Setting Price: Part 1 Tutorial
In the Pricing Decisions Tutorial, we provided the foundation marketers use to make pricing decisions. We now turn our attention to the methods marketers use to determine the price they will charge for their products. 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. We will continue our price discussion in the Setting Price: Part 2 Tutorial with steps 3, 4 and 5 that focus on adjustments to the initial price and payment options.
It is also important to understand that, just like many other marketing areas, technology serves a key role in pricing. For example, companies in such industries as retailing, travel, and insurance have turned to computerized methods for helping set the right price. In particular, marketers are using price optimization software, that is built using advanced mathematical modeling. These software programs take into consideration many of the internal and external pricing factors discussed in the Pricing Decision Tutorial along with other variables, such as sales history, in order to arrive at an ideal price. Marketers should know that much of what is discussed in Part 1 and Part 2 are also essential elements of these price setting programs.
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 high-end fashion company launches a new product line:
- The fashion company must decide at what price they will charge their immediate customers in the channel of distribution, such as a boutique clothing stores.
- The boutique clothing stores must decide at what price they will sell the the fashion line to their immediate customers, which are typically final consumers (e.g., retail shoppers).
As we see with the fashion company example, many organizations 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 just worrying about what the direct customer is willing pay. The marketer must also evaluate pricing their direct customers will change to indirect customers (e.g., retail shoppers). 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 forecast to sell 100,000 units if the price to the final customer is one price and resellers decide to raise the price 25% higher then the expected price, then the marketer’s sales may be much lower than forecast.
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 in this tutorial and in the next tutorial include:
1. Examine Objectives (covered in Part 1)
2. Determine an Initial Price (covered in Part 1)
3. Set Standard Price Adjustments (covered in Part 2)
4. Determine Promotional Pricing (covered in Part 2)
5. State Payment Options (covered in Part 2)
Books from KnowThis.com
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 overall company objectives, the marketing department will set its own objectives. Marketing department objectives may include financial objectives, such as return on investment (ROI), cash flow, and maximize profits, or non-financial marketing objectives, such as a percentage of market share, level of product awareness, and increase in store traffic, 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.
Additionally, the price setting process looks to whether the decisions made are in line with the decisions made for the other marketing areas (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, pricing decisions are potentially impacted by the existence of channel partners that 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:
Setting Price Using Cost Pricing
Under cost pricing, the marketer primarily looks at product costs (e.g., variable and fixed) 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 significant disadvantage is that it does not take into consideration the target market’s demand for the product. This could present considerable problems if the product is operating in a highly competitive market where competitors frequently alter their prices. There are several methods of cost pricing including:
1. 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:
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:
2. 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:
The calculation for setting initial price using Markup-on-Selling-Price is:
Comparison of Markup Methods – So why do some resellers use Markup-on-Cost while others use Markup-on-Selling-Price? The answer to this lies more with promotion than with pricing. In particular, Markup-on-Selling-Price is believed to aid promotion, especially for resellers who market themselves as low-price leaders. This is because the amount of money a reseller makes in percentage terms is 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 its markup would only be 23 percent ($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 make in monetary terms may be equal to another retailer who uses Markup-on-Cost and reports a higher markup percentage.
3. Cost-Plus Pricing Method
In the same way markup pricing arrives at the 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 his/her 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 materials 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 likely to remain constant.
4. Break-Even Pricing Method
Break-even pricing is associated with break-even analysis, which is a forecasting tool used by marketers to determine how many products must be sold before the company starts realizing a profit. Like the markup method, break-even pricing does not directly consider market demand when determining price. However, it does indicate the minimum level of demand that is needed before a product will show a profit. From this, the marketer can then assess whether the product can realistically achieve these levels.
The formula for determining break-even takes into consideration both variable and fixed costs (discussed in the Pricing Decisions Tutorial) as well as price, and is calculated as follows:
For example, assume a company operates a single-product manufacturing plant that has a total fixed cost (e.g., purchase of equipment, commercial mortgage, etc.) per year of (US) $3 million and the variable cost (e.g., raw materials, labor, electricity, etc.) is $45.00 per unit. If the product is sold directly to customers for $120, it will require the company to sell 40,000 units to reach the break-even point.
Again, it must be emphasize that marketers must determine whether the demand (i.e., number of units needed the break-even point) is realistically attainable. Simply plugging in a number for price without knowing how the market will respond to to this price is not an effect way to approach this method of price setting.
(Note: A common mistake when performing this analysis is to report the break-even in a monetary value such a breakeven in dollars (e.g., results report $40,000 instead of 40,000 units). The calculation presented above is a measure of units that need to be sold. Clearly, it is easy to turn this into a revenue break-even analysis by multiplying the units needed by the selling price. In our example, 40,000 units x $120 = $4,800,000.)
Setting Price Using Market Pricing
Under the market pricing method, cost is not the main factor driving price decisions. Rather, initial price is based on analysis of market research in which customer expectations are measured. The main goal is to learn what customers in an organization’s target market are likely to perceive as an acceptable price. Of course, this price should also help the organization meet its marketing objectives.
Market pricing is one of the most common methods for setting price, and the one that seems most logical given marketing’s focus on satisfying customers. So if this is the most logical approach why don’t all companies follow it? The main reason is that using the market pricing approach requires a strong market research effort to measure customer reaction. For many marketers, it is not feasible to spend the time and money it takes to do this right. Additionally, for some products, especially new high-tech products, customers are not always knowledgeable about the product to know what an acceptable price level should be. Consequently, some marketers may forego market pricing in favor of other approaches.
For those marketers who use market pricing methods include:
1. Backward Pricing Method
In some marketing organizations, the price the market is willing to pay for a product is an important determinant of many other marketing decisions. This is likely to occur when the market has a clear perception of what it believes is an acceptable level of pricing. For example, customers may question a product that carries a price tag that is double that of a competitor’s offerings but is perceived to offer only minor improvements compared to other products.
