A Guide to Pricing Strategies
The term pricing is a common reference in the business realm. It refers to the sellers' approach to putting in place the right purchase price for goods and services. The seller must set the correct place because price determines how buyers react, not only to the product/service but to the brand. Pricing strategy is how the seller pursues sales and marketing objectives by setting prices. They use a pricing model to implements its pricing strategy. The model is a set of instructions or rules that guide the seller in pricing setting and creation of margins.
In a business environment, sellers approach pricing as part of their marketing campaigns because pricing is, indeed, a marketing activity. In fact, textbooks defined marketing as a set of processes that communicate customer value in products to sell them; it is meant to serve the purpose of increasing customer demand. In this definition, they often include the 5 Ps of marketing, in which pricing is one, among Product, Placement, and Promotion.
Proper pricing must have financial objectives. It happens when the seller sets a price list (reference price, base price) for a selected product. The base price is what the customer usually pays to get the product or services. Hence, the financial objectives of pricing include:
- The maximization of unity sales and market share in terms of units sold. In this case, pricing is used for market capitalization, where the seller seeks to get the best out of their target market.
- Increase sales revenues and market share in terms of sales revenues. Every business seeks to make profits, from which they can pay their employees and do other activities. Everything is included every single product the seller puts out on the market. This comes in terms of the cost of production, supply, and intended profits.
- Maximize profits. It is not just enough to make profits. Businesses seek all avenues to get the best out of their products and services. This is why you will notice constant price changes for specific sellers. They are only seeking to maximize profits as per the current market situation.
- Leverage sales from related products or services. Most companies manufacturer more than one product. Hence, when they set prices, they also put in mind the possibility of benefiting from these other products.
In addition to this, sellers often implement pricing to purse position objectives. In other words, they seek to communicate and reinforce brand value. You may have noticed that there are similar products from different manufacturers on the market, where some are expensive, and others are cheaper, but buyers will go for the most expensive. It is may not because the other has less quality, but because of the brand value And this leads us to another positioning objective, which to create the perception of high quality, desirability, or value in products. A product, especially in the fashion industry, is often regarded as quality if it is very costly. This is a common perception in customers, and a seller must know how to price their products to meet these demands.
Pricing in Context
As much as pricing seems a common and easy term, it may not be very easy to explain, let alone understand. This is because pricing can be viewed as different from different contexts from marketing and economics perspectives. Hence, even pricing analysis can differ based on these two approaches. However, whatever approach you take, it will bring you down to five major themes of interest.
- Pricing defined as a marketing activity. In this case, pricing bases on how the seller sets the prices for their products in view of sales objectives.
- Pricing from the marketer's viewpoint. In this case, demand is seen as a function of price, where quantitative demand curves show the seller the prices that should optimize sales, revenues, units sold, and profits.
- Pricing for the economist's viewpoint, where the price is a function of demand. This is the reverse of the marketer's viewpoint.
- Marketers normally use any of the twelve pricing strategies or pricing models.
- The last theme of pricing is where the marketer tries to avoid popular pricing mistakes.
There are different pricing approaches that sellers use to set the right price for their products and services. In marketing, the strategy depends on different factors. A seller is free to use as many approaches as they wish to maximize the pricing objectives stated above. The section below is intended to equip business students and entrepreneurs with the knowledge to use different pricing approaches.
In this case, sellers calculate the cost of the product and then add a percentage of markup to determine the price. The learning objective of this section is to analyze the use of cost-plus pricing technique.
Import points to note:
- Cost-plus is the most straightforward way to calculate the price of a product. It is achieved in two ways: full cost and direct cost pricing, where full costs involved variables, fixed costs, and percentage markup. Direct-cost is the sum of variable costs and percentage markup.
- This method used by companies to tap into maximum profits. The firm can accomplish their profit-making objective by increasing its production to a point where marginal revenue is equal to the cost and then alter the price based on demand.
- Cost-based pricing is easy to use. And this is why many sellers use it, as it also requires very little information.
To understand cost-plus pricing, there are key terms, some mentioned above, that one has to be aware of. They include:
- Markups: This is the difference between the cost of a product and its selling price. This difference is added to the total cost incurred by the manufacturer or distributor to make a profit.
- Variable cost: This is the number of resources used that shifts with the change in a firm's activities.
- Rate of return: ROR or ROI is simply the rate of profit or loss. It is a ratio of money gained or lost on an investment in comparison to the amount of money invested.
