Pricing Strategies

The main objectives in choosing and setting the price of a product include the following:

1)Maximize profit.

2)Meet target sales or market share.

3)Maintain a price that is stable in relation to competitors' prices.

Internal Factors in Pricing a Product

The cost of producing and marketing the product is the main consideration in setting a price. Clearly, the company wants to make profits from the costs it incurred. Marketing strategies, such as product specifications, place of distribution, and ways or promoting the product are carefully considered.

The capacity of the plant is also to be considered. Companies may set higher prices when they are not operating at full capacity for them to recover fixed costs even if less units are sold. This is known as peak-load pricing.

External Factors in Pricing a Product

Market competition plays big role in product pricing. The type of market determines the ability of a company in setting prices. In industries under perfect competition, players have less to no control over price. It is set by the market. Under monopolistic competition, a monopoly virtually has the power to set prices since there are no competitors.

Legal factors are also considered. Generally, pricing strategies that kill healthy competition are prohibited by law. Predatory pricing involves setting prices so low to drive out competitors. Collusive pricing happens when companies conspire to set very high prices. Discriminatory pricing involves charging different prices from different customers. These pricing strategies are generally prohibited by law.

The law of demand and supply also determines price levels. Generally, the higher the demand, the higher the price sellers will charge. The higher the supply is, the lower the price. The sensitivity (elasticity) of price to changes in demand and supply, and vice versa, must also be studied

Pricing Methods

1)Cost-based pricing - Price is set by adding a certain mark-up above the cost of producing and selling the product.

2)Value-based pricing - Rather than focusing on costs, price is based on the value of the product as perceived by the buyer.

3)Competition-based pricing - Prices are based on competitors' prices. This is most applicable in pure competition markets where there are many market players.

4)Penetration pricing - Low prices are set for a new product for it to enter the market easily. Once the product has established itself, higher prices may then be set.

5)Price skimming - involves setting high prices for new products. The goal of price skimming is to sell as many units as possible to customers who do not care much about price. Once substantial amounts of cost have been recovered, prices may then be lowered in order to expand sales

Cost-Based Pricing

Cost-based pricing is a pricing method wherein a mark-up is added over costs incurred to come-up with the suggested price of the product.

The goal of doing business is to maximize wealth and profits. Cost-based pricing ensures that costs are fully recovered and desired profits are met.

Cost-Plus Pricing Formula

The price derived from applying mark-up over the cost of the product is known as cost-plus price.

Cost-Plus Price = Cost + Mark-up

The mark-up can be computed as a percentage of total costs, product costs, variable manufacturing costs, or total variable costs.

Example

ABC Company identified the following costs incurred in producing 500 units of its new product. Compute for the cost-plus price assuming a mark-up of:

1.) 20% based on total costs;

2.) 75% based on product costs;

3.) 125% based on variable manufacturing costs; and

4.) 50% based on total variable costs.

 Total Per unit

Direct material $ 3,000 $ 6,00

Direct labor $ 2,600 $ 5.20

Variable factory overhead $ 2,000 $ 4,00

Fixed factory overhead $ 1,500 $ 3,00

The company expects to incur $2,800 variable selling and administrative costs and $1,850 fixed selling and administrative costs. (Per unit: $5.60 for VS&A and $3.70 for FS&A)

1.) 20% based on total costs

Total cost per unit = $6.00 + 5.20 + 4.00 + 3.00 + 5.60 + 3.70 = $27.5

Price = Cost + Mark-up

Price = $27.60 + (20% x $27.60)

Price = $33.00

2.) 75% based on product costs

Total product cost per unit = $6.00 + 5.20 + 4.00 + 3.00 = $18.20

Price = $18.20 + (75% x $18.20)

Price = $31.85

3.) 125% based on variable manufacturing costs

Total product cost per unit = $6.00 + 5.20 + 4.00 = $15.20

Price = $15.20 + (125% x $15.20)

Price = $34.20

4.) 50% based on total variable costs

Total product cost per unit = $6.00 + 5.20 + 4.00 + 5.60 = $20.80

Price = $20.80 + (50% x $20.80)

Price = $31.20

Value-based pricing

Value-based pricing is a pricing method wherein prices are set based on the buyer's perceived value.

Unlike, cost-based pricing that places a certain markup on top of costs incurred, value-based pricing sets prices based on the benefits provided by the product.

