Everything you need to know about the methods adopted for pricing of products. Pricing is the activity of determining the value of a product and expressing that in terms of money and offering the products to the market for sale at that price.
Pricing involves the following aspects – determining the pricing objectives, identifying the pricing factors, market study, competition analysis etc. Pricing is a managerial task.
Pricing is a mechanism by means of which a business sets a specific price for a unit of its product or service being sold in the market.
The price of the product or service is a predefined agreement between the seller and the buyer. Once the company or the business sets a price of a unit of the product or the service sold, it cannot alter it without informing the buyers in advance.
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The methods of pricing products can be studied under the following heads:- 1. Cost Based Pricing Methods 2. Competition Based Pricing Methods 3. Demand Based Pricing Methods.
Some of the methods adopted for pricing of products are:-
1. Full Cost or Cost-Plus Pricing 2. Break-Even Analysis 3. Marginal Cost Pricing 4. Rate of Return Pricing 5. Going Rate Pricing 6. Product Tailoring
7. Refusal Pricing 8. Product-Line Pricing 9. Cyclical Pricing 10. Pricing Over the Life Cycle of a Product 11. Peak-Load Pricing.
Product Pricing Methods: Cost-Plus Pricing, Break-Even Analysis, Marginal Cost Pricing, Rate of Return Pricing and a Few Others
Product Pricing Methods – Top 3 Methods: Cost Based Pricing, Competition Based Pricing and Demand Based Pricing Methods
Since a pricing is such a crucial factor, it should be done appropriately. Even a small mistake in pricing will have very serious implications. There are several methods of pricing and the choice of the method to be adopted should be based on understanding of all the methods.
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The following are the methods of pricing:
Method # 1. Cost Based Pricing Methods:
Under each method in this classification, the cost of manufacture is the most important criterion.
a. Cost plus Pricing:
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This is a very simple method. The total manufacturing cost is calculated and the required profit is added in terms of a certain amount or percentage. This becomes the selling price.
Example:
The total cost of manufacture of a product is Rs.1,000/-. The manufacturer desires to have a profit of 30% on cost. Therefore the selling price is arrived at as follows – Rs.1,000/- + Rs.300 = Rs.1,300/-
This method has several advantages:
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(a) This is a very simple method. It is easier to calculate cost than to estimate demand.
(b) This is a very fair method to both-the seller and the buyer.
(c) This method does not cause severe competition among the manufacturers.
(d) This method ensures that the cost price is always recovered.
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This method has the following limitations:
(a) This method does not consider demand or prevailing market conditions.
(b) The cost which is calculated may not be accurate.
(c) This method does not consider competition.
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(d) This method becomes difficult in case of new products because of the absence of past experience regarding the calculation of cost.
(e) There is no effort to reduce or control cost.
b. Breakeven or Target Profit Pricing:
Under this method the total cost of manufacturing is split into fixed cost and variable cost. The breakeven is calculated. The breakeven is a point at which the total cost is equal to the total sales revenue or there is neither a profit nor a loss. This breakeven can be calculated at several levels of output: The price is fixed at a certain percentage based on such a calculation.
Method # 2. Competition Based Pricing Methods:
Under this classification, the prevailing competition is the basis of pricing. These methods are very suitable when the competition is very tough and there is very little product differentiation. Under this method a firm may not consider its costs or the demand existing for its own products. It believes that the price charged by the competitors is the best indicator to be followed.
The following are the methods of pricing based on competition:
a. Going-Rate Pricing:
Under this method a company bases its price on the price charged by the competitors. The competitor’s price is the sole guiding factor. A company may price its products on par with or more than or lesser than that of the competitor. A company does not consider factors like cost of manufacture, demand existing for its product etc. This method is suitable for a situation in which there is a small number of competitors and each competitor knows the other competitors well. Such a situation is also called Oligopoly.
b. Sealed-Bid Pricing:
Under this method a firm tries to guess the price bid by its competitors rather than its own cost. This method is generally found when certain jobs such as civil engineering contracts have to be executed on behalf of a client. The client advertises the description of the job and the parties interested in executing the job quote their prices in a document called quotation and send it to the client in sealed covers.
On a particular day the client opens all the sealed covers (called bids) and the contract to execute the job is awarded to the person quoting the least price. Therefore a person quoting the price (called the bidder) has to quote the least price in order to secure the contract.
Method # 3. Demand Based Pricing Methods:
Under these methods, a company does not consider its own cost but allows the demand to decide the price.
