Ch12 Pricing Decisions

12.1: A Process for Making Pricing Decisions

  • A manager’s freedom to select a price for a given good or service is constrained by several factors:

 First: the firm’s costs determine the floor of the range or feasible prices.

At the other extreme, the price sensitivity of demand for the product determines the ceiling of the range of acceptable prices. Beyond some price level, most potential customers seek less costly substitutes, such as private labels or do without the good or service.

  • This process is particularly appropriate for first-time pricing decisions as when a firm introduces a new product or enters a bid for non-routine contract work. It includes several steps involving detailed analyses of demand, costs, and the competition.

I. Strategic Pricing Objectives:

1-Maximize Sales Growth:

  • When a firm is an early entrant into a new product-market with the potential for substantial growth, its objective may be to maximize its product’s rate of sales growth (in units).
  • This suggests it should set a relatively low price to attract as many new customers as quickly as possible and to capture a large share of the total market before it becomes crowded with competitors. This low-priced strategy is called penetration pricing.
  • Penetration pricing is appropriate when, in addition to a large market:

1. Target customers are relatively sensitive to price.

2. The firm’s costs are low compared to competitors’ and the SBU is pursuing a low-cost strategy.

3. Production and distribution costs per unit are likely to fall substantially with increasing volume.

4. Low prices may discourage potential competitors from entering the market.

  • There is a major risk in using low prices to achieve maximum sales growth in the short term as a base for future profits. If market, competitive, or technological conditions change, those future profits may never be realized.

2-Maintain Quality or Service Differentiation

  • When a firm has a strong competitive position based on superior product quality or customer service, its primary pricing objective is to generate sufficient revenue to maintain that advantage.
  • Such a firm usually asks a premium price for its product for two reasons:

 First, it needs additional revenue to cover the R&D, production, distribution, and advertising costs it takes to maintain both the reality and the perception of superior quality or service.

 Second, customers are usually willing to pay more for a superior offering; high quality decreases the elasticity of demand.

  • A premium price policy is most appropriate for businesses pursuing differentiated defender strategies

3-Maximize Current Profit

  • Skimming
  • When firms pioneer the development of a new product-market, sometimes their pricing objective is to maximize short-run profits. They adopt a skimming price policy, setting the price very high and appealing to only the least price-sensitive segment of potential customers.
  • Skimming is most relevant to a small market & appropriate for businesses pursuing prospector strategies involving investments in the development and commercialization of a stream of new products with proprietary technology.
  • At the other end of the life cycle, some product-markets decline rapidly as customer preferences change or new technologies and substitute products are introduced.
  • Skimming is most relevant to a small market because a large market is more apt to attract competitors.
  • Harvesting
  • Often it’s too late to divest the product and earn a reasonable return, so firms facing the situation adopt a harvesting strategy to maximize short-term profits before demand for the product disappears. This typically involves cutting marketing, production, and operating costs of the product, while setting a high price to maintain margins and maximize profits.
  • This is an appropriate strategy only where there is no way – such as by making product improvements or increasing promotion – to sustain market demand or the item’s competitive position very far into the future.
  • Businesses with an established product in a market expected to grow or experience stable demand well into the future run into trouble because of strategic mistakes, such as failing to adapt to customers’ changing desires or to competitive threats, or building excess capacity.
  • Survival
  • If such mistakes are correctable, the firm may adopt a pricing objective of Survival, i.e. simply keeping the product alive while strategic adjustments are made.
  • Because short-term profits are less important than survival for products, this situation usually demands a low price to attract enough demand to keep the plant operating and maintain cash flow. So long, as the price covers variable costs and at least contributes to fixed costs, the firm may be able to buy time to correct its competitive weaknesses.
  • Social Objectives
  • Some organizations may forgo possible profits – at least among some price-sensitive customer segments – by offering a low price to those customers to achieve some broader social purpose.
  • This is most common among not-for-profit organizations such as performing arts organizations and public hospitals, especially if subsidized by government agencies, foundations, or private contributions and not relying on sales as their sole source of revenue.

II. Estimating Demand and Perceived Value

  • Demand sets the ceiling on the range of feasible prices for a product. The familiar demand curve depicts this variation in the quantity demanded at different prices. In most cases there is an inverse relation between a product’s price and the quantity demanded: the higher the price, the less people want to buy. Thus, the typical demand curve has a negative, or downward, slope.
  • However, luxurious products and those whose quality is difficult to objectively judge sometimes have positively sloping demand curves. Some customers use price as an indicator of the prestige or quality of such products, and they are induced to buy more as the price increases.
  • Factors Affecting Customer’s Price Sensitivity

The demand curve sums the reactions of many potential buyers to the alternative prices that might be charged for a product. The curve’s degree of slope reflects the fact that different buyers have different sensitivities to the product’s price.

