There are several methods through which a company can set prices. We can distinguish between three broad categories according to the emphasis that predominates as the basis for price setting:
Internal cost-based methods of pricing
The most widely used method for determining prices involves setting prices predominantly on the basis of the company’s costs. This method is referred to as ‘cost-plus’ pricing. In its simplest form it involves a company calculating average costs of production and then allocating a specified markup, which may be related to rate of return required by the company, to arrive at the selling price. The major advantage of this method is its simplicity. However, despite its widespread use, it has been criticized. Before we examine the basis of these criticisms we need to examine further the mechanics of cost-plus pricing, as well as some of the reasons why this apparently ‘simple’ approach to pricing may be more complex than it seems at first glance.
As we have seen, the mechanics of cost-plus pricing involve calculating variable costs per unit and adding to this an allocation of the total fixed costs. The first problem with cost-plus pricing is in both the calculation and allocation of these fixed costs. Lancaster and Massingham6 highlight these problems as follows:
Both the calculation of total fixed costs and the methods of allocating this total between products give rise to serious problems when using this method of pricing. For example, the amount of fixed costs which will be added to each product, and consequently the price clearly depends on the number of products produced. In turn, the number of products that a firm will produce will, ignoring stockholding, be a function of how many it can sell. How many will be sold, in turn, depends upon the price charged. Pricing in this way then is nonsensical; it means that for a given production capacity, if a company finds that it is selling less and cuts its production its market prices will need to increase. This, in turn, will probably lead to fewer sales, a further cut-back in production and even higher prices. To say the least this is an unsatisfactory state of affairs.
In many multi-product companies the allocation of fixed and semi-variable costs to individual products is often arbitrary. In practice, total fixed costs are allocated on the basis of either a standard volume or a forecast level of output.
A second problem with cost-plus pricing is in determining mark-up. Often the percentage markup is derived from a pre-determined target rate of profit or return. The problem with such predetermined mark-up rates is that they take no account of demand conditions. Where rigid percentage mark-ups are applied, particularly where these are based on internally determined requirements for profit, cost-plus has major disadvantages:
With these disadvantages there must be good reason why cost-plus remains widely used by companies and the advantages are as follows:
None of these potential advantages can compensate for the fact that cost-plus pricing, in its most rigid form, is not market oriented, and can lead to significant strategic disadvantages in the market.
Variations on cost-plus pricing
It would be strange if companies had not realized the problems of cost-plus pricing. Thus a number of variants on this approach, although still based on costs, may be needed.
Marginal or direct cost pricing is where prices are based not on full costs that include fixed costs, but direct or marginal costs. Fixed costs are not charged to production as they are treated as a period charge and written off to the profit and loss account. In this way, the problems associated with having to cover costs, and the methods of having to allocate fixed costs, are avoided. This makes use of the notion of ‘contribution’ discussed earlier. Needless to say, in the long run all costs, including fixed costs, must be covered, but marginal cost pricing does at least allow a company to take advantage of market opportunities and to use price as a more strategic tool of marketing. This approach is particularly useful for services marketing where the service cannot be stored, i.e. is highly perishable, such as cinema seats or hotel bedrooms. Prices can then be based on making a contribution to fixed costs by charging prices which cover variable, but not total costs.
EasyJet and Ryanair make good use of marginal-cost pricing in their marketing strategies. These operators cover their variable costs when selling an airline seat rather than let the plane fly with empty seats. Provided of course that there are enough ‘full price’ paying passengers, this is an effective way of not only making a contribution to profits, but at the same time making life difficult for costplus competitors.
Another example of marginal cost pricing can be found in the hotel industry. Hoteliers know that if a hotel room is not sold on a particular evening then the revenue that letting the room would generate for that evening is lost for ever. This is due to the service product characteristic of ‘perishability’, i.e. a service cannot be stored and sold again on another occasion.
This makes it imperative that demand and supply of services be balanced and matched. Price is the primary mechanism for achieving this match. In the case of the hotel reducing the price of unsold rooms, this allows the marketer to generate some contribution and the room should be let at a discount if the full price cannot be achieved. Marginal pricing, especially for services, makes sense and is popular. However, it necessarily leads to price variations which as Palmer and McMahon-Beattie7 show can lead to customer dissatisfaction and mistrust.
Variable mark-up pricing is an alternative to the fixed mark-up system of traditional cost plus pricing, and here the percentage added to costs can be varied. This approach has advantages over the fixed mark-up approach:
Despite these variations on rigid cost-plus pricing, it is a fact that cost-based pricing is an indication of a company that has failed to appreciate the significance of the marketing concept. This is not to deny the importance of costs, and cost information in pricing decisions, but costs are perhaps better used in an evaluative, rather that a decision-making role when it comes to setting prices.
