From time to time we come across instances where businesses are not realizing their full potential when setting prices. Sometimes this can mean missed revenue, in other cases it can have a negative effect on the brand, sending a mixed message of what it stands for. In either case profits can be lost. In this study, we take a look at the key factors to consider while reviewing the pricing strategy. Price is the only revenue generating element amongst the 4P’s, the rest being cost centers. Pricing is the manual or automatic process of applying prices to purchase and sales orders, based on factors such as: a fixed amount, quantity break, promotion or sales campaign, specific vendor quote, price prevailing on entry, shipment or invoice date, combination of multiple orders or lines, and many others. Automated systems require more setup and maintenance but may prevent pricing errors. In setting pricing policy, a company estimates the demand curve, the probable quantities it will sell at each possible price. It estimates how its costs vary at different levels of output. In this paper, we also study situations when companies often face situations where they may need to cut or raise prices. The firm facing a competitor’s price change must try to understand the competitor’s intent and the likely duration of the change.
Introduction
Simplistically speaking, price is the consideration given by the customer in exchange for a product in a commercial transaction. Anytime anything is sold, there must be a price involved. One of the four elements of the marketing mix, price is an important and strategic one. For, it not just apprises the customer about the value of the product but also communicates across its various features such as the product quality and its positioning. Too often when managers think about pricing, the first question they ask themselves is, “What should the price be?” In fact, what they must be asking is, “Have we addressed all the considerations that affect the final price?”
To work effectively, pricing efforts must complement an overall marketing strategy by sending a message that it is in sync with the company’s desired product image. Developing a pricing strategy is one thing; managing the change process to embed that strategy in the organization is quite another. The truth is that implementing effective pricing strategy involves changing the expectations and behaviors of all of the actors involved in the sales process. Customers must learn that they will be treated fairly and that abusive purchase tactics will not be rewarded with discounts. Sales must learn that they will be rewarded for closing deals that increase firm profitability rather than using price as a tactical lever to increase sales volume. Finance must learn to look beyond cost as a determinant of price to better understand the tradeoffs between price, cost, and market response. All successful pricing efforts share two qualities: the policy complements the company’s overall marketing strategy and the process is coordinated and holistic. Execution of a proper pricing strategy requires inputs and participation from all departments, and lack of communication or cooperation between them can make overall pricing performance dismal.
A company’s pricing policy sends a message to the market- it gives customers an important sense of a company’s philosophy. Ideally, a well-chosen price must look to generate optimal revenue and maximizing long term profits, be able to fit into the realities of the market place & support the products’ positioning and be consistent with the other variables in the marketing mix. From the marketer’s point of view, an efficient price is a price that is very close to the maximum that customers are prepared to pay. In economic terms, it is a price that shifts most of the consumer surplus to the producer. A good pricing strategy would be the one which could balance between the price floor (the price below which the organization ends up in losses) and the price ceiling (the price beyond which the organization experiences a no demand situation).
Understanding Pricing
Price is not just a number on a tag or an item; Price is all around us. We pay rent for our apartment, tuition for our education, and a fee to our physician or dentist. The airline, railway, taxi, and bus companies charge us a fare; the local utilities call their price a rate; and the local bank charges us interest for the money we borrow. The price for driving your car on the Pune-Mumbai expressway is a toll, and the company that insures your car charges you a premium. Clubs or societies to which you belong may make a special assessment to pay unusual expenses. Your regular lawyer may ask for a retainer to cover her services. The “price” of an executive is a salary, the price of a salesperson may be a commission, and the price of a worker is a wage. Finally, although economists would disagree, many of us feel that income taxes are the price we pay for the privilege of making money.
Throughout most of history, prices were set by negotiation between buyers and sellers. “Bargaining” is still a sport in some areas especially in India. Setting one price for all buyers is a relatively modern idea that arose with the development of large-scale retailing at the end of the nineteenth century. F. W. Woolworth, Tiffany and Co., John Wanamaker, and others advertised a “strictly one-price policy,” because they carried so many items and supervised so many employees. [1] Today the Internet is partially reversing the fixed pricing trend. Computer technology is making it easier for sellers to use software that monitors customers’ movements over the Web and allows them to customize offers and prices. New software applications are also allowing buyers to compare prices instantaneously through online robotic shoppers. As one industry observer noted, “We are moving toward a very sophisticated economy. It’s kind of an arms race between merchant technology and consumer technology”. [2] Traditionally, price has operated as the major determinant of buyer choice. This is still the case in poorer nations, among poorer groups, and with commodity-type products. Although non-price factors have become more important in recent decades, price still remains one of the most important elements determining market share and profitability. Consumers and purchasing agents have more access to price information and price discounters. Consumers put pressure on retailers to lower their prices. Retailers put pressure on manufacturers to lower their prices. The result is a marketplace characterized by heavy discounting and sales promotion.
