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Chapter 10 - Pricing and Credit Strategies

“The price is what you pay; the value is what you receive.”
Anonymous

Learning Objectives
Students will be able to:
1. Describe effective pricing techniques for both new and existing products and services.
2. Discuss the links among pricing, image, and competition.
3. Explain the pricing techniques used by retailers.
4. Explain the pricing techniques used by manufacturers.
5. Explain the pricing techniques used by service firms.
6. Describe the impact of credit on pricing.

Instructor’s Outline
I. Introduction
A. Overview
1. Pricing is almost always one of the entrepreneur’s greatest challenges.
a) If the price of your product or services is perceived to be too high, sales may
not reach an adequate level for the business to become profitable.
b) In the opposite extreme, pricing products or services too low may convey an
image of inferior quality.
c) Even if sales do occur, the lower price may not result in an adequate profit
margin.
2. A serious “side effect” of pricing too low is the reaction of customers when you
attempt to adjust prices upward.
a) Your customers will remember the initial low price and they may even feel
their loyalty is being taken advantage of.
3. In reality, the pricing process is somewhere between an exact science based on
logical factors and an intuitive insight based gut feeling.
4. Determining the most appropriate price for a product or service requires an
entrepreneur to consider how each of the following factors will interact with one
another.
a) Product or service costs
b) Market factors: supply and demand
c) Sales volume
d) Competitors' prices
e) The company's competitive advantage
f) Economic conditions
g) Business location
h) Seasonal fluctuations
i) Psychological factors
j) Credit terms and purchase discounts; Customers' price sensitivity; Desired
image
5. In academic terms, price is the monetary value of a good or service.

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a) Price is a measure of what a customer is required to give up to obtain a good


or service.
b) For an individual, price is a reflection of value. We, as individuals, pay no
more than what we believe the good or service to be worth.
c) The process of setting the price for any good or service must involve an
analysis of how the market views the value of that product or service.

B. Entrepreneurs must develop a keen sensitivity to the psychological and economic


thinking of their customers.
1. Without being “in tune” to the customer’s psychological and economic motivators
and the resultant most likely buying behavior, it is possible to price the good or
service incorrectly.
a) This needed customer orientation is an important non-quantitative factor in a
successful pricing process.
b) What the process achieves is seldom an “ideal” price, but a price range.
2. Price ceiling, which is the most the target group would be willing to pay, and the
price floor.
a) The price floor is established by the firm’s total cost to produce the product or
provide the service.
3. The final price that business owners set depends on the desired image they want
to create for their products or services: discount (bargain), middle-of-the-road
(value), or prestige (upscale).
4. Business owners must walk a fine line when pricing their products and services,
setting their prices high enough to cover costs and earn a reasonable profit but low
enough to attract customers and generate an adequate sales volume.
5. Furthermore, the right price today may be completely inappropriate tomorrow
because of changing market and competitive conditions.
6. Businesses faced with rapidly rising raw materials costs should consider:
a) Communicate with customers. Let your customers know what's happening.
b) Focus on improving efficiency everywhere in the company.
c) Consider absorbing cost increases to save accounts with long-term importance
to the company. Saving a large account might be more important than keeping
pace with rising costs.
d) Emphasize the value your company provides to customers. Unless a company
reminds them, customers can forget the benefits and value its products offer.
e) Anticipate rising materials costs and try to lock in prices early. It pays to keep
tabs on raw materials prices and to be able to predict cycles of inflation.
Chapter 10 - Pricing and Credit Strategies 199

IN THE FOOTSTEPS OF THE ENTREPRENEUR


What if the Customer Sets the Price?

Although this may sound ridiculous, would you believe that for the past 15 years Michael
Vasos, a successful London, England restaurant owner has operated one of his businesses
exactly that way. Around the corner is a restaurant where, upon completion of your meal, you
(the customer), pays the owner what you felt the meal was worth.

Vasos says that he “makes more money from this restaurant than any of my other
establishments.” The restaurant is booked every night and revenues exceed $1 million.
What does this tell us about ourselves? Do we not know the value of a product or are we
willing to reward an entrepreneur who we feel trust our judgments and basic honesty?
Answer: Student’s answers will vary.