The following are the methods:
a. Charging what the customer will bear – Under this method the price charged by the seller depends on the capacity of the customer to pay. If the customer’s capacity is high, a high price is charged and vice-versa.
b. Test marketing – Under this method, a company test markets its products in the market under different prices and selects that price which gives it the highest amount of profit.
c. Forecasting – Under this method, a company forecasts the price based on the historical demand data available with the company.
Product Pricing Methods – Cost Oriented and Competition Oriented
(A) Cost Oriented:
(i) Cost plus or Full cost pricing
(ii) Target pricing
(iii) Marginal cost pricing
(B) Competition – Oriented:
(i) Going rate pricing
(ii) Customary prices
(iii) Sealed price pricing
(iv) Loss leaders.
(C) Other Pricing Practices:
1. Cost Oriented:
(i) Cost Plus:
Here price is so determined as to cover full cost of a product viz. fixed cost plus variable cost + a profit margin.
Most prevalent method.
Formula-AVC + Charge for overhead+ % mark up
Example:
(ii) Marginal Cost Pricing:
Also called Direct cost/Differential cost pricing.
Price based on extra cost or variable cost.
VC being Re 1 (in above example)
P = Little more than Re. 1 i.e., 1.25 per unit (25 p. being profit margin)
(iii) Target Pricing:
Here prices are so fixed as to give desired return on investment say 10% on capital invested.
2. Competition Oriented:
(i) Going Rate Pricing – Firm fixes price on the basis of prevailing price or market price or price charged by price leader. Applicable where similar products are already sold in market.
(ii) Customary Price – Prices of certain goods are fixed by custom e.g. electric fans. Rule is going along with old prices to avoid price war (even if costs have gone up).
(iii) Sealed Bid Pricing – Here firms quote prices in sealed cover while bidding for jobs/contracts/tenders.
(iv) Loss Leaders – Fixing prices at very low levels for certain items to attract customer ever if it means some loss.
Product Pricing Methods – 2 Important Pricing Methods Adopted in the Foreign Markets: Cost-Oriented and Market-Oriented Export Pricing Methods
The export price structure, like the domestic price structure, begins on the factory floor. But there is no similarity in the costs included in the two strictures. The pricing of the products for domestic and export purposes shall be calculated in a somewhat different manner. The export price structure is the basis of all export price quotations, discount and commissions.
There are various methods of pricing the product in the foreign markets. The methods may be grouped into two i.e., cost oriented export pricing methods and market-oriented export pricing methods.
The pricing of the products for domestic and for the markets abroad is calculated in a somewhat different way. The price structure for export is the basis of all export price quotations, discount and commissions.
The various methods of pricing the product in the foreign markets are grouped into following two methods:
1. Cost oriented export pricing methods,
2. Market oriented export pricing methods.
These are being explained below:
Method # 1. Cost-Oriented Export Pricing Methods:
These are based on costs incurred in the production of the articles. As total costs include fixed costs and variable costs, export pricing may be based on full cost (fixed and variable) or only on variable costs. A reasonable profit will be added to the base cost to arrive at the export pricing.
Thus cost-oriented export pricing methods maybe:
i. Full cost or total cost method, and
ii. Variable cost or marginal cost method.
i. Full Cost or Total Cost Method:
This method is also known as cost-plus method and it is the most common method. Under this method for arriving at the export pricing, the total cost of production of the article is considered.
In addition to the fixed and variable costs incurred in the production of the item, all direct and indirect expenses needed for the export of the product including cost on transportation, freight, customs duties, risk. To this a reasonable profit allowance is added to the cost. From this amount the value of all assistance received from any source is deducted.
Given below are the various elements of the total cost:
a. Direct Cost:
It includes variable and other costs directly related to exports:
(i) Variable Costs- It includes expenditure on direct materials, direct labour, variable production overheads, and variable administrative overheads.
(ii) Other Costs Directly Related to Exports- These are in addition to the variable costs. This includes-
Selling costs advertising support to importers in the foreign market. Costs on Special packing, labeling, Commission to overseas agent, Export credit insurance, Bank charges, Inland freight, Forward charges, Inland insurance, Port charges, Duties on Exports of the product, expenditure on Warehousing at port, Documentation and incidental, expenditure therein, Interest on funds involved or cost of deferred credit Cost of after sale service, including free supply of spare parts, consular fees. Pre-shipment inspection and loss due to rejection of product.
b. Fixed Costs:
It includes overheads on production and Administration Publicity and advertising, Travel abroad, after sale service.
