PRICING

Samir K Mahajan

WHAT IS PRICE?

Price is the value placed on what is exchanged for satisfaction and utility. Price includes tangible (functional) and intangible (prestige) factors. It can be a barter.

Price goes by many names: Rent, tuition fee, rate, interest, toll, premium, bribe, dues, retainer, assessment, salary commission, wage, alimony, honorarium, barter.

Samir K Mahajan

UNDERSTANDING PRICING

Price represents the value of a good/service among potential purchases and for ensuring competition among sellers in an open market economy. Marketers need to understand the value consumers derive from a product and use this as a basis for pricing a product.

Price is the one element of marketing-mix that produces revenue ; the other elements produce cost . Prices are easiest marketing-mix element to adjust; product features , channels, even promotion take more time . Price also communicates to the market the company’s intended value positioning of its product or brand.

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Pricing is a critical decision made by a marketing executive because price has a direct effect on a firm’s profits. This is apparent from a firm’s profit equation: Profits = Total Revenue – Total Cost Where total revenue Total Revenue = Price * Quantity Price affects profit directly through price, and indirectly by effecting the quantity sold, and effects total costs through its impact on the quantity sold (i.e. economies of scale) Samir K Mahajan

UNDERSTANDING PRICING contd.

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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 buyer behaviour in recent decades, price still remains one of the most important elements determining company market share and profitability .

non-price factors have become more important in

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Throughout most of history , prices were set by negotiation between buyers and sellers. Bargaining is still prevalent in some areas.

Setting one price for all buyers scale retailing at the end of the nineteenth.

is a relatively a modern idea that arose with the development of large-

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Now, just one hundred years later , the internet promises to reverse the fixed pricing trend and take us back to an era of negotiated pricing. Web sites like Compare. Net and Price Scan.com

allow buyers to compare products and prices quickly and easily . Online auction sites like Bazee.com and Onsale.com make it easy for buyers and sellers to negotiate prices on thousand of items.

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Consumers and purchasing agents have more access to price information and price discounters. Consumers shop carefully , forcing 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.

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Most markets have three to five price points or tiers . Marriott Hotels is good at developing different brands for different price points: Marriott Vacation Club—Vacation Villas (highest price), Marriott Marquis (high price), Marriott (high-medium price), Renaissance (medium-high price), Courtyard (medium price), Towne Place Suites (medium-low price), and Fairfield Inn (low price).

Samir K Mahajan

FACTORS AFFECTING PRICE SETTING OR PRICE DECISIONS OR PRICE POLICY

A firm must set a price for the first time when it develops a new product, when it introduces its regular product into a new distribution channel or geographical area, and when it enters bids on new contract work. The firm must decide where to position its product on quality and price.

The firm has to consider many factors in setting its pricing policy. Usually, there is a six-step procedure: (1) selecting the pricing objective (2) determining demand (3) estimating costs (4) analysing competitors' costs, prices, and offers (5) selecting a pricing method (6) selecting the final price Samir K Mahajan

STEP 1: SELECTING PRICING OBJECTIVES

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A company can pursue any of the fie major objectives through pricing: Survival Maximum current profit Maximum market share Maximum market skimming product-quality leadership Survival: Companies pursue survival as their major objective if they are plagued with overcapacity, intense competition, or changing consumer wants . As long as prices cover variable costs and some fixed costs, the company stays in business.

Survival is a short-run objective; in the long run, the firm must learn how to add value or face extinction.

Maximum Current Profit: Many companies try to set a price that will maximize current profits. They estimate the demand and costs associated with alternative prices and choose the price that produces maximum current profit, cash flow, or rate of return on investment.

This strategy assumes that the firm has knowledge of its demand and cost functions; in reality, these are difficult to estimate.

In emphasizing current performance, the company may sacrifice long-run performance by ignoring the effects of other marketing-mix variables, competitors' reactions, and legal restraints on price.

Samir K Mahajan

SELECTING PRICING OBJECTIVES contd.

Maximum Market Share : Some companies want to maximize 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 .

Texas Instruments (TI) has practiced this market-penetration pricing . TI would build a large plant, set its price as low as possible, win a large market share, experience falling costs, and cut its price further as costs fall.

The following conditions favour setting a low price: (1) The market is highly price sensitive, and a low price stimulates market growth; (2) production and distribution costs fall with accumulated production experience; and (3) a low price discourages actual and potential competition.

