Lesson 16. PRICING AND ITS METHODS
Module 4. Elements of marketing mix – II. price
PRICING AND ITS METHODS
In simple terms, price is the exchange value of a product. For an organization, it is the quantum of money (in modern exchange economy or goods and services in barter trade) obtained by it by selling its goods/services. For a consumer, it is money given to the seller. Price as understood in terms of goods/services to satisfy need and wants of human beings and is called utility. Value represents the worth attached by consumers to goods/services. Price is represented by following formula:
For example if the buyer obtains 1 litre of whole milk for Rs 30, then to the seller the price is Rs. 30 and to the buyer it is 1 litre of whole milk.
16.2 Objectives of Pricing
Although most of the organization aim at profit maximization but in general the various objectives the organizations try to achieve are as follows: Short term profit maximization, long term profit optimization, minimum return on investment, minimum return on sales turnover, target sales volume, target market share, more penetration in the market, selling in new markets, combined target profit on entire product line whatever may be the profit in individual products, eliminating competition or keeping similarity with competitors, fast turn around and early cash recovery, stabilizing prices in the market, supplying goods at affordable prices for economically weaker sections of society, setting prices of goods to stimulate economic development.
16.3 Factors Influencing Pricing
External and internal factors as listed below are impacting the pricing decision.
16.3.1 External factors
Market conditions, consumers behavior for the concerned product, bargaining power of major consumers and suppliers, pricing policy of competitors, government laws specifically for pricing of products, legal rules, society's view point.
16.3.2 Internal factors
Marketing objectives of the organization, The nature of product, Price elasticity of demand of the product, Product's stage in product life cycle, Pattern of use and turn around rate of the product, cost of production, marketing costs, Extent of product differentiation, interaction and influence of marketing mix elements on price, Organization's product width and line length.
16.4 Methods of Pricing
The various methods of pricing are as follows.
16.4.1 Cost based pricing
This includes following four methods
· Mark up pricing/ cost plus pricing
· Absorption cost pricing/ full cost pricing
· Target profit pricing / Rate of return pricing
· Marginal cost pricing
220.127.116.11 Cost plus pricing / mark up pricing
In this method, the organization calculates the total cost of production and then adds some margin as per their choice. There is no specific rule for the amount of margin but in general, it is dependent upon type of product and market conditions. Two guidelines are used by organizations for deciding the margin. Higher the unit cost of product, more is the margin and vice versa. Slower the turnaround of the product, higher is the mark up and vice versa. Following formula can be used.
TC = unit cost (fixed + Variable)
r = Expected return on sales in percentage.
For example suppose fixed cost for making 10,000 ice cream cups is Rs. 1,00,000/- and the variable cost per ice cream cup is Rs 5/-. Then total cost per ice cream cup is Rs 15/-. If the organization wants 20 percent return on sales then mark up price will be
The method is simple but does not take into consideration consumers view point and competitors.
18.104.22.168 Absorption cost pricing / full cost pricing
In this method also total unit cost of production is worked out under normal level of production schedule. This total unit cost includes fixed, variable, administrative and selling expenses. To this unit cost, some mark up is arbitrarily added (profit). This total becomes the selling price.
This method is used by organizations which prefer safety. If the market consumes all the products of the organization then the organization receives desired profit. But this method does not consider demand aspects. If normal level of production is disturbed then all the calculations are also changed.
22.214.171.124 Rate of return pricing
This method is similar to absorption costing method. But unlike absorption costing in which arbitrarily mark up is chosen, here a rational approach is used to decide this mark up so that the return on investment as desired by the organization is achieved. This is an improvement over absorption costing method but the limitation is that as the rate of return is dependent on level of production and sales estimate, with the change in level of production, rate of return also changes.
