Pricing Decisions Tutorial
What do the following words have in common? Fare, dues, tuition, interest, rent, and fee. The answer is that each of these is a term used to describe what one must pay to acquire benefits from another party. More commonly, most people simply use the word price to indicate what it costs to acquire a product.
The pricing decision is a critical one for most marketers, yet the amount of attention given to this key area is often much less than is given to other marketing decisions. One reason for the lack of attention is that many believe price setting is a mechanical process requiring the marketer to utilize financial tools, such as spreadsheets, to build their case for setting price levels. While financial tools are widely used to assist in setting price, marketers must consider many other factors when arriving at the price for which their product will sell.
In this part of our highly detailed Principles of Marketing Tutorials, we begin a two-part discussion of the fourth marketing mix variable – price. For some marketers, more time is spent agonizing over price than any other marketing decision. In this tutorial we look at why price is important and what factors influence the pricing decision.
What is Price?
In general terms, price is a component of an exchange or transaction that takes place between two parties and refers to what must be given up by one party (i.e., buyer) in order to obtain something offered by another party (i.e., seller). Yet this view of price provides a somewhat limited explanation of what price means to participants in the transaction. In fact, price means different things to different participants in an exchange:
Buyers’ View – For those making a purchase, such as final customers, price refers to what must be given up to obtain benefits. In most cases, what is given up is financial consideration (e.g., money) in exchange for acquiring access to a good or service. But financial consideration is not always what the buyer gives up. Sometimes in a barter situation a buyer may acquire a product by giving up his/her own product. For instance, two farmers may exchange cattle for crops. Also, as we will discuss below, buyers may also give up other things to acquire the benefits of a product that are not direct financial payments, such as personal time required to learn how to use the product.
Sellers’ View – To the selling organization, price reflects the revenue generated for each product sold and is an essential factor in determining profit. For those responsible for marketing decisions, price serves as a marketing tool and is a key element in marketing promotions. For example, most retailers highlight product pricing in their advertising campaigns.
Price is commonly confused with the notion of cost as in “I paid a high cost for buying my new smartphone.” Technically, though, these are different concepts. Price is what a buyer pays to acquire products from a seller. Cost concerns the seller’s investment (e.g., manufacturing expense) in the product being exchanged with a buyer. For marketing organizations seeking to make a profit, the hope is that price will exceed cost so the organization can see financial gain from the transaction.
Finally, while product pricing is a main topic for discussion when a company is examining its overall profitability, pricing decisions are not limited to for-profit organizations. Not-for-profit organizations, such as charities, educational institutions and industry trade groups, also set prices. For instance, charities seeking to raise money may set different “target” levels for donations that reward donors with increases in status (e.g., name in newsletter), gifts, or other benefits. While a charitable organization may not call it a “price” in their promotional material, in reality these donations are equivalent to price since donors are required to give a contribution in order to obtain something of value.
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Price vs. Value
For most customers, price by itself is not the key factor when a purchase is being considered. This is because most customers compare the entire marketing offering and do not simply make their purchase decision based solely on a product’s price. Rather, price is one of several variables customers evaluate when they mentally assess a product’s overall value.
As we discussed back in the What is Marketing? Tutorial, value refers to the perception of benefits received for what someone must give up. Since price often reflects an important part of what someone gives up, a customer’s perceived value of a product will be affected by a marketer’s pricing decision. Any easy way to see this is through a value equation:
Value = perceived benefits received
perceived price paid
For the buyer, value of a product will change as perceived price paid and/or perceived benefits received change. However, the price paid in a transaction is not only financial, it can also involve other things that a buyer may be giving up. For example, in addition to paying money a customer may have to spend time learning to use a product, pay to have an old product removed, close down current operations while a product is installed, or incur other expenses.
However, for the purpose of this tutorial we will limit our discussion to how the marketer sets the financial price of a transaction.