From this amount following are deducted:
(i) Compensatory assistance,
(ii) Duty drawback,
(iii) Import replenishment benefits,
(iv) Expenditure on Freight and Insurance.
a. Its main advantage is that through this method exporter becomes aware of the full cost in marketing the product in a market abroad.
b. It is a very simple method.
Disadvantages:
When smaller numbers of units are to be exported it would be difficult for the exporter to supply the product at the same price because of its high cost of production per unit due to fixed costs. This method is justified only when the cost of information about demand and the administrative cost of applying a demand based pricing policy exceed the profit contribution arrived at by when this approach is applied.
In this method the price is determined on the basis of variable cost or direct cost, while fixed cost element in the total cost of production is totally ignored. The firm is concerned here only with the marginal incremental cost of producing the goods which are sold in foreign markets.
Now, the fixed cost remains fixed up to a certain level of output irrespective of the volume of output. On the other hand, variable costs vary in proportion to the volume of production. Thus, the variable or direct or marginal costs set the price after Output at break-even point (BEP).
This method is based on the following assumptions:
a. The export sales are bonus sales and any return over the variable costs contributes to the net profit.
b. The firm has been producing the goods for home consumption and the fixed costs have already been meet or in other words, breakeven point has been achieved. Thus, if the manufacturers are able to realise the direct costs, including those involved in export operations specifically, they would not affect the profitability of their firms. However, the profitability of firms should be assessed with reference to marginal cost which should normally constitute the basis for export pricing. Direct costs and other elements in calculating price will remain the same.
1. No Overhead Costs:
Export sales are additional sales. Hence these should not be burdened with overhead costs which are ordinarily met from the domestic trade.
2. Firms from Developing Countries:
This approach is advocated for firms from developing countries who are not well- known in foreign markets as compared to their competitors from developed countries. Therefore, lower prices based on variable costs may help them enter a market. Price may be used as a technique for securing market acceptance for products newly introduced into the market.
3. Large Market:
Since the buyers of products from developing countries are usually in countries with low national income, it is advisable for the firm to serve a large segment of the market at low prices. Low prices may serve to widen and create markets. In such countries price is still the decisive factor and quality is comparatively less important.
Disadvantages of Marginal Cost Pricing:
1. Attracts Anti-Dumping Process:
Developing countries might be charged of dumping their products in foreign markets because they would be selling their products below net prices and attract antidumping provisions which take away their competitive advantage.
2. Cut-Throat Competition:
The use of this approach may give rise to cut-throat competition among exporting firms from developing countries resulting in loss in valuable foreign exchange to the exporting countries.
Marginal cost pricing is not advisable in the following cases –
(i) If the importers are regularly purchasing the product at a low price, it will be difficult for exporters to increase the price of the commodities later on. It may lose their market.
(ii) This policy is not useful or of limited use to industries which are mainly dependent upon export markets and where over-heads or fixed costs are insignificant.
a. Large Domestic Market – There must be a large domestic market of the product so that the overheads may be charged from products manufactured for domestic market.
b. Higher Prices in Home Market – The home market has a capacity to bear the higher prices.
c. Mass Production – Mass production techniques must have been adopted so that the gap between the full and marginal costs may be reduced.
d. No Overhead Costs – Additional production for exports is possible without increasing overhead costs and within permissible production capacity.
Method # 2. Market-Oriented Export Pricing:
Both the above approaches are based on cost considerations only. The costs are, no doubt, important but the competitive prices should also be considered before fixing the export price, competitive prices mean the prices that are charged by the competitions for the same product or for the substitute of the product in the target market. Once this price level is established, the base price, or what the buyer can afford, should be determined.
The base price can be determined by following the three basic steps:
i. First, relevant demand schedules (quantities to be bought) at various prices should be estimated over the planning period;
ii. Then, relevant costs (total and incremental) of production and marketing costs should be estimated to achieve the target sales volume as per demand schedules prepared; and
iii. Lastly, the price that offers the highest profit contribution, i.e., sales revenues minus all fixed and variable costs.
The final determination of base price should be made after considering all other elements of marketing mix within these elements, the nature and length of channel of distribution is the most important factor affecting the final cost of the product. Besides, product adaptation costs should also be considered in fixing the base price.
The above three steps; though appear to be very simple, but it is not so because there are various other factors that should be looked into. The most appropriate method to estimate the demand of the product shall be the judgmental analysis of company and trade executives. One other way may be the extrapolation of demand estimates for target markets from actual sales in identical markets in terms of basic factors.
Having found out what the market can bear, the firm has to determine whether it can sell the product at that price profitably or not by working back from the market price.
