Setting Price: Part 2 Tutorial
In the Setting Price: Part 1 Tutorial we saw how marketers begin the process for setting an initial price for their product. However, for most marketers additional pricing decisions are still needed. In Part 2 of our Setting Price tutorial we continue our discussion of the five-step price setting process by looking at steps 3 through 5. Our coverage will include different price adjustments marketers make before settling on a final selling price. It will also examine different payment options and other issues that may affect pricing.
As noted in Part 1, not all marketers will follow this step-by-step approach. In fact, as we will see many marketers may choose to bypass steps 3 and 4 altogether. However, the majority of marketers will indeed go through all steps, thus marketers should have a good understanding of the options available.
Step 3: Set Standard Price Adjustments
With the first round of pricing decisions now complete, the marketer’s next step is to consider whether there are benefits to making adjustments to the list or published price. For our purposes, we will consider two levels of price adjustments – standard and promotional. The first level adjustments are those we label as “standard” since these are consistently part of the marketer’s pricing program and not adjustments that appear only occasionally as part of special promotions (see Step 4: Determine Promotional Pricing).
In most situations, standard adjustments are made to reduce the list price in an effort to: 1) stimulate interest in the product, or 2) indirectly pay channel partners for the services they offer when handling the product. In some circumstances, the adjustment goes the other way and leads to price increases in order to cover additional costs incurred when selling to different markets (e.g., higher shipping costs).
It should be noted, that given certain circumstances, organizations may not make adjustments to their list price. For instance, if the product is in high demand, the marketer may see little reason to lower the price. Also, if the marketer believes the product holds sufficient value for customers at its current list price then they may feel reducing the price will lead buyers to question the quality of the product (e.g., “How can they offer all those features for such a low price? Something must be wrong with it.“). In such cases, holding fast to the list price allows the marketer to maintain some control over the product’s perceived image.
For firms that do make standard price adjustments, options include:
1. Quantity Discounts
This adjustment offers buyers an incentive of lower per-unit pricing as more products are purchased. Most quantity or volume discounts are triggered when a buyer reaches certain purchase levels. For instance, a buyer may pay the list price when they purchase between 1-99 units but receive a 5 percent discount off the list price when the purchase exceeds 99 units.
Options for offering price adjustments based on quantity ordered include:
Discounts at Time of Purchase – The most common quantity discounts exist when a buyer places an order that exceeds a certain minimum level. While quantity discounts are used by marketers to stimulate higher purchase levels, the rational for using these often rests in the cost of product shipment. Shipping costs tend to decrease per item shipped. Why? Think about a large truck carrying product. In most cases, the expenses (e.g., truck driver expense, fuel, road tolls, etc.) required to move a truck from one point to another does not radically change as more product is shipped in the truck trailer (i.e., container). In other words, the total shipping cost is only a little higher if 1,000 items are carried in the truck (assuming all can fit in a trailer) compared to hauling just 10 items. Consequently, the transportation cost per item drops as more are ordered, thus allowing the supplier to offer lower prices for higher quantity.
Discounts on Cumulative Purchases – Under this method, the buyer receives a discount as more products are purchased over time. For instance, if a buyer regularly purchases from a supplier they may see a discount once the buyer has reached predetermined monetary or quantity levels (e.g., once 1,000 units are purchased the price drops on the next purchase). The key reason to use this adjustment is to create an incentive for buyers to remain loyal and purchase again.
2. Trade Allowances
Manufacturers, who rely on channel partners to distribute their products (e.g., retailers, wholesalers), often offer discounts off of list price called trade allowances. These discounts function as an indirect form of payment for a channel member’s work in helping to market the product (e.g., keep product stocked, talk to customers about the product, provide feedback to the manufacturer, etc.).
Essentially the difference between the trade discounted price paid by the reseller and the price the reseller charges its customer will be the reseller’s profit. For example, let’s assume the maker of snack food sells a product to retailers that carries a stated MSRP of (US) $2.95 but offers resellers a trade allowance price of $1.95. If the retailer indeed sells the product for the MSRP, the retailer will realize a 33% markup-on-selling-price ($1.95/(1-.33) = $2.95). Obviously, this percentage will be different if the retailer sells the product at a price that does not match the MSRP. However, the crucial point to understand is that marketers must factor in what resellers expect to earn when they are setting trade allowances. This amount needs to be sufficient to entice the reseller to handle and possibly promote the product.
