MGT301 - Principles of Marketing - Lecture Handout 25

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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

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 buyers balance the price
of a product or service against the benefits of owning it. Thus, before setting prices, the marketer must understand the
relationship between price and demand for its product. In this section, we explain how the price–demand 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 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 buyerbased approach (value-based pricing); and the competition-based approach (going-rate and sealed-bid pricing).

General Pricing Approaches

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 shows the total cost and total revenue expected at different sales volume levels. Figure shows a break-even point. Fixed costs are same regardless of sales volume. Variable costs are added to fixed costs to form total costs, which rise with volume. The total revenue curve starts at zero and rises with each unit sold.

Break-even Analysis and Target Profit Pricing

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.

Value-Based Pricing

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-tobusiness marketing situations, the pricing challenge is to find ways to maintain the company's 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 marketpenetration 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.

b) 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 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 captiveproduct 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.

e) 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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