This analysis gives an idea of the upper limit of what the firm can charge. The cost analysis gives the lower limit of what a firm can charge. The price of the product in the foreign market may be then fixed between these two limits. As the firm gathers experience, it would be able to set the price that gives the highest profitability.
However, in many cases, it happens that the market realisation is very low. In such circumstances, the exporter may compare his f.o.b. realisation (under market-oriented export pricing) with the direct cost or full cost as calculated under cost- oriented export pricing.
He can then determine whether he should export the goods or not. He can decide to export the goods even at a loss if he thinks that market prospectuses are better in future and the loss is only a short-term phenomenon and he feels a better realisation in future.
Whatever be the price determined by the firm for its product, it must consider the prices and non-price factors before taking a final decision.
Product Pricing Methods – Cost-Plus Pricing,Variable Cost Pricing,Target Return-On-Investment Pricing and Transaction Costs Analysis Methods
The pricing objectives provide guidelines for taking pricing decisions in the actual business world.
Some of the popular pricing methods are:
1. Full Cost or Cost-Plus Pricing:
The Cost-plus pricing or full cost pricing or markup pricing is widely prevalent in the business world. Full cost pricing means pricing at a level covering total costs and selling expenses plus a predetermined markup. Sometimes, a rigid predetermined markup is added to costs. Alternatively, the markups are flexible, varying with business conditions.
2. Marginal Cost or Variable Cost Pricing:
Under marginal cost pricing, fixed costs are ignored and prices are determined on the basis of marginal cost. Instead of using full costs as the lowest possible price, this method suggests that variable cost represents the price that can be charged. Since variable cost is the basis of pricing, it is also known as variable cost pricing. In marginal cost pricing the objective of the firm is to maximise its total contribution to fixed costs and profit.
3. Target Return-on-Investment Pricing:
It is based on standard costs which vary much less than actual costs. Target return on investment is well suited for an industry where price leadership is prevalent.
4. Transaction Costs Analysis:
Increasingly, managers are turning to the market to purchase intermediate goods and services. The advantages are – it frees capital and reduces problems for managers. However, the cost of using the market place are not insignificant. There are costs-associated with discovering prices and the ability to negotiate contracts.
Pricing Methods for Products – 11 Most Important Methods: Cost-Plus Pricing, Break-Even Analysis, Marginal Cost Pricing, Rate of Return Pricing Methods and a Few Others
The pricing objectives provide guidelines for taking pricing decisions in the actual business world. Let us discuss different pricing methods.
Method # 1. Full Cost or Cost-Plus Pricing:
Most people when asked how prices are arrived at will start from the cost of manufacture. The cost-plus pricing or full cost pricing or mark-up pricing is widely prevalent in the business world. Many business firms believe that prices should bear equitable relation to costs. Full-cost pricing means pricing at a level that covers total costs and selling expenses plus a pre-determined mark-up.
A number of studies beginning with the well-known study by two Oxford Economists, Hall and Hitch have shown that business community set their prices by taking cost and adding a fair profit percentage. Sometimes a rigid pre-determined mark-up is added to costs. Alternatively, the markups are flexible, varying with business conditions.
An example of a full-cost formula determined price might be like this –
Cost of materials and direct labour
+ a percentage addition to cover overheads (say, 100%)
+ a percentage addition for selling expenses (say, 25%)
+ a fair margin for profit (say, 12%)
Generally many small firms apply full costs pricing in a mechanical way in the belief that costs are a solid basis on which to fix price. However, the definition of cost is beset with difficulties. Costs may mean actual cost or expected cost or standard cost.
Method # 2. Break-Even Analysis:
Another cost-oriented pricing approach is break-even pricing or a variation called target profit pricing. The break-even analysis is a device showing the relationship between sales values, variable and fixed cost and profit and loss at different levels of activity. The firm tries to determine the price at which it will break even or make the target profit it is seeking.
A break-even chart shows the total cost and total revenue expected at different sales volume levels. The term break-even analysis is somewhat misleading in that the analysis is used to answer many other questions besides determining the break-even point—the volume at which net revenue is zero.
In the figure ahead total revenue function TR represents the total revenue that will be obtained if the firm charges a constant selling price per unit for the output. Similarly, total cost function TC represents the total cost which will be incurred if costs consist of a fixed amount, which is independent of the level of output and a constant variable cost per unit.