Thomas Nagle identified specific factors influencing variations in sensitivity to price across customers and products. Those factors are:

1-Unique Value effect: customers are less price sensitive when they perceive the product or service provides unique benefits; there are no acceptable substitutes

2-Price quality effect: customers are less price sensitive when they perceive the product or service offers high quality, prestige or exclusiveness.

3-Substitute awareness effect: customers are less price sensitive when they are relatively unaware of competing brands or substitute products or services.

4-Difficult comparison effect: customers are less price sensitive when it is difficult to compare objectively the quality or performance of alternative brands or substitutes.

5-Sunk investment effect: Customers are less price sensitive when the purchase is necessary to gain full benefits from assets previously bought.

6-Total expenditure effect: Customers are less price sensitive when their expenditure for the product of service is a relatively low proportion of t their total income.

7-End benefit effect:Customers- particularly industrial buyers purchasing raw materials or component parts- are less price sensitive when the expenditure is a relatively small proportion of the total cost of the end product.

8-Shared cost effect: Customers are less price sensitive when part of the cost of the product or service is borne by another party

9-Inventory effect: Customers are less price sensitive in the short run when they cannot store large quantities of the product as a hedge against future price increases.

  • Price Elasticity of Demand
  • The larger the proportion of price sensitive customers in a product’s market, the more sensitive overall demand is to change in the product’s price. This degree of responsiveness of demand to a price change is referred to as the price elasticity of demand.
  • Price elasticity of demand (E) = Percent change in quantity demanded

Percent change in price

  • If for instance a seller raised the price of a produced by 2 percent and demand subsequently fell by 6 percent, the price elasticity of demand for that product would be -3, indicating substantial elasticity.
  • Conversely, if a 2 percent increase produced by a 1 percent decline in the quantity demanded, then price elasticity is -1/2 indicating that demand is inelastic.
  • If a 2 percent price increase leads to a 2 percent decline in quantity; price elasticity is unitary. In such a case the seller’s total revenue stays the same because the smaller quantity sold is offset by the higher price.
  • There are major problems in using price elasticity and they are: failure to consider the response of competitors to the company’s change in price; that demand may be inelastic for a given price change, but elastic for a larger amount; that elasticity is; that a lowering of price may affect the sales of other items in the company’s product line’ and that it ignores any social benefits accorded the company for benefiting low- income segments via a price reduction.
  1. Estimating Costs

A firm’s costs take two forms: Fixed and variable.

1-Fixed costs (or overhead): are constant in the short term, regardless of production volume or sales revenue.

They include rent, interest, heat, executive salaries, and functional department

Because total fixed costs remain constant in the short term regardless of volume, the fixed cost per unit of a product declines as a firm produces and sells more of the product in a given period

2-Variable costs: vary in magnitude directly with the level of production, but they remain constant per unit regardless of how many units are produced. They involve such things as the costs of materials, packaging, and labor needed to produce each unit of the product.

Total costs equals sum of fixed and variable costs for a given level of production. The product’s price must cover this total cost figure- divided by the number of units produced.

Marketing mix costs: may include both fixed and variable costs, and other costs such as retailers or distributors markups.

Setting a high price with too little promotional support is likely to lead to sales problems. Similarly, setting a low price alongside an aggressive promotional programme can lead to profit and cash flow problems, as many dot-com retailers have learned the hard way.

Price setting for a product cannot occur in isolation. It requires considering the costs, of the planned overall marketing mix for the product, including product, promotion, and distribution decisions.

  • Measuring Costs

Activity- based costing systems: allocate costs across individual products by directly observing the level of various functional activities such as: shipping, receiving, supervising, and selling that are devoted to each item in the line- often generate very different estimates of the total costs associated with a given product that does the firm’s standard cost control system.

Such activity- based cost estimates are often more useful for making strategic marketing decisions, such as setting prices, because they reduce some of the distortions inherent in the allocation of indirect costs within standard cost accounting systems while avoiding the imprecision of the contribution margin approach.

  • Cost and Volume Relationships

A product’s average cost per unit- and the price necessary to cover that cost varies with the quantity produced.

Managers take two different volume- cost relationships into account when making pricing decisions:

1-Economies of scale- In the short run, companies can gain further economies by constructing larger and more efficient facilities. The average cost per unit is high if few units are produced, but it falls as production approaches the plant’s capacity because fixed costs are spread over more units.