II. Pricing Strategies and Tactics


A. New Products: Penetration, Skimming, or Sliding
1. Most entrepreneurs approach setting the price of a new product with a great deal
of apprehension because they have no precedent.
2. When pricing any new product, the owner should try to satisfy three objectives:
a) Get the product accepted. No matter how unusual a product is, its price must
be acceptable to the firm's potential customers.
b) Maintain market share as competition grows. If a new product is successful,
competitors will enter the market, and the small company must work to
expand or at least maintain its market share.
c) Earn a profit. Obviously, a small firm must establish a price for the new
product that is higher than its cost. Managers should not introduce a new
product at a price below cost because it is much easier to lower the price than
to increase it once the product is on the market.
3. Entrepreneurs have three basic strategies to choose from in establishing a new
product's price: penetration, skimming, and sliding down the demand curve.
4. Penetration
a) If a small business introduces a product into a highly competitive market in
which a large number of similar products are competing for acceptance, the
product must penetrate the market to be successful.
b) To gain quick acceptance and extensive distribution in the mass market, a
company introduces the product at a low price--just above total unit cost to
develop a wedge in the market and quickly achieve a high volume of sales.
c) The resulting low profit margins may discourage other competitors from en-
tering the market with similar products.
d) A penetration pricing strategy is used to introduce relatively low-priced goods
into a market where no elite segment and little opportunity for differentiation
exist.
e) The introduction is usually accompanied by heavy advertising and
promotional techniques, special sales, and discounts.
f) The objective of the penetration strategy is to achieve quick access to the
market in order to realize high sales volume as soon as possible.
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5. Skimming
a) A skimming pricing strategy often is used when a company introduces a new
product into a market with little or no competition.
b) Sometimes a company uses this tactic when introducing a product into a
competitive market that contains an elite group that is able to pay a premium
price.
c) The firm uses a higher-than-normal price in an effort to quickly recover the
initial developmental and promotional costs of the product.
d) Product development or start-up costs usually are substantial owing to
intensive promotional expenses and high initial costs.
e) The idea is to set a price well above the total unit cost and to promote the
product heavily to appeal to the segment of the market that is not sensitive to
price.
f) This pricing tactic often reinforces the unique, prestigious image of a store
and projects a quality picture of the product.
6. Sliding down the demand curve
a) One variation of the skimming pricing strategy is called sliding down the
demand curve.
(1) The small company introduces a product at a high price.
(2) Then, technological advancements enable the firm to lower its costs
quickly and to reduce the product's price sooner than its competition can.
b) By beating other businesses in a price decline, the small company discourages
competitors and, over time, becomes a high-volume producer.
c) Computers are a prime example.
d) Sliding is a short-term pricing strategy that assumes that competition will
eventually emerge.

B. Established Goods and Services


1. Odd pricing
a) Although studies of consumer reactions to prices are mixed and generally
inconclusive, many small business managers use the technique known as odd
pricing.
b) They set prices that end in odd numbers (frequently 5,7,9) because they
believe that an item selling for $12.95 appears to be much cheaper than an
item selling for $13.00.
2. Price lining
a) Price lining is a technique that greatly simplifies the pricing function.
b) The manager stocks merchandise in several different price ranges or price
lines. Each category of merchandise contains items that are similar in
appearance, quality, cost, performance, or other features.
c) Most lined products appear in sets of three--good, better, and best--at prices
designed to satisfy different market segment needs and incomes.
3. Leader pricing
a) Leader pricing is a technique in which the small retailer marks down the
customary price (i.e., the price consumers are accustomed to paying) of a
popular item in an attempt to attract more customers.
Chapter 10 - Pricing and Credit Strategies 201

b) The company earns a much smaller profit on each unit because the markup is
lower, but purchases of other merchandise by customers seeking the leader
item often boost sales and profits.
4. Geographic pricing
a) Small businesses whose pricing decisions are greatly affected by the costs of
shipping merchandise to customers across a wide range of geographic regions
frequently employ one of the geographic pricing techniques.
b) Zone pricing--a small company sells its merchandise at different prices to
customers located in different territories.
(1) The small business must be able to show a legitimate basis (e.g.,
difference in selling or transportation costs) for the price discrimination or
risk violating Section 2 of the Clayton Act.
c) Uniform-delivered pricing--a technique in which the firm charges all of its
customers the same price regardless of their location, even though the cost of
selling or transporting merchandise varies.
d) The firm calculates the proper freight charges for each region and combines
them into a uniform fee.
e) F.O.B. factory--the small company sells its merchandise to customers on the
condition that they pay all shipping costs.
5. Opportunistic pricing
a) When products or services are in short supply, customers are willing to pay
more for products they need.
b) Some businesses use such circumstances to maximize short-term profits by
engaging in price gouging.
c) Opportunistic pricing may backfire, however, because customers know that a
company that charges unreasonably high prices is exploiting them.
6. Discounts
a) Many small businesses use discounts, or markdowns, reductions from normal
list prices, to move stale, outdated, damaged, or slow-moving merchandise.
b) A seasonal discount is a price reduction designed to encourage shoppers to
purchase merchandise before an upcoming season.
c) Some firms grant purchase discounts to special groups of customers.
7. Multiple pricing
a) Multiple pricing is a promotional technique that offers customers discounts if
they purchase in quantity.
8. Bundling
a) Bundling is the grouping together of several products or services, or both, into
a package that offers customers extra value at a special price.
9. Suggested retail prices
a) Many manufacturers print suggested retail prices on their products or include
them on invoices or in wholesale catalogs.
b) Small business owners frequently follow these suggested retail prices because
doing so eliminates the need to make a pricing decision.
(1) Following prices established by a distant manufacturer may create
problems for the small firm.
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(2) Another danger of accepting the manufacturer's suggested price is that it


does not take into consideration the small firm's cost structure or
competitive situation.

