Setting Price: Part 1

In the Pricing Decisions Tutorial we provided the foundation marketers use to make pricing decisions. We now turn our attention to the process by which marketers determine price with a two-part look at the process marketers follow when setting product prices.

The central point of theses tutorials is a five-step process for setting price. We want to emphasize that while the process serves as a useful guide for making price decisions, not all marketers follow this step-by-step approach. Additionally it is important to understand that finding the right price is often a trial-and-error exercise where continual testing is needed.

Like all other marketing decisions, market research is critical to determining the optimal selling price. Consequently, the process laid out here is intended to open the marketer’s eyes to the options to consider when setting price and is in no way presented as a guide for setting the “perfect” price.

In Part 1 we look at Steps 1 and 2 with our primary emphasis on the approaches to setting an initial price.
Image by Walmart Corporate

Steps in the Price Setting Process

We view price setting as a series of decisions the marketer makes in order to determine the price direct and indirect customers pay to acquire the product. Direct customers are those who purchase products directly from the marketer. For example, consider the direct pricing decisions that take place when a new novel is sold:

  • Publisher of the book must decide at what price they will charge their immediate customers in the channel of distribution such as online booksellers (e.g., Amazon.com).
  • Booksellers must decide at what price they will sell the book to their immediate customers which are typically final consumers (e.g., website shopper).

As we see with the bookseller example, many companies also sell indirectly to the final customer through a network of resellers such as retailers. For marketers selling through resellers the pricing decision is complicated by resellers’ need to earn a profit and the marketer’s need to have some control over the product’s price to the final customer. In these cases setting price involves more than only worrying about what the direct customer is willing pay since the marketer must also evaluate pricing to indirect customers (e.g., resellers’ customers). Clearly sales can be dramatically different than what the marketer forecasts if the selling price to the final customer differs significantly from what the marketer expects. For instance, if the marketing organization has forecasted to sell 1,000,000 novels if the price to the final customer is one price and resellers decide to raise the price 25% higher than that price the marketer’s sales may be much lower then forecasted.

With an understanding that marketers must consider many factors (see the Pricing Decisions Tutorial) when setting price, we now turn to the process by which price is set. We present this as a five-step approach. As we noted earlier, while not all marketers follow these steps, what is presented does cover the methods used by many marketers.

The steps we cover include:
1. Examine Company and Marketing Objectives
2. Determine an Initial Price
3. Set Standard Price Adjustments
4. Determine Promotional Pricing
5. State Payment Options

Step 1: Examine Objectives

As we discussed in the Pricing Decisions Tutorial, marketing decisions including price are driven by the objectives set by the management of the organization. These objectives come at two levels. First, the overall objectives of the company guide all decisions for all functional areas (e.g., marketing, production, human resources, finance, etc.). Guided by these objectives the marketing department will set its own objectives which may include return on investment, cash flow, market share and maximize profits to name a few.

Pricing decisions like all other marketing decisions will be used to help the department meet its objectives. For instance, if the marketing objective is to build market share it is likely the marketer will set the product price at a level that is at or below the price of similar products offered by competitors.

Also, the price setting process looks to whether the decisions made are in line with the decisions made for the other marketing decisions (i.e., target market, product, distribution, promotion). Thus, if a company with a strong brand name targets high-end consumers with a high quality, full-featured product, the pricing decision would follow the marketer’s desire to have the product be considered a high-end product. In this case the price would be set high relative to competitors’ products that do not offer as many features or do not have an equally strong brand name.

Step 2: Determine an Initial Price

With the objectives in Step 1 providing guidance for setting price, the marketer next begins the task of determining an initial price level. We say initial because in many industries this step involves setting a starting point from which further changes may be made before the customer pays the final price.

Sometimes called list price or published price, marketers will often use this as a promotional or negotiating tool as they move through the other price setting steps. For companies selling to consumers, this price also leads to a projection of the recommended selling price at the retail level often called the manufacturer’s suggested retail price (MSRP). The MSRP may or may not be the final price for which products are sold. For strong brands that are highly sought by consumers the MSRP may in fact be the price at which the product will be sold. But in many other cases, as we will see, the price setting process results in the price being different based on adjustments made by the marketer and others in the channel of distributions.

Speaking of distribution channels, as we discussed in the Distribution Decisions Tutorial, some marketers will utilize multiple channel partners to handle product distribution. When resellers are involved marketers must recognize that all members of the channel will seek to profit when a sale is made. If a marketer seeks to sell the product at a certain retail price (e.g., MSRP) then the price charged to the first channel member to handle the product can potentially influence the final selling price. To see how this can cause problems, assume a marketer sets an MSRP of (US) $1.99 for a product that sells through a distribution channel. This channel consists of wholesalers, who must pay the marketer $1.89 to purchase the product, and retailers who in turn buy the product from wholesalers. In this example it is unlikely the retailer will sell the product at the MSRP since the wholesaler will add to the $1.89 purchase price and most likely raise the price charged to the retailer to a point that is higher than the MSRP. The retailer in turn will add to their purchase price when selling to consumers. In this scenario it is possible the final price to the consumer will be closer to $2.99 than the $1.99 MSRP. As this example shows marketers must take care in setting the initial price so that all channel partners feel it is worth their effort to handle the product.

