Methods of Pricing
Various books propose a variety of pricing methods. We present herewith two relevant methods of pricing employed by practitioners, namely cost-based methods and competition-based methods.
In the first category of methods, prices are determined on the basis of costs. In the second category, prices are set on the basis of what competitors are charging, though it is not necessary to charge the same price as competitors are charging. The firm may seek to fix its price lower or higher than rivals’ prices by a certain percentage.
Table of Contents
- 1 Methods of Pricing
- 1.1 Cost-plus or Full-cost Pricing
- 1.2 Target Return Pricing
- 1.3 Marginal Cost Pricing
- 1.4 Going-rate Pricing
- 1.5 Customary Prices
- 1.6 Price Quality Strategies
- 1.7 Psychological Pricing
- 1.8 Premium Pricing
- 1.9 Value Pricing
- 1.10 Demand-based Pricing
- 1.11 Techniques to Handle Price Warfare
- Cost-plus or Full-cost Pricing
- Target Return Pricing
- Marginal Cost Pricing
- Target Return Pricing
- Marginal Cost Pricing
- Price Quality Strategies
- Psychological Pricing
- Premium Pricing
- Value Pricing
- Demand-based Pricing
- Techniques to Handle Price Warfare
Cost-plus or Full-cost Pricing
This is the most common method used for pricing. Under this method, the price is set to cover costs (materials, labour and overhead) and pre-determined percentage or profit. The percentage differs strikingly among industries, among member firms and even among products of the same firm.
This may reflect differences in competitive intensity, differences in cost base and differences in the rate of turnover and risk. In fact, it denotes some vague notion of a just profit.
Let us discuss the factors determining the normal profit. Ordinarily margins charged are highly sensitive to the market situation. They, may, however, tend to be inflexible in the following cases:
- They may become merely a matter of common practice.
- Mark-ups may be determined by trade associations either by means of advisory price lists or by actual lists of mark-ups distributed to members.
- Profits sanctioned under price control as the maximum profit margins remain the same even after the price control is discontinued. These margins are considered ethical as well as reasonable.
Usually profit margins under price controls are set so as to make it possible for even the least efficient firms to survive. Thus, the margin of profits tends to be higher than what would be possible under competitive conditions.
Disadvantages of Cost-plus Pricing Method
Following are the commonly observed disadvantages of cost-plus or full-cost pricing method. A marketing manager should be sensitive to these issues before deciding in favour of such a method.
- It ignores demand – there is no necessary relationship between cost and what people will pay for a product.
- It falls to reflect the forces of competition adequately. Regardless of the margin of profit added, no profit is made unless what is produced is actually sold.
- Any method of allocating overheads is arbitrary and may be unrealistic given the nature of the product and the market in which it is being sold. Insofar as different prices would give rise to different sales volumes, units costs are a function of price, and, therefore, cannot provide a suitable basis for fixing prices. The situation becomes more difficult in multi-product firms.
- It may be based on a concept of cost, which may not be relevant for the pricing decision. Full cost pricing ignores marginal or incremental costs and uses average costs instead.
Advantages of Cost-plus Pricing Method
A clear explanation cannot be given for the advantage and widespread use of full-cost pricing, as firms vary greatly in size, product characteristics and product range. They also face varying degrees of competition in markets for their products.
However, the following points may explain its advantages:
- Full-cost pricing offers a means by which fair and plausible prices can be found with ease and speed, no matter how many products the firm handles.
- Prices based on full cost look factual and precise and may be more defensible on moral grounds than prices established by other means.
- Firms preferring stability use full cost as a guide to pricing in an uncertain market where knowledge is incomplete. In cases where costs of getting information are high and the process of trial and error is costly, they use it to reduce the cost of decision making.
- In practice, firms are uncertain about the shape of their demand curve and about the probable response to any price change. This makes it too risky to move away from full-cost pricing.
- It is difficult, except ex-post, to identify and compute direct costs.
