Basic Pricing Strategies and the Use of Break-even

Analysis
by Robert M. Schindler
Considering Costs in Setting Initial Prices

• Fixed Costs - those that do not vary with changes in the number
of product units that are sold. Examples include executives’
salaries, depreciation on the plant and equipment, interest on debt,
rent for facilities, insurance, general administration costs, and
advertising costs.

• Variable Costs - vary directly with the number of product units

that are sold. Examples include direct labor costs, costs of
materials, shipping costs, and sales commissions.
 Price xxx
- Variable Costs xxx
Contribution Margin xxx
- Fixed Costs xxx
Net Profit xxx
Bounds of the Initial Price
• the high end of the range is the product’s
VTC; sales will amount to zero if a price
exceeds the product’s VTC
• a price equal to a product’s VTC is simply
the highest practical price
• Any price above a product’s variable costs
will contribute to covering the
organization’s fixed costs.
• If enough of the products is sold, any level
of contribution could be sufficient to first
cover the fixed costs and then go on to
produce net profit.
• Any price above the variable costs
could be a viable price.
• A product’s VTC forms the upper bound of its price, which can be
referred to as its price ceiling.
• The level of the product’s variable costs forms the lower bound of
its price, which can be referred to as its price floor.
• When there is a substantial range between these bounds,
knowing them will leave the question of where within these
bounds should price be initially set.
• The decision is largely dependent on pricing strategy
considerations.
Skimming Strategy Penetration Strategy
• setting a price so high that most • setting a price so low that the new
customers will decline to buy the product sells briskly in the market
new product • per-item profits will tend to be low
• unit sales of skim-priced item will • the likelihood of selling a large
be low number of items makes penetration
• the high per-item profits involved a potentially viable strategy
skimming a potentially viable • the product’s low price enables it to
strategy rapidly “penetrate the market”
• appealing to those few customers • generates the large number of
willing to pay a lot, thus “skimming sales that could result in an overall
the cream of the market” profit even though only a small
amount is made on each unit sold
• by applying the skimming and penetration strategies to the task of
determining where a price should be set within the range of its
typical bounds, we are establishing these strategies as a form of
customer-based pricing.

• Neither strategy can be used without there first being an estimate

of the product’s VTC
In-line Strategy
• setting the price to be “in line with” the prices of
competing offerings
• does not mean prices will be the same as the price of
competing products, but they will be relatively close
• also a customer-based pricing
• starts with an understanding of the product’s value to the
customer
Strategic Factors in Setting Initial Prices

• Factors supporting skimming

- new product perceived as risky
- presence of protection against competitive products

• Factors supporting penetration

- ability of low price to serve as an incentive to buy
- protection against competitive price matching
- market conditions favoring a pioneer advantage

• Use in-line pricing when market conditions do not support skimming or

penetration
Factors Supporting Skimming

• the riskiness of the new product is likely to overwhelm customers’ concern

about price
- the excitement of the product’s new capabilities and pleasures of the
social acceptance of being among the first to own a new product tend to lead
them to accept high prices

• risky new products are likely to require substantial resources for promotion,
to educate the market about how to use the product and its benefits; a high
price would help finance such promotional efforts
• a high skim price need not last forever, there does need to be sufficient time
for the “cream skimming” to be complete
- if the entry of lower-priced competition is an immediate threat, then a
skimming strategy becomes nonviable
- protection against such competition can take many possible forms,
such as: patent on a product or process, control of limited natural
resources, ownership of choice retail locations, unique design or
production expertise, a prestigious brand image, or a superior company
reputation
Factors Supporting Penetration

• ability of the low price to serve as an incentive for the customer to buy
- a penetration strategy depends on a large market response to a low
price;
- a large market response might occur if the low price leads customers to
find new uses for the product
- a strong response might occur if the price is so low that it removes
much of the economic risk of the new product

ü if a low price leads customers to question the quality of the product or the
degree to which it carries a prestige image, then the low price may not lead
to a high level of sales
• a penetration strategy may tempt competitors to match low prices, so a
second factor supporting a penetration strategy is protection against
competitive price matching

• such protection could be conferred by being exceptionally low-cost

producer(which would create an advantage in a price war) or being so small
relative to competition that it would not be practical for the competition to
match low prices
• Under some market conditions, a company can develop an advantage over
competition as a result of being first to sell to customers in a market. This
benefit of being first is known as a pioneer advantage.
- the market conditions that make possible a pioneer advantage are an
important third factor supporting a penetration pricing strategy

- Low penetration price can enable the product to be the first sold in its
category to a large number of customers.

- If the market conditions for a pioneer advantage exist, then

penetration pricing could create protection against competition where
such protection did not already exist.
• Market conditions making possible a pioneer advantage could concern the
product’s costs. If there are large economies of scale in producing the
product, then the first company to sell a large amount of the product will
attain low production costs that may be hard for later competition to match.

• Market conditions making possible a pioneer advantage could also concern

the product itself. Being first may give the seller’s product a favorable image
(“We’re the original”), or customers may simply find it safer or more
convenient to stick with the brand that they know from experience that they
can trust.

ü Product loyalty can be long-lasting. One study found that a majority of 25 brands that were
market leaders in 1923 were still brands with the largest market shares 60 years later.
Importance of “Being Strategic”

• being strategic in the way the decision is made

• Strategic thinking involves consideration of supporting factors and the longer-
term implications of an action, as opposed to thinking that is reactive or short-
term.
• Skimming or penetration strategy be chosen only if one or more such
supporting factors are present.
• If market conditions support neither skimming nor penetration, then the in-line
strategy serves as a reasonable default.