Pricing Strategies

Price
 Price, in a narrow sense, is the amount of money charged
for a product or service. Broadly it may be defined as the
sum of all the values and benefits the consumers pay for
having or using the product or service.
 Price is the one element of the marketing mix that
produces revenue; the other elements produce costs.
 In 1992, Mckinsey & Co. examined 2400 companies and
demonstrated the importance of pricing for profitability.
 Mckinsey concluded that a 1 percent improvement in
price created an improvement in operating profit of 11.1
percent.
Pricing Strategies
Factors influencing Pricing Policy

 The factors and steps involved in setting a pricing

policy are as follows :
1. Pricing objective
2. Determining Demand
3. Estimating Costs
4. Competitors’ costs and prices
5. Selecting a pricing method
6. Selecting the final price
1.0 Pricing Objectives
 There are 5 major pricing objectives. They are:
1. Survival: Companies have Survival as their
major objective if they are plagued with
overcapacity, intense competition or changing
consumer wants. They must price so as to cover
variable costs and some fixed costs ie they must
generate positive contribution margin in the
short term to stay in business. However in the
long run they must learn to add value, recover
full costs or face extinction.
Contd.
2. Maximise Current Profit: Companies may set a price
that maximise current profit. They estimate the
demand and costs associated with alternative prices
and choose the price that produces maximum current
profit, cash flow or Return on Investment.
It is assumed that the company has knowledge of its
demand and cost functions but in reality these are
difficult to estimate. Besides in emphasising current
performance, the company may sacrifice its long term
performance.
 Contd.
3. Maximise Market Share: Some companies want to
maximise their market share. They believe that a higher
sales volume will lead to lower unit costs and higher
long run profit. They set the lowest price, assuming the
market is price sensitive. The following conditions
favour setting a lower price.
 The market is highly price sensitive and a low price
stimulates market growth.
 Production and distribution costs fall with accumulated
production experience.
 Low price discourages actual and potential competition.
Contd.
4. Maximise Market Skimming: Companies unveiling a new
product or technology favour setting high prices to maximise
market skimming.
 Sony is a frequent practioner of market skimming price where
prices start high and are slowly lowered over time.
 Market skimming makes sense under the following conditions:
1. A sufficient number of buyers have a high current demand.
2. The unit costs of producing a small volume are not so high that
they cancel the advantage of charging what the traffic will
bear.
3. The high initial price does not attract more competitors to the
market.
4. The high price communicates the image of a superior product.
Contd.
5. Product Quality Leadership: A company might aim to
be the product quality leader in the market.
 It would want its products to be perceived to be having
high quality, taste and status. It would like its products
to be priced high enough but yet within consumers’
reach
2.0 Determining Demand
 Each price will lead to a different level of demand. The
relation between alternative prices and the resultant
demand can be captured in a demand curve.
 The higher the price, lower the demand.
 In the case of prestige goods, the demand curve may
slope upwards meaning higher price would lead to
more demand. However if the price is too high the level
of demand may fall.
3.0 Estimating Costs
 A company’s costs take two forms – Fixed Costs (Over Heads)
and Variable Costs.
 Fixed Costs are costs that do not vary with production or sales
revenue ex. Costs of rent, electricity, salaries, depreciation,
interest etc.
 Variable costs vary directly with the level of production
 Total cost consists of the sum of the fixed cost and variable
cost.
 Average cost is the cost per unit and is equal to total costs
divided by production units.
 To price intelligently, management needs to know how its costs
vary with different levels of production
Contd.
 Ex Texas Instruments (TI) has a fixed plant capacity of producing
1000 calculators per day.
 The cost per unit would be high if only a few units are produced. As
production approaches 1000 units per day, the average cost falls
because the fixed costs are spread over more units.
 However average costs increases after 1000 units per day because
the plant becomes inefficient.
 Machines break down more often; workers have to line up for
machines and workers get in each other’s way.
Contd.
 If the plant capacity is increased to 2000 units per day
then the unit production cost would be reduced and a
3000 per day plant capacity would have even further
reduced cost.
 But after a 3000 unit per day plant capacity expansion
diseconomies of scale would creep in and so a 4000 per
day plant would be less efficient as average unit cost
would start increasing due to too many workers to
manage and paper work increasing and slowing things
down.
Experience & Learning Curve Effect on Cost
 The decline in the average cost due to accumulated
production experience is called the experience /
learning curve effect.
 Ex the average cost of producing 100,000 hand held
calculators at TI was $100. When it produced 200,000
calculators, the average cost fell to $90 and after its
accumulated production increased to 400,000, the
average cost was $80.
 It is said that every time accumulated production
doubles the cost reduces by a fixed percentage due to
the experience/learning curve effect.
Target Costing
 Costs can also be reduced due to concentrated effort by designers,
engineers and purchasing agents through target costing.
 Here you take the prevailing market price, deduct the profit margin
from the price to arrive at the target cost to be achieved.
 Each cost element ie design, engineering, manufacturing, sales
costs must be examined and different ways to bring down costs
must be considered.
 The objective is to bring down the cost projection to the target cost
level.
4.0 Analysing Competitors Costs, Prices and Offers
 Based on the market demand and company’s costs, there is a
range of possible prices that the company may charge. However a
company may like to take the competitor’s costs, prices and
possible price reactions into account.
 A firm must consider the nearest competitor’s price. If the firm
offers features not offered by the competitor, then the worth of
the features to the customer must be evaluated and added to the
competitor’s price.
 If the competitor’s offer contains certain features not offered by
the firm, their worth to the customer should be evaluated and
subtracted from the firm’s price. Now the firm can decide
whether to charge more, the same or less than the competitor.
 5.0 Select a Pricing Method
 Given the three Cs – the customer’s demand schedule, the
cost function and competitor’s price, the company is ready to
select a price.
 Costs set a floor to the price.
 Competitors’ prices and the price of substitutes provide an
orienting point.
 Customers’ assessment of unique features establishes the
price ceiling.
 Companies select a pricing method that includes one or more
of these considerations.
 The six major price setting methods are :
Contd.
1. Markup Pricing
2. Target return pricing
3. Perceived Value Pricing
4. Value pricing
5. Going Rate Pricing
6. Auction Type Pricing
Mark Up Pricing/Cost Based Pricing