IN THE STEPS OF THE ENTREPRENEUR


Nine Steps to Maximizing Profits Through Optimal Pricing

1. Compare your prices with those of competitors.

2. Check with associations who conduct pricing studies.

3. Attempt to develop a formula for setting prices that is specifically relevant to your business.

4. For service companies, one method is to calculate backward.

5. Set a price that includes the time you provide that cannot normally be charged to the client.

6. Attempt to find what is termed “a magic number”. Although your pricing formulas produce
a retail price of $30.95, you may discover that the volume you can sell is priced at $29.95
more than compensates for the one-dollar reduction. Your goal is to maximize total net
revenue and the $29.95 price may significantly increase sales volume.

7. Price shrinking may allow a new firm to set a higher-than-normal price initially and then
lower the price later. It is easier to explain a price reduction than a price increase.

8. Charge what the market will bear. Customer willingness to buy sets the price ceiling for
your product or service. Attempt to continue to add value in the eyes of your customers.

9. Charge what you’re worth. If the service you provide or the product you sell is unique or a
product of your special skills, don’t be embarrassed to charge what you’re worth.

III. Two Potent Pricing Forces: Image and Competition


A. Price Conveys Image
1. A company's pricing policies offer potential customers important information
about its overall image.
a) High prices frequently convey the idea of quality, prestige, and uniqueness.
2. Accordingly, when developing a marketing approach to pricing, business owners
must establish prices that are compatible with what their customers expect and are
willing to pay.
a) Too often, small business owners under price their goods and services,
believing that low prices are the only way they can achieve a competitive
advantage.
3. Business owners must recognize that the prices they set for their company's goods
and services send clear signals to customers about quality and value.
Chapter 10 - Pricing and Credit Strategies 203

B. Competition and Prices


1. An important part of setting appropriate prices is tracking competitors' prices
regularly; however, what the competition is charging is just one variable in the
pricing mix.
2. Businesses that offer customers extra quality, value, service, or convenience can
charge higher prices as long as customers recognize the "extras" they are getting.
3. Two factors are vital to studying the effects of competition on the small firm's
pricing policies.
a) The location of the competitors.
b) The nature of the competing goods.
4. In most cases, unless a company can differentiate the quality and the quantity of
extras it provides, it must match the prices charged by nearby competitors for
identical items.
a) Although the prices that distant competitors charge are not nearly as critical to
the small business as are those of local competitors, it can be helpful to know
them and to use them as reference points.
b) Before matching any competitor's price change, however, the small business
owner should consider the rival's motives.
5. The nature of competitors' goods also influences the small firm's pricing policies.
a) The manager must recognize which products are substitutes for those he sells
and then strive to keep prices in line with them.
6. In general, the small business manager should avoid head-to-head price
competition with other firms that can more easily achieve lower prices through
lower cost structures.
7. One of the deadliest games a small business can get into with competitors is a
price war.
a) Price wars usually begin when one competitor believes that they can achieve a
higher volume through lower price, or they believe they can exert enough
pressure on competitor’s profits to drive them out of business.
b) Entrepreneurs overestimate the power of price cuts to increase sales
sufficiently to improve net profitability.
8. In a price war, a company may cut its prices so severely that it is impossible to
achieve the volume necessary to offset the lower profit margins.
a) "If you have a 25 percent gross [profit] margin, and you cut your price 10
percent, you have to roughly triple your sales volume just to break even."
9. The underlying forces that dictate how a business prices its goods or services vary
greatly among industries.

IV. Pricing Techniques for Retailers


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GAINING THE COMPETETIVE EDGE


Don’t Forget to Raise Prices

It may sound silly to remind business owners that they need to raise prices when they
experience cost increases. Norm Brodsky’s advice is to increase prices in small increments that
reflect increased costs of doing business. When a business owner fails to increase their prices in
this fashion they eventually discover that big increases are a shock to customers. Even when
the new prices are in line with those of competitors the entrepreneur may loose customers.

Even in a period of low inflation costs do rise, (maybe 2.7 percent per year). If the costs are not
reflected in higher prices, the compound effect of even 2% over 5 years can take a significant
bit out of overall profits.

A. Markup
1. The basic premise of a successful business operation is selling a good or service
for more than it costs to produce it.
2. The difference between the cost of a product or service and its selling price is
called markup (or markon).
3. Markup can be expressed in dollars or as a percentage of either cost or selling
price:
a) Dollar markup = Retail price - Cost of the merchandise
b) Percentage (of retail price) markup = Dollar markup
Retail price
4. Percentage (of cost) markup = Dollar markup
Cost of unit
5. The cost of merchandise used in computing markup includes not only the
wholesale price of the merchandise but also any incidental costs (e.g., selling or
transportation charges) that the retailer incurs and a profit minus any discounts
(quantity, cash) that the wholesaler offers.
6. Once business owners have a financial plan in place, including sales estimates and
anticipated expenses, they can compute the firm's initial markup.
7. The initial markup is the average markup required on all merchandise to cover the
cost of the items, all incidental expenses, and a reasonable profit.
8. Initial dollar markup = Operating expenses + Reductions + Profits Net Sales +
Reductions
9. Operating expenses are the cost of doing business, such as rent, utilities, and
depreciation; reductions include employee and customer discounts, markdowns,
special sales, and the cost of stockouts.
10. Some businesses use a standard markup on all of their merchandise.
a) Usually used in retail stores carrying related products, it applies a standard
percentage markup to all merchandise.
b) Most stores find it much more practical to use a flexible markup, which
assigns various markup percentages to different types of products.
11. Once owners determine the desired markup percentage, they can compute the
appropriate retail price.
Chapter 10 - Pricing and Credit Strategies 205

12. Finally, retailers must verify that the computed retail price is consistent with their
planned initial markup percentage.