Maximum Market Skimming: Companies unveiling a new technology favour setting high prices to

maximize market skimming

. Sony is a frequent practitioner of market-skimming pricing, where prices start high and are slowly lowered over time. When Sony introduced the world's first high-definition television to the Japanese market in 1990, it was priced at $43,000. So that Sony could "skim" the maximum amount of revenue from the various segments of the market, the price dropped steadily through the years—a 28-inch HDTV cost just over $6,000 in 1993 and a 42-inch HDTV cost about $1,200 in 2004.

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 (3) the high initial price does not attract more competitors to the market; (4) the high price communicates the image of a superior product.

Samir K Mahajan

SELECTING PRICING OBJECTIVES contd.

Product- Quality Leadership: A company might aim to be the product-quality leader in the market. Many brands strive to be "affordable luxuries"—products or services characterized by high levels of perceived quality, taste, and status with a price just high enough not to be out of consumers' reach. Brands such as Starbucks coffee , Aveda shampoo, Victoria's Secret lingerie, and BMW cars, have been able to position themselves as quality leaders in their categories, combining quality, luxury, and premium prices with an intensely loyal customer base.

Other Objectives : Non-profit and public organizations may have other pricing objectives. A university aims for partial cost recovery, knowing that it must rely on private gifts and public grants to cover the remaining costs. A non-profit hospital may aim for full cost recovery in its pricing. A non-profit theatre company may price its productions to fill the maximum number of theatre seats. A social service agency may set a service price geared to client income.

Whatever the specific objective, businesses that use price as a strategic tool will profit more than those who simply let costs or the market determine their pricing.

Samir K Mahajan

STEP 2: DETERMINING DEMAND

Each price will lead to a different level of demand and therefore have a different impact on a company's marketing objectives.

The relation between alternative prices and the resulting current demand is captured in a demand curve.

In the normal case, demand varies inversely with price. The higher the price, the lower the demand. In the case of prestige or status goods, the demand curve sometimes slopes upward. A perfume company raised its price and sold more perfume rather than less! Some consumers take the higher price to signify a better product. However, if the price is too high, the level of demand may fall.

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Price Sensitivity: The demand curve shows the market's probable purchase of a commodity at alternative prices. It sums the reactions of many buyer who have different price sensitivities. Generally speaking, sensitive to products that cost a lot or are bought frequently.

They are customers are most price less price sensitive to low-cost items or items they buy infrequently.

price sensitive.

They are also less price sensitive when price is only a small part of the total cost of ownership (obtaining, operating, and servicing the product over its lifetime). Companies, of course, prefer customers who are less Samir K Mahajan

DETERMINING DEMAND contd.

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Estimating Demand Curves: Most companies make some attempt to measure their demand curves using several different methods say statistical analysis of past prices, quantities sold, and other factors. The data can be longitudinal (over time) or cross-sectional (different locations at the same time).

Price experiments

can be conducted. For instance, charging different prices in similar territories to see how sales are affected. Companies can use internet too. It can give price discounts to different groups of customers at different regions and see the response of the buyers in different market segments.

Surveys

can explore how many units consumers would buy at different proposed prices, although there is always the chance that they might understate their purchase intentions at higher prices to discourage the company from setting higher prices.

In measuring the price-demand relationship, the market researcher must have control for various factors that will influence demand.

Samir K Mahajan

DETERMINING DEMAND contd.

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Price Elasticity of Demand: Price elasticity measures response of the buyers of commodity with respect to change in its price. It is the ratio of percentage change in quantity demanded of a commodity to percentage change in its price.

Marketers need to know how responsive or elastic demand would be to a change in price. If demand hardly changes with a small change in price, we say the demand is inelastic (percentage change in quantity demanded is less than percentage change in price. If demand changes considerably with respect to change in price , demand is elastic

(percentage in change in quantity demanded is more than percentage change in price).

Demand is likely to be less elastic under the following conditions: (1) There are few or no substitutes or competitors; (2) buyers do not readily notice the higher price; (3) buyers are slow to change their buying habits; (4) buyers think the higher prices are justified.

If demand is elastic, sellers will consider lowering the price. A lower price will produce more sale and more total revenue. This makes sense as long as the costs of producing and selling more units do not increase disproportionately.

Price elasticity may be negligible with a small price change and substantial with a large price change. It may differ for a price cut versus a price increase.

Finally, long-run price elasticity may differ from short-run elasticity. Buyers may continue to buy from a current supplier after a price rise, but they may eventually switch suppliers. Here demand is more elastic in the long run than in the short run. Or the reverse may happen: Buyers may drop a supplier for a price rise but return later.

