A company engages in a pricing activity when it attempts to determine the best price at which it can sell its product. This is one of the basic elements of the marketing mix. Typically, the company will aspire to find the optimal price to maximize revenues. This might imply having a high price per unit or a low price and selling many units, making profits through volume. Companies choose pricing strategy (such as premium pricing, skimming, economy, and penetration) they believe will generate the most profit, and they will choose the final price according to a price model such as cost-plus pricing, target-return pricing, value-based pricing, and psychological pricing. Some companies employ price cuts to encourage sales or to liquidate stocks.
A company that wants to determine its pricing will need to estimate market demand for the product, current cost structure of the product, and competitor pricing as well as the positioning of the product. The last item is crucial, because positioning will often determine if a product will be priced high or low. For example, if a company decides that the product will be sold as a luxury item, the pricing will be high. But if they decide to make money through volume, the price will be very low. Cost structure is also very important to ensure the company does not sell its products below production cost. Cost structures include production, promotion, and distribution. Once all the elements have been determined, and the company objective has been decided, the company can determine the pricing model.
Other concerns that can affect product pricing include perishability (perishable products have less shelf life, hence must be priced to maximize sales) and life cycle (new products can use multiple pricing strategies, whereas older products are usually limited to economy pricing).
When determining pricing, the company must choose whether the product will be priced at a cost-plus or value-based structure. As such, four main pricing strategies exist: premium pricing, skimming, economy, and penetration.
A premium price implies that the product is of high quality and can justify an elevated price. The company will be able to demand a high price (or command premium pricing) because of the perceived uniqueness of the product. For example, companies selling products for which they have market exclusivity (because of a patent or a trademark) usually employ premium pricing. A good example is Rolex watches, which are perceived as status symbols and command a higher price than products of similar quality.
Skimming pricing is used when a new product enters a market for which a competitive advantage exists but for which the advantage is not sustainable. The advantage is not prestige, but rather technological in nature. As such, the company targets early technology adopters. For example, when the iPod was first sold in U.S. markets, Apple was able to sell its product at an elevated price; as technologically equivalent competitors entered the market, Apple was unable to justify the high price and had to drop it to compete with new competitors.
Economy pricing is used to price goods that have low cost and low differentiation. Basic commodities usually use economy pricing. Hence, the company tries to increase margins with volume sales rather than a high per-unit profit. Private labels that are developed by retail outlets are an example of economically priced goods.
Finally, penetration pricing is usually employed by a company that seeks to gain quick market share to establish a foothold in a market. For example, if a company wanted to develop a new geographic segment, they might be willing to sell their goods at a lower rate than usual to gain market recognition. Prices would be adjusted in time accordingly.
Complex Pricing Strategies
Pricing is often much more complex than the simple strategies discussed previously. As such, various complex models are used by companies. For example, some companies use captive pricing, wherein the initial purchase is low (penetration strategy) and subsequent purchases are elevated (premium pricing). Printers are a very good example of this hybrid strategy; whereas the initial purchase will be quite inexpensive (the printer), the following purchases (the ink cartridges) will usually be quite expensive. Other hybrid strategies include product bundling pricing (selling a premium item with economy items to move slow-moving items) or optional pricing (selling an economy product with premium options, which is often found in products such as cars). As such, the pricing strategy is limited only by the company’s creativity.
Once a pricing strategy is chosen, a pricing model must be determined. The four main pricing models are cost-plus pricing, target-return pricing, value-based pricing, and psychological pricing. Cost-plus pricing occurs when a company decides that the price of the item it wants to sell should be set at a fixed amount higher than the cost to produce. So, for example, a company for which a product costs $10 to produce could decide to apply a cost-plus pricing of 50 percent; hence it would sell its products for $15. Although cost pricing is simpler to implement, it does not take into account market demands and competition.
A company that chooses target-return pricing determines the sales objective it wants to reach. For example, a company that wants to achieve $1 million in net sales for its product may estimate it can sell 100,000 units this year, and the product costs $10 to produce. Hence, the final pricing of the product will be $10 (cost) and $10 (return per product unit) for a total cost of $20 per unit. Nonetheless, there is circular reasoning in target pricing; because the number of sales affects pricing, which, in turn, affects the number of sold units, it is mostly used in “stable” competitive environments.
Value-based pricing is commonly used when the company is in a very competitive market and needs to price its product relative to competitors. Hence, the product is priced according to competing products. For example, if competitors are selling a similar product at around $12, the product will have to be priced around the same price range (depending on market elasticity).
Finally, some companies use psychological pricing models when selling their products. Hence the price of their product will be a mix of popularity, perceived quality, and what the customer is willing to accept. Luxury items are the most often priced this way. For example, some running shoes are often priced upward of $150 per pair, even though costs to manufacture are relatively negligible and competing products of similar quality can be found much cheaper. In this case, customer willingness to pay $150 justifies the pricing model. This pricing model requires the most market knowledge, because it is quite easy for a company to overestimate consumer willingness to pay a premium and to price itself out of the market.
Although companies usually set a fixed price, there are a number of situations where they will engage in pricing discount. These techniques include quantity discounts (where prices are lowered when items are purchased in bulk), seasonal discounts (where prices are lowered depending on the season goods are purchased), cash discounts (where a rebate is offered to companies who pay their bills early), and promotional discounts (short-term discounts given to stimulate sales, often to clear out inventory or to regain market shares).
- Chenghuan Sean Chu, Phillip Leslie, and Alan T. Sorensen, Nearly Optimal Pricing for Multiproduct Firms (National Bureau of Economic Research, 2008);
- Pascal Courty and Mario Pagliero, Price Variation Antagonism and Firm Pricing Policies (Centre for Economic Policy Research, 2008);
- Oded Koenigsberg, Eitan Muller, and Naufel J. Vilcassim, “EasyJet Pricing Strategy: Should LowFare Airlines Offer Last-Minute Deals?” QME-Quantitative Marketing and Economics (v.6/3, 2008);
- Paul Peter and James H. Donnelly, Jr., A Preface to Marketing Management (McGraw-Hill Irwin, 2000);
- Akshay R. Rao, Mark E. Bergen, and Scott Davis, “How to Fight a Price War,” Harvard Business Review (March 2000);
- Oz Shy, How to Price: A Guide to Pricing Techniques and Yield Management (Cambridge University Press, 2008).
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