B. Follow-the-Leader Pricing
1. Some small companies simply follow the prices that their competitors establish.
2. Managers wisely monitor their competitors' pricing policies and individual prices
by reviewing their advertisements or by hiring part-time or full-time comparison
shoppers.

C. Below-Market Pricing
1. By setting prices below those of their competitors, these firms hope to attract a
sufficient level of volume to offset the lower profit margins.
2. Many retailers using a below-market pricing strategy eliminate most of the extra
services that their above-market-pricing competitors offer.

V. Pricing Techniques for Manufacturers


A. Cost-plus Pricing
1. The most commonly used pricing technique for manufacturers is cost-plus
pricing.
2. Using this method, manufacturers establish a price composed of direct materials,
direct labor, factory overhead, selling and administrative costs, plus the desired
profit margin.
3. The main advantage of the cost-plus pricing method is its simplicity.
4. Given the proper cost accounting data. computing a product's final selling price is
relatively easy.
5. Also, because it adds a profit onto the top of the firm's costs, the manufacturer is
guaranteed the desired profit margin.
6. It does not encourage the manufacturer to use its resources efficiently.
7. Finally, because manufacturers' cost structures vary so greatly, cost-plus pricing
fails to consider the competition sufficiently.

B. Direct Costing and Price Formulation


1. One requisite for a successful pricing policy in manufacturing is a reliable cost
accounting system that can generate timely reports to determine the costs of
processing raw materials into finished goods.
2. The traditional method of product costing is called absorption costing because all
manufacturing and overhead costs are absorbed into the finished product's total
cost.
a) Absorption costing includes direct materials and direct labor, plus a portion of
fixed and variable factory overhead costs, in each unit manufactured.
3. A more useful technique for managerial decision-making is variable (or direct)
costing, in which the cost of the products manufactured includes only those costs
that vary directly with the quantity produced.
a) Variable costing encompasses direct materials, direct labor, and factory
overhead costs that vary with the level of the firm's output of finished goods.
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4. A manufacturer's goal in establishing prices is to discover the cost combination of


selling price and sales volume that exceeds the variable costs of producing a
product and contributes enough to cover fixed costs and earn a profit.
a) Full-absorption costing is that it clouds the true relationships among price,
volume, and costs by including fixed expenses in unit cost.
b) Direct-costing basis yields a constant unit cost of the product no matter what
the volume of production is.
5. The starting point for establishing product prices is the direct-cost income
statement.
a) As Table 10.1 indicates, the direct-cost statement yields the same net profit as
does the full-absorption income statement.
b) The only difference between the two statements is the format.

C. Computing a Breakeven Selling Price


1. A manufacturer's contribution percentage tells what portion of total revenues
remains after covering variable costs to contribute toward meeting fixed expenses
and earning a profit.
2. This manufacturer's contribution percentage is 36.5 percent, which means that
variable costs absorb 63.5 percent of total revenues.
a) In other words, variable costs represent 63.5 percent (1.00 - 0.365 = 0.635) of
the product's selling price.
b) Suppose that this manufacturer's variable costs include the following:
Material $2.08/unit
Direct labor $4.12/unit
Variable factory overhead $0.78/unit
Total variable cost $6.98/unit
3. The minimum price at which the manufacturer would sell the item is $6.98. Any
price below that would not cover variable costs.
4. To compute the breakeven selling price for this product, find the selling price
using the following equation:
(Selling x Quantity) + (Variable cost x Quantity) +
Total
(price produced) (per unit produced) fixed cost
Profit = Quantity produced

which becomes:

Profit + (Variable Cost x Quantity) + Total


per unit produced) fixed cost
Profit = Quantity produced

5. Because the manufacturer's capacity in the short run is fixed, pricing decisions
should be aimed at using its resources most efficiently.
6. The fixed cost of operating the plant cannot be avoided, and the variable costs can
be eliminated only if the firm ceases to offer the product.
Chapter 10 - Pricing and Credit Strategies 207

7. Therefore, the selling price must be at least equal to the variable costs (per unit) of
making the product. Any price above that amount contributes to covering fixed
costs and providing a reasonable profit.
8. Over the long run, the selling price must cover total product costs--both fixed and
variable--and generate a reasonable profit.

