Price determination decisions can be based on a number of factors, including cost, demand, competition, value, or some combination of factors. However, while many marketers are aware that they should consider these factors, pricing remains somewhat of an art. For purposes of discussion, we categorize the alternative approaches to determining price as follows: (a) cost-oriented pricing; (b) competition-oriented pricing; and (c) value-based (demand) approaches.
The cost-plus method, sometimes called gross margin pricing, is perhaps most widely used by B2B marketers to set price. The manager selects as a goal a particular gross margin that will produce a desirable profit level. Gross margin is the difference between how much the goods cost and the actual price for which it sells.
A primary reason that the cost-plus method is attractive to marketers is that they do not have to forecast general business conditions or customer demand. If sales volume projections are reasonably accurate, profits will be on target. Consumers may also view this method as fair, since the price they pay is related to the cost of producing the item. Likewise, the marketer is sure that costs are covered.
A major disadvantage of cost-plus pricing is its inherent inflexibility. For example, department stores have often found difficulty in meeting competition from discount stores, catalog retailers, or furniture warehouses because of their commitment to cost-plus pricing. Another disadvantage is that it does not take into account consumers’ perceptions of a product’s value. Finally, a company’s costs may fluctuate so constant price changing is not a viable strategy. Thus, this strategy is frequently used when salespeople have the ability to negotiate the purchase of a large variety of product.
When the term mark-up is used, it is referring to the difference between the average cost and price of all merchandise in stock, for a particular department, or for an individual item. The difference may be expressed in dollars or as a percentage, though percentage is more common. For example, a man’s tie costs USD 4.60 and is sold for USD 8. The dollar mark-up is USD 3.40. The mark-up may be designated as a percent of selling price or as a percent of cost of the merchandise. In this example, the mark-up is 74 per cent of cost (USD 3.40/USD 4.60) or 42.5 percent of the retail price (USD 3.40/USD 8).
There are several reasons why expressing mark-up as a percentage of selling price is preferred to expressing it as a percentage of cost. One is that many other ratios are expressed as a percentage of sales. For instance, selling expenses are expressed as a percentage of sales. If selling costs are 8 per cent, this means that for each USD 100,000 in net sales, the cost of selling the merchandise is USD 8,000. Advertising expenses, operating expenses, and other types of expenses are quoted in the same way. Thus, there is a consistency when making comparisons in expressing all expenses and costs, including mark-up, as a percentage of sales (selling price).
Certainly costs are an important component of pricing. No firm can make a profit until it covers its costs. However, the process of determining costs and then setting a price based on costs does not take into consideration what the customer is willing to pay at the marketplace. As a result, many companies that have set out to develop a product have fallen victim to the desire to continuously add features to the product, thus adding cost. When the product is finished, these companies add some percentage to the cost and expect customers to pay the resulting price. These companies are often disappointed, as customers are not willing to pay this cost-based price.
Competition-oriented pricing is best utilized in highly competitive industries where buyers have proven to actively evaluate alternatives and to use pricing to assess quality. As discussed previously in this chapter, organizations have three options when basing pricing on the competition:
- Price the product higher than the competition thus sending a message that our brand is better, more consistent, and the product is a higher quality
- Price the product lower than the competition thus sending a message that we might be a lower quality but the customer can save money by purchasing our product. This is known as competing on price.
- Price the product the same as the competition thus engaging in non-price competition. This is appropriate if the competitive products are very similar and we choose to compete on something other than price.
Value-based (demand) pricing
Value-based pricing sets prices primarily, but not exclusively, on the value, perceived or estimated, to the customer rather than on the cost of the product or historical prices. This strategy focuses entirely on the customer as a determinant of the total price/value package. Marketers who employ value-based pricing might use the following definition: “It is what you think your product is worth to that customer at that time.”
Value-Based Pricing: Value-based pricing focuses entirely on the customer as a determinant of the total price or value package.
Goods that are very intensely traded (e.g., oil and other commodities) or that are sold to highly sophisticated customers in large markets (e.g., automotive industry) usually are sold based on cost-based pricing. Value-based pricing is most successful when products are sold based on emotions (fashion), in niche markets, in shortages (e.g., drinks at open air festival at a hot summer day) or for indispensable add-ons (e.g., printer cartridges, headsets for cell phones).
Many customer-related factors are important in value-based pricing. For example, it is critical to understand the consumer buying process. How important is price? When is it considered? How is it used? Another factor is the cost of switching. Have you ever watched the television program,”The Price is Right”? If you have, you know that most consumers have poor price knowledge. Moreover, their knowledge of comparable prices within a product category (e.g., ketchup is typically worse). So price knowledge is a relevant factor. Finally, the marketer must assess the customers’ price expectations. How much do you expect to pay for a large pizza? Color TV? Tablet? Swimming pool? These expectations create a phenomenon called “sticker shock” as exhibited by gasoline, automobiles, and ATM fees.
Value-based pricing is predicated upon an understanding of customer value. In many settings, gaining this understanding requires primary research. This may include evaluation of customer operations and interviews with customer personnel. Survey methods are sometimes used to determine value a customer attributes to a product or a service. The results of such surveys often depict a customer’s willingness to pay. The principal difficulty is that the willingness of the customer to pay a certain price differs between customers, between countries, even for the same customer in different settings (depending on his actual and present needs), so that a true value-based pricing at all times is impossible. Also, extreme focus on value-based pricing might leave customers with a feeling of being exploited which is not helpful for the companies in the long run. Two types of value-based pricing techniques are discussed below.
Improvement pricing is based on the functionality of a product. If this product is used, what is the cost savings to the customer over their current situation? This strategy is commonly used in industrial pricing, especially with factory equipment.
A flexible pricing mechanism made possible by advances in information technology, and employed mostly by Internet based companies. By responding to market fluctuations or large amounts of data gathered from customers – ranging from where they live to what they buy to how much they have spent on past purchases – dynamic pricing allows online companies to adjust the prices of identical goods to correspond to a customer’s willingness to pay. The airline industry is often cited as a success story. In fact, it employs the technique so artfully that most of the passengers on any given airplane have paid different ticket prices for the same flight.