Competition-based pricing as a method of determining a price uses the price set by competitors to orient the pricing decision. This method is based on assumptions, including that of product image and the position of the company, as being the same or similar to those of the competition. This can be improved upon with a more sophisticated method, involving setting a differential between the company operating it and the competition. The marketer may, for example, set a price 5 per cent below that of the market leader to allow for the market leader’s stronger reputation within the industry.
This approach to pricing has the disadvantage of being somewhat passive in nature, which tends to restrict the management of the company in terms of individualistic flair and style. Another drawback of this method, known as going rate pricing, is that it tends to ignore the company’s own cost and demand situation. Going rate pricing is popular in markets where costs are difficult to measure or the response of competitors is uncertain.
Going rate pricing is used extensively in the university sector to price undergraduate degree programmes. For government-funded universities, easily the largest sector, upper limits to fees are set by the government. However, there is no lower limit to these fees. Universities can charge what they want below the upper limit. Notwithstanding difference in costs, objectives, competitive structures and so on, virtually every University charge exactly the same price for their products. Although it is vital to consider competitors’ prices and costs, this information should be used to influence decisions on price rather than as a ‘formula’ for setting it.
Customer value-based pricing is a market-oriented method. Although complex in nature and application, this method moves away from a focus on costs or competition and concentrates on customers. With this approach, prices are determined on the basis of the perceived value of the product to the customer. The basic idea is that when customers purchase a product they go through a complex process of balancing benefits against costs.
In consumer product markets, the ‘benefits’ the customer derives correspond to the economist’s notion of ‘utility’ or satisfaction and may include both functional and psychological elements. For example, the customer may derive satisfaction, and hence value, from the quality of a product, or a particular product feature such as a satellite navigation system built into a new car.
An example of a psychological element of value might be the benefit which the customer derives from the status of a prestigious brand name. Clearly, the more benefits the customer perceives a product as offering, the more value that customer will place on this product and the more the customer will be prepared to pay. Again, we should note that it is the customer’s perception of value that matters and not that of the supplier.
Needless to say, a customer will not purchase a product where costs are seen as being greater than benefits. It is important to stress that costs may include more than just the purchase price, and it is the customer’s perception of these costs that is used in the evaluation process. For example, in assessing the cost of, say, a new car it is not just the initial purchase cost, but also maintenance, insurance, fuel and depreciation costs that the purchaser may consider.
In addition, just as there are psychological benefits, so too are there psychological costs. For example, a new car purchaser may well consider the costs of ‘loss of status’ if an otherwise ‘good value for money’ purchase might be ridiculed by peer groups. Certain Eastern European car manufacturers faced this problem in trying to market their models in parts of Western Europe. The Czech company, Skoda, in their advertising, actually acknowledged this problem as initially, the brand was regarded as a joke, but this is no longer the case. Effective marketing has now made the Skoda car a success story of recent years.
Product improvements, the backing of German group, Volkswagen and a repositioning of the brand have served to make Skoda one of the best value cars in the market. Although the car is still low priced compared to some of its competitors, this low price base has been turned to advantage by the company by building the value for money aspect. Customers who were attracted to this car become brand loyal and saw themselves as being astute in their choice. After all, they argued, they were securing the advantages of a Volkswagen product at a Skoda price.
Basically, the marketer must determine what the market will bear i.e. the highest price the customer will pay which is:
Benefits – Costs other than price = Highest price the customer will pay For the pricing decision maker the difficulty in this method is in measuring how the customer perceives the product the company is offering against the competition.
One method that can be used is to weigh product attributes against those of the competition. First, the customer is asked questions concerning different attributes of a product, e.g. quality and delivery. The customer is then asked how important each criterion is, e.g. the customer might think that after-sales service is more important than delivery and would then give this criterion a higher rating than delivery. The customer is next asked how the organization fares in comparison to other companies in the market place on these criteria. The customer’s perceived value of different competitive offerings can then be calculated.
Let us assume that competitor C has the highest overall value rating over competitors A and B. On this basis that company should be able to charge higher prices than competitors A and B for the product. If, say, the average price for this particular product in the industry is £10.00 and the average value rating is 36.5 then company C should be able to charge £10 x 36.5 ÷ 33.3 = £11.00 approximately, and still be competitive. If all three companies set their prices proportional to their value rating, then they would all be offering the same value to price.