- Fixed cost must be covered in the long run and firms feel that if they are not covered in the short run, they will not be covered in the long run either.
- A major uncertainty in setting a price is the unknown reaction of rivals to that price. When products and production processes are similar, cost-plus pricing may offer a source of competitive stability by setting a price that is more likely to yield acceptable profit to most other members of the industry also.
- Management tends to know more about product costs than other factors, which are relevant to pricing.
Cost-plus pricing is especially useful while deciding prices for public utility and for tailored or customized products. Product tailoring involves determining the product design after the selling price is determined. By working back from this price, the product design and the permissible cost are decided upon.
This approach takes into account the market realities, by looking from the viewpoint of the buyer in terms of what he wants and what he will pay. Cost plus pricing is also helpful for pricing products that are designed to the specification of a single buyer.
The basis of pricing is the estimated cost plus gross margin that the firm could have got by using facilities otherwise. It is also possible for monopoly buying, where the buyers know a great deal about suppliers’ costs.
They may make the products themselves if they do not like the price. The more relevant cost is the cost that the buying company would incur if it made the product by itself.
These reasons provide some explanation but do not justify it as the logical approach to pricing. It provides no escape from the great difficulties of cost identification and allocation. There are, moreover, difficulties in relating the markup to cover overheads to the (unknown) future volume of sales.
According to the full-cost formula, if one expects business activity to decline, one should logically increase his markup and, therefore, price. Common sense suggests that in a depression, this price policy will be highly imprudent.
The cost-plus pricing method is widely used in India due to two special reasons. The prevalence of the sellers’ market in India till recently made it possible for the manufacturers to pass on the increases in costs to the consumers.
Costs plus a reasonable margin of profit are taken into consideration for the purposes of price fixation in the price-controlled business in India. Thus this method has the tacit approval of the government. The cost-plus pricing method as a pricing convention relies on arbitrary costs and arbitrary mark-ups. It is widely adopted because it is simpler to apply.
Target Return Pricing
An important problem that a firm might have to face is adjusting prices to changes in costs. The popular policies that are often followed for deciding prices include revising prices to maintain a constant percentage markup over costs; revising prices to maintain profits as a constant percentage of total sales and revising prices to maintain a constant return on invested capital. The use of the above policies is illustrated below.
A firm sells 1,00,000 units per year at a factory price of ₹ 12 per unit. The various costs are given below:
|Variable Costs||Materials||₹ 3,60,000|
|Fixed Costs||Overhead||₹ 1,20,000|
|Selling and Administrative||₹ 1,80,000|
|Total investment cash, inventory and equipment||₹ 8,00,000|
Suppose, the labour and materials cost increases by 10 per cent. So let us look at how we should revise price according to the above-mentioned three policies.
The above data reveal that costs are ₹10,80,000, the sales are ₹12,00,000 and the profit is ₹1,20,000. The profit percentages according to the three policies are:
- Percentage over costs 1,20,000/10,80,000 × 100 = 11.1
- Percentage on sales 1,20,000/12,00,000 × 100 = 10
- Percentage on capital employed 1,20,000/8,00,000 × 100 = 15
The revised costs are ₹11,58,000 (₹10,80,000 + 36,000 + 42,000).
According to the first formula, we have to earn a profit of 11.1 per cent on costs. Our revised profits should be ₹1,28,667 and sales volume on this basis would be ₹12,86,67. The selling price would, therefore, be ₹13.87 per unit.
Under the second formula, the profit should be 10 per cent on sales. If sales are S, the profit would S/10 and the cost would be 9S/10. We know the cost and we have to find out the sales.
If 9S/10 = ₹11,58,000, S = ₹12,86,667
Therefore, the price per unit is ₹13.87
Under the third formula, we assume that the capital investment is the same. Therefore, the required profit is ₹1,20,000 (15 per cent on ₹8,00,000). The sales value would then be ₹ 12,78,000 and the selling price per unit would be ₹13.78.