3. Special Segment Pricing
In some industries, special classes of customers within a target market are offered pricing that differs from the rest of the market. The main reasons for doing this include: building future demand by appealing to new or younger customers, improving the brand’s image as being sensitive to customer’s needs, and rewarding long-time customers with price breaks.
For instance, many companies, including movie theaters, fitness facilities and pharmaceutical firms offer lower prices to senior citizens. Some marketers offer not-for-profit customers lower prices compared to that charged to for-profit firms. Other industries may offer lower prices to students or children.
Another example used by service firms is to offer pricing differences based on convenience and comfort enjoyed by customers when experiencing the service, such as higher prices for improved seat locations at a sporting or entertainment event.
4. Geographic Pricing
The sale of some products may require marketers pay higher costs due to the geographic area in which a product is sold. This may lead the marketer to adjust the price to compensate for the higher expense. The most likely cause for charging a different price rests with the cost of transporting a product from the supplier’s distribution location to the buyer’s location. If the supplier is incurring all costs for shipping, then they may charge a higher price for products in order to cover the extra transportation expense.
For instance, for a manufacturer located in Los Angeles, the transportation cost for shipping products by air to Hawaii is likely much more than it would be to ship the same amount of product by truck to San Diego. In this situation, since the manufacturer is incurring the shipping cost, they may set a different product price for Hawaiian purchasers compared to buyers in San Diego.
Transportation expense is not the only geographic-related cost that may raise a product’s price. As discussed in the Pricing Decisions Tutorial, special taxes or tariffs may be imposed on certain products by local, regional or international governments, which a seller may pass along in the form of higher prices.
5. Early Payment Incentives
For many years, marketers operating primarily in the business market offered incentives to encourage their customers to pay early. Typically, business customers are given a certain period of time, normally 30 or 60 days, before payment is due. To persuade faster payment that enables the seller to obtain the money quicker, marketers have offered early payment discounts often referred to as cash terms. This discount is expressed in a form that indicates how much discount is being offered and in what time frame. For example, the cash terms 2/10 net 30 indicates that if the buyer makes payment within 10 days of the date of the bill then they can take a 2 percent discount off some or all of the items on the invoice, otherwise the full amount is due in 30 days.
While this incentive remains widely used, its effectiveness in getting customers to pay early has greatly diminished. Instead, many customers, especially large volume buyers, simply remove the discount from the bill’s total and then pay within the required “net” time frame (or later!). For this reason many companies are discontinuing offering this discount.
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Step 4: Determine Promotional Pricing
The final price may be further adjusted through promotional pricing. Unlike standard adjustments, which are often permanently part of a marketer’s pricing strategy and may include either a decrease or increase in price, promotional pricing is a temporary adjustment that only involves price reductions. In most cases, this means the marketer is selling the product at levels that significantly reduce the profit they make per unit sold.
As one would expect, the main objective of promotional pricing is to stimulate product demand. But as we noted back in the Types of Sales Promotion Tutorial, marketers should be careful not to overuse promotional programs that temporarily reduce selling price. If promotional pricing is used too frequently, customers may become conditioned to anticipate the reduction. This results in buyers withholding purchases until the product is again offered at a lower price. Since promotional pricing often means the marketing organization is making very little profit off of each item sold, consistently selling at a low price could jeopardize the marketer’s ability to meet their financial objectives.
The options for promotional pricing include:
1. Markdowns
The most common method for stimulating customer interest using price is the promotional markdown method, which offers the product at a price that is lower than the product’s normal selling price. There are several types of markdowns including:
Temporary Markdown – Possibly the most familiar pricing method marketers use to generate sales is to offer a temporary markdown or “on-sale” pricing. These markdowns are normally for a specified period of time, the conclusion of which will result in the product being raised back to the normal selling price.
Permanent Markdown – Unlike the temporary markdown, where the price will eventually be raised back to a higher price, the permanent markdown is intended to move the product out of inventory. This type of markdown is used to remove old products that are: perishable and close to being out of date (e.g., donuts); older models that must be sold to make room for new models; or products that the marketer no longer wishes to sell.