Cost-plus pricing is the most basic method of calculating the price of a product. The firm simply works on the cost or manufacturing of the product and adds on a certain percentage as profit, so that the results give the selling price. We have already seen above that these calculations take two forms: the first one considering bother variable and fixed costs plus the percentage markup whereas the second is direct cost pricing; variable plus a percentage markup. Cost pricing is only used where competition is very high because it leads to a loss in the long run. This is a simple method, but it does not consider demand; hence there is no way of knowing whether the target customers will buy the product and the given price.
Companies use cost-plus pricing when seeking to get maximum profits. There are many ways to do this, but the most popular one is that the company calculates the cost of production and adds a calculated markup. Hence, this approach covers the cost of production while providing enough ROR for the company, enabling them to calculate how much profit they have made easily.
Calculating pricing with the cost-based approach is very basic, and does not require a lot of information. It is, therefore, very applicable where information on demand and cost is not easily accessible. Such additional information may be crucial in calculating an accurate estimate for marginal sales and revenues. But the process of getting more information can be quite costly and will demand the product be priced much higher. Hence, cost-plus is seen as the most convenient approach, both for the seller and the customer. This technique depends on arbitrary costs and arbitrary markups.
But this method has its disadvantages too. For instance, it does not consider the customer demand, current market prices, or competitor's price; hence it may or may not be competitive on the market. Also, the method does not communicate or build the brand value or product value from the customer's perspective.
This method can be looked at in terms of maximum unit sales involving setting the price point as close as possible to the peak of the demand curve. For many companies, this may mean either selling at a meager price or a loss. In other products and services, market-penetrating prices appear only shortly after product introduction. It is also called penetration pricing or loss-leader pricing, sometimes called predatory pricing, where it is intended to drive competitors out.
A 1900s salesman, King Gilette, may have lead to the popularization of this pricing strategy as loss-leader. This salesman built a profitable business to sell razor blades by offering away razor handles (with Gilette-Brand blades).
The reason one may opt to use this approach is that the seller may attempt to take the existing market share from the competition or secure the market before competitors enter. Or they may try to "lock-in" customers to a brand with expectations of profiting later. Also, this method can be used with the motive of achieving strong brand recognition through high unit sales and rapidly increasing market share.
This method is advantageous because it takes into account the prevailing market prices, competition, and availability of substitute products. Also, it offers faster means to increase market share and brand awareness for many kinds of products. And penetration pricing can allow the seller to reach cost-saving economies of scale much faster.
Disadvantages of this method may come when penetration pricing means low pricing. In this case, it can deliver low sales revenues than other strategies, and when the profits are too small, sellers fail to maintain this method for long. Also, penetration pricing can build brand recognition, but it will not enhance the brand image for super quality.
In economics, competition is defined as rivalry among sellers trying to achieve similar goals, such as increasing profits, market capitalization, and sales volumes using different aspects of marketing mix like price, product, distribution, and promotion. According to the Merriam-Webster Dictionary, competition in business is "the effort of two or more parties acting independently to secure the business of a third party by offering the most favorable terms."
Hence, competitor-based pricing or market-oriented pricing is pricing, where the price is set based on analysis and research compilation from the target market. In this case, a firm with a price their product based on what the other firm. Hence, the marketer will first research the market, then set the price based on the results they find in the field. For example, is a particular competitor has set the price of a product low, it is up to the firm to set there, either high or low.
One advantage of this strategy is that it prevents competition from damaging the company. They will be selling at the same price; hence, it depends on the quality of products from each brand. There are disadvantages to these approaches too. For instance, since the price will not grab the customer's attention, the business must device different methods of attracting these buyers. Also, the price may not be enough to cover the production costs and produce the desired profits.
Break-even point (BEP) is where expenses and revenue meet. They are equal; hence the seller cannot record net gain or loss, "break-even." This is one of the easiest yet least used analytical tools in management. It provides a wide view of the relationship between sales, costs, and profits. And break-even sales can be presented as a percentage of the actual sales. Manages can forecast when they might break even by linking the percentage of a point that the percent sales may be realized.
Other pricing techniques
As stated above, there are many other pricing techniques, but the ones above are the most commonly used. Other include the following:
- Premium pricing
The seller set price high enough to get acceptable margins over their cost but include another price aspect to communicate product quality, brand value, prestige, exclusivity, and many others.
- Value-based pricing
The price of a product reflects a customer's perception of its value.
- Time-based/Dynamic pricing
This is pricing that taps into customers' willingness to spend a specific amount of money, which varies from time to time.
- Price skimming
Seller uses this when introducing new products.
- Target pricing
Sellers choose a price based on the target ROI.
- Psychological pricing
All these pricing methods are important in achieving a company’s goals as well as economic needs of a nation.
Author: James Hamilton