transfer price affecting the division of the total profit among the parts of the company. This has led to the rise of transfer pricing regulations as governments seek to stem the flow of taxation revenue overseas, making the issue one of great importance for multinational corporations.

Intra-company transactions across borders are growing rapidly and are becoming much more complex. Compliance with the differing requirements of multiple overlapping tax jurisdictions is a complicated and time-consuming task. At the same time, tax authorities from each country are imposing stricter penalties, new documentation requirements, increased information exchange and increased audit/inspection activity.

Division managers are provided incentives to maximize their own division’s profits. The firm must set the optimal transfer prices to maximize company profits, or each division will try to maximize their own profits leading to lower overall profits for the firm. Double marginalization is when both divisions mark up prices in excess of marginal cost and overall firm profits are not optimal.

One can use marginal price determination theory to analyze optimal transfer pricing, with optimal being defined as transfer pricing that maximizes overall firm profits in a non-realistic world with no taxes, no capital risk, no development risk, no externalities, or any other frictions which exist in the real world. From marginal price determination theory, the optimum level of output is that where marginal cost equals marginal revenue. That is to say, a firm should expand its output as long as the marginal revenue from additional sales is greater than their marginal costs. In the diagram that follows, this intersection is represented by point A, which will yield a price of P*, given the demand at point B.

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Optimal Transfer Pricing Diagram: From marginal price determination theory, the optimum level of output is where marginal cost equals marginal revenue.

When a firm is selling some of its product to itself, and only to itself (i.e., there is no external market for that particular transfer good), then the picture gets more complicated, but the outcome remains the same. The demand curve remains the same. The optimum price and quantity remain the same. But marginal cost of production can be separated from the firm’s total marginal costs. Likewise, the marginal revenue associated with the production division can be separated from the marginal revenue for the total firm. This is referred to as the Net Marginal Revenue in production (NMR) and is calculated as the marginal revenue from the firm minus the marginal costs of distribution.

It can be shown algebraically that the intersection of the firm’s marginal cost curve and marginal revenue curve (point A) must occur at the same quantity as the intersection of the production division’s marginal cost curve with the net marginal revenue from production (point C).

Consumer Penalties

Penalties, in the form of fees and restricted user access, exist for consumers who violate terms in contracts.

Learning Objectives

Review the rationale and use of consumer penalties as part of pricing tactics

Key Takeaways

Key Points

  • Most organizations reserve the right to restrict a user’s access to the service if they violate the terms in the agreement.
  • Other forms of penalties can exist as fees. An early-termination fee is charged by a company when a customer wants or needs to be released from a contract before it expires.
  • Early payment penalties and fees also exist when people pay off a loan earlier than expected, making a firm lose out on interest fees. The fees typically negate this advantage at least in part.

Key Terms

  • surcharge: An addition of extra charge on the agreed or stated price.

Consumer Penalties

Penalties, in the form of fees and restricted user access, exist for consumers who violate terms in contracts. Terms of service are rules which one must agree to abide by in order to use a service.

Certain websites are noted for having carefully designed terms of service, particularly eBay and PayPal, which need to maintain a high level of community trust because of transactions involving money. Terms of service can cover a range of issues, including acceptable user behavior online, a company’s marketing policies, and copyright notices. Some organizations, such as Yahoo!, can change their terms of service without notice to the users.

Most organizations reserve the right to restrict a user’s access to the service if they violate the terms in the agreement. In serious cases, the user may have his or her account terminated. In extreme cases, the company may pursue legal action.

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Mobile Phones: Mobile phone service providers often charge an early termination fee on their service, which is a form of consumer penalty.