General Pricing Approaches

The price the company charges will be somewhere between one that is too low to produce a profit and one that is too high to produce any demand. Figure 11.5 summarizes the major considerations in setting price. Product costs set a floor to the price; consumer perceptions of the product's value set the ceiling. The company must consider competitors' prices and other external and internal factors to find the best price between these two extremes.

Companies set prices by selecting a general pricing approach that includes one or more of these three sets of factors. We will examine the following approaches: the cost-based approach (cost-plus pricing, break-even analysis, and target profit pricing), the buyer-based approach (value-based pricing), and the competition-based approach (going-rate and sealed-bid pricing).

Figure 11.5	Major considerations in setting price

The simplest pricing method is cost-plus 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 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:

Now suppose the manufacturer wants to earn a 20 percent markup on sales. The manufacturer's markup price is given by:¹⁴

The manufacturer would charge dealers $20 a 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 sales price, they will mark up the toaster to $40 ($20 1 50% of $40). This number is equivalent to a markup on cost of 100 percent ($20/$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. Suppose the toaster manufacturer charged $20 but sold only 30,000 toasters instead of 50,000. Then the unit cost would have been higher because the fixed costs are spread over fewer units, and the realized percentage markup on sales would have been lower. Markup pricing works only if that price actually brings in the expected level of sales.

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 have to make frequent adjustments as demand changes. Second, when all firms in the industry use this pricing method, prices tend to be similar and price competition is thus 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 profit pricing. The firm tries to determine the price at which it will break even or make the target profit it is seeking. Such pricing is used by General Motors, which prices its automobiles to achieve a 15 to 20 percent profit on its investment. This pricing method is also used by public utilities, which are constrained to make a fair return on their investment.

Target pricing uses the concept of a break-even chart, which shows the total cost and total revenue expected at different sales volume levels. Figure 11.6 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.

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:

Figure 11.6	Break-even chart for determining target price

If the company wants to make a target 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 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 the 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 11.1. The table shows that as price increases, break-even volume drops (column 2). But as price increases, demand for the toasters also falls off (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 profit of $200,000. To achieve this target return, the manufacturer will have to search for ways to lower fixed or variable costs, thus lowering the break-even volume.

Table 11.1	Break-Even Volume and Profits at Different Prices
(1) (2) (3) (4) (5) (6) Price Unit Demand Needed to Break Even Expected Unit Demand at Given Price Total Revenue (1) × (3) Total Costs* Profit (4) – (5) $14 75,000 71,000 $ 994,000 $1,010,000 –$ 16,000 16 50,000 67,000 1,072,000 970,000 102,000 18 37,500 60,000 1,080,000 900,000 180,000 20 30,000 42,000 840,000 720,000 120,000 22 25,000 23,000 506,000 530,000 –24,000
* Assumes fixed costs of $300,000 and constant unit variable costs of $10.

An increasing number of companies are basing their prices on the product's perceived value. Value-based pricing uses buyers' perceptions of value, not the seller's cost, as the key to pricing. Value-based pricing means that the marketer cannot design a product and marketing program and then set the price. Price is considered along with the other marketing mix variables before the marketing program is set.

Cost-based pricing is product driven. The company designs what it considers to be a good product, totals the costs of making the product, and sets a price that covers costs plus a target profit. Marketing must then convince buyers that the product's value at that price justifies its purchase. If the price turns out to be too high, the company must settle for lower markups or lower sales, both resulting in disappointing profits.

Value-based pricing reverses this process. The company sets its target price based on customer perceptions of the product value. The targeted value and price then drive decisions about product design and what costs can be incurred. As a result, pricing begins with analyzing consumer needs and value perceptions, and price is set to match consumers' perceived value. It's important to remember that "good value" is not the same as "low price." For example, Parker sells pens priced as high as $3,500. A less expensive pen might write as well, but some consumers place great value on the intangibles they receive from a fine writing instrument.

A company using value-based pricing must find out what value buyers assign to different competitive offers. However, measuring perceived value can be difficult. Sometimes, companies ask consumers how much they would pay for a basic product and for each benefit added to the offer. Or a company might conduct experiments to test the perceived value of different product offers. If the seller charges more than the buyers' perceived value, the company's sales will suffer. Many companies overprice their products, and their products sell poorly. Other companies underprice. Underpriced products sell very well, but they produce less revenue than they would have if price were raised to the perceived-value level.