Importance of Price
When marketers talk about what they do as part of their responsibilities for marketing products, the tasks associated with setting price are often not at the top of the list. Marketers are much more likely to discuss their activities related to promotion, product development, market research and other tasks that are viewed as the more interesting and exciting parts of the job. Yet pricing decisions can have important consequences for the marketing organization and the attention given by the marketer to pricing is just as important as the attention given to more recognizable marketing activities. Some reasons why attention to pricing is critical include:
Most Flexible Marketing Decision
For marketers, price is the most adjustable of all marketing decisions. Unlike product and distribution decisions, which can take months or years to change, or some forms of promotion which can be time-consuming to alter (e.g., television advertisement), price can be changed very rapidly. The flexibility of pricing decisions is particularly important in times when the marketer seeks a quick way to stimulate demand or to respond to competitor price actions. For instance, a marketer can agree to a field salesperson’s request to lower price for a potential buyer during a phone conversation. Likewise, a marketer in charge of online operations can raise prices on hot selling products with the click of a few on-screen buttons.
Need for Setting the Right Price
Pricing decisions made hastily without sufficient research, analysis, and strategic evaluation can lead the marketing organization to lose revenue. Prices set too low may mean the company is missing out on additional profits that could be earned if the target market is willing to spend more to acquire the product. Additionally, attempts to raise an initially low-priced product to a higher price may be met by customer resistance as they may feel the marketer is attempting to take advantage of its customers. Prices set too high can also impact revenue as it prevents interested customers from purchasing the product. Setting the right price level often takes considerable market knowledge and, especially with new products, testing of different pricing options.
Trigger of First Impressions
Often times, customers’ perception of a product is formed as soon as they learn the price, such as when a product is first seen in a store with the price tag attached. While the final decision to make a purchase may be based on the value offered by the entire marketing offering (i.e., actual and augmented product), it is possible the customer will not evaluate a marketer’s product at all based on price alone. It is necessary for marketers to know if customers are more likely to dismiss a product when all they know is its price. If so, pricing may become the most important of all marketing decisions if it can be shown that customers are avoiding learning more about the product because of the price.
Important Part of Sales Promotion
Many times price adjustments are part of sales promotions that lower price for a short term to stimulate interest in the product. However, as we noted in our discussion of promotional pricing in the Sales Promotion Tutorial, marketers must guard against the temptation to adjust prices too frequently. Continually increasing and decreasing price can lead customers to be conditioned to anticipate price reductions and, consequently, withhold purchase until the price reduction occurs again.
Affects Demand for Other Products
How a company prices one product can affect the overall demand for other products. This is especially the case where the demand for other products is directly tied to the demand for a main product. In particular, marketers making the bulk of their profits from the sale of goods and services used to support the main product must take this into consideration. For example, operators of gambling casinos often entice customers by offering very low hotel room rates knowing they can generate higher revenue in other ways when customers visit the casino (e.g., revenue from gaming, food, special shows, etc.). The hotel must be mindful of increasing hotel room rates as doing so could have an impact on revenue that comes from these other sources.
For the remainder of this tutorial, we look at factors affecting pricing decisions and how marketers set price. The final price for a product may be influenced by many factors which can be categorized into two main groups internal factors and external factors.
Internal Factors Affecting Pricing Decisions
When setting price, marketers must take into consideration several factors, which are the result of company decisions and actions. To a large extent, these factors are controllable by the marketer and, if necessary, can be altered. However, while the organization may have control over these factors, making a quick change is not always realistic. For instance, product pricing may depend heavily on the productivity of a manufacturing facility (e.g., how much can be produced within a certain period of time). The marketer knows that increasing productivity can reduce the cost of producing each product, which potentially allows the marketer to potentially lower the product’s price. But increasing productivity may require substantial changes at the manufacturing facility that take time (and are potentially costly) and will not translate into lower price products for a considerable period of time.
The internal factors affecting pricing decisions include:
1. Marketing Objectives
Marketing decisions are guided by the overall objectives of the company. While we will discuss this in more detail in the Marketing Planning and Strategy Tutorial, for now it is important to understand that all marketing decisions, including price, work to help achieve company objectives. Corporate objectives can be wide ranging and include different objectives for different functional areas (e.g., objectives for production, human resources, etc).
While pricing decisions are influenced by many types of objectives set up for the marketing functional area, there are four key objectives in which price plays a central role. In most situations, only one of these objectives will be followed, though the marketer may have different objectives for different products.
The four main marketing objectives affecting price include:
Return on Investment (ROI) – A firm may set as a marketing objective the requirement that all products attain a certain percentage return on the organization’s spending on marketing the product. This level of return, along with an estimate of sales, will help determine appropriate pricing levels needed to meet the ROI objective.