However, if company C sets a price of less than £11.00 it should begin to steal market share from its competitors because it will be perceived to be offering better value for money. This illustrates just one method of analyzing how the customer perceives the relative benefits of the products on offer. Taking this approach a stage further, it is useful to establish the Economic Value of a product to a Customer (EVC). Economic value pricing, sometimes also referred to as performance pricing, is a powerful pricing tool that is used principally in pricing industrial products. It requires extensive market research to allow the pricing decision maker to analyse:
How the customer uses the product – Different customers may use the ‘same’ product in different ways and make different cost/benefit evaluations e.g. one contractor may run earth-moving machinery 24 hours a day and place a premium on a machine which offers greater reliability and parts back-up to minimize ‘down time’. Another, perhaps smaller, contractor in the same business might only operate its machines 12 hours a day, but may not be able to afford a permanent team of mechanics. This contractor is likely to place more emphasis (i.e. value) on supplier /dealer servicing facilities. In short, the marketer must study and understand how the product fits into the operation of the customer.
Benefits – When we understand how the customer will use the product we can proceed to evaluate the ‘cost out’ of financial benefits of the product to the customer. Focusing on benefits helps develop a more detailed picture of the overall desirability of the product. When analysing benefits the product gives, it is useful to break them into core product benefits and augmented product benefits. Core attributes could be quality, reliability or other functional aspects. The augmented attributes could be delivery, service, guarantees and maintenance offered by the supplier. Focusing solely on physical and core attributes can lead marketers into the trap of marketing features of the product as opposed to benefits the product has to offer.
Costs – Just as benefits can be a group of core and augmented attributes, perceived in differing ways by different customers, so the same can be said for costs, in that costs are not just the price the customer forgoes. One aspect of this is when a buyer decides to change from an existing supplier to a cheaper source. The buyer may be thinking of lowering cost, but in fact the opposite may be the case as the alternative products may not be of as good quality as the previous products, or the new supplier may not be able to deliver the goods on time. The lost time from reject products and subsequent breakdown in the production runs can make savings achieved on price irrelevant. Total lifetime operating costs, including residual value of the product, should be calculated for each customer.
Trade-off between benefits and costs – If the customer makes a trade-off between costs and benefits it would seem sensible for the selling company to do the same. The simplest method is by analyzing only the core attributes and price. Once again, it is important therefore that the selling company looks at the use of the product and evaluates this in conjunction with costs and benefits offered. As the customer looks at price as part of the overall product package, so too must the marketer. If the firm wishes to adopt a value-based approach to pricing it must follow certain guidelines:
Despite the inherent wisdom of value-based pricing evidence shows it is still resisted by many companies (Hinterhuber8). Certainly customer/value-based pricing involves more analysis, time and effort than cost-based or competitor-based pricing, but it is essentially marketing oriented. Because of this, value-based pricing is useful in guiding other elements of marketing strategy. For example:
Other considerations in setting prices
We have discussed inputs to pricing decisions and merits of different pricing methods. In arriving at a final price, other considerations may influence the decision, such as:
In the absence of other information, price is often used as a singular indicator of quality. The pricing decision maker must be careful to ensure, particularly for a new product, that a low initial price does not put off customers because they suspect the quality.
It is now recognized that pricing sends many complex signals to customers. Moreover these price signals don’t always mean the same thing to each customer. As a result, they are often interpreted and acted upon in different ways. There are behavioural forces at work with respect to price involving psychological factors such as perception, learning and personality. These behavioural forces have led to the notion of considering the psychology of pricing processes. Examples include: Odd pricing: Often prices are set to end in an odd number (e.g. £4.99 instead of £5.00). There is some evidence that customers then see the product as falling into the lower priced category (i.e. £4.00) rather than the higher one to which it is actually much nearer.
Price and perceptions of quality: Price is often used by potential customers as an indication of quality, particularly where they are unfamiliar with a brand or supplier. This means that a low price may be taken as a sign of low quality and vice versa for a high price meaning it is possible to price a product too low.
Price and social status: Related to price as an indicator of quality, the marketer needs to be aware that some customers will connect the prices they and other people pay as being an indicator of status. Again, some customers may be deterred by low prices even if they know it represents the best possible value, because they feel it detracts from their social status.
Other products in the line/mix
In a multi-product company many products have interrelated costs and/or demand. When setting a price on an individual product in the line, consideration should be given to the overall profitability of the product mix, e.g. we might decide to set a lower price on an individual product than we might otherwise do because it helps to sell other, perhaps more profitable, items in the line.
Other elements of the marketing mix
As with all marketing mix elements, it is important that pricing reflects, and is consistent with, other elements of the mix. A high quality, expensively packaged product may be looked at with some ‘suspicion’ by potential buyers if it carries a ‘bargain’ price tag.
