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I. Introduction
Price plays an integral role in a company’s marketing strategy. A product’s price can make or break the sales on that product. Price can be the consumers’ single deciding factor in making the purchase and price can also cause consumers to make judgments about the quality of the product and it’s value. After all, price is in most cases the only means for quantitative comparison that consumers can use to make decisions. Setting the pricing strategy involves a complicated analysis of the product’s positioning strategy and the evaluation of competitors’ positioning strategies and price points. Product positioning, branding, and pricing strategy are pieces of the marketing mix that are tightly integrated.
There are several strategies that are typically used to determine pricing for a product or product line. As consumers, we are familiar with most of these pricing strategies. The objectives of pricing strategies include: gaining market share, achieving financial performance, (re)positioning the product, stimulating demand, and/or influencing competition.
Standard pricing strategies include: cost-based, going-rate, target profit, cost-plus, and break-even. Determining your break-even point (by calculating the fixed and variable costs that go into producing the product) will give you a price floor. By setting your price just above the price floor (cost-plus pricing), you’ll earn a profit and should remain competitive in the industry. This is known as cost-based, cost-plus or break-even pricing. The going-rate pricing strategy involves following competitors’ leads and setting your price just below or on the same level as those in the industry. Target profit strategy involved setting the financial profit goals and determining price based on those objectives.
One pricing strategy involves pricing the product at a low or competitive price but setting a higher margin for supplies (an example would be a printer and it’s ink cartridges or a razor and it’s blades). Another involves taking advantage of the complimentary nature of various products and determines how to best capitalize on these relationships. For example, if we notice that people generally purchase soda with their burger and fries, we can set a lower price on the burger and fries but set a higher margin on the soda. The consumer might get hooked by the lower price and then be more likely to purchase the entire meal. Fast food chains like McDonalds and Burger King have taken notice of their customers purchasing tendencies and capitalized on the complementary nature of their products by creating the ‘value meal’.
A relatively new pricing strategy is called the “Economic Value to the Customer”. This approach focuses on the perceived value of the product in the mind of the customer. “The EVC is useful for making sure a firm understands how benefits translate into a price ceiling (by reducing customer’s costs) and avoids the problem of pricing too low.” (http://www.MarketingProfs.com/Tutorials/evc.asp).
III. Price
Setting in the Real World
There are many approaches to pricing, some scientific, some not. This part of our research provides a framework for making pricing decisions that takes into account costs, the effects of competition and the customer's perception of value.
Setting the right price can influence the quantities of various items that consumers will buy, which in turn affects the total revenue and the profit in the store. In the end, the right price for the product is the price that the consumer is willing to pay for it. Hence, correct pricing decisions are a key to successful retail management. Systematic and informed decisions regarding pricing strategies must be made while considering a wide range of issues.
A demand curve is a graph showing how much of a product consumers will buy at various prices over a certain time period. It slopes downward because consumers buy less at higher prices, more at lower prices.
A major step toward making a profit in retailing is selling merchandise for more than it has cost you. The difference between the cost of the merchandise and the retail price is called the mark-up. These are the dollars that are now available to pay the operating expenses of the business. When establishing the mark-up on a product, two points should be noted:
1. The cost of the merchandise used in calculating mark-up consists of the base invoice price for the merchandise plus any transportation charges minus any quantity and cash discounts given by the seller.
2. Retail price, rather than cost, is ordinarily used in calculating percentage mark-up. The reason for this is that when other operating figures such as wages, advertising, and profits, are expressed as a percentage, all are based on retail price rather than on the cost of the merchandise being sold.
A quick note about how the terms: “cost”, “price”, “mark-up”
and “margin” are used in this work:
Cost is the total of the fixed and variable
expenses to manufacturer.
Price is the selling price per unit customers
pay for products or services.
Markup is a percentage of the cost.
Margin is the same dollar amount expressed as a percentage of the
selling price.
Example:
Assumptions: item costs $1.00 and sells for $1.50.
Markup is .50 or 50 percent of the cost.
Margin is .50 or 33 a percent of the selling price.
1. Profit Analysis
The graphic analysis of variation
in profit, total revenue and total cost as output increases over the short run
period.
Upper Part. The firm
maximizes its profit at output level at which the difference (AB) between TR
and TC is maximized. At that output level (q*) MR (the slope of TR curve) is
equal to MC (the slope of TC curve).
Lower Part. The graph shows
the profit curve, which measures the difference between the TR and TC, and
reaches its peak at the output q*. Note, that profit is negative at low levels
of output. As production begins, profit increases, reaching the maximum level
at an output of q*. If the firm were to produce nothing during that specific
month, its short run losses would be equal to its fixed cost. In this case the
fixed costs of $50 are the cost of capital equipment that the firm cannot avoid
even if it ceases operations.
If the firm is going to produce more than q*=8 profit would steadily decline and it would become negative. Therefore as output increases from low levels the firms profit increases, reaching maximum at a point where MR = MC. And then fall again as MC increase above the price of the product.
2) The
following steps must be used in order to establish optimal product prices.