The formula used is
In this method fixed cost are not considered and prices are decided based upon marginal cost. The marginal cost will include all the direct variable cost of the product. Only those costs which can be directly attributed to the specific product output are used. By this method all the direct variable cost are fully recovered and a part of fixed cost is also recovered. The method provides flexibility with respect to recovery of fixed cost. Depending upon type of consumer and type of market, fixed cost recovery portion may be adjusted. In a multi product organization, this method gives flexibility of recovering fixed costs through products at varying rates considering market situation while realizing on the marginal cost form the concerned product. As variable costs are controllable in short run, the price of the product is never rendered uncompetitive because of higher variable costs. The limitation is that the method is suitable only for short run period. There is possibility of some costs to be categorized as mixed cost (semi fixed or semi variable). Marginal costing does not consider this reality.
16.4.2 Demand/ market based pricing
This includes following 3 types of methods:
a) What the traffic can bear
Under this method, the maximum price which the consumers are able to pay in a given situation is charged by the organization. The method is more popular among retailers then producers. The method gives higher profit in short run but is not suitable for long run. The method is suitable for monopoly/oligopoly markets and inelastic product.
b) Skimming price
In this method initially very high price are set to realize very high profits. After a period of time, the prices can be lowered. The method is suitable for luxury novel products to specific segments of society which are less price sensitive.
c) Penetration pricing
This method is also adopted for new product introductions. Here the organization set low prices for the product. If the new product is not a luxury product and is generally not purchased by rich price insensitive consumers then by higher sales volume, the organization earn higher revenue till the competitors enter the market with their own versions of products.
16.4.3 Competition based pricing
These methods are based upon principle of similarity with competitors in pricing. Following three methods fall under this category.
a) Premium pricing: Setting price above the competitors’ price.
b) Discount Pricing: Setting price below the competitors’ price.
c) Parity Pricing: Setting price similar to the competitors’.
16.4.4 Other pricing methods
Apart from cost, demand and competition base, many more pricing methods are used by organizations which can be strictly placed in any of the three categories. They are as follows.
a) Product line pricing: For a large organization which manufactures variety of products, different product lines will be there. In each product line number of related products will be grouped. These related products of a product line share common manufacturing facilities and have interrelated cost of production and distribution. The sale of a particular product has influence on the sale of other product also. Therefore in such a situation instead of setting the price independently for an individual product to earn maximum profit, the optimum price is set for each individual product so the maximum profit results from combined sale of all the products of a product line.
b) Tender Pricing/sealed bid pricing: In many large projects, government work contracts, industrial marketing etc this method is employed. In this method the supplier or the firm who wants to do the work is required to submit their price in the form of sealed quotations. Generally the lowest quoted price tenders are selected and awarded the job. By quoting lesser price which will cover only cost of production, the firm may get the work order but the profit margin will be less.
c) Social welfare pricing / affordability pricing: In this method price of the product is set in such a way that it is affordable by all section of society. Here the cost of production is not the criteria but social service is the main objective.
d) Subsidy: The money is supplied in the form of subsidy to cover the cost of production such a system is prevalent in the public distribution system.
e) Differentiated pricing: In this method organisations set different prices for the same product based upon either type of consumer, market or volume purchased.
f) Going rate pricing: In this method the price is set considering the market disregarding cost of production. In the method, the price is set according to what others are charging in the market. The method is helpful when it is difficult to measure the cost of production.
g) Perceived value pricing: In this method the prices are set on the basis of perceived value of consumer. Here consumers’ perception of value is counted more important than sellers cost of production.
h) Value Pricing: In this method quite less price is charged for a quality product for loyal customers. This also necessitates organizations to lower cost of production without impacting quality.
i) Psychological Pricing: In this method, the organisation sets the price based upon consumer psychology. During purchase, consumers have a reference price in their mind and thus compare the products to be purchased with this reference price. Organisations thus manipulate this reference points so as to make a sale.
j) Two part pricing: This method is used when the product/ service can be divided into two different parts. For example, in case of some book libraries running in big cities. One part is of annual membership fee. This is a fixed component. The member can then take the books/magazines available in the library for a specified period on rent.
k) Loss leader pricing: In this method, prices of well known branded products are reduced to generate higher demand.
16.5 General Guidelines for Setting Price
The following guidelines can help set price of a product:
1. Deciding pricing objective
2. Estimating demand
3. Estimating cost
4. Comparing competitors’ cost, price and strategy
5. Deciding a pricing method.