From the point of view of sound business principles, prices should be deter-mined after taking into consideration the costs, demand, competition, elements of marketing mix, and legal considerations. However, in practice, marketers often rely on one of the three major determinants of prices i.e. costs, demand and competition. Based on the relative emphasis given to these factors, there are three practical approaches to the setting of the price of a product or service:
1) Cost-oriented pricing
2) Demand-oriented pricing
3) Competition-oriented pricing
Cost-oriented Pricing
When the selling price is determined based on the total product cost and a specified margin of profit, the approach is known as the cost-oriented approach to pricing or the cost-based pricing.
There are two methods of price setting which stem from the cost-oriented pricing:
1) Cost-plus pricing
2) Target-profit pricing or break-even analysis.
Let us learn these two methods in details.
1) Cost-plus Pricing
Some Firms set the selling price of their products by aggregating all the costs of the product (including the manufacturing cost, distribution and marketing costs) plus a predetermined margin of profit. The cost-plus pricing method has been explained in the following illustration:
Rs. Per Unit
Total manufacturing costs 30.00
Selling and promotional costs 4.00
Distribution and administration costs 6.00
Total costs 40.00
Margin of profit 10.00
Selling price 50.00
In this method, the product costs include both variable cost and fixed overhead costs. This approach can be simply stated as:
Selling Price = Variable Costs + Overhead Costs (Fixed Cost) + Profit Margin.
To make this method of cost-plus pricing more realistic, the company must consider the changes that are expected to occur in these costs as a result of change in the volume of production.
The pricing method enables the firm in covering all the costs and, in addition, to earn the desired margin of profit. Thus, the method is quite justifiable on grounds of fairness to both the sellers and the buyers. The method is also easy to understand and implement as there is generally less uncertainty about cost than the demand for the product. The margin of profit to be added to the cost has to be determined by the company. It can vary from industry to industry and from situation to situation. Retailers using the cost-plus method of pricing do not necessarily apply the same percentage of mark-up to every item.
This may also be a safe method in an uncertain market. It can safely be used for pricing the jobs like government contracts that are difficult to estimate in advance. For fixing prices for services, often cost-plus pricing method is adopted.
2) Break-even Analysis and Target-profit Pricing
This pricing method is slightly different from the cost-plus pricing method. Here, the firm wants to determine a price that will enable it to earn the desired profit. For this purpose, the break-even analysis is used by the firm and the break-even point is determined.
A break-even analysis relates total cost to total revenue. A break-even point is that level of production at which the total sales revenue (TR) equals the total cost (TC). In other words, a break-even point is the level of production or supply where the firms neither earns any profit nor suffers any loss.
For fixing of price through the break-even analysis, the company must consider different prices, their impact on the sales volume required to pass the break-even point and earn the desired profit. Possibility of achieving the break-even sales level at different price levels also must be examined. The break-even analysis is particularly useful for fixing the price of a new product.
Demand-oriented Pricing
Demand-oriented pricing is based on an estimate of how much sales volume can be expected at various prices which can be paid by different types of buyers. Instead of fixing the price on the basis of costs or competitors price, some firms often fix the selling price of their products on the basis of the demand. In other words, irrespective of the cost of the product or what the competitors are charging, a higher price is charged for a product or service when its demand is more. Similarty, lower price is charged when the demand is less, even though the costs are the same in both cases.
The two methods of pricing under this approach are:
1) Differential pricing
2) Perceived-value pricing
1) Differential Pricing
Generally different groups of buyers have different wants and desires. Consequently the intensity of their demand for the product would also be different. In such situations, for the same product sellers would be tempted to charge higher price for those having less elastic demand and lower price for those having more elastic demand. Differential pricing is normally basedon one of the four factors; the customer, place (location of the customer),time of purchase, and the product version.
Different prices may be fixed for different customers, persons or groups of persons. This may be possible due to the difference in the capacity of bargaining, ability to pay, level of knowledge about the product features or the availability of the product. For example, in a cinema hall tickets for different classes of seats are priced at different rates whereas there is no significant difference in the cinema shown to these classes.
If the prices are different for the same or similar product sold at different places, it is a case of location or place differential. In terms of time, the demand for a product frequently varies by season, day, or even by the hour of the day. The prices may be fixed to take advantage of the demand intensity at a particular season or point of time.
Under product based differential pricing, the seller charges substantially different prices from the buyers of slightly different versions of the same products, so that the difference in prices is more than proportionate to the cost of different product forms of versions.
Discriminatory prices are likely to generate customer ill-will and may also attract legal action. Hence, the seller has to consider the consequences well before deciding upon the discriminatory prices.
2) Perceived-value Pricing
Different buyers often have different perceptions of the same product on the basis of its value to them. A cup of tea is priced differently by hotels and restaurants of different categories, because buyers will assign different value to the same item. When you follow this 'perceived-value' method of pricing, you have to ascertain how different buyers perceive the product in terms of its quality, features and attributes (like colour, size, durability, softness etc.), and how they perceive the value of the product in terms of such product differences.
Competition-oriented Pricing
When the price is determined with reference to the price of a similar product charged by the competitor, and not on the basis of the costs of the product or the different perceptions of the product by different buyers, the pricing approach is referred to as competition-oriented pricing. The company firm may adopt going rate pricing for competition oriented princing.
Going Rate Pricing
This is the important method under competition-oriented pricing approach. In this case the firm does not maintain an elaborate record of various product costs. The firm also does not try to ascertain the difference in the intensity of demand or the perceptions of the value of the product in the minds of the buyers. The firm decides the price of its products on the 'going-rate' prices in the market. The price is not necessarily the same as that charged by the competitors or by the industry leader, it can be lower or higher. Whenever the industry leader or the trade association increases/decreases the price, the firm follows them. The practice of fixing the going rate price is quite popular among traders, especially among the retailers.
Those who adopt the going rate method of pricing argue that the prevailing rates represent the collective wisdom of the industry. Furthermore, it is often difficult to ascertain the customer's reaction to price differentials and their perception of the different product features. Moreover, this method is easy to adopt as there is no need to estimate the price elasticity of demand or various product costs. It is also felt that the adoption of the going-rate pricing method prevents price wars among competitors. This method is practiced mainly in the case of homogeneous products, under conditions of pure competition and oligopoly. The firm selling an undifferentiated product is under purely competitive market such firm has very little choice in setting its prices.