In these markets, it is important to undertake research to learn whether customers have mentally established a price points for products in a certain product category. The marketer can learn this by surveying customers with such questions as, “How much do you think these types of products should cost you?“
In situations where a price range is ingrained in the market, the marketer may need to use this price as the starting point for many decisions and work backwards to develop product, promotion, and distribution plans. For instance, assume a company sells products through retailers. If the market is willing to pay (US)$199 for a product but is resistant to pricing that is higher, the marketer will work backwards factoring out the profit margin retailers are likely to want (e.g., $40) as well as removing the marketer’s profit (e.g., $70). From this, the product cost will remain ($199 -$40-$70= $89). The marketer must then decide whether they can create a product with sufficient features and benefits to satisfy customers’ needs at this cost level.
2. Psychological Pricing Method
For many years, researchers have investigated customers’ response to product pricing. Some of the results point to several interesting psychological effects price may have on customers’ buying behavior and on their perception of individual products. We stress that certain pricing tactics “may” have a psychological effects since the results of some studies have suggested otherwise. But enough studies have shown an effect that this topic is worthy of discussion.
Methods of psychological pricing include:
Odd-Even Pricing – One effect, dubbed “odd-even” pricing, relates to how customers may perceive a significant difference in product price when pricing is slightly below a whole number value. For example, a product priced at (US) $299.95 may be perceived as offering more value than a product priced at $300.00. This effect can also be used to influence potential customers as those who have bought may mention the price to others as being lower than it actually is. This may be due to the buyer mistakenly recalling the price being “well below” the even number or the buyer wants to impress others with their success in obtaining a good value. For instance, in our example a buyer who pays $299.95 may tell a friend they paid “a little more than $200” for the product when, in fact, it was much closer to $300.
Prestige Pricing – Another psychological effect, called prestige pricing, points to a strong correlation between perceived product quality and price. The higher the price, the more likely customers are to perceive it as higher quality compared to a lower priced product. (Although, there is a point at which customers will begin to question the value of the product if the price is too high.) In fact, the less a customer knows about a product the more likely she/he is to judge the product as being higher quality based on only knowing the price (see Trigger of Early Perception). Prestige pricing can also work with odd-even pricing as marketers, looking to present an image of high quality, may choose to price products at even levels (e.g., $10 rather than $9.99).
Reference Pricing – As we discussed in the Consumer Buying Behavior Tutorial, the process involved in making purchase decisions can be quite complex. But for most customers, the purchase decision will involve a comparison of one product to another with price being a critical evaluative criterion. Because of this, marketers, who believe they have a price advantage, will create an arrangement where customers can easily compare one product to another. As an example, a retail grocery store may price its store brand coffee slightly below a leading premium brand and then place the store brand right beside the premium brand. With effective packaging and labeling, shoppers may feel the store brand is of similar quality but sells for less. In this way, the store hopes customers use the premium brand as a reference point, which will then present the store’s brand as being more attractive in terms of price.
3. Price Lining Pricing Method
As we have discussed many times throughout the Principles of Marketing Tutorials, marketers must appeal to the needs of a wide variety of customers. The difference in the “needs-set” between customers often leads marketers to realization that the overall market is really made up of a collection of smaller market segments (see Targeting Markets Tutorial). These segments may seek similar products but with different product features, such as different models whose product components (e.g., different quality of basketball sneakers) or service options (e.g., different hotel room options) will vary between markets.
Price lining or product line pricing is a method that primarily uses price to create a separation between the different models. With this approach, even if customers possess little knowledge about a set of products, they may perceive they are different based on price alone. The key is whether the prices for all products in the group are perceived as representing distinct price points (i.e., enough separation between each). For instance, a marketer may sell a base model, an upgraded model, and a deluxe model each at a different price. If the differences in features for each model is not readily apparent to a customer, such as differences that are inside the product and not easily viewed (e.g., difference between digital cameras), then price lining will help the customer recognize that differences do exist as long as the prices are noticeably different.
Price lining can also be effective as a method for increasing profitability. In many cases, the cost to the marketer for adding different features to create different models or service options does not alone justify a significant price difference. For example, an upgraded model may cost 10 percent more to produce than a base model but using the price lining method the upgraded product price may be 20 percent higher, thereby making it more profitable than the base model. The increase in profitability offered by price lining is one reason marketers introduce multiple models. Offering more than one model allows the company to satisfy the needs of different segments. It also presents an option for a customer to “buy up” to a higher priced and more profitable model.
Setting Price Using Competitive Pricing
As we noted in the Pricing Decisions Tutorial, how competitors price their products can influence the marketer’s pricing decision. Clearly when setting price it makes sense to look at the price of competitive offerings. For some, competitor’s price serves as an important reference point from which they set their price.
In some industries, particularly those in which there are a few dominant competitors and many small companies, the top companies are in the position of holding price leadership roles where they are often the first in the industry to change price. Smaller companies must then assume a price follower role and react once the big companies adjust their price.
When basing pricing decisions on how competitors are setting their price, organizations may follow one of the following approaches:
Below Competition Pricing – A marketer attempting to reach objectives that require high sales levels (see Marketing Planning and Strategy Tutorial) may monitor the market to ensure their price remains below competitors.
Above Competition Pricing – Marketers using this approach are likely to be perceived as market leaders in terms of product features, brand image, or other characteristics that support a price that is higher than what competitors are charging for their products.
Parity Pricing – A simple method for setting the initial price is to price the product at the same level at which competitors price their product.
We continue our discussion of pricing decision in Setting Price: Part 2 Tutorial.