A) The
Fundamentals: Price Floors and Ceilings
Think of cost as the floor–you must set prices above the floor to cover costs or you will quickly go out of business. If you decide to set prices at or below cost it should be for a temporary, specific purpose such as to gain market entrance.
Think of customer “perceived value” as the ceiling–this is the maximum price customers will pay based upon what the product is worth to them. This is sometimes described as “what the market will bear.” Perceived value is created by an established reputation, marketing messages, packaging, sales environments, etc. An obvious and important component of perceived value is the comparison customers and prospects make between you and your competition.
Somewhere between the floor and the ceiling is probably the right price for your product or service; a price that enables you to make a fair profit and seems fair to your customers. Consequently, once you understand your cost floor and your value price ceiling, you can make an informed decision about how to price your product or service.
B) The Starting
Point: Calculating Break-Even Point
Before you can decide upon a fair price for your product, you need to know how much it's costing you! You'll need to know this no matter which pricing method you use.
Once you've identified costs, you can determine your break-even point. This is the point at which you neither make nor lose money in producing a product or delivering a service. For example, you would be at the break-even point if it cost you $100 to produce a product that you sell for $100.
A break-even analysis is the process you use to uncover those break-even numbers. To begin your break-even analysis, add up all fixed costs and determine what your variable costs are at different production volumes.
Fixed costs,
sometimes referred to as overhead, are expenses that don't vary according to
production amounts–such as rent for office space (and storage space if you
store inventory), office equipment (telephones, faxes, computers, etc.),
insurance, utilities, etc.
Variable costs are
expenses that do vary with the amount of service provided or goods produced.
They include costs such as hourly pay for a contractor on a specific project,
raw materials, etc. Some variable costs don't depend specifically on the number
of products produced but are still variable, such as advertising or promotion
expenses.
You must know the cost of your overhead (fixed costs) as well as the incremental cost-per-unit (variable costs) before you can determine your break-even points.
Next, substitute your figures into the following break-even formulas.
C) Calculating
Break-Even Revenue
To calculate break-even dollars–the amount of revenue needed to cover both fixed and variable costs so your business neither makes nor loses money–use the following formula:
|
Fixed Costs
|
= Revenue to |
Example: Calculating Break-Even Revenue
As an example, let's try to determine an appropriate hourly rate (revenue) to charge for a consultant or service business.
Using the break-even revenue formula, plug in total fixed costs of $30,000, variable cost-per-unit of $15 (hourly pay to consultant), and unit selling price of $30 (per hour of consulting). The formula yields a break-even annual revenue of $60,000.
|
$30,000 |
= $60,000 |
This company needs revenues of $60,000 just to cover costs. If it doesn't have enough business at these rates, it loses money by being in business. If it makes more than $60,000 in revenue, it's making money.
D) Calculating
Break-Even Units
To determine how many units must be produced and sold to break-even, use the following formula:
|
Fixed
Costs |
= Number of
units needed |
* Where Unit Contribution
Margin =
Selling Price per Unit - Variable
cost per unit
Example: Calculating Break-Even Number of Units
The "unit" produced in this example is one hour of consulting. In our example, the number of hours required just to cover costs is 2,000.
|
$30,000 |
= 2,000 units (hours per
year) |
If you assume consulting hours are spread out evenly over a 50-week work year, 40 hours must be billed and collected each week just to break-even.
|
2,000 hours per year |
= 40 hours
per week |
With 40 hours of consulting per week by one person, the business only breaks even. Unless that person can consult additional hours to make a profit while marketing the service and managing the requisite paperwork, this business cannot turn a profit. Since this is highly unlikely (unless the consultant is an insomniac) this doesn't appear to be a realistic pricing model.
3. Pricing for Profit: Cost-Based Pricing
After you've determined your break-even points that establish "floors" for your price, there are strategies for establishing pricing based upon additional financial objectives, such as:
a) Establishing
a high price to make high profits initially. This strategy is used to recover
high research and development costs or to maximize profits before competitors
enter the market. (Pharmaceutical companies often use this strategy when
introducing new drugs.)
b) Setting
a low price on one or more products to make quick sales to support another
product in development. (Some companies also employ this strategy when they
need to increase cash flow.)
c) Setting
prices to meet a desired profit goal. For example, if the desired profit per
unit is 20 percent and unit costs are $10 (taking into account your fixed and
variable costs), set your price at $12.
3. Pricing for Profit: Value-Based Pricing
How high can a price be before the product or service is priced out of the market?
To understand the customer's perception of the value of your product or service, look at more subjective criteria such as customer preferences, product benefits, convenience, product quality, company image and alternative products offered by the competition.
a. How
do your customers describe what they get for their money?
b. Do
they save a great deal of money or time by purchasing your product or service?
c. Do
they gain a competitive advantage from using your service?
d. Is
it more convenient to use your service rather than try to do it themselves?
e. What
are the customer's choices?
f.
What does the competition charge?
With this information, you can begin to understand the maximum price the customer will pay for the benefit received. Often, a customer may think it's worth paying $75 per hour for the convenience and security of dealing with a local business, rather than a paying an impersonal chain $30 per hour. If the customer, however, is only willing to pay $30 per hour, you have to ask yourself whether you can make any money in this business.