Most of the American firms start with a rate of return they consider satisfactory, and then set a price that will allow them to earn that return when their plant utilisation is at some ‘standard rate’ – say, 80 per cent. In other words, they determine standard costs at standard volume and add the margin necessary to return a target of profit over the long run.
Rate of return pricing is a refined variant of full-cost pricing. Naturally, it has the same inadequacies, viz. it tends to ignore demand and fails to reflect competition adequately. It is based upon a concept of cost, which may not be relevant to the pricing decision at hand and overplays the precision of allocated fixed costs and capital employed.
Marginal Cost Pricing
Both under full-cost pricing and rate-of-return pricing, prices are based on total costs comprising fixed and variable costs. Under marginal cost pricing, fixed costs are ignored and prices are determined on the basis of marginal cost. The firm uses only those costs that are directly attributable to the output of a specific product.
A pricing decision involves planning for the future, and as such, it should deal solely with the anticipated and, therefore, estimated revenues, expenses, and capital outlay. All past outlays which give rise to fixed costs are historical and shrunk costs.
With marginal cost pricing, the firm seeks to fix its prices so as to maximize its total contribution to fixed costs and profit. Unless the manufacturer’s products are in direct competition with each other, this objective is achieved by considering each product in isolation and fixing its price at a level that is calculated to maximize its total contribution.
There are two assumptions behind the use of such a method viz. the firm is able to segregate its markets so that it is able to charge higher prices in some markets and lower prices in others, and there are no legal restrictions.
Advantages of Marginal Cost Pricing
With marginal cost pricing, prices are never rendered uncompetitive merely because of a higher fixed overhead structure, or because hypothetical unit fixed costs are higher than those of the competitors. The firm’s prices will only be rendered uncompetitive by higher variable costs, and these are controllable in the short run while certain fixed costs are not.
Marginal costs more accurately reflect the future as distinct from present cost levels and cost relationships. When making a pricing decision one is more interested in changes in cost that will result from that decision. Marginal cost represents these changes, while total costs include fixed costs, which are not incurred as a result of the pricing decision.
Marginal cost pricing permits a manufacturer to develop a far more aggressive pricing policy than does full-cost pricing. An aggressive pricing policy should lead to higher sales and possibly reduced marginal costs through increased marginal physical productivity and lower input factor prices.
However, before entering into a more differentiated and more flexible pricing policy, it would be necessary to consider the impact of unstable prices on consumer goodwill.
Marginal cost pricing is more useful for pricing over the life cycle of a product, which requires short-run marginal cost and separable fixed cost data relevant to each particular stage of the cycle, not long-run full-cost data.
Marginal cost pricing is more effective than full-cost pricing because of two characteristics of modern business:
- The prevalence of multi-product, multi-process, and multi-market concerns makes the absorption of fixed costs into product costs absurd. The total costs of separate products can never be estimated satisfactorily, and the optimal relationships between costs and prices will vary substantially both among different products and between different markets.
If markets are to be segmented successfully, it is necessary to know the variable costs and specific fixed costs attributable to each segment. In this type of business, one constantly considers proposals for changing selling prices, or terms of sale, for segmenting the market to gain the advantage of the different layers of consumer demand, and for selecting the most profitable business when capacity is limited.
These are usually short-run problems because the underlying conditions are always changing, and marginal cost pricing is the most suitable method of short-run pricing.
- In many businesses, the dominant force is an innovation combined with constant scientific and technological development and the long-run situation is often highly unpredictable. There is a series of short runs and one must aim at maximizing the contribution in each short run.
When rapid developments are taking place, fixed costs and demand conditions may change from one short run to another, and only by maximizing contribution in each short run will the profit be maximized in the long run.
Disadvantages of Marginal Cost Pricing
Some accountants are not fully conversant with the marginal cost techniques themselves, and are not, therefore, capable of explaining their use to management.
The encouragement to take on business, which makes only a small contribution, may be so strong that when an opportunity for higher contribution business arises, such business may have to be foregone because of inadequate free capacity unless there is an expansion in organization and facilities with the attendant increase in fixed costs.
