The Great Recession of 2008 to 2009 caused a fundamental and lasting shift in consumer attitudes toward price and quality. In response, many companies have changed their pricing approaches to bring them in line with changing economic conditions and consumer price perceptions. More and more, marketers have adopted the strategy of good-value ­pricing—offering the right combination of quality and good service at a fair price.

In many cases, this has involved introducing less-­expensive versions of established brand name products or new lower-price lines. For example, Walmart launched an extreme-value store brand called Price First. Priced even lower than the retailer’s already-low-priced Great Value brand, Price First offers thrift-conscious customers rock-bottom prices on grocery staples. Good-value prices are a relative thing—even premium brands can launch value versions. Mercedes-Benz recently released its CLA Class, entry-level models starting at $31,500. From its wing-like dash and diamond-block grille to its 208-hp turbo inline-4 engine, the CLA Class gives customers “The Art of Seduction. At a price reduction.”4

In other cases, good-value pricing involves redesigning existing brands to offer more quality for a given price or the same quality for less. Some companies even succeed by offering less value but at very low prices. For example, Spirit Airlines gives customers “Bare Fare” pricing, by which they get less but don’t pay for what they don’t get (see Real Marketing 10.1).

An important type of good-value pricing at the retail level is called everyday low pricing (EDLP). EDLP involves charging a constant, everyday low price with few or no temporary price discounts. The ALDI supermarket chain practices EDLP, with a good-value pricing value proposition that gives customers “more ‘mmm’ for the dollar” every minute of every day. Perhaps the king of EDLP is Walmart, which practically defined the concept. Except for a few sale items every month, Walmart promises everyday low prices on everything it sells. In contrast, high-low pricing involves charging higher prices on an everyday basis but running frequent promotions to lower prices temporarily on selected items. Department stores such as Kohl’s and JCPenney practice high-low pricing by having frequent sale days, early-bird savings, and bonus earnings for store credit-card holders.

Value-based pricing doesn’t mean simply charging what customers want to pay or setting low prices to meet competition. Instead, many companies adopt value-added ­pricing strategies. Rather than cutting prices to match competitors, they add quality, services, and value-added features to differentiate their offers and thus support their higher prices.

For example, premium audio brand Bose doesn’t try to beat out its competition by offering discounts or by selling lower-end, more affordable versions of its speakers, headphones, and home theater system products. Instead, for more than 50 years, Bose has poured resources into research and innovation to create high-quality products that merit the premium prices it charges. Bose’s goal is to create “better sound through research—an innovative, high-quality listening experience,” says the company. “We’re passionate engineers, developers, researchers, retailers, marketers . . . and dreamers. One goal unites us—to create products and experiences our customers simply can’t get anywhere else.” As a result, Bose has hatched a long list of groundbreaking innovations and high-quality products that bring added value to its customers. Despite its premium prices, or perhaps because of them, Bose remains a consistent leader in the markets it serves.5

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 level. For example, a ­company must pay each month’s bills for rent, heat, interest, and executive salaries regardless of the company’s level of output. Variable costs vary directly with the level of production. Each smartphone or tablet produced by Samsung involves a cost of computer chips, wires, plastic, packaging, and other inputs. Although these costs tend to be the same for each unit produced, they are called variable costs because the total varies with the number of units produced. Total costs are the sum of the fixed and variable costs for any given level of production. Management wants to charge a price that will at least cover the total production costs at a given level of production.

The company must watch its costs carefully. If it costs the company more than its competitors to produce and sell a similar product, the company will need to charge a higher price or make less profit, putting it at a competitive disadvantage.

To price wisely, management needs to know how its costs vary with different levels of production. For example, suppose Lenovo built a plant to produce 1,000 tablet computers per day. Figure 10.3A shows the typical short-run average cost curve (SRAC). It shows that the cost per tablet is high if Lenovo’s factory produces only a few per day. But as production moves up to 1,000 tablets per day, the average cost per unit decreases. This is because fixed costs are spread over more units, with each one bearing a smaller share of the fixed cost. Lenovo can try to produce more than 1,000 tablets per day, but average costs will increase because the plant becomes inefficient. Workers have to wait for machines, the machines break down more often, and workers get in each other’s way.

Figure 10.3

Cost per Unit at Different Levels of Production per Period

If Lenovo believed it could sell 2,000 tablets a day, it should consider building a larger plant. The plant would use more efficient machinery and work arrangements. Also, the unit cost of producing 2,000 tablets per day would be lower than the unit cost of producing 1,000 units per day, as shown in the long-run average cost (LRAC) curve ( Figure 10.3B). In fact, a 3,000-capacity plant would be even more efficient, according to Figure 10.3B. But a 4,000-daily production plant would be less efficient because of increasing diseconomies of scale—too many workers to manage, paperwork slowing things down, and so on. Figure 10.3B shows that a 3,000-daily production plant is the best size to build if demand is strong enough to support this level of production.