VI. Pricing Techniques for Service Firms


A. The Basis for Pricing
1. Service businesses must establish their prices on the basis of the materials used to
provide the service, the labor employed, an allowance for overhead, and a profit.
2. A service firm must have a reliable, accurate accounting system to keep a tally of
the total costs of providing the service.
a) Most service firms base their prices on an hourly rate, usually the actual
number of hours required to perform the service.
b) Some companies, however, base their fees on a standard number of hours,
determined by the average number of hours needed to perform the service.
c) For most firms, labor and materials constitute the largest portion of the cost of
the service.
d) To establish a reasonable, profitable price for service, the small business
owner must know the cost of materials, direct labor, and overhead for each
unit of service.
e) Using these basic cost data and a desired profit margin, the owner of the small
service firm can determine the appropriate price for the service.
3. Consider a simple example for pricing a common service--television repair.
a) Ned's TV Repair Shop uses the direct-costing method to prepare an income
statement for exercising managerial control.
b) See Table 10.2.
4. Smart service shop owners compute the cost per production hour at regular
intervals throughout the year because they know that rising costs can eat into their
profit margins very quickly.
5. Rapidly rising labor costs and materials prices dictate that the service firm's price
per hour be computed even more frequently.

VII. The Impact of Credit on Pricing


A. Introduction
1. Individuals on the eastern seaboard have more credit cards and the highest credit
limits.
a) In contrast, the most conservative credit card users were located in the
Midwest.
b) Interest payments on credit card balances have now become a significant part
of our monthly budget.
2. Today’s entrepreneur needs to take all of the steps necessary to be compliant with
the customer’s desire to buy now and pay later.
3. Companies must pay to use the system, typically 1 to 6 percent of the company’s
total credit card charges, which they must factor into the prices of their products
or services.
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a) They also pay a transaction fee of 5 to 50 cents per charge and must purchase
or lease equipment to process transactions.
b) Given customer expectations, small businesses find it difficult to refuse major
cards, even when the big card companies raise the fees that merchants must
pay.
(1) Fees operate on a multi-step process.
4. Before it can accept credit cards, a business must obtain merchant status from
either a bank or an independent sales organization (ISO).
a) The accompanying Gaining the Competitive Edge feature describes how a
small company can obtain merchant status.
5. More small businesses also are equipping their stores to handle debit-card
transactions, which act as electronic checks, automatically deducting the purchase
amount from a customer’s checking account.
a) The equipment is easy to install and to set up, and the cost to the company is
negligible.
b) The payoff can be big, in the form of increased sales.
6. Credit card sales have many associated fees.
a) Not all merchant account providers charge all of these fees, but expect to see
some of these:
(1) application fee (usually waived)
(2) equipment fee
(3) licensing fee
(4) transaction fee
(5) holdbacks and chargebacks.
Chapter 10 - Pricing and Credit Strategies 209

GAINING THE COMPETITIVE EDGE


How to Obtain Merchant Status

Acquiring merchant status enables a small business to accept credit-card payments for goods
and services. Offering customers the convenience of paying with credit cards enhances a
company’s reputation and translates directly into higher sales. Qualifying for merchant status is
not easy for many small companies, however, because banks view it in the same manner as
making a loan to a business. Although small storefront businesses with short operating
histories many have difficulty qualifying for merchant statues, home-based businesses and
mail-order companies or entrepreneurs doing business over the World Wide Web typically have
the greatest difficulty convincing banks to set them up with credit card accounts.

What can business owners do to increase their chances of gaining merchant status so that they
can accept customers without driving their costs sky-high? Try these tips:
• Recognize that business start-ups and companies that have been in business
less than three years face the greatest obstacles in gaining merchant status.
• Apply with your own bank first.
• Know what information the bank or ISO is looking for and be prepared to
provide it.
• Make sure you understand the costs involved.
• Shop around.
• Have a knowledgeable attorney to look over your contract before you sign it.

Accepting credit cards is not important for every business, but for those whose customers
expect that convenience, acquiring merchant status can spell the difference between making a
sale and losing it.

1. Use the World Wide Web to research how businesses on the Web conduct credit-
card transactions. How do they secure the privacy of these transactions?
Answer: Student’s answers will vary. Most web hosting companies that offer credit card
transactions offer secure sites. The key is to make sure that the transaction is being
processed through SSL (Secure Socket Layer).

B. E-Business And Credit Cards


1. When it comes to online business transactions, currently the most common way to
make a payment is via credit cards.
2. Debit cards - which authorize merchants to electronically debit your bank account
- are also being used.
3. A number of electronic payment systems - sometimes referred to as "electronic
money" - are under development for simplifying purchases online.
4. Some new Internet-based payment systems would allow value to be transmitted
through computers.
a) Consumers can use them to make "micro-payments". Micro-payments are
extremely small payments - for an item like a sheet of music or a short article.
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b) When consumers use electronic money to make a purchase, they decrease the
balance on their card or computer by the amount of the purchase.
c) Some cards can be "reloaded" with additional value, say, at a cash machine;
other cards are "disposable" - you can throw them away after you use them.
5. Many potential consumers are hesitant about online transactions for reasons of
security and privacy.
a) In a recent study conducted by CyberDialogue, an online customer
intelligence firm, 60 percent of online users still feel that submitting
information is riskier than by telephone, and more than one-third feel that it is
an invasion of privacy.
b) Because of merchant and consumer vulnerability, credit card processing
companies have developed a variety of ways to compensate for the exposure
to risk.
6. E-commerce requires the business to integrate a variety of electronic services into
a seamless shopping experience.
a) While this is not currently a perfected process, nor is it one without inherent
hassles for the merchant – the payoff of a small local entrepreneur being able
to tap into a global market is often well worth the trouble.

