What are some pricing objectives? Setting the right price is more than simply calculating the cost of production and then tacking on a markup for profit. The price often impacts how consumers view a product and may determine whether they will purchase it. The price also helps differentiate the product from the competition. Setting a specific pricing objective is important to do before establishing the price point. There are a variety of pricing objectives. Some of the most common ones include the following:

• Maximizing profits. This occurs when the price is set so that the total revenue earned from the product exceed the total costs by the greatest amount.

• Achieving greater market share. A company’s market share is the percentage of total industry sales or revenues it is able to capture. Unfortunately, achieving greater market share does not always translate into higher profits.

• Maximizing sales. Maximizing sales often means charging low prices that can result in losses. Firms cannot survive for long with losses. However, maximizing sales may be an appropriate short-run objective to rid the company of excess inventory, such as last year’s models.

• Building traffic. Many retail stores, such as grocery stores and department stores, may advertise low sales prices on a few goods to increase traffic in their stores and build a stronger customer base. They also hope customers will purchase other, more profitable items while they are shopping for the bargains.

• Matching the status quo prices. The objective of status quo pricing is to match competitors’ prices, possibly to avoid a price war that could be damaging to all sellers. The airfare wars of the past hurt every airline carrier, so they have chosen to compete on nonprice factors instead.

• Covering costs to survive. If a company is struggling to build a customer base, it may set its prices to generate just enough revenues to cover its costs. However, this is not a suitable long-term objective. Survival prices might generate sales, but they will not generate profits.

• Creating an image. Some products are priced high because firms hope that consumers will associate high prices with high quality. This is the case for many specialty goods, such as luxury cars, perfume, and designer clothing, shoes, and accessories.

• Ensuring affordability to all. Some organizations charge low prices to enable more people to afford their products. For example, some insurance companies have low-cost automobile policies for people on tight budgets.

How do you choose the right pricing objective? The ideal pricing objective is determined by considering the business and financial goals of a product or a company. If one of the business goals is to become a market leader and amass the greatest market share, then maximizing quantity of sales may be a more appropriate choice over building traffic; if a business objective is aggressive production growth, then profit maximization will be important. Survival and status quo pricing may be better suited when market conditions are poor or unstable or when a firm is entering a market for the first time. The pricing objectives may change over the life cycle of a product as well. And because the price is only one element in the marketing mix, marketers must develop their pricing strategies in coordination with their product branding, packaging, promotion, and distribution strategies too.

Why is a product’s price an important component in the marketing mix? As consumers, we know a product’s price represents what we must pay to acquire it. From the seller’s perspective, the price is the only revenue-generating component of the marketing mix. Product, promotion, and distribution are all cost components. The price can also serve as a marketing tool and is often used in promotional campaigns.

Trying to set the right price can be a real challenge for marketers. The price of a product has to be low enough to motivate customers to buy it but high enough that a company can cover its costs and earn a profit from the good or service. In addition, market and economic conditions are always changing, as are the prices of competing products. As a result, companies should evaluate their pricing strategy to remain competitive.

How does value affect a product’s price? The price is what customers actually pay for a product, but the value is the derived benefit of the entire product offering. The price can also affect how a customer views a product’s value. Recall that the total product offer consists of all benefits associated with a product, and each level of benefit (core, actual, and augmented) adds more value to the product. There can be other costs associated with purchasing a product, such as the cost of learning how to use it or the costs associated with disposing of it later. These costs can also affect the product’s overall value to the customer.

What are the major pricing strategies? After determining the pricing objective, choosing the best pricing strategy to achieve that objective is chosen next. Certain strategies work better with certain objectives. In addition, some pricing strategies are used at different times to accommodate changes in a firm’s marketing strategies, market conditions, and product life cycles. Although there is no one right way to determine the price of a good or service, there are several strategies sellers can use. The most common pricing strategies include cost-based pricing, demand-based pricing, competition-based pricing, and everyday low pricing.

There are also several alternative pricing strategies and strategies that affect price perceptions. Figure 13.8 outlines these pricing strategies.

Figure 13.8

Pricing Strategies and Price Perceptions

What is cost-based pricing? One of the easiest and simplest ways to price a product is to use cost-based pricing. This pricing strategy (also known as cost-plus pricing) is based on covering a firm’s costs and providing for a set amount of profit. Suppose you manufacture 100 units of a product at a total cost of $2,000. This makes the average cost per unit produced $20. If you want to make a unit profit margin, or markup, of 20 percent, which is $4 $(0.20\times \text{\$}20),$ you would price the product at $24. The total revenue you would then generate would equal $2,400, and your profit would equal $400, which is 20 percent above your total costs.

