Chapter Six: Pricing Decisions

6.1. Meaning and significance of pricing

6.2. Pricing objectives
6.3. Factors affecting pricing decisions
6.4. Basic methods of determining price
6.5. Pricing policies and strategies
1. PRICING STRATEGY

6.1 INTRODUCTION

A marketer should make a sound decision related to the price of its product or service because
the consumer’s perception of price will affect the business. For instance if buyers perceive a
price to be high, they may purchase competitors brand, leading to a loss of sales. If price is too
low, sales might increase, but profit may suffer.
6.2 MEANING OF PRICE
Price is the amount of money charged for a product or service or it is the sum of the values that
consumers exchange for the benefit of using the product/service. Therefore pricing represents the
value of a good or service for both the seller and buyers.
From business point of view pricing is important because it is the only revenue generating
elements of a marketing mix, others consume resource.
6.3 Pricing Objectives
To be useful, the pricing objective the management selects must be compatible with the
overall goals set by the company and the goals for its marketing program. Let's assume that
a company's goal is to increase return on investment from its present levels of 15 percent to
20 percent within 3 years.
It follows that the pricing objective during this period must be to achieve some stated
percentage return on investment. It would not be logical, in this case, to adopt the pricing
objective of maintaining the company's market share or of stabilizing price.

The following pricing objectives shall be discussed:

 profit-oriented: to achieve a target return; to maximize profit

 sales-oriented: to increase sales volume; to maintain or increase market share
  status quo-oriented: to stabilize prices; to meet competition
Recognize that all of these objectives can be sought and hopefully attained not just through
pricing but also through other marketing activities such as product design and distribution
channels.

A. Profit-oriented objectives

Profit objectives may be set for the short or long run. A company may select one of two profit-
oriented objectives for its pricing policy.

Achieve a target return: A firm may price its product to achieve a target return, a specific
percentage return on its sales or its investment. Many retailers and wholesalers use a target
return on sales as a pricing objective for short periods such as a year or a fashion season. They
add an amount to the cost of the product, called a markup, to cover anticipated operating
expenses and provide a desired profit for the period. Achieving a target return on investment is
measured in relation to a firm's net worth (Its asset minus its liabilities). The leading firm in an
industry often selects this pricing goal.

Maximizing profits: The pricing objective of making as much money as possible is probably
followed more than any other objective. The trouble with this objective is that to some people,
profit maximization has an ugly connotation, suggesting profiteering, high prices, and monopoly.
In both economic theory and business practice, however, there is nothing wrong with profit
maximization. Theoretically, if profits become high in an industry because supply is short in
relation to demand, new capital will be attracted to increase production capacity. This will
increase supply and eventually reduce profits to normal levels. In the market place it is difficult
to find many situations where profiteering has existed over an extended period of time. A profit-
maximization goal is likely to be far more beneficial to company if it is pursued over the long
term. To do this, however, firms may have to accept modest profit or even losses over the short
term.

The objective should be to maximize profits on total output rather than on each single product. In
fact, a company may maximize total profit by setting low, relatively unprofitable prices on some
products in order to stimulate sales of others.
 B. Sales-oriented objectives

In some companies management's pricing is focused on sales volume or to maintain or increase

the firm's market share.

Increase sales volume: This pricing objective of increasing sales value volume is typically
adopted to achieve rapid growth or to discourage potential competitors from entering a market.
The goal is usually stated as a percentage increase in sales volume over some period.
Management may seek higher sales volume by discounting or by some other aggressive pricing
strategy. Occasionally companies are willing to incur a loss in the short run to expand sales
volume or meet sales objectives.
Increase market share: In some companies, both large and small, the pricing objective is to
maintain or increase market share. Why is market share protected or pursued so vigorously?
Most industries today are not growing much, if at all, and have excess production capacity.
Many firms need added sales to more fully utilize their production capacity and in turn, gain
economies of scale and better profits. Since the size of the market isn't growing in most cases,
businesses that need added volume have to grab a bigger market share.
C. Status quo objectives

Two closely related goals – stabilizing prices and meeting competition – are the least aggressive
of all pricing objectives. They are intended simply to maintain the firm's current situation – that
is, the status quo. With either of these objectives a firm seeks to avoid price competition.