 The most elementary pricing method is to add a standard

mark up to the producer’s cost.
 Construction companies submit bids by estimating the
total project cost and adding a standard mark up for
profit. Lawyers and accountants also typically price by
adding a standard markup on their time and costs.
 Let us examine the method by taking the following costs
and sales expectations of a toaster manufacturer.
Contd.

Variable cost per unit = Rs.10

Fixed cost = Rs.300,000
Expected unit sales = 50,000 nos
unit cost = variable cost + fixed cost/unit sales
= Rs.10 + rs.300,000/50,000 = Rs.16
Now assume the manufacturer wants to earn a 20 percent mark
up on sales then the
Mark up price = unit cost/(1- desired return on sales)
= Rs.16/1-0.2 = Rs.20.
Contd.
 The manufacturer would charge dealers Rs.20 per toaster and
make a profit of Rs.4 per unit. The dealers in turn will mark up the
toaster.
 Mark ups are generally higher on seasonal items (to cover the risk
of not selling), specialty items, slower moving items, items with
high storage and handling costs and demand – inelastic items
such as prescription drugs.
 Mark up pricing works only if the marked - up price actually
brings in the expected level of sales.
 However as it ignores current demand, perceived value and
competition, it is not likely to lead to optimal pricing
Contd.

 Still, mark up pricing remains popular since sellers can

determine costs much more easily than they can
estimate demand.
 As all firms in the industry use this pricing method, prices
tend to be similar. Price competition is therefore
minimised.
Target Return Pricing

 In this method, the firm determines the price that

would yield its target rate of return on investment (ROI)
 Target pricing is used by General Motors, which prices
its automobiles to achieve a 15 to 20 percent ROI.
 This method is also used by public utilities which need
to make a fair return on investment.
Contd.
 Example :
 Investment by toaster manufacturer = Rs. 10,00,000
 Target ROI = 20% = 20/100 x 10,00,000 = Rs. 200,000.
 Expected unit sales = 50,000 nos.
 Variable cost = Rs. 10 per unit
 Fixed cost = Rs. 3000,000.
 Therefore unit cost = Rs. 10 + 300000/50,000 = Rs. 16
per unit.
Contd.
 Target Return Price = unit cost + Desired return on
investment/unit sales
= Rs, 16 + 0.2 x 10,00,000/50,000 = Rs. 20 per unit.
 As can be seen to earn a ROI of 20% on Rs.
10,00,000 investment or Rs. 200,000, the
manufacturer must sell 50,000 units at Rs.20 each.
Contd.
 What happens if the manufacturer is not able to sell
50,000 units? The manufacturer needs to prepare the
Break Even chart to learn what happens at other sales
levels.

Break even volume = Fixed cost/Contribution = Fixed

cost/Price – variable cost = 300,000/20-10 = 30,000 units.
At the break even level the manufacturer makes no profit or
loss. If the manufacturer sells above break even volume it
will make a profit and below it will make a loss.
 Total Revenue

Target
Break-even point
} Profit
Total
cost
.