How Companies Price
Pricing is carried out by companies in a variety of ways. In small firms it is generally the boss who takes a final call on the price using his own intuition and knowledge about the subject. In larger companies a more systematic process is followed while pricing a product and the matter is handled by division and product-line managers. The top management sets pricing objectives and policies and the lower management uses these objectives as guidelines to propose a price number. In some companies there is a separate pricing department set up to decide or assist others in determining appropriate prices, especially in industries where pricing is a key. The pricing department generally reports to the next higher departments like marketing department, finance department or directly to the top management. Some people who exert a considerable influence on the price of a product include sales managers, production managers, finance managers and accountants. For some executives pricing is a big headache and gets worse every day. Many companies which cannot handle the issue of pricing give up and choose to stick to cost margin pricing and industry prices. Another common mistake which many companies make is that they do not revise their prices very often based on the external environment and consider pricing as an independent entity separate from the marketing mix independently of the marketing mix.
Successful companies have often used pricing as a strategic tool and have leveraged its effect on the bottom line. Prices and offerings are not standardized but rather customized across various segments and customer groups. The importance of pricing for profitability was demonstrated in a 1992 study by McKinsey & Company. After examining 2,400 companies, McKinsey concluded that a 1% improvement in price created an improvement in operating profit of 11.1%. By contrast, 1 % improvements in variable cost, volume, and fixed cost produced profit improvements, respectively, of only 7.8%, 3.3%, and 2.3%. [3] To effectively design and implement the right kind of pricing strategies it is essential that the company have a clear understanding of consumer pricing psychology and must adopt a systematic approach to setting, adapting and changing prices. For a pricing strategy to work it is crucial for a company to understand the relationship between price and quantity demanded in the market and also the impact of pricing on sales by estimating the demand curve for the product. Experiments can be performed for existing products at prices above and below the current price in order to determine its price elasticity of demand.
Pricing Mechanisms
Based on the marketing objectives for the product, various companies follow different pricing methodologies for their products. Given below is a list of some of these mechanisms; although the list is not exhaustive, it depicts the logical framework adopted by companies when they go about pricing their products.
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Cost plus pricing
This pricing mechanism involves setting the price of a product by adding a fixed amount or percentage to the cost incurred in making or buying it. Although this method is still widely used, it is considered as quite old fashioned and hence considered as a discredited pricing strategy.
Cost plus pricing (more commonly known as ‘mark-up’ pricing) technique is widely used in pricing retail goods where the retailer wants to know with some certainty what the gross profit margin per sale is going to be. One advantage of this method of pricing is that the business will know till what extent their costs are being covered. The major disadvantage of this method is that it may lead to pricing of the products un-competitively with respect to other available products in the market.
For example, if the cost incurred per unit for an imaginary product is say Rs. 100, and the company decides to apply a mark-up of 50% on its cost. In this case, the price will now be Rs. 150, and the company makes a profit of Rs. 50 per unit sale of this product.
Cost incurred
Rs. 100
Mark up percentage
50%
Price
Rs. 150
The obvious question which arises after carrying out this exercise is how much of a mark-up should be applied on the cost so that the final price is justified? Generally the mark-up is decided by the going competitive trend in the market for similar products, but sometimes factors such as the customers’ willingness to pay for the product, availability of substitutes and the product positioning also play a crucial role in determining the optimal mark-up over cost that must be applied.
Demand oriented pricing
Good pricing starts with understanding how the customer’s perception of value affects the prices they are willing to pay. There is a close relationship between price and demand for the product. Each price the company might charge will lead to a different level of demand. In the normal case, demand and price are inversely related, and the demand curve slopes downwards. Thus, consumers with limited budgets are not encouraged to buy more if the price is high.
In the case of prestige goods, the relationship between price and demand may be reversed, and the demand curve in such cases slopes upwards. This means that consumers think that higher price means better quality.