Price stabilization often is the objective in industries where the product is highly standardized
and one large firm acts as a leader in setting prices. Smaller firms in these industries tend to
"follow the leader" when setting their prices.

Even in industries where there are no price leaders, countless firms deliberately price their
products to meet the prevailing market price. This pricing policy gives management an easy
means of avoiding difficult pricing decisions.

Firms that adopt status-quo pricing objectives to avoid price competition are not necessarily
passive in their marketing. Quite the contrary! Typically these companies compete aggressively
using other marketing mix elements – product, distribution, and especially promotion. This
approach is called non-price competition.

6.4 Basic methods of determining price

1. 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 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 three sets of factors. We
examine these 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).

a) Cost-Based Pricing
Cost-Plus Pricing

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 any manufacturer had the following costs and
expected sales: Then the manufacturer's cost per toaster is given by:

To illustrate markup pricing, suppose a given manufacturer had the following costs and expected
sales:

 Variable cost (VC) = birr 24

 Fixed cost (FC) = birr 600000
 Projected unit sales (PUS) = 100000 units
Then the manufacturer’s cost per unit is given by:

 Unit cost (UC) = VC + (FC/PUS) = 24 + (600000 /

100000) = birr 30

Assume the manufacturer wants to earn a 25 percent markup (desired rate of return) on sales.
Then the manufacturer’s markup price would be given by:

 Markup price = UC / (1 – desired return on sales)

= 30 / (1 – 0.25) = Birr 40

Therefore, the said manufacturer would charge dealers Birr 40 per unit and make a profit of Birr
10 a unit. Unit price can be calculated as follows;

Unit price= cost + (mark up*cost)

= 30 + (0.25*30)

= 37.5 birr

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 minimized. Third, many
people feel that cost-plus pricing is fairer to both buyers and sellers. Sellers do not take
advantage of buyers when buyer’s demand becomes great, yet the sellers earn a fair return on
their investment.

This activity helps you calculate the cost, the price, and the profit of a product based on some
given variables. Suppose a manufacturer of a given product had the following costs and
projected sales:

 Variable cost = birr 5

 Fixed cost = birr 25 000
 Projected sales = 5000
On the basis of the data, find out:
  the unit cost
 the markup price
 the total profit for the projected sales
Breakeven pricing

Breakeven pricing, also called target profit pricing, is another cost-oriented pricing approach.
The manufacturer in this case wants to determine the price at which it will break even or make
the profit it seeks. Breakeven pricing uses the concept of a breakeven chart. A breakeven chart
shows the total cost and total revenue expected at different sales volume levels. Fixed costs
remain constant regardless of sales volume. Variable costs are added to fixed costs to form total
costs, which may rise with volume of sales. The total revenue curve starts at zero and rises with
each unit sold. The slop of the total revenue curve reflects the price per unit.

Then total revenue (TR) and total cost (TC) curve cross at X (= 37500 units). This is the
breakeven volume. At birr 40, the manufacturer must sell at least 37500 units to break even. At
that level of sales volume, the total revenue covers the total cost. Breakeven volume can be
calculated using the following formula:

 Breakeven Volume = FC / (Price – VC) = 600000 / (40 – 24) = 37500

 Breakeven revenue =FC/(1-VC/P) =600000/(1-24/40) = 1500000 Birr
If the manufacturer wants to make a target profit, it must sell more units at birr 40 each.

On the basis of the data given below, calculate the breakeven volume and break-even revenue for
a hypothetical manufacturer.

 Fixed cost = birr 450 000

 Unit price = birr 37
 Variable cost = birr 27
2. Buyer-based Approach
An increasing number of companies are basing their prices on the product’s perceived value.
Perceived-value pricing uses buyers’ perceptions of value, not the seller’s cost, as the key to
pricing. The company uses the non-price variables in the marketing mix to build up perceived
value in the buyers’ minds. Price is designed to match the perceived value of the product and its
accompanying services.

