Simple Price Concepts

All firms set prices for their products. Poor pricing is easy. But, pricing well is very difficult. Proper determination of product pricing requires knowledge, preparation, and insight. Good pricing separates top executives from the pack.

The four P’s of marketing are:

  1. Product
  2. Price
  3. Placement
  4. Promotion

Pricing is the most important. The reason is that the other 3 P’s all deal with creating value whereas pricing is method for capturing value. Bad pricing decisions decrease the effectiveness of product, placement, and promotion.

A firm’s environment costs of:

  1. Costs
  2. Demand
  3. Competition
  4. Antitrust/Legal

Slotting Allowance

Slotting Allowance is money that a firm gives to a retailer for the privilege of putting a product on the store shelf. The amount of money spent on slotting allowances alone is more than all of advertising and consumer promotion expenditures, such as coupons, combined.

Smart Cards

Many stores, especially grocery stores, use smart cards to track a customer’s purchasing behavior. A customer is encouraged to scan her cards each time she makes a purchase. The retailers collect purchasing data into a database with her name, all of the purchases she’s ever made, and what kinds of coupons she uses. This information can be used to determine price sensitivity and can be used to create targeted pricing schemes. In theory, the data can be used to charge different prices to different individuals for the same product. One supermarket chain in California is doing this. There is a kiosk in supermarket which displays customized special offers when the smart card is inserted. Another retailer has a terminal display on the shopping cart itself where a customer puts your card in the slot. The cart buzzes if it wants her attention. For example, it might tell her that she will get 25 cents off the cookies she just passed.

Profit Maximization – Raise Prices or Increase Market Share?

Consider the following situation:

A soap manufacturer has annual sales of 100000 units. The selling price is $1 per bar. It costs $30000 to set up a factory to make soap, and it costs $0.60 to make each bar.

$3000 are fixed costs and $0.60 are variable costs. Fixed costs do not change as more bars are made. But, variable costs increase each time the firm makes another bar of soap. The profit of the firm is:

 

Profit = (100000 bars)*($1 per bar) – $3000 – (100000 bars)*($0.60 per bar)

 

= $100000 – $30000 – $60000

= $10000

Would the firm be better off if sales were increased by 1% (1000 bars) or if, instead, the price were increased by 1% ($0.01)?

Profit for 1% Increase in Sales = (101000 bars)*($1 per bar) – $3000 – (101000 bars)*($0.60 per bar)

= $101000 – $30000 – $60600

= $10400

Profit for 1% Increase in Price = (100000 bars)*($1.01 per bar) – $3000 – (10000 bars)*($0.60 per bar)

= $101000 – $30000 – $60000

= $11000

This example can be extended to firms in general. A study by McKinsey and Company based on average economics showed that, on average, a 1% increase in a product’s price cases a 11.1% increase in profits. But, a 1% increase in sales, on average, only results in a 3.3% increase in the firm’s profit.

Some Easy, but Poor Ways to Set Price

Firms often use these easy techniques for setting price; but they result in foregone profits:

  • Cost-Driven Pricing

  • Customer-Driven Pricing

  • Competition-Driven Pricing

Cost-Driven Pricing

Firms engaging in cost-driven pricing set prices based on their costs and profit objectives. Cost-Driven Pricing is sometimes called “Cost Plus Pricing.”

A firm typically puts a significant amount of money upfront into product design. Then, the engineering team turns the product design over to the manufacturing team which determines how to produce the product at a cost that will be at least marginally profitable. Next, the finance team is asked for determine, based on per unit cost and markup, what the product selling price should be. Finally, the marketing and sales group is tasked with sell the product at the cost that has been predetermined. Here is an Example of Cost-Driven pricing:

A firm has a product which has a marginal cost of $3 per unit. This marginal cost is constant regardless of the volume produced. The fixed costs for setting and remaining in production are $4.5M.

The per unit cost is $3 per unit plus ($4.5M / [Number of Units Produced]). Obviously, the per unit cost decreases as the number of units produced increases.

Many companies get around the lack of a static unit cost by artificially setting a desired production rate. So, let’s assume that this firm decides it wants to sell a million units. Then, the price per unit is:

Price Per Unit = $3 + ($4.5M/ 1M) = $7.50

The firm wants to make a profit of $1.50 per unit. So, it will try to sell the product for $9.

But… Will customers really pay $9 for the product? What are competitors charging? The sales number of one million units is totally made up!

What if the firm is only able to sell 750000 units at $9 each? It will only break even. That’s obviously not the desired outcome. Does the firm raise price? Lower the price? It would need to know what the demand curve for the product looks like in order to answer these questions. Otherwise, there’s no way of knowing what the effect of changing the price will be.

The problem is that Cost-Driven Pricing gives an apparent sense of objectivity to the price. The price is not objective.

A Cost-Driven Pricing scheme ignores customers. It fails to capture customers’ additional willingness to pay. The firm has no idea about what customers are willing to pay – if they’re willing to pay anything at all!

Another problem with Cost-Driven Pricing is that it ignores competitors. Competitors could be charging a lot less for similar items.

Cost-Driven Pricing usually results in charging one price to all customers. A one price fits all philosophy is often not a good practice because the firm cannot engage in price discrimination.

There are advantages to this pricing scheme. Its easy to understand and implement. If it works, the firm will have cover all of its variable costs and, in addition, the markup should cover some of the business’ general administrative costs. A decent return on investment will result.

These disadvantages of Cost-Driven Pricing outweigh the advantages.

Customer Driven Pricing

The problems with Cost Driven Pricing can be avoided by asking what price that customer is willing to pay. Then, the firm charges the maximum price that the customer is willing to pay.

There are problems with Customer Driven Pricing too. First, Customer Driven Pricing ignores the competition. And it ignores the costs of making the product.

Customer Driven Pricing is particularly poor for pricing a new product because customers don’t know how much they like it or how much value they place on it. Lastly, if customers know this is how a firm is setting prices, why would they tell the firm what they’re willing to pay? They have no incentive to tell the truth.

Competition Driven Pricing

Competition Driven Pricing focuses on what the competition is charging.

Problems with Competition Driven Pricing:

  • Price wars can result.
  • Competition Driven Pricing ignores costs. A competitor may have a whole different cost structure which allows them to make a profit at a much lower selling price.
  • Ignores customer willingness to pay. The firm’s product may be better or worse than the competitors, making the customer willing to pay more or less for it.

Each of these strategies as positive points. But, none of them are optimal. Optimal pricing strategy takes in account costs, customers, competition, and the legal environment.

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