Marketers also need to be informed of the price elasticity of the demand curve i.e. how sensitive demand will be to price changes. This information will be useful whilst deciding to increase or decrease the price of the product. If the demand is too price sensitive and changes hugely with a slight change in price, it is said to be price elastic. Conversely, if the demand is price insensitive and hardly changes with per unit change in price, then it is said to be price inelastic.
Price sensitivity varies for with the type of product in question. Buyers are less price sensitive when they are buying a product that is unique or has high quality, prestige or exclusiveness. Also, buyers are less price sensitive when there are less number of substitutes available, or when they are not easily able to compare the quality of substitutes. The same behavior applies when the total expenditure for a product is low relative to their income or when the cost is shared by another party. [4]
Competitor based pricing
Customers are faced with a wide array of options when there is strong competition in the market. In such a situation the customer becomes mindful of the offerings available before him and is able to determine the reasonable and market price for the product, hence making a decision that may be based on comparing relative product quality, customer service or convenience. Most firms in a competitive market are unable to set a price substantially different from their competitors and tend to use ‘going-rate’ pricing which is in line with the prices charged by their competitors. Such businesses are known as ‘price takers’ as they accept the going market price as determined by the market forces.
Value based pricing
Value based pricing uses buyers’ perceptions of value, not the seller’s costs as the key to pricing a product. Various customer groups do not just differ in terms of how they rate individual product features such as quality or functionality and performance; the same applies to price. This is because consumers not only differ in terms of how much they are willing to spend on a product or service; they also differ in terms of the extent to which price actually influences their purchase decision. In value based pricing the marketer does not design a product and marketing program before setting a price. The company first assesses customer needs and value perceptions, post which it is able to set its target price based on these customer perceptions. Based on this target price and value it is decided what costs can be incurred for developing the product and then the product design is initiated.
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Good value pricing [5] is a trend which has picked up in the past decade where marketers have tweaked their pricing approaches to bring them into line with the changing economic conditions and consumer price perceptions. Good value pricing is a modified version of value based pricing and offers the customer just the right combination of quality and good service at a fair price.
This method of pricing has been adopted for numerous products in the recent past where companies have been able to introduce less expensive versions of established, brand-name products. Recent examples include McDonalds’ ‘value menus’, Armani’s less expensive ‘Armani Exchange fashion line’ and Tata Motors’ economical car ‘Nano’. An important type of good value pricing at the retail level is the ‘everyday low pricing’ (ELDP) which involves charging a constant, low price with free or no temporary price discounts.
Pricing strategies
Pricing strategy mainly revolves around three elements-cost and profit objectives, competition, and consumer demand. A successful pricing strategy is one which is devised based on a solid analytical foundation which goes well beyond high level customer values and competitive anecdotes. This requires the use of quantified models involving customer decision making and an insight into competitive economics.
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New product pricing strategies
The introductory phase of the product is challenging, especially when it comes to pricing. As such, the pricing strategy for any product changes across its lifetime as the product passes through its life cycle. Depending on the product’s positioning and the competitive scenario, companies may choose to employ the relevant pricing strategy.
Market-Skimming Pricing
Sometimes companies introduce their products at high initial prices to ‘skim’ revenues layer by layer from the market. As the product spends time in the market, its price is continuously reduced to make it more affordable and appealing to new buyers. In this way the company is able to skim maximum amount of revenue from various segments of the market.
This strategy makes sense only if the product meets certain criteria. Firstly, the products’ quality and image must support its high price, and there must be enough buyers in the market ready to pay the high price for the product. Secondly, the cost of initially producing small volumes must not supersede the effect of charging a high price in the initial stages. Finally, there must be enough entry barriers to the market to prevent entry of competitors who might undercut the high price and steal away potential buyers.
Use of the Price skimming strategy is frequently observed in the electronics and technology industry and companies have successfully used this strategy to maximize their revenues. Sony used this strategy this strategy when it introduced the world’s first high definition television (HDTV) into the Japanese market in 1990. These high tech television sets were initially priced at $43,000 and were purchased only by customers who wanted new technology and could afford to have them. Over the next several years Sony rapidly reduced the price on its HDTV sets to attract new buyers. The price of the HDTV in 2001 was $2000 which was a price that was affordable to many. Today the price of the same TV set is even lower and it continues to fall, enabling Sony to attract customers from various segments of the market and generate maximum revenue from them.
Market-penetration pricing
In this strategy, companies set a rather low initial price in order to penetrate the market quickly and deeply in order to attract a large number of customers quickly and consolidate a sizable market share. The loss of revenue due to low initial price is offset by the high sales volume, which helps in recovering this lost revenue when the price of the product returns to normal. Also due to the high sales volume production costs are low, allowing companies to further cut prices.