Below an output level of Q, losses are incurred since TR<TC. For output levels above Q, TR>TC and profits are earned. To determine the break-even point we have to plot the total revenue function. For a product with a constant selling price of Rs. P per unit the total revenue function is constructed by drawing a line through the origin with a slope of P. Next we have to plot the total cost function.
Given that the total cost consists of a fixed component (Rs. F) which is independent of the quantity of output produced and a variable component (Rs. V) which increases at a constant amount for each unit of output produced, then the total cost function is constructed by drawing a line that intersects the vertical cost axis and has the slope of V. Lastly we have to determine the point where total revenue and total cost lines intersect, drop a perpendicular to the horizontal axis to get the value of Q.
The determination of the break-even point by algebraic methods consists of setting the total revenue and total cost functions equal to each other and solving the resulting equation for the break-even volume.
Total revenue is equal to selling price per unit times the quantity sold –
The difference between the price per unit and the variable cost per unit (P-V) is sometimes referred to as the contribution margin per unit. It measures how much each unit of output contributes to meeting fixed costs and net profits. The break-even volume is equal to the fixed cost divided by the contribution margin per unit.
Method # 3. Marginal Cost Pricing or Variable Cost Pricing:
In the cost-plus pricing and the rate of return pricing, prices are based on total costs — fixed as well as variable. Under marginal cost pricing, fixed costs are ignored and prices are determined on the basis of marginal cost. Instead of using full costs as the lowest possible price, this method suggests that variable cost represents the price that can be charged.
Since variable cost is the basis of pricing it is also known as variable cost pricing. In marginal cost pricing the objective of the firm is to maximize its total contribution to fixed costs and profit.
This system has several advantages. First, under marginal cost pricing, prices are never rendered uncompetitive because of higher fixed costs and orders will not be necessarily rejected because the prevailing price is below the average cost. Variable costs are controllable in the short-run and hence prices based on variable costs will be flexible. Secondly, marginal pricing helps a business man to pursue a far more aggressive pricing policy than full-cost pricing. An aggressive price policy will increase the sale and possibly reduce marginal cost through increased physical productivity and lower input prices.
Thirdly, marginal pricing is more helpful to fix price over the life-cycle of the product which requires short-run marginal cost and separate fixed cost data relevant to each stage of the cycle. Fourthly, marginal cost pricing is more useful than full-cost pricing because of the prevalence of multiproduct, multi-process and multi-market firms which makes the absorption of fixed costs into product costs difficult.
There are certain limitations of marginal cost pricing. First, it is argued that marginal pricing cannot be applied in practice because of administrative difficulties. Many businessmen are not familiar with marginal cost and marginal revenue. It is also difficult for businessmen to estimate future demand and costs accurately as a result of which there exists a discrepancy between planned and actual figures and profits are never maximized.
Secondly, the application of marginal pricing is that it leads to frequent price changes, which are not liked by the consumers. Buyers prefer stable prices and do not like rising prices in periods of temporary shortages. Thirdly, during a period of business recession firms using marginal pricing may cut prices in order to maintain business and this may induce other firms to reduce their prices also. This would lead to cut-throat competition. Lastly, it is also maintained that marginal pricing might lead to losses as overheads are not covered by it.
The view that marginal pricing leads to losses is based on the assumption that marginal costs are always below average costs, whereas they normally exceed the average costs. A rigid application of full cost pricing may prove disastrous, for it is a mistake not to produce because the price does not cover full cost.
Sometimes, it is wise to produce below average cost in order to increase total profit rather than stop production. Marginal cost pricing provides the upper and lower limits of pricing while full cost pricing clings only to the middle point.
Method # 4. Rate of Return Pricing:
Pricing to achieve a planned rate of return on investment is popular among a number of business firms. Here the rate of return is taken as a given target. Whenever there is a change in the unit cost, the price is so adjusted that the target rate of return can be realized. The target rate of return may be set in three different ways. First, it may be set at the total profit as a percentage of total cost. Thus –
Method # 5. Going Rate Pricing:
Whereas, in naive full-cost pricing the emphasis is on cost of production, in going rate pricing it is on the market. In its simplest form, the going rate pricing prescription is simply to examine the general price structure in the industry and fix one’s own price accordingly. Going rate pricing is also known as imitative pricing.
This system of pricing is popular for the following reasons:
(1) Where costs are difficult to measure this is the logical first step in a rational pricing policy,
(2) Going rate pricing is very popular in oligopolistic situations. It is followed to avoid a price war with the price leader. Many cases of going rate pricing are situations of price leadership. Where price leadership is well established, charging according to what competitors are charging may be the only safe policy. Going rate pricing may be a way in which firms try to avoid hazards of price war in an oligopolistic market.