There are many advantages of cost-based pricing. Besides being easy to calculate and easy to administer, it requires a minimum amount of information. However, it has several disadvantages as well. Cost-based pricing ignores whether a price is compatible with consumers’ expectations or can compete with the prices of similar products. Cost-based pricing also provides a firm little incentive to operate more efficiently to hold its costs down. Many pharmaceutical companies use cost-based pricing to recover the expensive research and development costs associated with a new drug and to earn a targeted profit level. The monopoly power granted by patents on new drugs means there is no competition, so the pharmaceutical companies find little need to consider consumer demand when setting prices on the new drugs.

How does product demand impact pricing? Demand-based pricing (sometimes called value-based pricing) is the strategy of setting the price of a product based on its demand or its perceived value. A higher price will be charged when the demand or the perceived value of the product is high. A lower price will be charged when its demand or perceived value is low. This pricing strategy assumes firms can accurately estimate the perceived value or demand for their goods or services. Sometimes this is the case, but it is usually very difficult to do in practice. Nevertheless, many firms try.

Demand-based pricing can be defined further by other pricing strategies: target costing and price discrimination.

• Target costing estimates the value customers receive from a product and, therefore, the price they are willing to pay for it. The firm then subtracts an acceptable profit margin to obtain an estimated cost for the product. Firms then work to get costs down to this targeted level. IKEA has successfully used target cost pricing. The company starts with a product need and its price in mind and then designs and manufactures the product to meet those goals.12

• Price discrimination occurs when a business charges different prices to different customers for an identical good or service for reasons not associated with costs. Customers who are price insensitive are charged higher prices, and customers who are more price sensitive are charged lower prices. For example, because senior citizens are often on fixed budgets, restaurants and movie theaters frequently offer them lower prices. Salespeople often charge different prices to customers based on their perceived demand for big-ticket items, such as cars and furniture, so don’t tell them how much you value or love their good or service! For price discrimination to work, firms have to be able to successfully segment customers based on their differences in demand and how price sensitive they are. Moreover, the product must be a type of good or service that cannot be easily resold by the customers who are able to purchase it at the lower price. Many organizations price discriminate because it is profitable.

  

• Competition-based pricing is a pricing strategy that is based on the degree of competition in a market, which, in turn, affects a company’s price-setting ability. Recall that markets can be categorized based on their degree of competition:

  • A perfectly competitive market is one with many suppliers and homogeneous products, such as gasoline, agricultural, and raw material commodities. All the products are virtually the same and sold at the same price, so individual sellers have little or no control over the prices they can charge.

  • A monopolistically competitive market is a market in which there are many firms, but they have the ability to differentiate their products somewhat and can therefore charge different prices for them. For example, Oakley, Inc., which makes sunglasses and goggles for sports and fashion, has successfully differentiated its products and can charge higher prices.

  • An oligopoly is a market in which there are only a few sellers. The airline, oil, and textbook industries are examples. To avoid price wars, rarely do these firms compete on the basis of price. Instead, they compete aggressively on product differentiation and charge higher prices if their total product offerings are unique. Periodically, a firm (usually the market leader) charges a different price, and all other firms follow with similar price changes.

  • A monopoly is a market supplied by a single firm. Because there is no competition, the monopolist has great price-setting latitude. Sometimes monopolists capture their markets by using predatory pricing, the practice of charging very low prices with the intent of destroying the competition. Predatory pricing is illegal, but that hasn’t prevented it from occurring.

What pricing strategy offers low prices all the time? Some retail stores rarely put individual products on sale and instead offer everyday low pricing on all of their products. Walmart has successfully used this strategy. When pricing changes, it is a “roll-back” not a sale.

Are there pricing strategies that work better in certain phases of the product life cycle? When launching a new product, companies may need to use a different type of pricing strategy than they would for an existing product (refer back to Figure 13.8).

• Price skimming involves charging a high price for a product when it is first introduced and there are few if any competitors. The idea is to initially skim off as much profit as possible to recoup the product’s development costs. However, the high price is likely to encourage competitors to enter the market at a lower price. When they do, the firm then lowers the product’s price.

• Penetration pricing involves charging the lowest possible price for a new product to quickly build market share for a product. If the increased production to satisfy growing sales results in lower per unit costs, then the product’s profits can actually rise even though its price is lower. Penetration pricing is also appropriate during the growth stage of a product’s life cycle and when customers are price sensitive. It may also create goodwill among consumers and inhibit competitors from entering the market. However, penetration pricing can may make it difficult to increase a product’s price later and possibly lead to a poor-quality image for a brand or company.

What strategies are used to affect people’s price perceptions? For many consumers, a high price indicates good quality. Consumers are more likely to associate price with quality when a product is complex and they are not familiar with it or its brand name. There are several types of pricing strategies that can be used to affect people’s perceptions of a product.