Perceived value: A less-expensive pen might write as well, but some consumers will pay much more for the intangibles. This Parker model runs $185. Others are priced as high as $3,500.

During the past decade, marketers have noted a fundamental shift in consumer attitudes toward price and quality. Many companies have changed their pricing approaches to bring them into line with changing economic conditions and consumer price perceptions. According to Jack Welch, former CEO of General Electric, "The value decade is upon us. If you can't sell a top-quality product at the world's best price, you're going to be out of the game…. The best way to hold your customers is to constantly figure out how to give them more for less."¹⁵

Thus, more and more, marketers have adopted value pricing strategies—offering just the right combination of quality and good service at a fair price. In many cases, this has involved the introduction of less expensive versions of established, brand name products. Campbell introduced its Great Starts Budget frozen-food line, Holiday Inn opened several Holiday Express budget hotels, Revlon's Charles of the Ritz offered the Express Bar collection of affordable cosmetics, and fast-food restaurants such as Taco Bell and McDonald's offered "value menus." In other cases, value pricing has involved redesigning existing brands in order to offer more quality for a given price or the same quality for less.

In many business-to-business marketing situations, the pricing challenge is to find ways to maintain the company's pricing power—its power to maintain or even raise prices without losing market share. To retain pricing power—to escape price competition and to justify higher prices and margins—a firm must retain or build the value of its marketing offer. This is especially true for suppliers of commodity products, which are characterized by little differentiation and intense price competition. In such cases, many companies adopt value-added strategies. Rather than cutting prices to match competitors, they attach value-added services to differentiate their offers and thus support higher margins. "Even in today's economic environment, it's not about price," says a pricing expert. "It's about keeping customers loyal by providing service they can't find anywhere else."¹⁶

An important type of value pricing at the retail level is everyday low pricing (EDLP). EDLP involves charging a constant, everyday low price with few or no temporary price discounts. In contrast, high–low pricing involves charging higher prices on an everyday basis but running frequent promotions to lower prices temporarily on selected items below the EDLP level. In recent years, high–low pricing has given way to EDLP in retail settings ranging from Saturn car dealerships to upscale department stores such as Nordstrom.

Retailers adopt EDLP for many reasons, the most important of which is that constant sales and promotions are costly and have eroded consumer confidence in the credibility of everyday shelf prices. Consumers also have less time and patience for such time-honored traditions as watching for supermarket specials and clipping coupons.

The king of EDLP is Wal-Mart, which practically defined the concept. Except for a few sale items every month, Wal-Mart promises everyday low prices on everything it sells. In contrast, Kmart's recent attempts to match Wal-Mart's EDLP strategy failed. To offer everyday low prices, a company must first have everyday low costs. Wal-Mart's EDLP strategy works well because its expenses are only 15 percent of sales. However, because Kmart's costs are much higher, it could not make money at the lower prices and quickly abandoned the attempt.¹⁷

Consumers will base their judgments of a product's value on the prices that competitors charge for similar products. One form of competition-based pricing is going-rate pricing, in which a firm bases its price largely on competitors' prices, with less attention paid to its own costs or to demand. The firm might charge the same as, more than, or less than its major competitors. In oligopolistic industries that sell a commodity such as steel, paper, or fertilizer, firms normally charge the same price. The smaller firms follow the leader: They change their prices when the market leader's prices change, rather than when their own demand or costs change. Some firms may charge a bit more or less, but they hold the amount of difference constant. Thus, minor gasoline retailers usually charge a few cents less than the major oil companies, without letting the difference increase or decrease.

Going-rate pricing is quite popular. When demand elasticity is hard to measure, firms feel that the going price represents the collective wisdom of the industry concerning the price that will yield a fair return. They also feel that holding to the going price will prevent harmful price wars.

Competition-based pricing is also used when firms bid for jobs. Using sealed-bid pricing, a firm bases its price on how it thinks competitors will price rather than on its own costs or on the demand. The firm wants to win a contract, and winning the contract requires pricing less than other firms. Yet the firm cannot set its price below a certain level. It cannot price below cost without harming its position. In contrast, the higher the company sets its price above its costs, the lower its chance of getting the contract.