PRICING METHODS

Pricing is an important element of the marketing mix. Pricing is affected not only by the cost of manufacturing the product, but also by (i) the company's objectives in relation to market share and sales; (ii) the nature and intensity of competition; (iii) stage of the product life-cycle at which the product is currently positioned; (iv) nature of product whether as consumer or industrial product and if the former whether it is a luxury or necessity. Before making any pricing decision it is important to understand all these factors.

Although there are several factors affecting the pricing decisions, it would be useful to discuss the pricing methods most commonly used. These methods are:

1.   Cost-plus or Full-cost pricing

2.   Pricing for a rate of return, also called target pricing

3.   Marginal cost pricing

4.   Going rate pricing, and

5.   Customary prices.

The first three methods are cost-oriented as the prices are determined on the basis of costs. The last two methods are competition-oriented as the prices here are set on the basis of what competitors are charging.

1. Cost-plus or Full-cost Pricing

This is most common method used in pricing. Under this method, the price is set to cover costs (materials, labour and overhead) and a predetermined percentage for profit. The percentage differs strikingly among industries, among members-firms and even among products of the same firm. This may reflect differences in competitive intensity, differences in cost base and differences in the rate of turnover and risk. In fact, it denotes some vague notion of a just profit.

What determines the normal profit? Ordinarily margins charged are highly sensitive to the market situation. They may, however, tend to be inflexible in the following cases : (i) they may become merely a matter of common practice, (ii) mark-ups may be determined by trade associations either by means of advisory price lists or by actual lists of mark-ups distributed to members, (iii) profits sanctioned under price control as the maximum profit margins remain the same even after the price control is discontinued. These margins are considered ethical as well as reasonable. Its inadequacies are:

1. It ignores demand-there is no necessary relationship between cost and what people will pay for a product.

2. It fails to reflect the forces of competition adequately. Regardless of the margin of profit added, no profit is made unless what is produced is actually sold.

3. Any method of allocating overheads is arbitrary and may be unrealistic. Insofar as different prices would give rise to different sales volumes, unit costs are a function of price, and therefore, cannot provide a suitable basis for fixing prices. The situation becomes more difficult in multi-product firms.

4. It may be based on a concept of cost which may not be relevant for the pricing decision.  

Explanation for the widespread use of Full-cost Pricing

A clear explanation cannot be given for the widespread use of full-cost pricing, as firms vary greatly in size, product characteristics and product range, and face varying degrees of competition in markets for their products. However, the following points may explain its popularity:

1.   Prices based on full-cost look factual and precise and may be more defensible on moral grounds than prices established by other means.

2.   Firms preferring stability, use full-cost as a guide to pricing in an uncertain market where knowledge is incomplete. In cases where costs of getting information are high and the process of trial and error is costly, they use it to reduce the cost of decision-making.

3.   In practice, firms are uncertain about the shape of their demand curve and about the probable response to any price change. This makes it too risky to move away from full-cost pricing.

4.   Fixed costs must be covered in the long-run and firms feel insecure that if they are not covered in the long-run either.

5.   A major uncertainty in setting a price is the unknown reaction of rivals to that price. When products and production processes are similar, cost-plus pricing may offer source of competitive stability by setting a price that is more likely to yield acceptable profit to most other members of the industry also.

6.   Management tends to know more about products costs than other factors which are relevant to pricing.

7.   Cost-plus pricing is specially useful in the following cases:

a) Public utilities such as electricity supply, transport, where the objective is to provide basic amenities to society at a price which even the poorest can afford.

b) Product tailoring, i.e. determining the product design when the selling price is predetermined. The selling price may be determined by government, as in case of certain drugs, cement, fertilisers. By working back from this price, the product design and the permissible cost is decided upon. This approach takes into account the market realities by looking from the viewpoint of the buyer in terms of what he wants and what he^. will pay.

c) Pricing products that are designed to the specification of a single buyer as applicable in case of a turnkey project. The basis of pricing is estimated cost plus gross margin that the firm could have got by using facilities otherwise.

d) Monopsony buying-where the buyers know a great deal about  Suppliers' costs as in case of an automobile buying, components from its ancillary units. They may make the products themselves if they do not like the price. The more relevant cost is the cost that the buying company, say, the automobile manufacturer, would incur if it made the product itself.  

