Given the importance of pricing in marketing strategy, pricing decisions are among the most complex decisions to be made in developing a marketing plan. Decisions regarding price require a tightly integrated balance among a number of important issues. Many of these issues possess some degree of uncertainty regarding the reactions to pricing among customers, competitors, and supply chain partners. These issues are critically important in establishing initial prices, and to modifying the pricing strategy over time. As we review these issues, keep in mind that they are interrelated and must be considered in the context of the firm’s entire marketing program.
For example, increases in product quality or the
addition of new product features often come with an increase in price. Pricing is also influenced by distribution, especially the image and reputation of the outlets where the good or service is sold. Finally, companies often use price as a tool of promotion. Coupons, for example, represent a combination of price and promotion that can stimulate increased sales in many different product categories. In services, price changes are often used to fill unused capacity (e.g., empty airline or theater seats) during non-peak demand.
The Firm’s Cost Structure
The firm’s costs in producing and marketing a product are an important factor in setting prices. Obviously, a firm that fails to cover both its direct costs (e.g., finished goods/components, materials, supplies, sales commission, transportation) and its indirect costs (e.g., administrative expenses, utilities, rent) will not make a profit. Perhaps the most popular way to associate costs and prices is through breakeven pricing, where the firm’s fixed and variable costs are considered:
For example, increases in product quality or the
addition of new product features often come with an increase in price. Pricing is also influenced by distribution, especially the image and reputation of the outlets where the good or service is sold. Finally, companies often use price as a tool of promotion. Coupons, for example, represent a combination of price and promotion that can stimulate increased sales in many different product categories. In services, price changes are often used to fill unused capacity (e.g., empty airline or theater seats) during non-peak demand.
The Firm’s Cost Structure
The firm’s costs in producing and marketing a product are an important factor in setting prices. Obviously, a firm that fails to cover both its direct costs (e.g., finished goods/components, materials, supplies, sales commission, transportation) and its indirect costs (e.g., administrative expenses, utilities, rent) will not make a profit. Perhaps the most popular way to associate costs and prices is through breakeven pricing, where the firm’s fixed and variable costs are considered:
To use breakeven analysis in setting prices, the firm must look at the feasibility of selling more than the breakeven level in order to make a profit. The breakeven number is only a point of reference in setting prices, as market conditions and customer demand must also be considered. Another way to use the firm’s cost structure in setting prices is to use cost-plus pricing a strategy that is quite common in retailing. Here, the firm sets prices based on average unit costs and its planned markup percentage:
Cost-plus pricing is not only intuitive; it is also very easy to use. Its weakness, however, lies in determining the correct markup percentage. Industry norms often come into play at this point. For example, average markups in grocery retailing are typically in the 20 percent range, while markups can be several hundred percent or more in furniture or jewelry stores. Customer expectations are also an important consideration in determining the correct markup percentage.
Although breakeven analysis and cost-plus pricing are important tools, they should not be the driving force behind pricing strategy. The reason is often ignored: Different firms have different cost structures. By setting prices solely on the basis of costs, firms run a major risk in setting their prices too high or too low. If one firm’s costs are relatively higher than other firms, it will have to accept lower margins in order to compete effectively. Conversely, just because a product costs very little to produce and market does not mean that the firm should sell it at a low price (movie theater popcorn is a good example). Even if the firm covers its costs, the fact is that customers may not be willing to pay their prices. Hence, market demand is also a critical factor in pricing strategy. In the final analysis, cost is best understood as an absolute floor below which prices cannot be set for an extended period of time.
Although breakeven analysis and cost-plus pricing are important tools, they should not be the driving force behind pricing strategy. The reason is often ignored: Different firms have different cost structures. By setting prices solely on the basis of costs, firms run a major risk in setting their prices too high or too low. If one firm’s costs are relatively higher than other firms, it will have to accept lower margins in order to compete effectively. Conversely, just because a product costs very little to produce and market does not mean that the firm should sell it at a low price (movie theater popcorn is a good example). Even if the firm covers its costs, the fact is that customers may not be willing to pay their prices. Hence, market demand is also a critical factor in pricing strategy. In the final analysis, cost is best understood as an absolute floor below which prices cannot be set for an extended period of time.
Perceived Value Both the firm and its customers are concerned with value. Value is a difficult term to define because it means different things to different people.6 Some customers equate good value with high product quality, while others see value as nothing more than a low price. We define value as a customer’s subjective evaluation of benefits relative to costs to determine the worth of a firm’s product offering relative to otherproduct offerings. A simple formula for value might look like this:
Customer benefits include everything the customer obtains from the product offering such as quality, satisfaction, prestige/image, and the solution to a problem. Customer costs include everything the customer must give up such as money, time, effort, and all non-selected alternatives (opportunity costs). Although value is a key component in setting a viable pricing strategy, good value depends on much more than pricing. In fact value is intricately tied to every element in the marketing program and is a key factor in customer satisfaction and retention.