When demand increases, the demand curve shifts towards the "north-east". Consumers want to buy more of the product at every price. Equilibrium price and quantity will rise. This change could be caused by a rise in income, a fall in the price of a complement, a rise in the price of a substitute, an increase in peoples' preference for the good, the expectation of future price increases or a shortage, or an increase in population.
A few value-based pricing strategies are listed below that take into account the break-even point, but are heavily weighted with subjective judgments–not just the numbers. The objective of these strategies is to increase or at least maintain demand for your products and/or services.
1) Price
the same as competitors. This strategy is used when offering a commodity
product, when prices are relatively well established (such as with professional
services) or when you have no other means to set prices. Your challenge then
becomes to determine how to lower your costs so you can produce a higher profit
than your competitors.
2) Establish
a low price (compared to the competition) on a product in order to capture a
large number of customers in that
market. This strategy may also be used to achieve non-financial objectives such
as product awareness, meeting the competition or establishing an image of being
low-cost. It works if you are able to maintain profitability at the low price,
or if you're able to maintain an acceptable level of sales should you later
raise prices.
3) If
your product has a mystique and uniqueness that is valuable to customers, you
might have the ability to charge a very high price relative to your cost. Also,
if your target market is affluent and you are positioning your product as a
"prestige" product, an especially high price could be in order. (For
example, do Rolex watches cost that much more to make than other brands?
The high cost, however, brings a "status" benefit to Rolex's affluent
market.) This strategy of charging "what customers are willing to
pay"–even though it's high–requires alertness and a willingness to change
on your part because customers (and competitors) might decide that you're
making too much of a profit!
4. Discounts
Your pricing strategy might include discounts to customers who offer you a business benefit.
a. You
may offer cash discounts to customers who pay promptly. This rewards those who
help your company maintain a steady, positive cash flow and reduce
credit-collection costs.
b. Offering
quantity discounts for large orders often makes economic sense when the
cost-per-unit to sell or deliver a product declines as the quantity increases.
For example, a caterer might fill an order for 12 dozen cupcakes for one
customer at 10¢ each, while cupcakes sitting in the bakery display rack might
be sold to several customers throughout the day for 20¢ each. This is because
the possibility that some of the cupcakes won't sell has to be taken into
account, there are costs associated with having the store open for random
customers' convenience, etc.
c. Seasonal
discounts given to buyers who purchase during a product's slow season reward
customers who essentially assist a company in balancing its cash flow and in
meeting production demands.
d. Trade-in
allowances for returned old products that you may either re-use or re-sell for
a profit may benefit both a company and customers.
e. Promotional allowances often make economic sense. For example, if your product is sold by a retail chain which includes your product in its ads or in promotional activities, those activities leverage your marketing efforts. If so, you might choose to discount your price to this retail chain.
A significant part of marketing, and pricing for that matter, involves consumer psychology. Some recent studies have been conducted to determine the best way to present products with multiple options. Most products are presented with a base price and the option to add-on extra features (an example is the purchase of a new car or a made-to-order computer). The subtractive option does just the opposite. The base model is priced higher, but contains many or all of the add-ons. After a purchase, the consumer tends to feel unsatisfied and generally questions the purchase after the event. This is known among marketers and psychologists as cognitive dissonance. Typically, the more expensive the purchase is, the greater the intensity of cognitive dissonance. Interestingly enough, it was determined that consumers are more receptive to subtractive option strategy. Not only were the customers presented with the subtractive option strategy more likely to chose more options, spending more money, but they also walked away more satisfied with their purchase. “To top all of this off, although these customers found making option choices more difficult and time consuming, they found the task more enjoyable and felt that they got more value from their final choice.” (MacInnis).
When marketers determine the pricing strategies that they intend to implement, they must also examine the legal and ethical issues that come into play. Some pricing practices that have been outlawed in the United States include: horizontal price fixing, price discrimination, deceptive pricing, price fixing, and withholding pricing information. Horizontal price fixing involves price conspiracies among competitors, blocking new competitors from entering the market. Price discrimination involves charging different customers different prices without an underlying cost basis for the discrimination. Deceptive pricing involves deceiving a customer by setting a high price; later it is reduced. Fixing prices in the channel of distribution (vertical pricing) also falls under the anti-trust laws. Also, the Consumer Credit Protection Act requires full disclosure of pricing information.
In conclusion, we can see that early pricing strategies were based strictly on the needs of the company and also the evaluation of competitors’ price points. We have evolved to focus more on the needs of the consumer and the psychology that plays into purchasing. By incorporating the fundamentals with some of the new strategies we should be able to best position the product and price it at the optimum point.
Works
Cited
MacInnis, Debbie. “Profitable Strategies for Presenting Products with Multiple Options”.
MarketingProfs.com. http://www.MarketingProfs.com/Tutorials/optionframe.asp
2000-2001.
“The Economic Value to the Customer”. MarketingProfs.com.
http://www.MarketingProfs.com/Tutorials/evc.asp 2000-2001.