Seasonal Markdown – Products that are primarily sold during a particular time of the year, such as clothing, gardening products, sporting goods and holiday-specific items, may see price reductions at the conclusion of its prime selling season.
2. Loss Leader
An important type of pricing program used primarily by retailers is the loss leader. Under this method, a product is intentionally sold at or below the cost the retailer pays to acquire the product from suppliers. The idea is that offering such a low price will entice a high level of customer traffic to visit a retailer’s store or e-commerce website. The expectation is that customers will easily make up for the profit lost on the loss leader item by purchasing other items that are not following loss leader pricing. For instance, many convenience stores, that also provide gasoline, may use gas pricing as a loss leader. Their hope is that the low price, which is often displayed on large roadside signage, will generate traffic to the inside of their store, where customers will purchase regularly priced products, such as food and drinks.
Marketers should be aware that some governmental agencies view loss leaders as a form of predatory pricing and, therefore, consider it illegal. Predatory pricing occurs when an organization is deliberately selling products at or below cost with the intention of driving competitors out of business. Of course, this differs from our discussion, in which loss leader pricing is considered a form of promotion and not a form of anti-competitive activity.
In the U.S., several state governments have passed laws under the heading Unfair Sales Act (sometimes referred to as the Minimum Markup Law), which prohibit the selling of certain products below cost. The main intention of these laws is to protect small firms from below-cost pricing activities of larger companies. States that enforce such laws primarily do so for specific product categories, such as gasoline and tobacco.
3. Sales Promotion
As we noted in the Sales Promotion Tutorial, marketers may offer several types of pricing promotions to simulate demand. As we noted in Chapter 14, marketers may offer several types of pricing promotions to simulate demand. While we have already discussed “on-sale” pricing as a technique to build customer interest, there are other sales promotions that are designed to lower price. These include rebates, coupons, trade-in, and loyalty programs. To manage these promotions, marketers often utilize campaign management software that incorporates customer identification and tracking to determine the best opportunities for offering special promotions.
For online retailers, identifying and tracking customers may be relatively easy if customers have previously purchased and their login information is retained by their web browser or on the retailer’s mobile app. In situations where customers are not easily identified, a retailer may place a small data file, called a cookie, or other device identifiers on a visitor’s computer or mobile device. These identifiers enable retailers to monitor users’ behavior, such as how often they visit, how much time they spend on the site, what information they access, and much more. For example, the marketer may offer a special promotion if a visitor has come to the site at least five times in the last six months but has never made a purchase.
At brick-and-mortar retail stores, campaign management software is also used to offer customers price reductions or other incentives. For example, a sales promotion may be triggered when customers use a store loyalty card. If a customer’s characteristics match requirements in the software program, they may be offered a special incentive, such as 10 percent off if they also purchase another product.
4. Bundle Pricing
Another pricing adjustment designed to increase sales is to offer discounted pricing when customers purchase several different products at the same time. Termed bundle pricing, the technique is often used to sell products that are complementary to a main product. For buyers, the overall cost of the purchase shows a savings compared to purchasing each product individually. For example, a camera retailer may offer a discounted price when customers purchase both a digital camera and a high-end camera case that is lower than if both items were purchased separately. In this example, the retailer may promote this as, “Buy both the digital camera and the durable camera case and save 25%.“
Bundle pricing is also used by marketers as a technique that avoids making price adjustments on a main product for fear that doing so could affect the product’s perceived quality level (see Step 3: Set Standard Price Adjustments). Rather, the marketer may choose to offer adjustments on other related or complementary products. In our example, the message changes to, “Buy the digital camera and you can get durable camera case for 50% less.” With this approach, the marketer is presenting a price adjustment without the perception of it lowering the price of the main product.
5. Dynamic Pricing
The concept of dynamic pricing has received a great deal of attention in recent years due to its prevalent use by airlines, hotels, and ridesharing services. But the basic idea of dynamic pricing has been around since the dawn of commerce. Essentially, dynamic pricing allows for point-of-sale (i.e., at the time and place of purchase) price adjustments to take place for customers meeting certain criteria established by the seller. The most common and oldest form of dynamic pricing is haggling, the give-and-take that takes place between buyer and seller as they settle on a price. While the word haggling may conjure up visions of transactions taking place among vendors and customers in a street market, the concept is widely used in business-to-business markets as well, where it carries the more reserved label of negotiated pricing.