In India, cost-plus method is widely used. There are two special reasons which could explain its wide use in India.

1.   The prevalence of sellers^' market in India makes it possible for the manufacturers to pass on the increases in costs to the consumers.

2.   Costs plus a reasonable margin of profit are taken into consideration for the purposes of price fixation in the price-controlled industries in India. Thus, this method has the tacit approval of the Government.  

To conclude, cost-plus is a pricing convention relying on arbitrary costs and arbitrary mark-ups. It is adopted because it is simpler to apply.  

2. Pricing for a Rate of Return

An important problem that a firm might have to face is one of adjusting the prices to changes in costs. For this purpose the popular policies that are often followed are as under:

1. Revise prices to maintain a constant percentage mark-up over costs.

2. Revise prices to maintain profits as a constant percentage of total sales

3. Revise prices to maintain a constant return on invested capital.  

Rate of return pricing is a refined variant of full-cost pricing. Naturally, it has the same inadequacies, viz., it tends to ignore demand and fails to reflect competition adequately. It is based upon a concept of cost which may not be relevant to the pricing decision at hand and overplays the precision of allocated fixed costs and capital employed.

3. Marginal Cost Pricing

Both under full-cost pricing and the rate-of-return pricing, prices are based on total costs comprising fixed and variable costs. Under marginal cost pricing, fixed costs are ignored and prices are determined on the basis of marginal cost. The firm uses only those costs that are directly attributable to the output of a specific product.

With marginal cost pricing, the firm seeks to fix its prices so as to maximise its total contribution to fixed costs and profit. Unless the manufacturer's products are in direct competition with each other, this objective is achieved by considering each product in isolation and fixing its price at a level which is calculated to maximise its total contribution.

Advantages

1.   With marginal cost pricing, prices are never rendered uncompetitive merely because of a higher fixed over-head structure. The firm's prices will only be rendered uncompetitive by higher variable costs, and these are controllable in the short-run while certain fixed costs are not.

2.   Marginal cost pricing permits a manufacturer to develop a far more aggressive pricing policy than does full-cost pricing. An aggressive pricing policy should lead to higher sales and possibly reduced marginal costs through increased marginal physical productivity and lower input factor prices.

3.   Marginal cost pricing is more useful for pricing over the life-cycle of a product, which requires short-run marginal cost and separable fixed cost data relevant to each particular state of the cycle, not long-run full-cost data.  

Marginal cost pricing is more effective than full-cost pricing because of two characteristics of modern business:

a)   The prevalence of multi-product, multi-process and multi-market concerns makes the absorption of fixed costs into product costs absurd. The total costs of separate products can never be estimated satisfactorily, and the optimal relationships between costs and prices will vary substantially both among different products and between different markets.

b)   In many businesses, the dominant force is innovation combined with constant scientific and technological development, and the long-run situation is often highly unpredictable. There is a series of short-runs of production and one must aim at maximising contribution in each short-run. When rapid developments are taking place, fixed costs and demand conditions may change from one short-run to another, and only by maximising contribution in each short-run will profit be maximised in the long-run.  

Limitations

1.   The encouragement to take on business which makes only a small contribution may be so strong that when an opportunity for higher contribution business arises, such business may have to be foregone because of inadequate free capacity, unless there is an expansion in organisation and facilities with the attendant increase in fixed costs.