Cash Flow – Firms may seek to set prices at a level that will ensure that sales revenue will at least cover product production and marketing costs. This is most likely to occur with new products, where the organizational objectives allow a new product to simply meet its expenses while efforts are made to establish the product in the market. This objective allows the marketer to worry less about product profitability and instead directs energies to building a market for the product.
Market Share – The pricing decision may be important when the firm has an objective of gaining a hold in a new market or retaining a certain percent of an existing market. For new products under this objective, the price is set artificially low in order to capture a sizeable portion of the market and will be increased as the product becomes more accepted by the target market. For existing products, firms may use price decisions to ensure they retain market share in instances where there is a high level of market competition and competitors who are willing to compete on price.
Maximize Profits – Older products that appeal to a market that is no longer growing may have a company objective requiring the price be set at a level that optimizes profits. This is often the case when the marketer has little incentive to introduce improvements to the product (see Decline Stage of the Product Life Cycle) and will continue to sell the same product at a price premium for as long as some in the market is willing to buy.
2. Marketing Strategy
Marketing strategy concerns the decisions marketers make to help the company satisfy its target market and attain its business and marketing objectives. Price, of course, is one of the key marketing mix decisions and since all marketing mix decisions must work together, the final price will be impacted by how other marketing decisions are made. For instance, marketers selling high-quality products would be expected to price their products in a range that will add to the perception of the product being at a high level.
It should be noted, not all companies view price as a key selling feature and, consequently, it may not play a major role in helping the marketer meet its objectives. Some firms, for example those seeking to be viewed as market leaders in product quality, de-emphasize price and concentrate on a strategy highlighting non-price benefits (e.g., quality, durability, service, etc.). Such non-price competition can help the company avoid competing against new products that sell for a lower price. It can also protect against potential price wars that often break out between competitive firms that follow a market share objective and use price as a key selling feature.
For many for-profit organizations, the starting point for setting a product’s price is to determine first how much it will cost to get the product to their customers. Obviously, whatever price customers pay must exceed the cost of producing a good or delivering a service, otherwise the company will lose money. When analyzing cost, the marketer will consider all costs needed to get the product to market including those associated with production, marketing, distribution and company administration (e.g., office expense). These costs can be divided into two main categories:
Fixed Costs – Also referred to as overhead costs, these represent costs the marketing organization incurs that are not affected by level of production or sales. For example, for a manufacturer of writing instruments that has just built a new production facility, whether they produce one pen or one million they will still need to pay the monthly commercial mortgage for the building. From the marketing side, fixed costs may also exist in the form of expenditure for fielding a sales force, carrying out an advertising campaign, and paying a service to host the company’s website. These costs are fixed because there is a level of commitment to spending that is largely not affected by production or sales levels.
Variable Costs – These costs are directly associated with the production and sales of products, and may change as the level of production or sales changes. Typically, variable costs are evaluated on a per-unit basis since the cost is directly associated with individual items. Most variable costs involve costs of items that are either components of the product (e.g., parts, packaging) or are directly associated with creating the product (e.g., electricity to run an assembly line). However, there are also marketing variable costs, such as certain promotional expenses (e.g., cost of redeemed coupons) that could fluctuate based on sales volume. Variable costs, especially for tangible products, tend to decline as more units are produced. This is due to the producing company’s ability to purchase product components for lower prices since component suppliers often provide discounted pricing for large quantity purchases.
Determining individual unit cost can be a complicated process. While variable costs are often determined on a per-unit basis, applying fixed costs to individual products is less straightforward. For example, if a company manufactures five different products in one manufacturing plant how would it distribute the plant’s fixed costs (e.g., mortgage, production workers’ cost) over the five products? In general, an organization will assign fixed cost to individual products if it can clearly associate the cost with the product, such as assigning the cost of operating production machines based on how much time it takes to produce each item. Alternatively, if it is too difficult to associate to specific products the company may simply divide the total fixed cost by production of each item and assign it on percentage basis.
4. Ownership Options
An important decision faced by marketers as they are formulating their pricing strategy deals with who will have ownership of the product (i.e., holds legal title) once an exchange has taken place. There are two basic options available:
Buyer Owns Product Outright – The most common ownership option is for the buyer to make payment and then obtain full ownership. Under this condition, the price is generally reflective of the full value of the product.