Samir K Mahajan

STEP 3: ESTIMATING COSTS

Demand sets a ceiling on the price the company can charge for its product. Costs set the floor. The company wants to charge a price that covers its cost of producing, distributing, and selling the product, including a fair return for its effort and risk. Yet, when companies price products to cover full costs, the net result is not always profitability.

Types of Costs And Levels of Production: A company's costs take two forms, fixed and variable. Fixed costs (also known as overhead) are costs that do not vary with production or sales revenue e.g. rent, heat, interest, salaries, and so on, regardless of output. Variable costs vary directly with the level of production (units produced) e.g. cost of raw materials, packaging, wage etc. Variable costs tend to be constant per unit produced. Total costs consist of the sum of the fixed and variable costs for any given level of production. Average cost is the cost per unit at that level of production; it is equal to total costs divided by production. Management wants to charge a price that will at least cover the total production costs at a given level of production.

Activity-based Cost Accounting: Today's companies try to adapt their offers and terms to different buyers. A manufacturer, for example, will negotiate different terms with different retail chains. One retailer may want daily delivery (to keep inventory lower) while another may accept twice-a-week delivery in order to get a lower price. The manufacturer's costs will differ with each chain, and so will its profits. To estimate the real profitability of dealing with different retailers, the manufacturer needs to use activity-based cost (ABC) accounting.

ABC accounting tries to identify the real costs associated with serving each customer.

It allocates indirect costs like clerical costs, office expenses, supplies, and so on, to the activities that use them, rather than in some proportion to direct costs. Both variable and overhead costs are tagged back to each customer. Companies that fail to measure their costs correctly are not measuring their profit correctly and are likely to misallocate their marketing effort.

Samir K Mahajan

Target Costing : Costs change with production scale and experience. They can also change as a result of a concentrated effort by designers, engineers, and purchasing agents to reduce them through target costing.

to establish a new product's desired functions and the price at which the product will sell, given its appeal and competitors' prices.

Market research is used Deducting the desired profit margin from this price leaves the target cost that must be achieved.

Each cost element—design, engineering, manufacturing, sales—must be examined, and different ways to bring down costs must be considered.

The objective is to bring the final cost projections into the target cost range. If this is not possible, it may be necessary to stop developing the product because it could not sell for the target price and make the target profit.

Samir K Mahajan

STEP 4: ANALYSING COMPETITORS' COSTS, PRICES, AND OFFERS Within the range of possible prices determined by market demand and company costs, the firm must take competitors' costs, prices, and possible price reactions into account. The firm should first consider the nearest competitor's price. If the firm's offer contains features not offered by the nearest competitor, their worth to the customer should be evaluated and added to the competitor's price. If the competitor's offer contains some 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 it can charge more, the same, or less than the competitor. But competitors can change their prices in reaction to the price set by the firm.

Samir K Mahajan

STEP 5: SELECTING A PRICING METHOD Given the three Cs—the customers' demand schedule, the cost function, and competitors' prices —the company is now ready to select a price. Costs set a floor to the price. Competitors' prices and the price of substitutes provide an orienting point (adjusting to a market). Customers' demand schedule establishes the price ceiling.

Companies select a pricing method that includes one or more of these three considerations. We will examine six price-setting methods: mark-up pricing, target-return pricing, perceived-value pricing, value pricing, going-rate pricing, and auction-type pricing.

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Mark-up Pricing: The most elementary pricing method is to add a standard mark up to the product's cost or selling price. Construction companies submit job bids by estimating the total project cost and adding a standard mark up for profit. Lawyers and accountants typically price by adding a standard mark up on their time and costs.

Suppose a toaster manufacturer has the following costs and sales expectations: Variable cost per unit $10 Fixed cost $300,000 Expected unit sales 50,000 Samir K Mahajan

The manufacturer's unit cost is given by: Unit cost = variable cost per unit + fixed cost per unit = $10 + $300,000 ÷ 50,000 = $16 If the company wants to earn a 20 percent mark-up on cost , the mark up price would be Mark-up price on cost = Unit cost (1 + desired return on cost) = 16 X (1 + 0.2) = 19.2 Now assume the manufacturer wants to earn a 20 percent mark-up on sales.

given by: The manufacturer's mark-up price is Mark-up price on sale = Unit cost ÷ (1 – desired return on sales) = 16 ÷ ( 1 – 0.2 ) = $ 20 The manufacturer would charge dealers $20 per toaster and make a profit of $4 per unit. The dealers in turn will mark up the toaster. If dealers want to earn 50 percent on their selling price, they will mark up the toaster to $40. This is equivalent to a cost mark-up of 100 percent.

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.