(3) It may be less costly and troublesome to the business than the exact calculation of costs and demand and seems to have practical advantages over a highly individualistic pricing policy.
Going rate pricing is not confined to small and medium-sized businesses. Some large American Companies faced with what they regarded as a market determined price and adopted a price set either by the market or by a price leader.
Method # 6. Product Tailoring:
Product tailoring refers to a policy of tailoring the cost of a product to a pre-determined price. It is an inverted cost-price relationship in which the price of the product appears to determine its cost instead of the other way round. In contrast to cost plus theory of pricing we have a price minus theory of cost.
Product tailoring is directly applicable only when the design is fluid and when the target price is sharply defined by the economic situation in respect to substitutes and demand. This approach has the virtue of starting with market-price realities; it looks at the problem from the viewpoint of the buyers in terms of what he wants and what he will pay. This approach has a general applicability since the consumer is king and product design is quite generally subject to modification.
Method # 7. Refusal Pricing:
Refusal pricing refers to pricing products that are designed to the specifications of a single buyer. Such products are priced on the basis of incremental cost plus a gross margin equivalent to the opportunity cost.
Under this system, a floor price is set and the seller is engaged in refusal pricing for he has to decide whether or not to make the product at all; he is not deciding what to charge for the product that he has already decided to manufacture. But even here cost sets only a floor for prices; otherwise the seller might miss potential immediate profits and ignore the effects of price upon future business.
Method # 8. Product-Line Pricing:
Many companies selling a wide range of products gear their pricing strategy to the product-line as a whole rather than to individual products in the line. The problem of product-line pricing is to find the proper relationship among the prices of members of a product group. Product-line pricing may refer to products that are physically distinct and also the products that are physically the same but sold under different demand conditions. The latter is known as differential pricing or price discrimination. Price discrimination is thus a particular type of product-line pricing.
There are alternative methods of product-line pricing. In all these methods prices are determined either by cost or elasticity of demand.
i. According to the first method, prices are proportional to full cost and produce the same percentage net profit margin for all products. Under this scheme, each product assumes its full allocated uniform percentage profit over this full cost. This pattern of product-line prices is produced by a strict adherence to cost- plus pricing. Relative prices are then determined by the accounting conventions that govern the allocations of common costs among products. In practice these allocations are necessarily arbitrary from economic viewpoint. Moreover, this method gives no consideration to market factors.
ii. According to the second method, prices are proportional to incremental costs. This means that the prices produce the same percentage contribution margin over incremental costs for all products. The difference between the full-cost method and the incremental method is that while in the former method we take into account both average variable and fixed costs; in the latter method we consider only average variable costs.
This method is largely free from the defect of arbitrary allocation of common costs found in the first method since incremental costs usually require little arbitrary allocation of variable overheads. The defect of this method is that this price pattern does not take into account differences in demand and competitive conditions.
If members of product line differ in superiority over competing products or are able to tap market sectors that can stand differential prices or different degrees of non-price competition, then a pattern of product-line prices that is proportional to incremental costs misses significant profit opportunities. Incremental cost is a handy too for product-line pricing; but its utility is destroyed if it becomes a basis for a mechanical cost-plus pricing formula.
iii. According to the third method, prices with profit margins are proportional to conversion costs. Conversion costs are costs of converting raw materials into finished products and are equal to the sum of labour and overhead costs.
This method of pricing has been advocated by W.L. Churchill on the grounds that conversion costs reflect the firm’s social contribution whereas purchased costs do not.
iv. According to the fourth method, prices should produce contribution margins that depend upon the elasticity of demand of different market segments. Buyers with high incomes are usually less sensitive to price than those that make up the mass market and it is often profitable to put higher profit margins on products for elite class markets than for mass markets.
v. According to the fifth method, prices should be systematically related to the stage of market and competitive development of individual members of the product line. Many products pass through life cycles. They start as novelties, then develop into distinctive specialities and ultimately degenerate into a common product. Different prices can be charged for the different stages of the life cycle of a product.
Two demand characteristics peculiar to multiple-product lines are significant for pricing purpose. The first is the interdependence of the demand for various members of the product-line. Interdependence takes many forms. Products may be substitutes or complementary. The second demand characteristic in multiple-product lines is their importance as instruments for market segmentation and price discrimination.
They provide opportunities for breaking the market into smaller sectors that differ in price elasticity and hence can profitably charge different prices. Product design and pricing are major methods for achieving segmentation. Not only can market segmentation increase profits by setting prices that take advantage of the different elasticity of demand in each sector; it can also increase total sales by penetrating mass markets at prices that cover incremental costs and contribute a little to overhead.