Buyer Has Right to Use but Does Not Have Ownership – Many products, especially those labeled as services, permit customers to make payment in exchange for the right to use a product but not to own it. This is seen in the form of usage, rental, or lease payment for such goods and services as: mobile phone services, manufacturing equipment, and internet file storage sites. In most cases, the price paid by the customer is not reflective of the full value of the product compared to what the customer would have paid for ownership of the product. It should be noted, under some lease or rental plans there may be an option for customers to buy the product outright (e.g., car lease), often requiring a large final payment.
External Factors Affecting Pricing Decisions
There are a number of influencing factors, which are not controlled by the company but will impact pricing decisions. Understanding these factors requires the marketer conduct research to monitor what is happening in each market the organization serves since the effect of these factors can vary by market. The external factors affecting pricing decisions include:
1. Elasticity of Demand
Marketers should never rest on their marketing decisions. They must continually use market research and their own judgment to determine whether marketing decisions need to be adjusted. When it comes to adjusting price, the marketer must understand what effect a change in price is likely to have on target market demand for a product. Understanding how price changes impact the market requires the marketer have a firm understanding of the concept economists call elasticity of demand, which relates to how purchase quantity changes as prices change.
Elasticity is evaluated under the assumption that no other changes are being made (i.e., “all things being equal”) and only price is adjusted. The logic is to see how price by itself will affect overall demand. Obviously, the chance of nothing else changing in the market but the price of one product is often unrealistic. For example, competitors may react to the marketer’s price change by changing the price on their product. Despite this, elasticity analysis does serve as a useful tool for estimating market reaction.
Elasticity deals with three types of demand scenarios:
Elastic Demand – Products are considered to exist in a market that exhibits elastic demand when a certain percentage change in price results in a larger and opposite percentage change in market demand. For example, if the price of a product increases (decreases) by 10%, the demand for the product is likely to decline (rise) by greater than 10%.
Inelastic Demand – Products are considered to exist in a market that exhibits inelastic demand when a certain percentage change in price results in a smaller and opposite percentage change in market demand. For example, if the price of a product increases (decreases) by 10%, the demand for the product is likely to decline (rise) by less than 10%.
Unitary Demand – This demand occurs when a percentage change in price results in an equal and opposite percentage change in market demand. For example, if the price of a product increases (decreases) by 10%, the demand for the product is likely to decline (rise) by 10%.
For marketers, the pivotal issue with elasticity of demand is to understand how it impacts company revenue. In general, the following scenarios apply to making price changes for a given type of market demand, though it should be clear these effects will only apply to relatively small changes in price::
For Elastic Markets – Increasing price lowers total revenue, while decreasing price increases total revenue.
For Inelastic Markets – Increasing price raises total revenue, while decreasing price lowers total revenue.
For Unitary Markets – There is no change in revenue when price is changed.
2. Competitive and Other Products
Marketers will undoubtedly look to market competitors for indications of how price should be set. For many marketers of consumer products, researching competitive pricing is relatively easy, particularly with the help of internet search engines, searching retailers’ websites, and using price comparison apps. Price analysis can be somewhat more complicated for products sold in the business market. This is because final price may be affected by a number of factors including whether competitors allow customers to negotiate the final price.
Analysis of competition will include pricing by direct competitors, related products, and primary products.
Direct Competitor Pricing – Almost all marketing decisions, including pricing, will include an evaluation of competitors’ offerings. The impact of this information on the actual setting of price depends on the competitive nature of the market. For example, products that dominate markets and are viewed as market leaders may not be heavily influenced by competitor pricing, since they are in a commanding position to set prices as they see fit. On the other hand, in markets where a clear leader does not exist, the pricing of competitive products will be carefully considered. However, marketers must not only limit research to competitive prices. They must also pay close attention to how these companies will respond to the marketer’s pricing decisions. For instance, in highly competitive industries, such as gasoline or airline travel, competitors may respond quickly to competitors’ price adjustments, thereby reducing the effect of such changes.
Related Product Pricing – Products offering new ways for solving customer needs may look to pricing of products that customers are currently using even though these other products may not appear to be direct competitors. For example, a marketer of a new online golf instruction service that allows customers to access golf instruction via their computer may look at prices charged by local golf professionals for in-person instruction to gauge where to set their price. While, on the surface, online golf instruction may not be a direct competitor to a golf instructor, marketers for the online service can use the cost of in-person instruction as a reference point for setting price.