Consider the various prices different sellers charge for the same items. A bottle of beer that can
be bought at 3 birr at the nearby grocery will perhaps take 5 to 7 birr in three-star hotels, and 20
to 25 birr at Sheraton Addis. Each succeeding hotel can charge more because of the value added
by the particular atmosphere in and around that hotel.

3. Competition-based Approaches
Rather than emphasizing demand, cost, or profit factors, a price setter can stress what
competitors or "the market" is doing. Marketers can use either pricing below competition or
pricing above competition.

a. Pricing below competition

A variation of competition based pricing is to set a price below the level of your main
competitors. Pricing below competition is done by discount retailers, which stress low marks
high volume and a few customer services. Even full service retailers may price below the
competitive level by eliminating specific services. The risk in pricing below competition is that
consumers begin to view the product as undifferentiated commodities with all off the focus on
price differences. If that happens, then consumers choose the brand with the lowest price. In
turn, competing firms are likely to wind up in a price war that diminishes or eliminates profits.

b. Pricing above competition

Producers or retailers sometimes set their prices above the prevailing market level. Usually,
pricing above competition occurs when the product is distinctive or when the seller has acquired
prestige in its field. Most communities have an elite clothing boutique and a prestigious jewelry
store where price tags are noticeably above the level set by other stores with seemingly similar
products.

Manufacturers for prestige brands of high cost products often employ above-market pricing.
 2. Pricing Adjustment Strategy
Strategy Description

Discount and allowance pricing Reducing prices to reward customer responses such as paying early or promoting the
product.

Segmented pricing Adjusting prices to allow for differences in customers, products, or locations

Psychological pricing Adjusting prices for psychological effect

Promotional pricing Temporarily reducing prices to increase short run sales

Geographical pricing Adjusting prices to account for the geographic location of customers

International pricing Adjust prices for international market

1. Discount and allowance pricing

Most companies adjust their basic price to reward customers for certain responses, such as the
early payment of bills, volume purchases, and off-season buying. These price adjustments—
called discounts and allowances—can take many forms. The many forms of discounts include a
cash discount, a price reduction to buyers who pay their bills promptly. A typical example is
“2/10, net 30,” which means that although payment is due within 30 days, the buyer can deduct 2
percent if the bill is paid within 10 days. A quantity discount is a price reduction to buyers who
buy large volumes. A seller offers a functional discount (also called a trade discount) to trade-
channel members who perform certain functions, such as selling, storing, and record keeping. A
seasonal discount is a price reduction to buyers who buy merchandise or services out of season.
Allowances are another type of reduction from the list price. For example, trade-in allowances
are price reductions given for turning in an old item when buying a new one. Tradein allowances
are most common in the automobile industry but are also given for other durable goods.
Promotional allowances are payments or price reductions to reward dealers for participating in
advertising and sales support programs.
 2. Segmented Pricing

Companies will often adjust their basic prices to allow for differences in customers, products,
and locations.

In segmented pricing, the company sells a product or service at two or more prices, even though
the difference in prices is not based on differences in costs. Segmented pricing takes several
forms.

Under customer-segment pricing, different customers pay different prices for the same product
or service. Museums and movie theaters, for example, may charge a lower admission for
students and senior citizens. Under product-form pricing, different versions of the product are
priced differently but not according to differences in their costs.

Using location-based pricing, a company charges different prices for different locations, even
though the cost of offering each location is the same. For instance, state universities charge
higher tuition for out-of-state students, and theaters vary their seat prices because of audience
preferences for certain locations.

Finally, using time-based pricing, a firm varies its price by the season, the month, the day, and
even the hour. Movie theaters charge matinee pricing during the daytime. Resorts give weekend
and seasonal discounts.

For segmented pricing to be an effective strategy, certain conditions must exist. The market must
be segment able, and segments must show different degrees of demand. The costs of segmenting
and reaching the market cannot exceed the extra revenue obtained from the price difference. Of
course, the segmented pricing must also be legal. Most importantly, segmented prices should
reflect real differences in customers’ perceived value.