Product life cycle
The competitive situation for a product changes throughout the life cycle of a product. Each different phase in the cycle may require a different strategy. Pricing plays a particularly important role in this respect. Care should be used in interpreting the possible strategic implications of each of the life cycle stages.
Pricing in the introductory stage of the life cycle – With an innovatory product, developers can expect to have a competitive edge for a period of time. With innovatory new products, a company can elect to choose between two pricing strategies:
Price skimming is where the setting of a high initial price can be interpreted as an assumption by management that eventually competition will enter the market and erode profit margins. The company sets a high price so as to ‘milk’ the market and achieve maximum profits available in the shortest period of time. This ‘market skimming’ strategy involves the company estimating the highest price the customer is willing or able to pay, which will involve assessing the benefits of the product to the potential customer. This strategy has been successfully carried out by firms marketing innovative products that have substantial consumer benefits. An example of price skimming was Apple’s iPod. Launched in 2005, the initial price was set at £450. It now is possible to purchase variants of the iPod for less than £100.
After the initial introduction stage of the product the company will lower the price of the product in successive stage so as to draw in the more price-conscious customers. When a company adopts this strategy the following variables are usually present:
Price penetration is where setting a low price or a ‘market penetration strategy’ is carried out by companies whose prime objective is to capture a large market share in the quickest time period possible. Conditions which prevail in such circumstances include:
Pricing in the growth stage For a period of time after introduction, the market will continue to grow. The fact that new companies are entering the market means the market will be divided between competing companies, but as the market is still growing, new companies may not take any sales away from the innovator for some time. When new companies come in to the market they tend to emphasize non-product attributes of their product, as opposed to the innovator. If this occurs, the innovating company will usually lower the price of its own product so as to discourage competition.
Pricing at the maturity stage As the market for the product continues to expand and develop, the use of the product becomes more widespread, and with the entrance of new competitors, the price of the product will become increasingly important in competitive strategy. A new supplier entering the market or an existing company can only increase market share by taking share away from other companies. The means for achieving this is often on the basis of price competition, since by the time the market reaches maturity stage, product differentiation and other forms of differentiation may have been eroded.
Pricing in the decline stage During this stage, price-cutting initiated in the maturity stage will tend to continue. At this stage, a careful appraisal of profit margins will need to be made. Prices may be eroded to the point where either total or even only marginal costs are no longer being covered. As we considered in Chapter 4, at this stage in the product life cycle, decisions as to whether to harvest or divest the product need to be made. These decisions will need to take account of possible ways of reducing costs to try and maintain profit margins.
Other interested parties
Pricing decisions will need to take account of various other parties that might be interested in, or be affected by, the pricing decision. For example, there may be legal aspects to pricing decisions, with possibly government departments and/or ‘watchdog’ bodies playing a key role in pricing decisions. For example, some privatized companies in the UK, such as gas, electricity and water companies, have to meet stringent regulatory requirements with respect to their pricing.
A further ‘interested party’ to take account of in pricing decisions is the distributor. Where products and services are marketed using intermediaries we need to remember that in many markets the final selling price may not be determined by the producer, but by intermediaries. There is now no longer resale price maintenance which means that a supplier to a retailer can only recommend (not stipulate) a retail price. The final price is set by the retailer who adds a mark-up, so to this extent the supplier can try to influence the final market price. The extent that intermediaries are free to set prices effectively means that the marketer has little control over final price. In addition, we must also determine factors like credit terms and discounts as part of pricing strategy.
Many branded product marketers have sometimes been incensed by their inability to force distributors to sell their brands at the prices they would like. Tesco supermarket chain sold Levi jeans at a lot less than the manufacturer’s ‘recommended’ prices. Challenged by Levis, Tesco won the right to sell the brand at these reduced prices in their stores subject to certain conditions being met. Perfume houses, haute couture clothing brands, books and over-the-counter pharmaceuticals are examples where the branded marketer has effectively lost control over prices charged.
This does not mean that unless you own or control the channel of distribution that planning and managing pricing and much of what we have discussed in this chapter are unimportant. In fact, just the opposite is the case. The increasing power of intermediaries to control price in many markets means that the brand marketer must increasingly search for ways to counteract this power. One of the most powerful tools is to use dominant brands. Even the most influential retailers would not like to lose some of the best known and best selling brands from their shelves. They know that such brands command price premiums and serve to attract customers to shop at their stores. Brand marketers must also work closely with distributors to mutually agree price and promotional campaigns. Another way to gain control over price is to market direct to customers. Needless to say, with the popularity of the Web, this is the route that many marketers are choosing to go.
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