Suppose Lenovo runs a plant that produces 3,000 tablets per day. As Lenovo gains ­experience in producing tablets, it learns how to do it better. Workers learn shortcuts and become more familiar with their equipment. With practice, the work becomes better organized, and Lenovo finds better equipment and production processes. With higher volume, Lenovo becomes more efficient and gains economies of scale. As a result, the average cost tends to decrease with accumulated production experience. This is shown in Figure 10.4.6 Thus, the average cost of producing the first 100,000 tablets is $10 per tablet. When the company has produced the first 200,000 tablets, the average cost has fallen to $8.50. After its accumulated production experience doubles again to 400,000, the average cost is $7. This drop in the average cost with accumulated production experience is called the experience curve (or the learning curve).

Figure 10.4

Cost per Unit as a Function of Accumulated Production: The Experience Curve

If a downward-sloping experience curve exists, this is highly significant for the company. Not only will the company’s unit production cost fall, but it will fall faster if the company makes and sells more during a given time period. But the market has to stand ready to buy the higher output. And to take advantage of the experience curve, Lenovo must get a large market share early in the product’s life cycle. This suggests the following pricing strategy: Lenovo should price its tablets lower; its sales will then increase, its costs will decrease through gaining more experience, and then it can lower its prices further.

Some companies have built successful strategies around the experience curve. However, a single-minded focus on reducing costs and exploiting the experience curve will not always work. Experience-curve pricing carries some major risks. The aggressive pricing might give the product a cheap image. The strategy also assumes that competitors are weak and not willing to fight it out by meeting the company’s price cuts. Finally, while the company is building volume under one technology, a competitor may find a lower-cost technology that lets it start at prices lower than those of the market leader, which still operates on the old experience curve.

The simplest pricing method is cost-plus pricing (or markup pricing)—adding a standard markup to the cost of the product. Construction companies, for example, submit job bids by estimating the total project cost and adding a standard markup for profit. Lawyers, accountants, and other professionals typically price by adding a standard markup to their costs. Some sellers tell their customers they will charge cost plus a specified markup; for example, aerospace companies often price this way to the government.

To illustrate markup pricing, suppose a toaster manufacturer had the following costs and expected sales:

Then the manufacturer’s cost per toaster is given by the following:

Now suppose the manufacturer wants to earn a 20 percent markup on sales. The manufacturer’s markup price is given by the following:7

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 the sales price, they will mark up the toaster to $\text{\$}40(\text{\$}20+50\%\text{of}\text{\$}40)$. This number is equivalent to a markup on cost of 100 percent $(\text{\$}20/\text{\$}20).$

Does using standard markups to set prices make sense? Generally, no. Any pricing method that ignores demand and competitor prices is not likely to lead to the best price. Still, markup pricing remains popular for many reasons. First, sellers are more certain about costs than about demand. By tying the price to cost, sellers simplify pricing; they do not need to make frequent adjustments as demand changes. Second, when all firms in the industry use this pricing method, prices tend to be similar, so price competition is minimized. Third, many people feel that cost-plus pricing is fairer to both buyers and sellers. Sellers earn a fair return on their investment but do not take advantage of buyers when buyers’ demand becomes great.

Another cost-oriented pricing approach is break-even pricing (or a variation called ­target return pricing). The firm sets a price at which it will break even or make the target return on the costs of making and marketing a product.

Target return pricing uses the concept of a break-even chart, which shows the total cost and total revenue expected at different sales volume levels. Figure 10.5 shows a break-even chart for the toaster manufacturer discussed here. Fixed costs are $300,000 regardless of sales volume. Variable costs are added to fixed costs to form total costs, which rise with volume. The total revenue curve starts at zero and rises with each unit sold. The slope of the total revenue curve reflects the price of $20 per unit.

Figure 10.5

Break-Even Chart for Determining Target Return Price and Break-Even Volume

The total revenue and total cost curves cross at 30,000 units. This is the break-even volume. At $20, the company must sell at least 30,000 units to break even, that is, for total revenue to cover total cost. Break-even volume can be calculated using the following formula:

If the company wants to make a profit, it must sell more than 30,000 units at $20 each. Suppose the toaster manufacturer has invested $1,000,000 in the business and wants to set a price to earn a 20 percent return, or $200,000. In that case, it must sell at least 50,000 units at $20 each. If the company charges a higher price, it will not need to sell as many toasters to achieve its target return. But the market may not buy even this lower volume at the higher price. Much depends on price elasticity and competitors’ prices.

The manufacturer should consider different prices and estimate break-even volumes, probable demand, and profits for each. This is done in Table 10.1. The table shows that as price increases, the break-even volume drops (column 2). But as price increases, the demand for toasters also decreases (column 3). At the $14 price, because the manufacturer clears only $4 per toaster ($14 less $10 in variable costs), it must sell a very high volume to break even. Even though the low price attracts many buyers, demand still falls below the high break-even point, and the manufacturer loses money. At the other extreme, with a $22 price, the manufacturer clears $12 per toaster and must sell only 25,000 units to break even. But at this high price, consumers buy too few toasters, and profits are negative. The table shows that a price of $18 yields the highest profits. Note that none of the prices produce the manufacturer’s target return of $200,000. To achieve this return, the manufacturer will have to search for ways to lower the fixed or variable costs, thus lowering the break-even volume.

Table 10.1

Break-Even Volume and Profits at Different Prices