3. Psychological Pricing

Price says something about the product. For example, many consumers use price to judge
quality. A $100 bottle of perfume may contain only $3 worth of scent, but some people are
willing to pay the $100 because this price indicates something special.
In using psychological pricing, sellers consider the psychology of prices, not simply the
economics. For example, consumers usually perceive higher-priced products as having higher
quality. When they can judge the quality of a product by examining it or by calling on past
experience with it, they use price less to judge quality. But when they cannot judge quality
because they lack the information or skill, price becomes an important quality signal.

Another aspect of psychological pricing is reference prices—prices that buyers carry in their
minds and refer to when looking at a given product. The reference price might be formed by
noting current prices, remembering past prices, or assessing the buying situation. Sellers can
influence or use these consumers’ reference prices when setting price. For example, a grocery
retailer might place its store brand of bran flakes and raisins cereal priced

4. Promotional Pricing

With promotional pricing, companies will temporarily price their products below list price and
sometimes even below cost to create buying excitement and urgency. Promotional pricing takes
several forms. A seller may simply offer discounts from normal prices to increase sales and
reduce inventories. Sellers also use special-event pricing in certain seasons to draw more
customers. Manufacturers sometimes offer cash rebates to consumers who buy the product from
dealers within a specified time; the manufacturer sends the rebate directly to the customer.
Rebates have been popular with automakers and producers of cell phones and small appliances,
but they are also used with consumer packaged goods. Some manufacturers offer lowinterest
financing, longer warranties, or free maintenance to reduce the consumer’s “price.” This
practice has become another favorite of the auto industry.

5. Geographical Pricing

Charge the same price for customers in different locations (based on transport costs) or same
price for all customers (and different profits at different locations)?
FOB-origin pricing, this practice means that the goods are placed free on board (hence, FOB) a
carrier. At that point the title and responsibility pass to the customer, who pays the freight from
the factory to the destination. Because each customer picks up its own cost, supporters of FOB
pricing feel that this is the fairest way to assess freight charges.
Uniform delivered pricing is the opposite of FOB pricing. Here, the company charges the same
price plus freight to all customers, regardless of their location. The freight charge is set at the
average freight cost. Price = base price + average freight cost
Zone pricing falls between FOB-origin pricing and uniform-delivered pricing. The company
sets up two or more zones. All customers within a given zone pay a single total price; the more
distant the zone, the higher the price. Price = base price + (average) freight cost for zone in
question

Using basing-point pricing, the seller selects a given city as a “basing point” and charges all
customers the freight cost from that city to the customer location, regardless of Select a the city
from which the goods are actually shipped.

Basing point, charge for freight from the basing point to the customer's location – however, the
product may be physically produced closer to the customer! [“Virtual freight costs”] If all sellers
use same basing point, price competition is eliminated.

Freight-absorption pricing Seller absorbs all or part of the actual freight charges in order to get
the desired business;- Argument: more business => less costs, which covers the freight costs

3.Product Mix Pricing Strategies

The strategy for setting a product's price often has to be changed when the product is part of a
product mix. In this case, the firm looks for a set of prices that maximizes the profits on the total
product mix. Pricing is difficult because the various products have related demand and costs and
face different degrees of competition. We now take a closer look at the five product mix pricing
situations

Product Line Pricing

Companies usually develop product lines rather than single products. In product line pricing,
management must decide on the price steps to set between the various products in a line. The
price steps should take into account cost differences between the products in the line, customer
evaluations of their different features, and competitors' prices. In many industries, sellers use
well-established price points for the products in their line. The seller's task is to establish
perceived quality differences that support the price differences. The price steps should take into
account cost differences between products in the line. More importantly, they should account for
differences in customer perceptions of the value of different features.

Optional-Product Pricing

Many companies use optional-product pricing—offering to sell optional or accessory products

along with their main product. For example, a car buyer may choose to order power windows,
cruise control, and a CD changer. Pricing these options is a sticky problem. Automobile
companies have to decide which items to include in the base price and which to offer as options.
Until recent years, The economy model was stripped of so many comforts and conveniences that
most buyers rejected it.