The Price/Revenue Relationship All firms understand the relationship between price and revenue. However, firms cannot always charge high prices due to competition from their rivals. In the face of this competition, it is natural for firms to see pricecutting as a viable means of increasing sales. Price cutting can also move excess inventory and generate short-term cash flow. However, all price cuts affect the firm’s bottom line. When setting prices, many firms hold fast to these two general pricing myths:
Myth #1: When business is good, a price cut will capture greater market share.
Myth #2: When business is bad, a price cut will stimulate sales.
Unfortunately, the relationship between price and revenue challenges these assumptions and makes them a risky proposition for most firms. The reality is that any price cut must be offset by an increase in sales volume just to maintain the same level of revenue. Let’s look at an example. Assume that a consumer electronics manufacturer sells 1,000 high-end stereo receivers per month at $1,000 per system. The firm’s total cost is $500 per system, which leaves a gross margin of $500. When the sales of this high-end system decline, the firm decides to cut the price to increase sales. The firm’s strategy is to offer a $100 rebate to anyone who buys a system over the next three months. The rebate is consistent with a 10 percent price cut, but it is in reality a 20 percent reduction in gross margin (from $500 to $400). To compensate for the loss in gross margin, the firm must increase the volume of receivers sold. The question is by how much? We can find the answer using this formula:
The Price/Revenue Relationship All firms understand the relationship between price and revenue. However, firms cannot always charge high prices due to competition from their rivals. In the face of this competition, it is natural for firms to see pricecutting as a viable means of increasing sales. Price cutting can also move excess inventory and generate short-term cash flow. However, all price cuts affect the firm’s bottom line. When setting prices, many firms hold fast to these two general pricing myths:
Myth #1: When business is good, a price cut will capture greater market share.
Myth #2: When business is bad, a price cut will stimulate sales.
Unfortunately, the relationship between price and revenue challenges these assumptions and makes them a risky proposition for most firms. The reality is that any price cut must be offset by an increase in sales volume just to maintain the same level of revenue. Let’s look at an example. Assume that a consumer electronics manufacturer sells 1,000 high-end stereo receivers per month at $1,000 per system. The firm’s total cost is $500 per system, which leaves a gross margin of $500. When the sales of this high-end system decline, the firm decides to cut the price to increase sales. The firm’s strategy is to offer a $100 rebate to anyone who buys a system over the next three months. The rebate is consistent with a 10 percent price cut, but it is in reality a 20 percent reduction in gross margin (from $500 to $400). To compensate for the loss in gross margin, the firm must increase the volume of receivers sold. The question is by how much? We can find the answer using this formula:
As the calculation indicates, the firm would have to increase sales volume by 25 percent to 1,250 units sold in order to maintain the same level of total gross margin. How likely is it that a $100 rebate will increase sales volume by 25 percent? This question is critical to the success of the firm’s rebate strategy. In many instances, the needed increase in sales volume is too high. Consequently, the firm’s gross margin may actually be lower after the price cut.
Rather than blindly use price cutting to stimulate sales and revenue, it is often better for a firm to find ways to build value into the product and justify the current price, or even a higher price, rather than cutting the product’s price in search of higher sales volume. In the case of the stereo manufacturer, giving customers $100 worth of music or movies with each purchase is a much better option than a $100 rebate. Video game manufacturers, such as Microsoft (Xbox) and Sony (PlayStation 3), often bundle games and accessories with their system consoles to increase value. The cost of giving customers these free add-ons is low because the marketer buys them in bulk quantities. This added expense is almost always less costly than a price cut. And the increase in value may allow the marketer to charge higher prices for the product bundle.
Rather than blindly use price cutting to stimulate sales and revenue, it is often better for a firm to find ways to build value into the product and justify the current price, or even a higher price, rather than cutting the product’s price in search of higher sales volume. In the case of the stereo manufacturer, giving customers $100 worth of music or movies with each purchase is a much better option than a $100 rebate. Video game manufacturers, such as Microsoft (Xbox) and Sony (PlayStation 3), often bundle games and accessories with their system consoles to increase value. The cost of giving customers these free add-ons is low because the marketer buys them in bulk quantities. This added expense is almost always less costly than a price cut. And the increase in value may allow the marketer to charge higher prices for the product bundle.
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