C. Installment Credit
1. Small companies that sell big-ticket consumer durables--major appliances, cars,
and boats--frequently rely on installment credit.
2. The time horizon may range from just a few months up to 30 or more years.
a) Most companies require the customer to make an initial down payment.
b) One advantage of installment loans for a small business is that the owner
retains a security interest as collateral on the loan.
c) If the customer defaults on the loan, the owner still holds the title to the
merchandise.
d) Because installment credit absorbs a small company's cash, many rely on
financial institutions such as banks and credit unions to provide the in-
stallment credit.

D. Trade Credit
1. Companies that sell small-ticket items frequently offer their customers trade
credit; that is, they create customer charge accounts.
2. The typical small business bills its credit customers each month.
3. To speed collections, some offer cash discounts.
4. The small business owner must make sure that the firm's cash position is strong
enough to support that additional pressure.
5. For manufacturers and wholesalers, trade credit is traditional.
6. Small businesses must be willing to grant credit to purchasers in order to get, and
keep, their business; they must work extremely hard, and often be very tough,
with debtors who do not pay as they agreed to.

Chapter Summary
1. Describe effective pricing techniques for both new and existing products and services.
Chapter 10 - Pricing and Credit Strategies 211

 Pricing a new product is often difficult for the small business manager, but it should
accomplish three objectives: getting the product accepted; maintaining market share as
the competition grows; and earning a profit.
 There are three major pricing strategies generally used to introduce new products into the
market: penetration, skimming, and sliding down the demand curve.
 Pricing techniques for existing products and services include odd pricing, price lining,
leader pricing, geographic pricing, opportunistic pricing, discounts, multiple pricing,
bundling, and suggested retail pricing.

2. Discuss the links among pricing, image, and competition.


 Company pricing policies offer potential customers important information about the
firm’s overall image. Accordingly, when developing a marketing approach to pricing,
business owners must establish prices that are compatible with what their customers
expect and are willing to pay. Too often, small business owners underprice their goods
and services, believing that low prices are the only way they can achieve a competitive
advantage. They fail to identify the extra value, convenience, service, and quality they
give their customers—all things many customers are willing to pay for.
 An important part of setting appropriate prices is tracking competitors’ prices regularly;
however, what the competition is charging is just one variable in the pricing mix. When
setting prices, business owners should take into account their competitors’ prices, but
they should not automatically match or beat them. Businesses that offer customers extra
quality, value, service, or convenience can charge higher prices as long as customers
recognize the “extras” they are getting. Two factors are vital to studying the effects of
competition on the small firm’s pricing policies: the location of the competitors and the
nature of the competing goods.

3. Explain the pricing techniques used by retailers.


 Pricing for the retailer means pricing to move merchandise. Markup is the difference
between the cost of a product or service and its selling price.
 Age of retail price, but some retailers put a Standard markup on all their merchandise;
more frequently, they use a flexible markup.

4. Explain the pricing techniques used by manufacturers.


 A manufacturer’s pricing decision depends on the support of accurate cost accounting
records. The most common technique is cost-plus pricing, in which the manufacturer
charges a price that covers the cost of producing a product plus a reasonable profit. Every
manufacturer should calculate a product’s breakeven price, the price that produces neither
a profit nor a loss.

5. Explain the pricing techniques used by service firms.


 Service firms often suffer from the effects of vague, unfounded pricing procedures and
frequently charge the going rate without any idea of their costs. A service firm must set a
price based on the cost of materials used, labor involved, overhead, and a profit. The
proper price reflects the total cost of providing a unit of service.

6. Describe the impact of credit on pricing.


212 Section IV Small Business Marketing Strategies

 Offering consumer credit enhances a small company’s reputation and increases the
probability, speed, and magnitude of customers’ purchases. Small firms offer three types
of consumer credit: credit cards, installment credit, and trade credit (charge accounts).

Discussion Questions
1. What does a price represent to the customer? Why is a customer orientation to pricing
important?
Answer - price is the monetary value of a good or service. Price is a measure of what a
customer is required to give up to obtain a good or service. For an individual, price is a
reflection of value. We, as individuals, pay no more than what we believe the good or
service to be worth. In the total marketplace, all potential customers evaluate the available
goods and services and establish the demand for each. Value, like beauty, is in the eye of the
beholder. The process of setting the price for any good or service must involve an analysis of
how the market views the value of that product or service.
Entrepreneurs must develop a keen sensitivity to the psychological and economic thinking of
their customers. Without being “in tune” to the customer’s psychological and economic
motivators and the resultant most likely buying behavior, it is possible to price the good or
service incorrectly. This needed customer orientation is an important non-quantitative factor
in a successful pricing process. What the process achieves is seldom an “ideal” price, but a
price range. This price range can be described as the area between the price ceiling, which is
the most the target group would be willing to pay, and the price floor. The price floor is
established by the firm’s total cost to produce the product or provide the service.