2.   In a period of business recession, firms using marginal cost pricing may lower prices in order to maintain business and this may lead other firms to reduce their prices leading to cut-throat competition. With the existence of idle capacity and the pressure of fixed costs, firms may successively cut down prices to a point at which no one is earning sufficient total contribution to cover its fixed costs and earn a fair return on capital employed.  

In spite of its advantage, due to its inherent weakness of not ensuring the coverage of fixed costs, marginal cost pricing has usually been confined to pricing decision relating to special orders.

4. Going-rate Pricing

Instead of the cost, the emphasis here is on the market. The firm adjusts it own price policy to the general pricing structure in the industry. Where costs are particularly difficult to measure, this may seem to be the logical first step in a rational pricing policy. Many cases of this type are situations of price leadership. Where price leadership is well established, charging according to what competitors are charging may be the only safe policy.

It must be noted that `going-rate pricing' is not quite the same as accepting a price impersonally set by a near perfect market. Rather it would seem that the firm has some power to set its own price and could be a price maker if it chooses to face all the consequences. It prefers, however, to take the safe course and conform to the policy of others.

5. Customary Pricing

Prices of certain goods become more or less fixed, not by deliberate action on the sellers' part but as a result of their having prevailed for a considerable period of time. For such goods, changes in costs are usually reflected in changes in quality or quantity. Only when the costs change significantly the customary prices of these goods are changed.

Customary prices may be maintained even when products are changed. For example, the new model of an electric fan may be priced at the same level as the discontinued model. This is usually so even in the face of lower costs. A lower price may cause an adverse reaction on the competitors leading to a price war so also on the consumers who may think that the quality of the new model is inferior. Perhaps, going along with the old price is the easiest thing to do. Whatever be the reasons, the maintenance of existing prices as long as possible is a factor in the pricing of many products.

It a change in customary prices is intended, the pricing executive must study the pricing policies and practices of competing firms and the behavior and emotional make-up of his opposite number in those firms. Another possible way out, specially when an upward move is sought, is to test the new prices in a limited market to determine the consumer reaction.

OBJECTIVES OF PRICING POLICY

Before a marketer fixes a price, he should keep in mind certain basic considerations. The price policy he adopts is closely related to his other policies, like production programme, advertising policy and selling methods. For example, it may be necessary to reduce the price to offset the probable loss of sales from a lower advertising budget or to enable fuller utilisation of plant capacity more quickly. Aggressive sales campaign may be necessary to meet the advent of a new competitor. Your price should not be so high that it attracts others to compete with you. A low price policy may result in such a high volume of sales and low unit costs that profits are maximised even at low prices.

"My policy is to reduce the price, extend the operations and improve the article. You will note that the reduction of price comes first. I have never considered any costs as fixed. Therefore, I first reduce the price to a point where I believe more sales will result. The new price forces the costs down.. (by forcing) everybody in the plant to the highest point of efficiency," Henry Ford quoted in Phillip and Duncan, Marketing, 3rd Edition, 1956, p. 696.

If a marketing manager is to make effective pricing decisions, he should be clear about the firm's long-term marketing objectives for the entire range of products and services. If the firm is interested in increased market share, it would have to resort to penetration pricing. If it is interested in short-term profitability, it may have a higher price even at the expense of sales volume and market share.

NON-PRICE COMPETITION

The basic aim of non-price competition is to alter those characteristics of the product other than price which influence the decision of the buyers. The various forms of non-price competition are : (a) Advertising and creating brand loyalties, (b) changes in the quality of goods and services, (c) prompt deliveries, (d) free gifts and contests and, (e) better after-sales service. The more complex the product the greater are the characteristics which could be modified in response to customer tastes or as a result of changes in technology. Among the major factors responsible for the growth of non-price competition are (a) the tendency towards price uniformity, (b) desire to hold customers on the basis of attributes other than price, as for example, convenience and early deliveries or longer period of guarantee, (c) adoption of measures necessary even to make price competition effective. From the point of view of consumers non-price competition is a boom as they may get better quality goods and services.