Market-penetration pricing works only for products meeting certain conditions. Firstly the market must be highly price sensitive so that potential customers are willing to switch over to your product willingly and produces more market growth for the product. Secondly, the high sales volume must allow the production and distribution costs to fall, so that companies are able to initially set a low penetrable price for the product. Finally, the low price must prevent competition from entering the market and steal away the low price position of the player, or else the low price advantage may only be temporary.
Diligent Media Corporation of the Essel Group used this Market penetration strategy when they introduced the news daily DNA in 2005 across major cities in India. At the time, the market consisted of established players such as Times of India, Indian Express and Sakaal to name a few. The newspaper was initially offered as a yearly subscription which was priced at Rs. 100 per year in a market that is very price sensitive. This price was substantially lower than the daily price of Rs. 3 to Rs. 5 commanded by the established players in the market. The bundling of the product as a yearly subscription ensured a high sales volume plus the offering was at such a low price that it attracted the customer’s attention and got them to switch to the new product, at least temporarily. The strategy proved successful for DNA and today the news daily commands the second largest market share in Mumbai. [6]
Product Mix pricing strategies
When a product is part of a product mix, the strategy for setting a products’ price often has to be changed. In such situations, firms are on a lookout for prices that would maximize the total profits of the product mix as such. Also pricing becomes a difficult task as different products have different demands and face different degrees of competition.
Product line pricing
Some companies develop entire product lines rather than a single product. To price these separate offerings in the product line companies employ Product line pricing strategy where in the management decides the price steps set between the various products. The price steps are not arbitrarily decided but take into account cost differences between the products in the line and account for differences in customer perception of value of the different features of the various products.
Bata, a major footwear company offers an entire range of products in the Indian market, from premium European collection priced at Rs. 2499 to ordinary leather shoes priced at Rs. 749. It offers similar product range for women and children too, starting from economy to premium prices. This pricing strategy allows Bata to offer products across different segment of the Indian market at prices based on customer’s value perception and affordability.
Optional Product pricing
In this pricing strategy, companies offer to sell optional or accessory products along with the main product. It involves pricing of optional or accessory products along with a main product which the company is offering. Pricing these optional offerings can be tricky as firms have to correctly decide which items to include in the base price and which to offer as options.
Optional product pricing is widely used by automobile companies in a bid to improve sales. Car manufacturers such as Tata Motors offer various models of the same car with different sets of accessories and add-ons for each offering. Being differently priced too, these models appeal to different sets of customers and enables Tata Motors to tap into various customer segments having specific needs.
Captive product Pricing
Some companies make products which have to be used with along with a main product the customers are already using, like razor blades, mosquito repellents etc. For these products companies apply a Captive Product pricing strategy. In this pricing strategy, the prices on the main products are set low while the supplies are highly priced. For once the customer has bought the main product they will be compelled to use supplies of the same company in order to continue using the same product. However, the supplies should not be priced too high as the customers might resent the brand once they are trapped into using the product and have to pay a high price at the same time for it. Gillette sells low priced razors which are a one-time buy for the consumer and mainly makes money from the subsequent cartridges that customers buy. A Gillette Mach3 razor along with a single replacement cartridge comes for Rs. 200, but once you’ve bought the razor you are committed to buy the razor cartridges of the same company and make, which are priced at Rs. 750 for eight cartridges.
In case of services, the captive productive pricing is called ‘two-part pricing’, the first part generally being a fixed fee post which customers have to pay a variable usage rate. This strategy is seen to be employed in amusement parks where customers have to pay a one- time fixed entry fee to enter the park and then pay separately for the specific rides and services they wish to enjoy at the place.
Product Bundle Pricing
This strategy involves combining several products and offering the bundle at a reduced price than individual product offerings. Using this strategy, sellers are able to promote sales of products which consumers might otherwise not buy individually. However, the combined price must be low enough to get the customers to buy the bundle.
An example of such strategy being used may be seen in the case of fast food restaurants such as McDonalds, which bundles various products like burgers, fries and soft-drink at a ‘combo price’. Similarly, resorts sell specially priced vacation packages that include airfare, accommodation, meals and entertainment.
Price Adjustment Strategies
The base price set for a product may not last during the products lifecycle. According to changing market situations and various customer differences, companies need to adjust its base price. The following are some of the strategies which are used by companies to account for the changing market conditions.