In a period of business recession, firms using marginal cost pricing may lower prices in order to maintain business and this may lead other firms to reduce their prices leading to cut-throat competition.
With the existence of idle capacity and the pressure of fixed costs, firms may successively cut down prices to a point at which no one is earning sufficient total contribution to cover its fixed costs and earn a fair return on capital employed.
In spite of its advantages, due to its inherent weakness of not ensuring the coverage of fixed costs, marginal cost pricing has usually been confined to pricing decisions relating to special orders. In practice, full-cost pricing still forms the basis of most pricing decisions. Of course, marginal cost data have been used to supplement the total costs in pricing decisions.
Business situations requiring the use of marginal costing include marketing situations where the price is the primary determinant of an offer; where initial product acceptance is being sought to facilitate entry into a new market.
Where the product is being targeted to a low-quality market segment; where price competition is intense, and when the price responsiveness of demand is high i.e. a little reduction in price may lead to a substantial increase in volume.
Instead of the cost, the emphasis here is on the market and market situation. The firm adjusts its own pricing policy to the general pricing structure in the industry. Where costs are particularly difficult to measure, this may seem to be the logical first step in a rational pricing policy. It may also reflect the collective wisdom of the industry.
This type of situation leads to price leadership. Where price leadership is well established, charging according to what competitors are charging may be the only safe policy. It may simply be a way in which firms try to escape the hazards of price in an oligopolistic market.
It may be less costly and troublesome to the business than the exact calculation of costs and demand and has a practical advantage over a highly individualistic pricing policy.
Many big Indian companies have adopted a policy of following competitors, which implies that they follow a price set either by the market or by a price leader. It must be noted that ‘going-rate pricing’ is not quite the same as accepting a price impersonally set by a near-perfect market.
Rather, it would seem that the firm has some power to set its own price and could be a price maker if it chooses to face all the consequences. It prefers, however, to take the safe course and conform to the policy of others.
Prices of certain goods become more or less fixed, not by deliberate action on the sellers’ part but as a result of their having prevailed for a considerable period of time. For such goods, changes in costs are usually reflected in changes in quality or quantity. Only when the costs change significantly, are the customary prices of these goods changed.
Customary prices may be maintained even when products are changed. For example, the new model of an electric fan may be priced at the same level as the discontinued model. This is usually so even in the face of lower costs.
A lower price may cause an adverse reaction from the competitors, leading them to a price war, as also as the consumers who may think that the quality of the new model is inferior. Going along with the old price is the easiest thing to do. Whatever the reason, the maintenance of existing prices as long as possible is a factor in the pricing of many products.
If a change in customary prices is intended, the marketing executive must study the pricing policies and practices of competing firms; the behavior and emotional makeup of the people of similar designations as him in those firms.
Another possible way out, especially when an upward move is sought, is to test the new price in a limited market to determine consumer reactions.
Other popular methods of pricing are discussed below:
Perceived Value Pricing Method
In this method, prices are decided on the basis of the customer’s perceived value. They see the buyer’s perceptions of value, not the seller’s cost as the key indicator of pricing. They use various promotional methods like advertising and brand building for creating this perception.
Value Pricing Method
In this method, the marketer charges a fairly low price for a high-quality offering. This method proposes that price represents a high-value offer to consumers.
Going Rate Pricing
In this method, the firm bases its price on the average price of the product in the industry or prices charged by competitors.
Sealed Bid Pricing
In this method, the firms submit bids in sealed covers for the price of the job or the service. This is based on the firm’s expectation about the level at which the competitor is likely to set up prices rather than on the cost structure of the firm.
In this method, the marketer bases prices on the psychology of consumers. Many consumers perceive price as an indicator of quality. While evaluating products, buyers carry a reference price in their minds and evaluate the alternatives on the basis of this reference price. Sellers often manipulate these reference points and decide their pricing strategy.