Fixed
cost

10 20 30 40 50
Sales Volume in units (thousands)
Contd.
 If you look at the break even chart, you will realise
that the fixed costs remain at Rs.300,000
regardless of sales volume. Variable costs are
added to fixed costs to form total costs, which rise
with volume. The revenue line starts at zero and
rises with each unit sold. The slope of the total
revenue line reflects the price of Rs.20 per unit.
 The revenue and total cost lines cross at 30,000
units. This is the break even volume
Contd.
 If the company charges a higher price, it will not need
to sell as many toasters to achieve its target return.
 But the market may not buy even this lower volume
at the higher price. Much depends on the price
elasticity and competitors’ prices.
 The manufacturer should consider different prices
and estimate break even volumes, probable demand
and profits for each price. The table is as shown
below:
Price unit Expec- Total Revenue Total costs Profit
demand ted unit
demand at
needed to given price
break even

Rs.14 75,000 71,000 994,000 1010000 -16000

16 50,000 67,000 1072000 970,000 102000

18 37,500 60,000 1080000 900,000 180000

20 30,000 42,000 840,000 720,000 120000

22 25,000 23,000 506,000 530,000 -24,000

Contd.
 The table shows that as price increases, break even volume
drops. But as price increases demand for the toaster also
falls off.
 The table shows that a price of Rs.18 yields the highest
profits.
 It may also be seen that none of the prices produce the
manufacturers target profit of Rs.200,000.
 To achieve this target return, the manufacturer will have to
search for ways to lower fixed or variable costs, thus
lowering the break even volume.
Perceived Value Pricing
 Increasingly companies now base their prices on the customers’
perceived value.
 Perceived value is made up of several elements such as the
buyers’ image of the product performance, channel deliverables,
warranty quality, customer support and softer attributes such as
the supplier’s reputation and esteem.
 The sellers should deliver the values promised by their value
proposition through marketing mix elements like, advertising
and sales force to communicate the enhanced perceived value in
buyers’ mind so that they perceive the value.
Contd.
Example:
 Caterpillar uses perceived value to set prices for its
construction equipment. It priced its tractor at $100,000
although a similar competitor’s tractor was priced at $90,000.
When a prospective customer asked a dealer why he should
pay $10,000 more, the caterpillar dealer answers as follows:
 $90,000 – is the tractor’s price if it is only
equivalent to the competitor’s tractor.
 $7,000 - price premium for superior durability.
 $6,000 - Price premium for superior reliability
 $5,000 - Price premium for superior service
Contd.
 $2,000 – price premium for longer warranty on parts.
 $120,000 – the normal price to cover Caterpillar’s
superior value.
 - $10,000 – discount
________
$100,000 – Final price.
 The dealer thus explains how caterpillar’s equipment
delivers more value than the competitor’s.
 Although the customer is paying $10,000 premium, he is
actually getting $20,000 extra value.
Value Pricing
 Value Pricing means charging a fairly low price for high
quality offering. Examples of value pricing are Walmart,
IKEA, South West Airlines, Reliance Mart, Peter England.
 Value pricing is not a matter of simply setting lower prices.
 It is a matter of re-engineering the company’s operations
to become a low cost producer without sacrificing quality
and lowering prices significantly to attract a large number
of value conscious customers.
 An important type of value pricing is Every Day Low Pricing
(EDLP)
Contd.
 A retailer who uses an EDLP pricing policy charges
a constant low price with little or no price
promotions and special sales.
 These constant prices eliminate week to week
price uncertainty and can be contracted to the
“high – low” pricing of promotion oriented
competitors
 In “high – low” pricing, the retailer charges high
prices on an everything basis but then runs
frequent promotions in which prices are
temporarily lowered below EDLP level.
 Going Rate Pricing
 Here the firm bases its price largely on competitors
prices.
 The firm may charge the same, more, or less than major
competitors.
 The smaller firms follow the leader changing their prices
when the market leader’s price changes rather than
when their own demand or costs change
 Auction Type Pricing
 Most agricultural produce ( such as tea, coffee, spices etc. )
minerals, exotic art materials, antiques etc. are sold in auction.
 Ex. English Auction ( Ascending Bids)
 Dutch Auctions (Descending Bids): One seller and many buyers
and one buyer and many sellers.
 Sealed Bid Auctions: Would be suppliers can submit only one
bid and cannot know other bids. Many government
departments, large corporations and institutions use this
method to procure supplies.
 Group Pricing
 Consumers and business buyers may form groups to
avail volume discounts and other concessions. Ex.
Housing and other co-operatives may form a
consortium to buy materials, neighbours pooling
together to avail bulk discounts in whole sale markets.
 Quality
Low High