Discount and allowance pricing
Some companies use such price adjustments to reward customers for certain responses, such as early payment of bills, volume purchases and off-season buying. Companies then reward their customers in the form of discount payments and allowances, either to reward their past response or to induce similar buying behavior. Discounts include cash discounts, where there is a price reduction in case customers pay the bill promptly, or quantity discounts where in the customer receives a price reduction after buying a product in large amounts at a single time. A functional discount, also known as a trade discount is offered by the seller to trade channel members for performing certain activities like selling, storing and record keeping. A seasonal discount is a price reduction to buyers who buy merchandise or services in the off season.
Allowances are another type of reduction from the list price of the product. Trade-in allowances are price reductions given for turning in an old item when buying a new one. Such allowances are most common in the automobile and electronic industry.
Segmented pricing
Companies often vary their prices for different segments according to differing customer needs, locations and products. Thus in segmented pricing, a company may sell a product or service at two different prices, the difference not being attributed to differences in costs. Segmented pricing takes several forms. Customer-segment pricing involves different types of customers paying different prices for the same product or service. This strategy is usually seen to be used in museums which charge different admission charges for children and senior citizens. Another form of segmented pricing is product-form pricing, where in different products of similar types are priced differently without having cost as a basis for pricing. For example, the price of a 1 liter bottled drinking water maybe Rs. 20, the price of a half-liter bottle is Rs. 12, and the price of a 2 liter bottle is Rs. 35. Although the water in the bottles comes from the same source and is packaged by the same company, the prices for different forms of packaging are not price proportionally to their volumes.
Under location pricing, company charges different prices for different locations even though the cost of offering for all locations is the same. For example in a movie theatre, seats are sold as Gold, Silver and Platinum for varying prices depending on their location within the theatre, although the cost of setting up each seat is the same. Time pricing is another pricing strategy where companies sell the product or service depending on the time it is purchased. Airlines regularly employ such strategies to sell their tickets at varying costs, depending on when the customer buys them although the cost incurred by the airline per passenger is the same.
Psychological pricing
Price is not merely the amount a customer pays for the product or service received; it also says something about the product. Many consumers use price to judge the quality of the product. Using psychological pricing, firms consider the psychology of the consumers and are not simply limited to economics. Because most consumers consider highly priced products as having high quality, having a high premium on the product may do wonders. However, such customer behavior disappears as the customer comes in contact with the product and judges it by examination or relying on past experience. Having said this, in cases where they lack skill and sufficient information about the product, price becomes the only indicator for consumers about the quality of the product.
Vodka manufacturer Heublein used this pricing strategy very effectively to their advantage some years ago when their vodka brand Smirnoff was attacked by another competing brand named Wolfschmidt, who claimed to have the same quality as Smirnoff and was priced one dollar less than it. To counter this move, Heublein smartly raised the price of Smirnoff by one dollar, introduced a brand named Relska in the market to compete with the competitor brand Wolfschmidt and finally introduced another brand Popov which was priced even lower than Wolfschmidt. Using price as a signal, Heublein was successfully able to communicate to the consumers of the quality of Smirnoff and made money on it, although in reality all its three products were similar in nature but just differently positioned.
Setting the Price
A firm must set a price for the first time when it develops a new product and when it introduces its regular product into a new distribution channel or geographical area. It must also decide how to position its product on quality and price. The following framework is generally seen to be followed by most companies.
Step 1: Selecting the Pricing Objective
It is here where the company first decides where it wants to position its market offering. The clearer a firm’s objectives, the easier it is to set price. A company can pursue any of five major objectives through pricing i.e. survival, maximum current profit, maximum market share, maximum market skimming, or product-quality leadership.
Survival
In dire situations, companies tend to pursue survival as their major objective if they are afflicted with overcapacity, intense competition, or changing consumer needs. As long as prices cover variable costs and some of the fixed costs, the company would do well to stay in business. Survival must never be a long term objective for any firm. It should be treated as a short term emergency objective and in the longer run the firm must find ways to add value to the business or face the danger of winding up.
Maximum current profit
Many companies look to maximize current profits by setting prices accordingly. After estimating product demand and associated costs, it chooses a price for the product that would maximize short term gains, cash flows or return on investment. An assumption for applying this strategy is that the firm has prior knowledge of its demand and cost functions which in reality are difficult to estimate. Also the company might have to sacrifice long
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