If the company tries to produce more than capacity, average costs per unit would rise. The overworked machinery would break down more often, workers would get in each other’s way, and other inefficiencies would occur.

2-Experience curve- the fall in production and marketing costs per unit as a firm gains accumulated experience. Its average costs per unit decline as it gains experience. Its production workers discover efficient shortcuts, procurement costs fall, and the accumulated impact of past advertising and marketing efforts may enable the firm to succeed with smaller per-unit marketing expenditures.

  1. Analyzing Competitors Costs and Prices
  • To implement a low- cost strategy, the manager must be sure that the product’s costs are truly lower than any competitor’s offer and that those lower costs are reflected in the product’s relative price.
  • The manager needs to learn and track the price, costs, and relative quality of each competitor’s offer.
  • A manager can estimate competitor’s relative cost positions in a service industry by comparing their numbers of employees or the number and size of outlets and then looking at efficiency ratios like sales per employee or sales per square foot.

12.2: Methods Managers Use to Determine an Appropriate Price Level

- Various pricing methods fall into three categories: cost- oriented pricing, competition-oriented pricing, and demand or customer- oriented pricing.

1-Cost-Oriented Methods

  • Cost- plus or markup pricing: does not explicitly consider the price sensitivity of demand or the pricing practices of competitors.

It is convenient and easy to apply- when a firm faces hundreds or thousands of pricing decisions each year.

It is widely used among firms that must submit competitive bids for a variety of projects.

The typical procedure for determining price under the markup approach is to first calculate cost per unit by adding variable cost to fixed costs divided by an expected level of unit sales:

This approach largely ignores the price sensitivity of demand. It assumes a level of sales before the price is set.

If the manager’s assumption about likely sales volume is wrong, the desired markup is not achieved. A shortfall in units sold would mean that fixed costs would be spread over fewer units and the realized markup would be smaller than desired.

  • Rate-of-return or target return pricing – brings one or more cost element into the pricing decision- the cost of capital tied up in producing and distributing the product. The objective is to set a price yielding a target rate of return on investment.

This pricing approach demands that managers: (1) estimate the unit sales volume of the product, (2) figure unit costs, (3) estimate the amount of capital involved in producing and selling the product, and (4) select a target of return on investment.

When managers make these estimates accurately, the target return methods results in a more rational pricing decision that then simpler markup method.

This method does not explicitly consider the interaction between alternative prices and demand.

As with markup pricing, the realized return falls below the target level because fixed costs have to be covered by a smaller unit volume. The impact of such variations in volume can be examined by preparing a break-even analysis.

2-Competition-Oriented Methods

  • A common industry price structure reflects the collective wisdom about finding the price that will yield a fair return and minimize the chances that a price war will jeopardize the profits of all industry firms.
  • Firms that pursue a competition-oriented pricing approach do not ignore cost or return-on- investment considerations. Instead, they try to control costs to make adequate returns at prices consistent with those of competitors. But if this cannot be done, the target rate or return may be the factor that is changed.
  • Firms adopt a going-rate or competitive parity pricing approach, where they maintain prices equal to those of one or more major competitors.
  • Price virtually ceases to be a controllable element of the marketing mix under such circumstances. No firm can increase its price without some assurance that others will follow, because most customers would switch to lower-priced competitors.
  • A firm would be reluctant to price below the competition lest other companies also cut their prices and reduce profits for all concerned.
  • Prices are usually quite stable in such industries until a price leader decides an increase in industry prices is necessary to meet increased costs and maintain returns.

The ability of a firm to be a price leader whose pricing decisions are emulated by other companies is not determined solely by its size or market share. The leader also tends to be one of the most efficient firms in the industry; that is, it is one of the last to feel the need for a price increase. Often leaders are also perceived to have good marketing expertise and have had past success in making price increases stick.

  • In industries where product quality, service, or availability vary across brands, a firm may still base its pricing on what its competitors are charging, but try to hold its prices either below or above the competition. Such discount or premium price policies usually reflect differences in positioning strategies.
  • Sealed bidding is common with dealing with the government. Buyers request a formal bid with no later opportunity for change. In public procurement the bids are opened publicly, enabling bidders to learn what competitors bid. Such is not typically the case with private bidding.
  • One approach used to set a bid price is an expected value :

E(X)= P(X)Z(X)

  • Internet Auction Sites Make Accurate Cost Estimates More Critical

Some business-to-business sites focus on seller’s auctions. These sites are usually specialized by industry and facilitate global spot markets for relatively standardized materials, component parts, used equipment and the like.