However, technological advances offer a new dimension for the use of dynamic pricing. Unlike haggling, where the seller makes price adjustments based on a person-to-person discussion with a buyer, dynamic pricing uses sophisticated price optimization software to adjust price. It achieves this by combining customer data (e.g., who they are, how they buy, when they buy) with pre-programmed price offerings. If a customer meets certain criteria then special pricing may be offered.
As noted, dynamic pricing is also widely used in the service sector. For instance, airline ticket pricing will vary based on such criteria as type of customer (e.g., business vs. leisure traveler) and date of purchase. Additionally, in some industries, dynamic pricing is used to respond to changes in demand. Known as surge pricing, pricing software may increase prices from a regular level to a higher level as demand increases. For example, surge pricing is used by ridesharing services (e.g, Uber, Lyft) to adjust prices higher during times of peak demand.
Step 5: Payment Options and Timing of Payment
With the price decided, the final step for the marketer is to determine in what form and in what time frame customers will make payment. As one would expect payment is most often in a monetary form though in certain situations the payment may be part of a barter arrangement in which products or services are exchanged.
Form of Payment
The monetary payment decision can be a complex one. One issue marketers face is deciding in what form payments will be accepted. These options include cash, check, money orders, credit card, online payment systems (e.g., PayPal), contactless payments (e.g., QR codes), and digital currency (e.g., Bitcoin). For international purchases, currency issues and other uncertainties may require the use of alternative payment options including bank drafts, letters of credit, and international reply coupons, to name a few.
Handling of Payment
Marketers must also decide how the actual payment will be handled. While some forms of payment are obvious for certain transactions (e.g., retail stores accept payments by cash, credit card, debit card), others may limit payment options (e.g., cash payment not accepted for orders placed over the phone). Additionally, in business-to-business transactions, payment may take place in the form of bank transfers. In the retail environment, one of the fastest growing methods for making payment is through mobile devices. Mobile payments using mobile devices (e.g., phones, watches) allow customers making purchases by simply holding their device near an electronic reader on a payment terminal.
Time Frame of Payment
One final pricing decision considers when payment will be made. Many marketers find promotional value in offering options to customers for the date when payment is due. Such options include:
Immediate Payment in Full – Requires the customer make full payment at the time the product is acquired.
Immediate Partial Payment – Requires the customer make a certain amount or percentage of payment at the time the product is acquired. This may be in the form of a down payment. Subsequent payments occur either in one lump sum or at agreed intervals (e.g., once per month) through an installment plan.
Future Payment – Provides the buyer with the opportunity to acquire use of the product with payment occurring some time in the future. Future payment may require either payment in full or partial payment.
Other Issues When Setting Price
Two pricing approaches that do not fit neatly into the price setting process we’ve described are auction and bid pricing. Both follow a model in which one or more participants in a purchasing transaction make offers to another party. The difference exists in terms of which party to a transaction is making the offer.
Auction Pricing
Auction pricing is a pricing method where the buyer, in large part, sets the final price. This pricing method has been around for hundreds of years, but today it is most well-known for its use in the auction marketplace business models, such as eBay and business-to-business marketplaces. While marketers selling through auctions do not have control over the final price, it is possible to control the minimum price by establishing a price floor or reserve price. In this way, the product is only sold if a bid is at least equal to the floor price.
Bid Pricing
Bid pricing typically requires a marketer compete against other suppliers by submitting its selling price to a potential buyer who chooses from the submissions. From the buyer’s perspective, the advantage of this method is that suppliers are more likely to compete by offering lower prices than would be available if the purchase was made directly without competitive offers. Bid pricing occurs in several industries, though it is a standard requirement when selling to local, state, national, and many international governments.
In a traditional bidding process, the offer is sealed or unseen by competitors until the end of the process when bids are unsealed. The fact that marketers often operate in the dark in terms of available competitor research makes this type of pricing one of the most challenging of all price setting methods. However, many purchase situations are now adopting an auction method, called reverse auction, to make the bidding process more transparent. Reverse auctions are typically conducted on the internet and, in most cases, limited to business-to-business purchasing. With a reverse auction, a buyer informs suppliers of its product needs and then identifies a time when suppliers may bid against each other. Usually the time is limited and suppliers can often see what others are offering.