Primary Product Pricing – As we discussed in the Product Decisions Tutorial, marketers may sell products viewed as complementary to a primary product. For instance, Bluetooth headsets are considered complementary to the primary product cellphones. The pricing of complementary products may be affected by pricing changes made to the primary product since customers may compare the price for complementary products based on the primary product price. To illustrate, companies selling accessory products for the Apple iPad may do so at a cost that is only 10 percent of the purchase price of the iPad. However, if Apple decided to drop the price dramatically, for instance by 50 percent, the accessory at its present price would now be 20 percent of the of iPad price. This may be perceived by the market as a doubling of the accessory’s price. To maintain its perceived value, the accessory marketer may need to respond to the iPad price drop by also lowering the price of the accessory.
3. Customer Expectations
Possibly the most obvious external factor influencing price setting concerns what customers and channel partners expect from products they are considering for purchase. As we discussed, when it comes to making a purchase decision, customers assess the overall “value” of a product much more than they assess the price alone. When deciding on a price, marketers need to conduct customer research to determine what price points are acceptable. Pricing beyond these price points could discourage customers from purchasing.
Firms within the marketer’s channels of distribution also must be considered when determining price. Distribution partners expect to receive financial compensation for their efforts, which usually means they will receive a percentage of the final selling price. The percentage or margin between what they pay the marketer to acquire the product and the price they charge their customers must be sufficient for the distributor to cover their costs and earn a desired profit.
4. Currency Considerations
Marketers selling internationally must be acutely aware of how monetary exchange rates can affect the price of its products in foreign markets. Depending on fluctuations in currency rates, a product’s price in the importing country’s currency can be significantly different from what the marketer has planned, which can have notable marketing implications. For instance, a company seeking to be a low-price market leader may find this strategy works when selling in its home market but when selling in an importing country with a weak currency the product’s price may be at a mid-price level compared to competitive products. This could dramatically impact the perceived value of the product by customers in this market.
Alternatively, if the currency of the marketer’s country is weak compared to the currency in the buyer’s market, a product could sell at a price that is much lower than what the marketer expects. This could lead customers in the importing country to perceive the product to be of lower quality compared to similar products selling at higher prices.
Additionally, in some situations, currency issues may not even permit a buyer and a seller to negotiate an exchange. This is likely to occur when a country’s currency is not widely recognized or when a currency’s value is fluctuating rapidly. Under these conditions, a seller from one country may refuse to accept the currency offered by a buyer from another country. To overcome this, the two parties may agree to an exchange arrangement that does not involve currency. The primary method for carrying out this exchange is through the use of one or more bartering techniques, collectively called countertrade, where a seller ships product to a buyer and in exchange receives the buyer’s product.
As an example, a U.S. marketer of chemical products may negotiate a trade with an African mining company whose currency is not stable. The exchange may involve the U.S. company trading fertilizer in exchange for minerals mined by the African firm. While the value of countertrade occurring is not easily measured, it is believed to be quite significant and is an essential trading option used by many companies throughout the world.
5. Government Regulation
Marketers must be aware of regulations that impact how price is set in the markets in which their products are sold. These regulations are primarily government enacted meaning that there may be legal ramifications if the rules are not followed. Price regulations can come from any level of government and vary widely in their requirements. For instance, in some industries, government regulation may set price ceilings (how high price may be set) while in other industries there may be price floors (how low price may be set).
Additional areas of potential pricing regulation of concern to marketers include such issues as:
Deceptive Pricing – When the method of pricing misleads customers into believing the price is lower than what they actually pay.
Price Discrimination – When a seller deliberately charges some customers a different price than other customers without a valid reason for doing so.
Predatory Pricing – When a seller intentionally sets price low to drive competitors from the market.
Price Fixing – When two or more parties (e.g., competitors) agree on a price to charge within a market for similar products.
Finally, when selling beyond their home market, marketers must recognize that local regulations may make pricing decisions different for each market. This is particularly a concern when selling to international markets where failure to abide by regulations can lead to severe penalties. For example, countries may institute tariffs on products shipped into the country. Often these tariffs are intended to protect domestic industries by raising the final selling price of product for the importing company. Consequently, marketers must have a clear understanding of regulations in each market they serve.