2. How does pricing affect a small firm's image?


Answer - One of the toughest decisions small business owners face, but it is also one of the
most important. Prices that are too high will hurt a company's sales. Pricing products or
services too low, a common tendency among start-up businesses, will rob a company of
profits, threaten its long-term success, and leave customers with the impression that its
products or services are of inferior quality. Improper pricing has destroyed countless
businesses.

3. What competitive factors must the small firm consider when establishing prices?
Answer - Most entrepreneurs approach setting the price of a new product with a great deal of
apprehension because they have no precedent. When pricing any new product, the owner
should try to satisfy three objectives. 1) Get the product accepted. No matter how unusual a
product is, its price must be acceptable to the firm's potential customers. 2) Maintain market
share as competition grows. If a new product is successful, competitors will enter the market,
and the small company must work to expand or at least maintain its market share. 3) Earn a
profit. Obviously, a small firm must establish a price for the new product that is higher than
its cost. Managers should not introduce a new product at a price below cost because it is
much easier to lower the price than to increase it once the product is on the market.

4. Describe the strategies a small business could use in setting the price of a new product. What
objectives should the strategy seek to achieve?
Answer - Entrepreneurs have three basic strategies to choose from in establishing a new
product's price: penetration, skimming, and sliding down the demand curve.
Chapter 10 - Pricing and Credit Strategies 213

 Penetration--introducing a product into a highly competitive market in which a large


number of similar products are competing for acceptance, the product must penetrate the
market to be successful. The objective is to gain quick acceptance and extensive
distribution in the mass market; a company introduces the product at a low price--just
above total unit cost to develop a wedge in the market and quickly achieve a high volume
of sales.
 Skimming--often is used when a company introduces a new product into a market with
little or no competition. The objective is to quickly recover the initial developmental and
promotional costs of the product. This pricing tactic often reinforces the unique,
prestigious image of a store and projects a quality picture of the product.
 Sliding down the demand curve--a variation of the skimming pricing strategy is called
sliding down the demand curve. The objective is to beat other businesses in a price
decline; the small company discourages competitors and, over time, becomes a high-
volume producer.

5. Define the following pricing techniques: odd pricing, price lining, leader pricing, geographic
pricing, and discounts.
Answer - Although studies of consumer reactions to prices are mixed and generally
inconclusive, many small business managers use the technique known as odd pricing. They
set prices that end in odd numbers (frequently 5,7,9) because they believe that an item selling
for $12.95 appears to be much cheaper than an item selling for $13.00. Price lining is a
technique that greatly simplifies the pricing function. The manager stocks merchandise in
several different price ranges or price lines. Each category of merchandise contains items that
are similar in appearance, quality, cost, performance, or other features. Leader pricing is a
technique in which the small retailer marks down the customary price (i.e., the price
consumers are accustomed to paying) of a popular item in an attempt to attract more
customers. Geographic pricing. Small businesses whose pricing decisions are greatly affected
by the costs of shipping merchandise to customers across a wide range of geographic regions
frequently employ one of the geographic pricing techniques. a) Zone pricing--a small
company sells its merchandise at different prices to customers located in different territories.
b) Uniform delivered pricing--a technique in which the firm charges all of its customers the
same price regardless of their location, even though the cost of selling or transporting
merchandise varies. c) F.O.B. factory--the small company sells its merchandise to customers
on the condition that they pay all shipping costs. Opportunistic Pricing. When products or
services are in short supply, customers are willing to pay more for products they need. Many
small businesses use discounts, or markdowns, reductions from normal list prices, to move
stale, outdated, damaged, or slow-moving merchandise. Multiple pricing is a promotional
technique that offers customers discounts if they purchase in quantity. Bundling is the
grouping together of several products or services, or both, into a package that offers
customers extra value at a special price.

6. Why do many small businesses use the manufacturer's suggested retail price? What are the
disadvantages of this technique?
Answer - Many manufacturers print suggested retail prices on their products or include them
on invoices or in wholesale catalogs. Small business owners frequently follow these
suggested retail prices because doing so eliminates the need to make a pricing decision.
214 Section IV Small Business Marketing Strategies

Following prices established by a distant manufacturer may create problems for the small
firm such as it does not take into consideration the small firm's cost structure or competitive
situation.