Companies that offer products with unique and distinguished features, as well as highly customized products and services, are more inclined in using value-based pricing over other pricing methods.

Value-based pricing is more applicable in situations where individual quotes are given to individual orders or jobs. Examples include: attorney fees for specific cases, architectural design, general repairs, car customization, and other custom products and services.

Target Costing

When charging value-based price, the seller still considers relevant costs. Though mark-up is not directly computed on the basis of cost, the selling price must be enough to cover for the costs to be incurred. Generally, those that use value-based pricing tend to ask for relatively high prices; hence, enough to cover costs.

Sometimes, the reverse of cost-plus pricing happens in value-based pricing. The price is quoted first and then target costs are determined to achieve a profit. The seller will have to work on a certain budget to meet a desired income. When this happens, costs must be minimized without sacrificing customer satisfaction.

Example

Mr. Davis wishes to have his car, a 1969 Cadillac Coupe, restored. It has been sitting in his barn for a while and rust has eaten most of its parts. He approached KustomKars Company to do the job. Based on the value it would give the owner, the company quotes an all-in price of $30,000. Mr. Davis agrees to the price as he believes that it is a fair measure of the benefit he will receive.

KustomKars now has to work within a budget and make sure that the total cost it will incur will be within $30,000 if it wishes to make a profit. If the company wishes to earn at least $2,000, then target costs must be set at up to $28,000. However, the satisfaction of the customer must not be sacrificed. The perceived value must still be met.

Competition-Based Pricing

Competition-based pricing is a pricing method that makes use of competitors' prices for the same or similar product as basis in setting a price.

This pricing method focuses on information from the market rather than production costs (cost-plus pricing) and product's perceived value (value-based pricing).

The price of competing products is used a benchmark. The business may sell its product at a price above or below such benchmark. Setting a price above the benchmark will result in higher profit per unit but might result in less units sold as customers would prefer products with lower prices.

On the other hand, setting a price below the benchmark might result in more units sold but will cause less profit per unit.

In a perfectly competitive market, sellers almost have no control over prices. It is solely determined by the supply and demand, and products are sold at the market price or going rate.

Advantages and Disadvantages of Competition-Based Pricing

One of the advantages of competition-based pricing is that no complex computations are required. Sellers simply follow a market price, or a price set by market leaders.

Also, in a highly competitive market, the burden of price-based marketing is lifted. However, other forms or marketing efforts might be needed.

When sellers adopt the same price as those charged by competitors, certain marketing efforts must be made to attract sales since price is not a major factor; it is neither an advantage nor a disadvantage. Additional efforts include aggressive advertising, better customer support, market saturation, etc.

Penetration Pricing and Price Skimming

The two most commonly used pricing methods for new products are: penetration

pricing and price skimming.

Penetration Pricing

Penetration pricing is a pricing method that involves setting low prices with the intention of quickly introducing a new product to the market.

Penetration pricing aims to attract customers away from competitors by offering lower prices initially. Once the product has been accepted and has established its brand in the market, prices may be increased to yield greater profits.

Price Skimming

Price skimming involves setting high initial prices to recover costs and make huge profits in the early stages of the product's life cycle. It is very common in technological markets (mobile phones, gaming consoles such as Sony PlayStation and Microsoft X-box, etc.).

Once the upper class market has been served, the price is lowered to cater to a larger clientele. Those who were not able to afford the product during its initial offering will be able to buy it after subsequent price adjustments. This results in a larger market share and continuous sales.

Advantages and Disadvantages of Penetration Pricing

Penetration pricing gets the new product diffused into the market quickly. Buyers are enticed by low prices. However, when prices are set very low, it results in low profit per unit. This, nonetheless, may be compensated by higher volume of sales.

Penetration pricing can also help the business establish market dominance. By setting low prices, possible entrants will be discouraged in entering the market. Current competitors may also be forced to leave if they cannot keep up with low prices.

On the downside, setting substantially low prices might cause customers to question the quality of the product. Also, once 

Advantages and Disadvantages of Price Skimming

The main advantage of price skimming is higher profits in the early stages of the product's life cycle. This is common in technological markets where repeat purchase is uncommon.

Research and developments costs in technological markets are high. These costs are recovered early on by setting high selling prices. Also, customers often associate high prices with good quality.

A business that adopts price skimming limits its sales. Because of high initial price, sales volume is restricted. Also, when the price is dropped later on, customers might not be as excited as when the product was first released.