In this method, the buyer charges an odd price to get noticed by the consumer. A typical example of odd pricing is the pricing strategy followed by Bata. Bata prices are always an odd number like ₹899.99, etc.
This is a method in which the marketer decides pricing strategy depending on the location of the customer like domestic pricing, international pricing, third world pricing, etc. Multinational firms follow such a pricing strategy as they operate in different geographic locations.
This is a method in which the marketer discriminates his pricing on a certain basis like the type of customer, location, and so on. It occurs when a company sells a product or service at two or more prices that do not reflect a proportional difference in the costs.
One can sell at different prices in different segments. Different prices for different forms of the same product can sell the same product at two different levels depending on the image differences.
Price Quality Strategies
Companies can also follow a value pricing strategy. The customers perceive the products to be either highly-priced, medium-priced, or low-priced. Similarly, they evaluate the product quality and place them as high, medium, and low.
Companies can also follow a value pricing strategy. The customers perceive the products to be either highly-priced, medium-priced, or low-priced. Similarly, they evaluate the product quality and place them as high, medium, and low.
Correspondingly, companies can have nine pricing strategies namely premium pricing strategy (high price and high quality (type-1)); high-value strategy (high quality and medium price (type-2)); super value strategy (high quality and low price strategy (type-3));
overcharging strategy (medium quality and high price (type-4)); medium value strategy (medium quality and medium value (type-5)); good value strategy (medium quality and low price strategy (type-6)); rip off strategy (low product quality and high price (type-7)); false economy strategy (low quality and medium price strategy (type-8)) and economy strategy (low product quality and low price strategy (type-9)).
The diagonal strategies 1, 5, and 9 can all coexist in the same market; that is one firm offers a high-quality product at a high price, another firm offers an average-quality product at an average price, and still another firm offers a low-quality product at a low price.
All three competitors can coexist as long as the market consists of three groups of buyers: those who insist on quality, those who insist on price, and those who balance the two considerations. Positioning strategies 2, 3, and 6 represent ways to attack the diagonal position. Positioning strategies 4, 7, and 8 lead to overpricing the product in relation to its quality.
Companies follow a premium-pricing strategy when they wish to skim the market. Both the quality of the product and price is high in this market. Though the number of customers in this market is few they buy only premium products.
A high-value strategy is a case where the customers find the product to be of high quality and medium price strategy and when the quality is high and the price is low, people find super value in the product. This is a strategy where people are delighted due to high quality and affordable prices.
When customers perceive the quality to be average and the price to be high, then they may not buy the product in a free economy. In this case, the seller is believed to be overcharging the customer. A volume player who wants to cater to a large part of the market without diluting the brand image follows a medium-value strategy.
In many cases, though the quality is medium companies penetrate the market by charging a low price and customers buy products on the rationale of getting good value from the business. Though they do not perceive the quality to be so great, still they buy due to lower price perception. When the quality is perceived as low but the price is high, it is an unsustainable strategy and is called a ‘rip off’ strategy.
When the price is medium and the quality is low, many times customers get duped due to a false perception of the price being low. This is called a false economy strategy. When the marketer is at the bottom of the pyramid, he charges a low price for a low-quality product to satisfy low-value customers.
In this method, the marketer bases prices on the psychology of consumers. Many consumers perceive the price as an indicator of quality. While evaluating products, buyers carry a reference price in their mind and evaluate the alternatives based on this reference price.
Sellers often manipulate these reference points and decide their pricing strategy. Put in other words, setting prices according to the psychographics of the aimed at market segment is referred to as psychological pricing.
The ultimate combination of psychological pricing and clarity is demonstrated by PlanGrid’s page. PlanGrid provides a planning app for the construction industry, and they emphasize their ties to that market with every part of their pricing page design.
As you’ll see below, the plan names are different-sized tools and machines used in construction, from the hammer to the crane, and each of the tiers has a beautiful illustration as well.
Premium pricing is the practice in which a high-end product is sold at a higher than that of competing brands to give it a snob appeal through an aura of exclusivity. It is also referred to as skimming, image pricing, or prestige pricing.