Captive-Product Pricing

Companies that make products that must be used along with a main product are using captive
product pricing. Examples of captive products are razor blades, camera film, video games, and
computer software. Producers of the main products (razors, cameras, video game consoles, and
computers) often price them low and set high markups on the supplies. Thus, camera
manufactures price its cameras low because they make its money on the film it sells. In the case
of services, this strategy is called two-part pricing. The price of the service is broken into a fixed
fee plus a variable usage rate. Thus, a telephone company charges a monthly rate—the fixed
fee—plus charges for calls beyond some minimum number—the variable usage rate. Amusement
parks charge admission plus fees for food, midway attractions, and rides over a minimum. The
service firm must decide how much to charge for the basic service and how much for the variable
usage. The fixed amount should be low enough to induce usage of the service; profit can be
made on the variable fees.

By-Product Pricing

In producing processed meats, petroleum products, chemicals, and other products, there are often
by-products. If the by-products have no value and if getting rid of them is costly, this will affect
the pricing of the main product. Using by-product pricing, the manufacturer will seek a market
for these by-products and should accept any price that covers more than the cost of storing and
delivering them. This practice allows the seller to reduce the main product's price to make it
more competitive. By-products can even turn out to be profitable. For example, many lumber
mills have begun to sell bark chips and sawdust profitably as decorative mulch for home and
commercial landscaping.

6.5 PRICE AND NON-PRICE COMPETITION

Competition between marketers to attract customers and generate income is made in different
ways, which can be broadly categorized into price and non-price competition.
a) Price competition – Here sellers influence demand of the purchaser primary through
changes in price level. Sellers move along a demand curve by raising or lowering their prices.
Price competition is a flexible tool because price can be adjusted quickly and easily. However,
of all the controllable marketing variables pricing strategy is the easiest for competitors to
duplicate i.e. competitors can have the flexibility to adjust their prices.
b) Non-price competition – Emphasizing on factors other than price in relation to competitors
product occurs when the sellers decides not to focus on price and use other factors to
distinguish their product from competitors offer. It includes quality, delivery service, unique
feature etc. Even though this competitive tool is challenging and difficult to adapt, it helps the
firm to develop ‘good will’
6.6 FACTORS TO CONSIDER WHEN SETTING PRICES
A company’s pricing decisions are affected by both internal company factors and external
environmental factors. In the next part of this unit these factors will be discussed in detail.
6.6.1 Internal Factors Affecting Pricing Decision

a) Marketing Objectives
The co’s marketing objective has a great influence on the pricing decision of the firm. These
objectives might include
i. Survival – firms usually consider survival as their major objective when they are troubled
by too much capacity, heavy competition or changing consumer want. Here in order to
keep the plant going, a company may set a low price hoping to increase demand.
ii. Current profit maximization – In this case the company chooses the price that will
produce the maximum current profit or cash rather than long run performance.
iii. Market share leadership – company may also want to obtain the dominant market share.
They believe that the company with large market share will enjoy the lowest costs and
 highest longer profit. In order to be a market share leader, these firms set price as low as
possible.
iv. Product quality leadership – A company with this objective wants to have the highest
quality product on the market which may call for charging a high price to cover R & D
costs.
v. Other objectives – A company might also use price to achieve other specific objectives.
For instance, it can set low price to prevent competitors from entering the market or set
price at competitors level to stabilize the market.
b) Marketing Mix Strategy
Price is the only marketing tool that the company uses to achieve its marketing objectives. Price
decision must be coordinated with product design, distribution and promotion decision to form a
consistent and effective marketing program. Decisionmade for other marketing mix elements
may affect pricing decision. For example, the decision to position the product on high quality
will mean that the seller must change higher price to cover its higher costs.