Marketers have at their disposal several approaches for setting the initial price which include:

  • Cost Pricing
  • Market Pricing
  • Competitive Pricing
  • Bid Pricing

Setting Price Using Cost Pricing

Under cost pricing the marketer primarily looks at production costs as the key factor in determining the initial price. This method offers the advantage of being easy to implement as long as costs are known. But one major disadvantage is that it does not take into consideration the target market’s demand for the product. This could present major problems if the product is operating in a highly competitive market where competitors frequently alter their prices.

There are several types of cost pricing including:

  • Markup Pricing
  • Cost-Plus Pricing
  • Breakeven Pricing

Cost Pricing: Markup Method

This pricing method, often utilized by resellers who acquire products from suppliers, uses a percentage increase on top of product cost to arrive at an initial price. A major general retailer, such as Walmart, may apply a set percentage for each product category (e.g., women’s clothing, automotive, garden supplies, etc.) making the pricing consistent for all like-products. Alternatively, the predetermined percentage may be a number that is identified with the marketing objectives (e.g., required 20% ROI).

For resellers that purchase thousands of products (e.g., retailers) the simplicity inherent in markup pricing makes it a more attractive pricing option than more time-consuming methods. However, the advantage of ease of use is sometimes offset by the disadvantage that products may not always be optimally priced resulting in products that are priced too high or too low given the demand for the product.

Resellers differ in how they use markup pricing with some using the Markup-on-Cost method and others using the Markup-on-Selling-Price method. In the next two sections we cover each option. We will demonstrate each using an item that costs a reseller (US) $50 to purchase from a supplier and sells to customers for (US) $65.

Markup-on-Cost Pricing Method

Using this method, markup is reflected as a percentage by which initial price is set above product cost as reflected in this formula:

Markup Amount  =  Markup Percentage
    Item Cost

$15     =  30%
$50

The calculation for setting initial price is determined by simply multiplying the cost of each item by a predetermined percentage then adding the result to the cost:

Item Cost + (Item Cost x Markup Percentage) = Price

50 + (50 x .30 = $15)   =   $65

Markup-on-Selling-Price Pricing Method

Many resellers, and in particular retailers, discuss their markup not in terms of Markup-on-Cost but as a reflection of price. That is, the markup is viewed as a percentage of the selling price and not as a percentage of cost as it is with the Markup-on-Cost method. For example, using the same information as was used in the Markup-on-Cost, the Markup-on-Selling-Price is reflected in this formula:

Markup Amount = Markup Percentage
Selling Price

$15 = 23%
$65

 

The calculation for setting initial price using Markup-on-Selling-Price is:

                 Item Cost                   =    Price
(1.00 – Markup Percentage)

        $50           =    $65
(1.00 – .23)

Comparison of Markup Methods

So why do some use Markup-on-Cost while others use Markup-on-Selling-Price? One answer is that it is a traditional way for resellers in certain industries to discuss how they arrive at price (e.g., “We only make 5% of the price of the product.”). But many feel the reason is that Markup-on-Selling-Price serves as an aid to company promotion because the amount of money a reseller makes is in percentage terms always lower when calculated using Markup-on-Selling-Price than it is with Markup-on-Cost. For example, in the Markup-on-Cost example where the markup is 30% the gross profit is $15 ($65-$50). If the reseller using Markup-on-Selling-Price received a gross profit of $15 their markup would only be 23% ($50/[1.00-.23] = $65).

Consequently, a retailer’s advertisement may say: “We Make Little, But Our Customers Save A Lot” and back this up by saying they only make a small percentage on each sale. When in reality how much they really make in monetary terms may be equal to another retailer who uses Markup-on-Cost and reports a higher markup percentage.

Cost Pricing: Cost-Plus Method

In the same way markup pricing arrives at price by adding a certain percentage to the product’s cost, cost-plus pricing also adds to the cost by using a fixed monetary amount rather than percentage. For instance, a contractor hired to renovate a homeowner’s bathroom will estimate the cost of doing the job by adding their total labor cost to the cost of the materials used in the renovation. The homeowner’s selection of ceramic tile to be used in the bathroom is likely to have little effect on the labor needed to install it whether it is a low-end, low priced tile or a high-end, premium priced tile. Assuming most material in the bathroom project are standard sizes and configuration, any change in the total price for the renovation is a result of changes in material costs while labor costs are constant.