Incremental cost concept is relevant for product-line pricing. Incremental concepts — comparing added revenue with added cost — can alone provide a criterion of whether or not an additional division of market is worthwhile. Incremental cost sets a lower limit for price in the most elastic sector of the market.
Method # 9. Cyclical Pricing:
Many pricing decisions of a firm relate to the fluctuations in business conditions. Fluctuations in economic activity are known as business cycle. It has upswings and downswings. During the upswing the demands for the firm’s products increase while during the downswing the demand for the firm’s products decline.
It is common knowledge that the prices of agricultural products and certain raw materials and manufactured goods have been predominantly flexible over the cycle. But the prices of certain other raw materials and most manufactured products are generally inflexible. This is due to the fact that price leaders are reluctant to change their prices frequently and they often attempt to limit price cuts in periods of declining demand. They also refrain from major price increases in periods of rising demand.
There are four reasons for price inflexibility:
i. Demand:
It is a common belief among industrialists that demand for their products is highly inelastic and hence price changes will not lead to any appreciable change in demand. An increasing portion of the nation’s output consists of durable goods. For such goods demand is more responsive to changes in consumer than to changes in the prices of the goods.
ii. Competition:
Secondly, from the point of view of price competition, much of industrial pricing is done under oligopoly conditions and even the price leader has to maintain a degree of price stability in order to ward off retaliation from others. This in effect freezes prices and delays changes, usually until other prices have started moving.
iii. Costs:
Thirdly, on the cost side, variable cost per unit tends to remain stable over long periods and over wide ranges of output on account of the rigidity of prices of raw materials and labour. Fixed costs per unit vary inversely with volume and with cyclically sensitive material prices. Current full costs, consequently, appear cyclically rigid and the prevalence of cost-plus pricing imparts some of the cost rigidity to prices.
iv. Profits:
Fourthly, on the side of profits, many firms, especially the price leaders who have considerable latitude in price making have generally as their goal a “reasonable” profit than profit maximization. Hence they may not lower or raise prices appreciably during the course of a business cycle.
The practical problems of cyclical pricing arise as to the degree, the timing and the pattern of cyclical price changes. A cyclical change in the level of net prices may take a variety of forms, viz., (1) changes in list prices, (2) changes in product- mix and product-line differentials, and (3) changes in the structure of discount and merchandising allowances.
In formulating policy on cyclical pricing, several possible policies are as follows:
(1) Price rigidity
(2) Price Fluctuations that conform to cost changes –
i. Current full cost
ii. Standard full cost
iii. Incremental cost.
(3) Price fluctuations that conform to prices of substitutes.
(4) Price fluctuations that conform to changes in the general price level.
(5) Price fluctuations that stabilize market share.
(6) Price fluctuations that conform to changes in industry demand determinants.
These policies might be characterized more accurately as objectives, since some of them cannot be fully attained.
(1) Price Rigidity:
Absolute or approximate stability of the company’s price level over the course of the business cycle is a policy followed by some producers of industrial materials and equipment. It is largely based upon two assumptions – (a) that the wide cyclical fluctuations in demand are caused by basic economic changes (e.g., in incomes, profits and expectations) and (b) that changes in the firm’s prices within the range of feasibility will be ineffective in altering these conditions or in tempering these cyclical fluctuations in demand.
(2) Price Fluctuations that Conform to Cost Changes:
Confining cyclical changes in price to changes in company costs is another popular cyclical price policy. This policy has several variants depending upon which concept of cost is employed, full cost, incremental cost or some form of standard cost. In essence, it amounts to stabilizing some sort of unit profit margin.
(3) Price Fluctuations that Conform to Prices of Substitutes:
The use of substitute products as a cyclical pricing guide is an appropriate price policy in many situations. By keeping the spread between the firm’s product and substitute products stable or by manipulating it to obtain specified volume objectives, this cyclical pricing policy can protect or improve the company’s market position. It may also stabilize the industry’s share of the vast substitute market. In industries that have strong price leadership, the cyclical price policy employed by many price followers is of this type.
(4) Price Fluctuations that Conform to Changes in the General Price Level:
Keeping the price in line with the falling purchasing power of money is a depression pricing standard that has strong appeal. But this kind of blanket index of purchasing power is an inferior pricing guide.