Economy Penetration
Low Strategy

Price
Skimming Premium
High
Pricing Strategies
Penetration Pricing
 Price set to ‘penetrate the market’
 ‘Low’ price to secure high volumes
 Typical in mass market products – chocolate bars, food
stuffs, household goods, etc.
 Suitable for products with long anticipated life cycles
 May be useful if launching into a new market
Market Skimming
 Market Skimming
 High price, Low volumes
 Skim the profit from the market
 Suitable for products that have
short life cycles or which will
face competition at some point
in the future (e.g. after a patent
runs out)
 Examples include: Playstation,
Many are predicting a firesale in jewellery, digital technology,
laptops as supply exceeds new DVDs, etc.
demand.
Copyright: iStock.com
Value Pricing
Value Pricing
 Price set in accordance with
customer perceptions about the
value of the product/service
 Examples include status
products/exclusive products

Companies may be able to set prices

according to perceived value.

Copyright: iStock.com
Loss Leader
Loss Leader
 Goods/services deliberately sold below cost to
encourage sales elsewhere
 Typical in supermarkets, e.g. at Christmas, selling bottles
of gin at £3 in the hope that people will be attracted to
the store and buy other things
 Purchases of other items more than covers ‘loss’ on item
sold
 e.g. ‘Free’ mobile phone when taking on contract
package
Psychological Pricing
Psychological Pricing
 Used to play on consumer perceptions
 Classic example - £9.99 instead of £10.99!
 Links with value pricing – high value goods priced according
to what consumers THINK should be the price
Going Rate (Price Leadership)
Going Rate (Price Leadership)
 In case of price leader, rivals have difficulty in competing on price
– too high and they lose market share, too low and the price
leader would match price and force smaller rival out of market
 May follow pricing leads of rivals especially where those rivals
have a clear dominance of market share
 Where competition is limited, ‘going rate’ pricing may be
applicable – banks, petrol, supermarkets, electrical goods – find
very similar prices in all outlets
Tender Pricing
Tender Pricing
 Many contracts awarded on a tender basis
 Firm (or firms) submit their price for carrying out the work
 Purchaser then chooses which represents best value
 Mostly done in secret
Price Discrimination
Price Discrimination
 Charging a different price for
the same good/service in
different markets
 Requires each market to be
impenetrable
 Requires different price
elasticity of demand in each
Prices for rail travel differ for the same
market
journey at different times of the day

Copyright: iStock.com
Destroyer Pricing/Predatory Pricing
Destroyer/Predatory Pricing
 Deliberate price cutting or offer of ‘free gifts/products’ to
force rivals (normally smaller and weaker) out of business
or prevent new entrants
 Anti-competitive and illegal if it can be proved
Absorption/Full Cost Pricing
Absorption/Full Cost Pricing
 Full Cost Pricing – attempting to set price to cover both
fixed and variable costs
 Absorption Cost Pricing – Price set to ‘absorb’ some of the
fixed costs of production
Marginal Cost Pricing
Marginal Cost Pricing
 Marginal cost – the cost of producing ONE extra or ONE fewer
item of production
 MC pricing – allows flexibility
 Particularly relevant in transport where fixed costs may be
relatively high
 Allows variable pricing structure – e.g. on a flight from Delhi to
New York – providing the cost of the extra passenger is covered,
the price could be varied a good deal to attract customers and fill
the aircraft
Marginal Cost Pricing
 Example:

Aircraft flying from Delhi to Mumbai – Total Cost (including

normal profit) = Rs15,000 of which Rs13,000 is fixed cost*
Number of seats = 160, average price = Rs93.75
MC of each passenger = 2000/160 = Rs12.50
If flight not full, better to offer passengers chance of flying at
Rs12.50 and fill the seat than not fill it at all!
*All figures are estimates only
Contribution Pricing
Contribution Pricing
 Contribution = Selling Price – Variable (direct costs)
 Prices set to ensure coverage of variable costs and a
‘contribution’ to the fixed costs
 Similar in principle to marginal cost pricing
 Break-even analysis might be useful in such
circumstances
Target Pricing
Target Pricing
 Setting price to ‘target’ a specified profit level
 Estimates of the cost and potential revenue at different
prices, and thus the break-even have to be made, to
determine the mark-up
 Mark-up = Profit/Cost x 100
Cost-Plus Pricing
Cost-Plus Pricing
 Calculation of the average cost (AC) plus a mark up
 AC = Total Cost/Output