PRICE THE 2ND P OF MARKETING MIX:General Pricing Approaches, Fixed Cost

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Principles of Marketing MGT301

Lesson 25

Lesson overview and learning objectives:

In last Lesson we discussed the price its definition, focused on the problem of setting prices and

considered the factors marketers must consider when setting prices today we will look at general

pricing approaches, we will also examine pricing strategies for new-product pricing, product mix

pricing.

PRICE THE 2ND P OF MARKETING MIX.

A. Setting Pricing Policy

Pricing policy setting starts with setting the pricing objective that can be: Profit Oriented

(concerned with increase in profit), Sales Oriented (basically concerned with increase in sales) and

Status Quo Oriented. Whereas costs set the lower limit of prices, the market and demand set the

upper

limit.

Both

consumer and industrial

1 . S e le c tin g t h e p r ic in g o b je c tiv e

buyers balance the price

of a product or service

2 . D e te r m in in g d e m a n d

against the benefits of

owning it. Thus, before

3 . E s tim a tin g c o s ts

setting

prices,

the

marketer

must

4 . A n a ly z in g c o m p e tito r s '

c o s ts , p r ic e s , a n d o ffe r s

understand

the

relationship

between

5 . S e le c tin g a p r ic in g m e th o d

price and demand for its

product. In this section,

6 . S e le c tin g fin a l p r ic e

we explain how the

pricedemand

relationship varies for different types of markets and how buyer perceptions of price affect the

pricing decision. Costs set the floor for the price that the company can charge for its product. The

company wants to charge a price that both covers all its costs for producing, distributing, and

selling the product and delivers a fair rate of return for its effort and risk. A company's costs may

be an important element in its pricing strategy. Companies with lower costs can set lower prices

that result in greater sales and profits. Company's pricing decisions are also affected by

competitors' costs and prices and possible competitor reactions to the company's own pricing

moves there fore while setting the prices theses facts should also kept in mind. Final step is setting

the final price by using different methods.

B. General Pricing Approaches

The price the company charges will be somewhere between one that is too low to produce a profit

and one that is too high to produce any demand. Figure summarizes the major considerations in

setting price. Product costs set a floor to the price; consumer perceptions of the product's value set

the ceiling. The company must consider competitors' prices and other external and internal factors

to find the best price between these two extremes. Companies set prices by selecting a general

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pricing approach that includes one or more of three sets of factors. We examine these approaches:

the cost-based approach (cost-plus pricing, break-even analysis, and target profit pricing); the buyer-

based approach (value-based pricing); and the competition-based approach (going-rate and sealed-bid

pricing).

a) Cost-Based Pricing

Cost-Plus Pricing

The simplest pricing method is cost-plus pricing--adding a standard markup to the cost of the

product. Construction companies, for example, submit job bids by estimating the total project cost

and adding a standard markup for profit. Lawyers, accountants, and other professionals typically

price by adding a standard markup to their costs. Some sellers tell their customers they will charge

cost plus a specified markup; for example, aerospace companies price this way to the government.

To illustrate markup pricing, suppose any manufacturer had the following costs and expected sales:

Then the manufacturer's cost per toaster is given by:

Unit Cost = variable Cost + Fixed Cost

---------------

Price - Variable Cost

The manufacturer's markup price is given by:

Markup Price

Unit Cost

---------------

(1-desired return on sale)

Do using standard markups to set prices make sense? Generally, no. Any pricing method that

ignores demand and competitor prices is not likely to lead to the best price. Markup pricing works

only if that price actually brings in the expected level of sales. Still, markup pricing remains popular

for many reasons. First, sellers are more certain about costs than about demand. By tying the price

to cost, sellers simplify pricing--they do not have to make frequent adjustments as demand

changes. Second, when all firms in the industry use this pricing method, prices tend to be similar

and price competition is thus minimized. Third, many people feel that cost-plus pricing is fairer to

both buyers and sellers. Sellers earn a fair return on their investment but do not take advantage of

buyers when buyers' demand becomes great.

Break-even Analysis and Target Profit Pricing

Another cost-oriented pricing approach is break-even pricing(or a variation called target profit

pricing he firm tries to determine the price at which it will break even or make the target profit it is

seeking. This pricing method is also used by public utilities, which are constrained to make a fair

return on their investment.

Target pricing uses the concept

of a break-even chart, which

T o ta l re v e n u e

shows the total cost and total

T a rg e t p ro fit

1200

revenue expected at different

T o ta l c o s t

sales volume levels. Figure

1000

B r e a k -e v e n p o in t

shows a break-even point.