Thus, the marketer must consider the total marketing mix when setting prices. If the product is
positioned on non-price factors, then decision about other marketing mix tools will strongly
affect price. If price is a crucial positioning factor then price will strongly affect the decision of
other marketing mix elements.
c) Costs
Costs set the floor for the price that the company can charge for its product. The price of the
product usually must cover cost of production, promotion and distribution, plus a profit for the
offering to be of value to the firm. In addition when products are priced on the basis of costs plus
a fair profit, there is an implicit assumption that this sum represents the economic value of the
product in the market place.

Cost-oriented pricing is the most common approach in practice, and there are two variations:
Markup pricing and cost – plus pricing.

1) Markup pricing – This is commonly used in retail business, where a percentage is added to
the retailers invoice price to determine the final selling price.
2) Cost – plus pricing – Closely related to markup pricing is cost – plus pricing, where the costs
of producing a product are totaled and a profit amount or percentage is added on.
Cost-oriented approaches to pricing have the advantage of simplicity and many practitioners
believe that they generally yield a good pricing decision. However, such approaches have been
criticized for two basic reasons. First, cost approaches give little or no consideration to demand
factors. Second, cost approaches fail to reflect competition adequately. Only in industries where
all firms use this approach and have similar cost component, this approach yields similar prices
and minimize price competition.
6.6.2 External Factors Affecting Pricing Decisions
The external environmental factors, which affect pricing decision, are;
a) Demand
The relationship between price and consumer purchase decision can be explained by the
economist law of demand which state that consumer usually buy more units at lower price and
less units at higher prices.
Price elasticity can also be used to describe the influence of demand on price decision. Price
elasticity of demand is a measure of consumers’ price sensitivity and it is estimated by dividing
relative changes in the quantity sold by the relative price change.
Percentage change in quantity demand
e =
Percentage change in price

Although difficult to measure, there are two methods commonly used to estimate price elasticity.
First, price elasticity can be estimated from historical data. Second, price elasticity can be
estimated by sampling a group of consumers from the target market and polling them concerning
various price/quantity relationship.

b) Competition
The level of competition also affects pricing. Therefore in order to set or change Prices, the firm
must consider its competition and how competition will react to the price of the product. Here
emphasis must be given by the firm for the following factors.
 Number and size of competitors.
 Location of competitors.
 Number of products sold by competitors.
  Cost structure of competitors.
 Past/previous reaction of competitors to price change.
These factors determine whether the firm’s selling price should be at, below, or above
competition. (Each of these pricing strategies will be discussed later under pricing strategy).
C. Government Regulations
Prices of certain goods and services are regulated by state and federal governments. Public
utilities such as gasoline, taxi-fare are examples of state regulations of prices. Since most
marketing managers are not trained as lawyers, they usually seek legal counsel when developing
pricing strategies to ensure conformity to state and federal legislations.
6.7 PRICING STRATEGY
Pricing strategy can be used to develop (fix) price of existing or new products.
6.7.1 Pricing Strategies for New Products
When a company introduces a new product for the market, it can apply any one of the following
pricing strategies.
A) A Skimming policy – This involves setting price at high level usually in the introduction
stage of the product life cycle and lower the price in the later stages. The firm is essentially
trying to “skim the cream” of demand of those people that strongly desire the product at a
premium price.

B) A Penetration policy – Here the seller changes a relatively low price on a new product.
Generally this policy is used when the firm expects competition to move in rapidly and where
demand for the product is, at least in the short run, price elastic (i.e. a small percentage change in
price in leads to a high percentage change in quantity demand). This policy is also used to
achieve economies of scale. In latter stage the firm will be required to alter its price so as to
meets changes in the market place.
6.7.2 Pricing Strategies for Existing Products
When a company introduces a new product for itself but not for the market, it can take one of the
three strategies; pricing above the market, pricing below the market and market price.
a) Pricing above the market – This is when a firm sets a price to its product higher than
similar products sold by its competitors. If one uses price above the market the product
 must be distinct or should have some unique features than competitor’s product in the
eyes of the consumer.
b) Pricing below the market – Marketers use this price when they plan to get profit by
increasing sales volume or when they are able to reduce cost per unit.
c) Market price – This is like the price that is reflecting the prevailing/current market, i.e.
applying the price that is currently charges by our competitors.