The firm may decide to charge a high initial price to take advantage of the fact that some buyers are willing to pay a much higher price than others as the product is of high value to them. The skimming pricing is followed to cover the product development cost as early as possible before competitors enter the market.
Companies can charge prices based on the value they create for their consumers. In this method, the marketer charges a fairly low price for a high-quality offering. This method proposes that price represents a high-value offer to consumers. Price is a numerical evaluation of how much consumers value what the company is selling.
The merit of this method is that it determines price as a variable that entirely depends on the value that the customer shall enjoy from the purchase of a good or service. Unfortunately, the most common pricing strategies and methodologies forget about the customer. Instead, people in charge of pricing justify price points based on internal reasons or simply adopting existing market prices.
Value-based pricing requires a lot of research. However, unlike cost-plus and competitor-based pricing, it is impossible to determine a number that correctly reflects how consumers feel. Moreover, unlike pricing done by market norms, this method focuses on isolating qualities that distinguish the product in question from the substitutes available in the market.
Value-based pricing models and software utilize customer data, as well as breakdowns of the relative value of different features within your offering.
Demand-based pricing is the method in which consumer response to various price points in a range of prices is analyzed to arrive at the highest acceptable price. Price stickiness is an issue that affects most product categories and industries when deciding on the pricing strategy. Managers do often suffer the ambiguity of pricing strategy choices.
Irrespective of the plethora of pricing methods that exist and the confusion that runs high in the minds of consumers, it makes enormous good sense to suggest that pricing should be based on adjustments in consumer demand.
Sellers make price adjustment decisions based on factors such as the proportion of households that buy the product, the category into which the product falls-normal, luxury, Giffen or Veblen, etc, and the price sensitivity of consumers towards the product.
Consumer-driven benefits are reflected by characteristics such as the proportion of households that buy the product and the sensitivity of those shoppers to price changes. Consumer-driven costs of price adjustment are measured by the relative expensiveness of an item.
Techniques to Handle Price Warfare
Price warfare is defined as the usage of pricing strategy as a means to secure a competitive advantage in the market. Companies indulge in price warfare to increase their consumer base, and consumer loyalty and increase their market share.
However, the usage of price as a means to secure a competitive advantage in the market is restricted by the probability of competing firms following suit. Unless affirm has complete command of its cost structure and is able to rationalize prices continuously, it is highly unlikely that it shall succeed in the market by reducing prices.
At the heart of the rationale that works against the usage of price warfare is the ability to compete firms to respond with aggressive price cuts, which may only lead to a status quo among competing firms with a reduction in the overall profit levels for each firm.
Techniques to handle price warfare require the building of core competencies that shall allow a firm to respond to a price cut announced by a firm with further value creation. Doing so requires the firm to indulge in product differentiation to stand out in the market by virtue of features, technology, and service delivery or after-sales service.
Prices are easy to compare when there are substitutes available in the market, allowing consumers to compare the value proposition of each product keeping the price as a static factor. When price changes occur, it is only natural for consumers to change tastes and preferences and consequently their demand for a product.
In order to avert this, firms should look to continuously upgrade the functional value and the value addition of their products. In terms of strategic marketing, this amounts to a blue ocean strategy where by the firm does not compete with its rival based on prices but looks to differentiate its products to create a niche segment of loyal consumers which is hard to break into for rival firms.
In other words, the marketing strategy of the firms should enable them to move from a cost-based model to a value-based model.
The other strategy to counter price warfare is to cooperate rather than compete. A cooperation strategy works well in industries with scope for joint price determination. This ensures that price adjustments affect the entire industry and not a select few companies.
Cooperation strategy amount to the formation of a cartel, where firms belonging to the industry shall in codified terms decide not to attack each other based on price and output changes. Examples of such cooperation exist in oligopolies.
OPEC for example is a cartel of oil and petroleum-producing nations. It ensures that any changes made to prices occur in a democratic framework by means of consensus building among firms.