Samir K Mahajan

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Target-return Pricing : In target-return pricing, 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.

Suppose the toaster manufacturer has invested $1 million in the business and wants to set a price to earn a 20 percent ROI, specifically $200,000. The target-return price is given by the following formula:

Target-return price = unit cost + (desired return x invested capital) ÷ unit sales = $16 + ( 0.20 X $1.000.000 ) ÷ 50,000 = $20 The manufacturer will realize this 20 percent ROI provided its costs and estimated sales turn out to be accurate.

Samir K Mahajan

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Perceived -Value Pricing: An increasing number of companies now base their price on the customer's perceived value.

They must deliver the value promised by their value proposition, and the customer must perceive this value. They use the other marketing-mix elements, such as advertising and sales force, to communicate and enhance perceived value in buyers' minds.

Perceived value is made up of several elements, such as the buyer's image of the product performance, the channel deliverables, the warranty quality, customer support, and softer attributes such as the supplier's reputation, trustworthiness, and esteem.

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Value Pricing: In recent years, several companies have adopted value pricing. They win loyal customers by charging a fairly low price for a high-quality offering . In the early 1990s, Procter & Gamble created quite a stir when it reduced prices on supermarket staples (necessary commodity) such as Pampers and Luvs diapers, liquid Tide detergent, and Folger's coffee to value price them. It redesigned the way it developed, manufactured, distributed, priced, marketed, and sold products to deliver better value at every point in the supply chain.

Value pricing is not a matter of simply setting lower prices; it is a matter of reengineering 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.

Samir K Mahajan

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Going-Rate Pricing: In going-rate pricing, the firm bases its price largely on competitors' prices. The firm might charge the same, more, or less than major competitor(s).

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," changing their prices when the market leader's prices change rather than when their own demand or costs change. Some firms may charge a slight premium or slight discount, but they preserve the amount of difference. Thus minor gasoline retailers usually charge a few cents less per gallon than the major oil companies, without letting the difference increase or decrease.

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Auction-type Pricing : Auction-type pricing is growing more popular, especially with the growth of the Internet. There are thousands of electronic marketplaces selling everything from pigs to used vehicles to cargo to chemicals. One major purpose of auctions is to dispose of excess inventories or used goods . Companies need to be aware of the three major types of auctions and their separate pricing procedures.

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English auctions (ascending bids). One seller and many buyers.

On sites such as Yahoo! and eBay, the seller puts up an item and bidders raise the offer price until the top price is reached. English auctions are being used today for selling antiques, cattle, real estate, and used equipment and vehicles.

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Dutch auctions (descending bids). One seller and many buyers, or one buyer and many sellers.

In the first kind, an auctioneer announces a high price for a product and then slowly decreases the price until a bidder accepts the price. In the other, the buyer announces something that he wants to buy and then potential sellers compete to get the sale by offering the lowest price. Each seller sees what the last bid is and decides whether to go lower.

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Sealed-bid auctions. Would-be suppliers can submit only one bid and cannot know the other bids.

The U.S. government often uses this method to procure supplies. A supplier will not bid below its cost but cannot bid too high for fear of losing the job.

Samir K Mahajan

STEP 6: SELECTING THE FINAL PRICE Pricing methods narrow the range from which the company must select its final price. In selecting that price, the company must consider additional factors, including the impact of other marketing activities, company pricing policies, gain-and-risk-sharing pricing, and the impact of price on other parties . The final price must take into account the brand's quality and advertising relative to the competition.

Company Pricing Policies : The price must be consistent with company pricing policies. At the same time, companies are not averse to establishing pricing penalties under certain circumstances. Airlines charge amount to those who change their reservations on discount tickets. Banks charge fees for too many withdrawals in a month or for early withdrawal of a certificate of deposit. Many companies set up a pricing department to develop policies and establish or approve decisions. The aim is to ensure that salespeople quote prices that are reasonable to customers and profitable to the company.

Gain-and-risk-sharing Pricing : Buyers may resist accepting a seller's proposal because of a high perceived level of risk. The seller has the option of offering to absorb part or all of the risk if it does not deliver the full promised value. Baxter, a leading medical products firm, approached Columbia/HCA, a leading health care provider, with an offer to develop an information management system that would save Columbia several million dollars over an eight-year period. When Columbia balked, Baxter offered to guarantee the savings; if they were not realized, Baxter would write a check for the difference. Baxter got the order! Baxter could have gone further and proposed that if Baxter's information system saved Columbia more than the targeted amount, Baxter's share of the additional savings would be 30 percent.

Samir K Mahajan

Ref: Kotler