(5) Price Fluctuations that Stabilize Market Share:
Price is an important background determinant of the market share particularly when products and services are dissimilar. Moreover, price policy has a profound effect upon the larger share of the substitute market. Market share can be a useful pricing guide for cyclical pricing. The adoption of such a policy presupposes moderately accurate and current information about what is happening to market positions. It also requires alertness and flexibility in pricing.
(6) Price Fluctuations that Conform to Changes in Demand Determinants:
The demand schedules, both of the industry and of the firm, shift continuously as a result of the changes in general business conditions and changes in special outside conditions that affect that product. If these shifts in demand are pronounced, they should be taken into account in setting prices. In fact, they are often more important than the elasticity of demand.
To change prices in relationship to some appropriate index of shifts in demand for the product is a form of recession pricing policy. Sometimes it is possible to find a direct relationship between some index like disposable national income and the past fluctuations of the price of product. This functional relationship can then provide a rough criterion of the appropriate price at any given or forecasted level of demand.
The use of any such historical relationship as an absolute recession pricing criterion has severe limitations that destroy its usefulness in most industries. This pricing method implicitly assumes- (1) that flexible rather than rigid prices are appropriate, (2) that changes in the price in the past have adjusted for changes in demand correctly, (3) that these past pricing objectives are today’s objectives, and (4) that cost behaviour and competitive reactions will be the same as in similar periods in the past.
Method # 10. Pricing over the Life Cycle of a Product:
The innovation of a new product and its degeneration into a common product is termed as the life cycle of a product. A product has a life cycle comprising four stages of introduction, growth, maturity and decline. The cycle begins with the innovation of a new product and it is often followed by patent protection. At the introductory stage the product is not known to the consumers and hence the market is unexplored.
This stage is followed by a rapid expansion in its sales as the product gains market acceptance. Then competitors enter the market with rival products and the distinctiveness of the new product starts diminishing. The speed of degeneration differs from product to product. How long will be the overall life cycle and the duration of each phase would depend upon the type of the product and the degree of innovations affected in a given product line.
At the introductory stage the product is put on the market, hence awareness and acceptances are minimal. So here the emphasis should be on promotional activities so as to acquaint customers with the product and gain acceptance.
In the initial stage with distinctive speciality a firm can charge high price but as this characteristic fades away and the product becomes a pedestrian one, he has to either soften the pricing or bring out a change in the product to create some fresh interest so as to compete well with the new products brought out in the market.
The sales of the product rise slowly and if it is accepted by the consumers, there follows a period of rapid growth in sales volume. This stage is marked by increase in the number of competitors, major product improvements, penetration of other market segments, etc. So during this phase emphasis must be given in opening new distribution channels and retail outlets.
When the product reaches maturity, sales growth continues but at a diminishing rate due to declining number of potential customers. Special promotional efforts are needed to cope with such a situation.
Finally, the product reaches a stage of declining sales as it faces competition from better products or better substitutes developed by the competitors. At this stage the product has to be redesigned or the cost of production reduced so that they can continue to make some contribution to the company.
In the introductory stage a firm with distinctive speciality can charge high price but as this characteristic fades away the firm has to reduce prices. In a stage of maturity,
price reduction alone may not pay as other firms might do the same. Thus there is a need for continuous review of prices with reference to cost of production, product life cycle, elasticity of demand, selling costs, etc.
Method # 11. Peak-Load Pricing:
Peak-load pricing is used when there are definite limits to the amount of good and services a firm can provide and customer demand tends to vary over time. This is a typical problem with service industries whose services cannot be stored or storage of which is very expensive.
During the peak period demand is high and capacity is almost fully utilized while during the slack period demand is low and considerable amount of capacity remains unutilized. For example, in the telephone industry where consumption of service varies over the day but capacity must be able to meet the peak consumption of customers. During the peak periods that occur during the day time the telephone capacity is fully utilized while during nights there remains considerable amounts of unutilized capacity.
Peak-load pricing suggests that prices should be set at higher levels for the peak periods of demand while lower prices may be charged during the off-peak periods. The most important advantage of peak-load pricing is that it depresses peak demands and stimulates demand in the off-peak period. In this way it seeks to avoid excessive over-utilization or excessive under-utilization of capacity.
This form of pricing is practiced by the telephone and electricity industry. The rate of telephone service is high during the peak period and low during the slack period. This tends to shift price- sensitive callers to low demand period and thus depress peak demands. Again, the low off-peak rates may help increase revenues by attracting some callers that normally do not use the phone for communication purposes. In this way the telephone industry may operate by avoiding both under-utilization and over-utilization of capacity.