800

Fixed costs are same regardless

600

of sales volume. Variable costs

400

are added to fixed costs to

F ix e d c o s t

form total costs, which rise

200

with volume. The total revenue

curve starts at zero and rises

S a le s v o l u m e in u n it s ( t h o u s a n d s )

with each unit sold.

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Principles of Marketing MGT301

Fixed Cost

Break-even Volume =

---------------

Price - Variable Cost

The manufacturer should consider different prices and estimate break-even volumes, probable

demand, and profits for each.

b) Value-Based Pricing

An increasing number of companies are basing their prices on the product's perceived value.

Value-based pricing uses buyers' perceptions of value, not the seller's cost, as the key to pricing.

Value-based pricing means that the marketer cannot design a product and marketing program and

then set the price. Price is considered along with the other marketing mix variables before the

marketing program is set.

Figure compares cost-based pricing with value-based pricing. Cost-based pricing is product driven.

The company designs what it considers to be a good product, totals the costs of making the

product, and sets a price that covers costs plus a target profit. Marketing must then convince

buyers that the product's value at that price justifies its purchase. If the price turns out to be too

high, the company must settle for lower markups or lower sales, both resulting in disappointing

profits.

Cost-based versus value-based pricing

Value-based pricing reverses this process. The company sets its target price based on customer

perceptions of the product value. The targeted value and price then drive decisions about product

design and what costs can be incurred. As a result, pricing begins with analyzing consumer needs

and value perceptions, and price is set to match consumers' perceived value.

A company using value-based pricing must find out what value buyers assign to different

competitive offers. However, measuring perceived value could be difficult. Sometimes, consumers

are asked how much they would pay for a basic product and for each benefit added to the offer.

Or a company might conduct experiments to test the perceived value of different product offers.

If the seller charges more than the buyers' perceived value, the company's sales will suffer. Many

companies overprice their products, and their products sell poorly. Other companies under price.

Under priced products sell very well, but they produce less revenue than they would have if price

were raised to the perceived-value level.

During the past decade, marketers have noted a fundamental shift in consumer attitudes toward

price and quality. Many companies have changed their pricing approaches to bring them into line

with changing economic conditions and consumer price perceptions. The best way to hold your

customers is to constantly figure out how to give them more for less."

Thus, more and more, marketers have adopted value pricing strategies--offering just the right

combination of quality and good service at a fair price. In many cases, this has involved the

introduction of less expensive versions of established, brand-name products. In many business-to-

business marketing situations, the pricing challenge is to find ways to maintain the company's

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pricing power--its power to maintain or even raise prices without losing market share. To retain

pricing power--to escape price competition and to justify higher prices and margins--a firm must

retain or build the value of its marketing offer. This is especially true for suppliers of commodity

products, which are characterized by little differentiation and intense price competition. In such

cases, many companies adopt value-added strategies. Rather than cutting prices to match

competitors, they attach value-added services to differentiate their offers and thus support higher

margins.

c) Competition-Based Pricing

Consumers will base their judgments of a product's value on the prices that competitors charge for

similar products. One form of competition-based pricing is going-rate pricing, in which a firm bases

its price largely on competitors' prices, with less attention paid to its own costs or to demand. The

firm might charge the same, more, or less than its major competitors. In oligopolistic industries

that sell a commodity such as steel, paper, or fertilizer, firms normally charge the same price. The

smaller firms follow the leader: They change their prices when the market leader's prices change,

rather than when their own demand or costs change. Some firms may charge a bit more or less,

but they hold the amount of difference constant. Thus, minor gasoline retailers usually charge a

few cents less than the major oil companies, without letting the difference increase or decrease.

Going-rate pricing is quite popular. When demand elasticity is hard to measure, firms feel that the

going price represents the collective wisdom of the industry concerning the price that will yield a

fair return. They also feel that holding to the going price will prevent harmful price wars.

Competition-based pricing is also used when firms bid for jobs. Using sealed-bid pricing, a firm bases

its price on how it thinks competitors will price rather than on its own costs or on the demand.

The firm wants to win a contract, and winning the contract requires pricing less than other firms.

Yet the firm cannot set its price below a certain level. It cannot price below cost without harming

its position. In contrast, the higher the company sets its price above its costs, the lower its chance

of getting the contract.