• Prestige pricing (also known as premium pricing) is the practice of charging a high price to invoke perceptions of high quality and privilege. For those brands for which prestige pricing may apply, the high price itself is a motivator for consumers. The higher perceived value because of the higher price actually increases the product’s demand and creates a higher price that becomes self-sustaining. Some people have called this the snob effect. Examples of this strategy include the pricing of luxury and designer items.

• Psychological pricing (sometimes called odd or fractional pricing) is the practice of charging a price just below a whole number to give the appearance of a lower price. Charging $9.99 as opposed to $10.00 is an example of psychological pricing. Gas stations and restaurants often use psychological pricing.

• A loss leader is a product that is priced below its costs. Stores use loss leaders to attract customers into the store with the hopes that they will be attracted to buy other more expensive items.

• Reference pricing refers to using an inflated price (the regular retail price or the manufacturer’s suggested retail price) that is then discounted to appear as if the product is a good value. A variation of this strategy occurs when stores provide both a more expensive “gold-plated” version of a product and a lower-priced alternative. This makes the alternative appear to be a bargain.

How might production be affected by pricing strategies? No matter which pricing strategy is selected, it is important to determine how much product can be produced at that price level before generating a profit. A breakeven analysis, which determines the production level at which total revenue is just enough to cover total costs, is useful to conduct with any pricing strategy. At the breakeven point, no profit has been made, and no losses have been incurred. The first step in conducting a breakeven analysis is to determine costs. There are two types of costs that make up the total product cost: fixed costs and variable costs. Fixed costs (sometimes called overhead costs) are any costs that do not vary with the production level. Fixed costs typically include expenses such as salaries, rent, insurance, and loan repayments. Variable costs are costs that vary with the production level. Examples include wages, raw materials, and energy costs. Average variable costs (or per unit variable costs) equal total variable costs divided by the production level. A convenient formula for calculating the breakeven production level is as follows:

For example, suppose that the total fixed costs equal $600, the product’s selling price is $24, and the average variable costs are $14. The breakeven volume of production is therefore $\text{\$}600/\left(\text{\$}24-\text{\$}14\right),$ or 60 units. Any production level below the breakeven volume will result in losses, and any production level above the breakeven level will result in profits. Any changes in the fixed or variable costs or in the price will affect the breakeven volume of production.

What are common types of price adjustments? Most businesses adjust their prices periodically to promote their products. Several tactics are used to do this, as Figure 13.9 shows. One way is to use discounts, a deduction from the regular price charged. Discounts come in many forms:

Figure 13.9

Price Adjustments (Tactics)

• Cash discounts (discounts for paying with cash)

• Promotional discounts (discounts when using a particular promotional code or coupon)

• Quantity discounts (discounts for buying large quantities)

• Seasonal discounts (discounts for buying goods and services out of season)

• Forms of allowance, such as a trade-in allowance (discounts for trading in old products for new ones)

Another way to adjust prices is to use rebates. Rebates are partial refunds on what a customer has already paid for a product. An example is a mail-in rebate. The customer mails the rebate to the manufacturer, which then sends the buyer a check or a debit card that can be used for future purchases.

Bundling is another type of price adjustment. With bundling, two or more products that usually complement one another are combined and sold at a single price. The single price is usually lower than the sum of the individual products’ prices. Bundling is quite common in the fast-food industry, where products are bundled to make a complete meal. Cable, DSL, and satellite television companies bundle groups of channels sold at a single price as well as combine them with phone and Internet services. A vacation package is also a bundled product, consisting of airfare, car rental, hotel accommodations, and other amenities.

Dynamic pricing is another price-adjustment technique. Instead of a fixed price being charged, with dynamic pricing, it can quickly change at any time, depending on the interaction of buyers and sellers. Auctions are a traditional form of dynamic pricing. eBay and Priceline.com are other examples.

Can you determine the effect a change in price will have on demand? Before adjusting prices, it is good to determine how consumers might respond to the price adjustment. For some products, a price adjustment can significantly affect consumer demand. For other products, demand might not be affected much at all. The degree to which demand for a product will be affected by price changes is what economists refer to as the price elasticity of demand, or simply price elasticity. When demand for a product does not change when prices rise the product is said to be price inelastic. Essential items, such as gasoline and electricity, tend to be inelastic. Elastic goods, such as restaurant meals, movie tickets, and luxury or big-ticket items, usually will see a drop in demand when their prices rise. Consequently, producers should determine the price elasticity of demand for their products before they change their prices. If a price increase is being proposed, it is better if the demand for the product is relatively inelastic because the demand for it will fall less. Assuming costs are kept the same, the firm’s profits will increase. By contrast, price increases for products that are more elastic will experience a decrease in demand, negatively affecting a firm’s overall profits.

Of course, there are factors that affect the degree of elasticity besides a product’s price. For example, products with fewer substitutes are more inelastic than products with more substitutes. Over time, the elasticity of an item may change because consumers have time to alter their buying habits.