Pricing decisions are subject to an incredibly complex array of environmental and competitive

forces. A company sets not a single price, but rather a pricing structure that covers different items in

its line. This pricing structure changes over time as products move through their life cycles. The

company adjusts product prices to reflect changes in costs and demand and to account for

variations in buyers and situations. As the competitive environment changes, the company

considers when to initiate price changes and when to respond to them.

C. New-Product Pricing Strategies

Pricing strategies usually change as the product passes through its life cycle. The introductory stage

is especially challenging. Companies bringing out a new product face the challenge of setting prices

for the first time. They can choose between two broad strategies: market-skimming pricing and market-

penetration pricing.

a) Market-Skimming Pricing

Many companies that invent new products initially set high prices to "skim" revenues layer by layer

from the market. Intel is a prime user of this strategy, called market-skimming pricing. Market

skimming makes sense only under certain conditions. First, the product's quality and image must

support its higher price, and enough buyers must want the product at that price. Second, the costs

of producing a smaller volume cannot be so high that they cancel the advantage of charging more.

Finally, competitors should not be able to enter the market easily and undercut the high price.

Market-Penetration Pricing

Rather than setting a high initial price to skim off small but profitable market segments, some

companies use market-penetration pricing. They set a low initial price in order to penetrate the

market quickly and deeply--to attract a large number of buyers quickly and win a large market

share. The high sales volume results in falling costs, allowing the company to cut its price even

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further. Several conditions must be met for this low-price strategy to work. First, the market must

be highly price sensitive so that a low price produces more market growth. Second, production and

distribution costs must fall as sales volume increases. Finally, the low price must help keep out the

competition, and the penetration pricer must maintain its low-price position--otherwise, the price

advantage may be only temporary.

D. Product Mix Pricing Strategies

The strategy for setting a product's price often has to be changed when the product is part of a

product mix. In this case, the firm looks for a set of prices that maximizes the profits on the total

product mix. Pricing is difficult because the various products have related demand and costs and

face different degrees of competition. We now take a closer look at the five product mix pricing

situations

a) Product Line Pricing

Companies usually develop product lines rather than single products. In product line pricing,

management must decide on the price steps to set between the various products in a line.

The price steps should take into account cost differences between the products in the line,

customer evaluations of their different features, and competitors' prices. In many industries, sellers

use well-established price points for the products in their line. The seller's task is to establish

perceived quality differences that support the price differences.

b) Optional-Product Pricing

Many companies use optional-product pricing--offering to sell optional or accessory products

along with their main product. For example, a car buyer may choose to order power windows,

cruise control, and a CD changer. Pricing these options is a sticky problem. Automobile companies

have to decide which items to include in the base price and which to offer as options. Until recent

years, The economy model was stripped of so many comforts and conveniences that most buyers

rejected it.

c) Captive-Product Pricing

Companies that make products that must be used along with a main product are using captive-

product pricing. Examples of captive products are razor blades, camera film, video games, and

computer software. Producers of the main products (razors, cameras, video game consoles, and

computers) often price them low and set high markups on the supplies. Thus, camera

manufactures price its cameras low because they make its money on the film it sells. In the case of

services, this strategy is called two-part pricing. The price of the service is broken into a fixed fee plus a

variable usage rate. Thus, a telephone company charges a monthly rate--the fixed fee--plus charges

for calls beyond some minimum number--the variable usage rate. Amusement parks charge

admission plus fees for food, midway attractions, and rides over a minimum. The service firm must

decide how much to charge for the basic service and how much for the variable usage. The fixed

amount should be low enough to induce usage of the service; profit can be made on the variable

fees.

d) By-Product Pricing

In producing processed meats, petroleum products, chemicals, and other products, there are often

by-products. If the by-products have no value and if getting rid of them is costly, this will affect

the pricing of the main product. Using by-product pricing, the manufacturer will seek a market for

these by-products and should accept any price that covers more than the cost of storing and

delivering them. This practice allows the seller to reduce the main product's price to make it more

competitive. By-products can even turn out to be profitable. For example, many lumber mills have

begun to sell bark chips and sawdust profitably as decorative mulch for home and commercial

landscaping.

Sometimes, companies don't realize how valuable their by-products are.

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Product Bundle Pricing

Using product bundle pricing, sellers often combine several of their products and offer the bundle

at a reduced price. Thus, theaters and sports teams sell season tickets at less than the cost of single

tickets; hotels sell specially priced packages that include room, meals, and entertainment; computer

makers include attractive software packages with their personal computers. Price bundling can

promote the sales of products consumers might not otherwise buy, but the combined price must

be low enough to get them to buy the bundle.

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