7. What is a markup? How is it used to determine prices?


Answer - The basic premise of a successful business operation is selling a good or service
for more than it costs to produce it. The difference between the cost of a product or service
and its selling price is called markup (or markon). Markup can be expressed in dollars or as
a percentage of either cost or selling price:
a) Dollar markup = Retail price - Cost of the merchandise
b) Percentage (of retail price) markup = Dollar markup
Retail price
c) Percentage (of cost) markup = Dollar markup
Cost of unit
The cost of merchandise used in computing markup includes not only the wholesale price of
the merchandise but also any incidental costs (e.g., selling or transportation charges) that the
retailer incurs and a profit minus any discounts (quantity, cash) that the wholesaler offers.
Once business owners have a financial plan in place, including sales estimates and
anticipated expenses, they can compute the firm's initial markup. The initial markup is the
average markup required on all merchandise to cover the cost of the items, all incidental ex-
penses, and a reasonable profit

8. What is a standard markup? A flexible markup?


Answer - Some businesses use a standard markup on all of their merchandise. Usually used
in retail stores carrying related products, it applies a standard percentage markup to all
merchandise. Most stores find it much more practical to use a flexible markup, which assigns
various markup percentages to different types of products. Once owners determine the
desired markup percentage, they can compute the appropriate retail price.

9. What is follow-the-leader pricing? Why is it risky?


Answer - It is when small companies simply follow the prices that their competitors
establish. Managers wisely monitor their competitors' pricing policies and individual prices
by reviewing their advertisements or by hiring part-time or full-time comparison shoppers. It
doesn't take into consideration cost differences and it is a "me-too" strategy eliminating some
differentiation.

10. What is cost-plus pricing? Why do so many manufacturers use it? What are the
disadvantages of using it?
Answer - The most commonly used pricing technique for manufacturers is cost-plus pricing.
Using this method, manufacturers establish a price composed of direct materials, direct labor,
factory overhead, selling and administrative costs, plus the desired profit margin. The main
advantage of the cost-plus pricing method is its simplicity. Given the proper cost accounting
data. computing a product's final selling price is relatively easy. Also, because it adds a profit
onto the top of the firm's costs, the manufacturer is guaranteed the desired profit margin.
However, it does not encourage the manufacturer to use its resources efficiently. And,
Chapter 10 - Pricing and Credit Strategies 215

because manufacturers' cost structures vary so greatly, cost-plus pricing fails to consider the
competition sufficiently.

11. Explain the difference between full-absorption costing and direct costing. How does
absorption costing help a manufacturer determine a reasonable price?
Answer - One requisite for a successful pricing policy in manufacturing is a reliable cost
accounting system that can generate timely reports to determine the costs of processing raw
materials into finished goods. The traditional method of product costing is called absorption
costing because all manufacturing and overhead costs are absorbed into the finished product's
total cost. Absorption costing includes direct materials and direct labor, plus a portion of
fixed and variable factory overhead costs, in each unit manufactured. A more useful
technique for managerial decision-making is variable (or direct) costing, in which the cost of
the products manufactured includes only those costs that vary directly with the quantity
produced. A manufacturer's goal in establishing prices is to discover the cost combination of
selling price and sales volume that exceeds the variable costs of producing a product and
contributes enough to cover fixed costs and earn a profit. Full-absorption costing is that it
clouds the true relationships among price, volume, and costs by including fixed expenses in
unit cost. Direct-costing basis yields a constant unit cost of the product no matter what the
volume of production is.

12. Explain the techniques for a small service firm setting an hourly price.
Answer - Service businesses must establish their prices on the basis of the materials used to
provide the service, the labor employed, an allowance for overhead, and a profit. Most
service firms base their prices on an hourly rate, usually the actual number of hours required
to perform the service. Some companies, however, base their fees on a standard number of
hours, determined by the average number of hours needed to perform the service. For most
firms, labor and materials constitute the largest portion of the cost of the service. To establish
a reasonable, profitable price for service, the small business owner must know the cost of
materials, direct labor, and overhead for each unit of service. Using these basic cost data and
a desired profit margin, the owner of the small service firm can determine the appropriate
price for the service. Smart service shop owners compute the cost per production hour at
regular intervals throughout the year because they know that rising costs can eat into their
profit margins very quickly.

13. What is the relevant price range for a product or service?


Answer - Setting prices with a customer orientation is more important than trying to choose
the ideal price for a product. For most products, there is an acceptable price range, not a
single ideal price. This price range is the area between the price ceiling defined by customers
and the price floor established by the firm's cost structure. Identifying the price ceiling
requires entrepreneurs to understand their customers' characteristics and buying behavior.
The price floor depends on a company's cost structure, which can vary considerably from one
business to another. The entrepreneur's goal should be to position the firm's prices within this
acceptable price range. The final price that business owners set depends on the desired image
they want to create for their products or services: discount (bargain), middle-of-the-road
(value), or prestige (upscale). Business owners must walk a fine line when pricing their
products and services, setting their prices high enough to cover costs and earn a reasonable
216 Section IV Small Business Marketing Strategies

profit but low enough to attract customers and generate an adequate sales volume.
Furthermore, the right price today may be completely inappropriate tomorrow because of
changing market and competitive conditions.

14. What advantages and disadvantages does offering trade credit provide to a small business?
Answer – Companies that sell small-ticket items frequently offer their customers trade
credit; that is, they create customer charge accounts. The typical small business bills its credit
customers each month. The small business owner must make sure that the firm's cash
position is strong enough to support that additional pressure. For manufacturers and
wholesalers, trade credit is traditional. Small businesses must be willing to grant credit to
purchasers in order to get, and keep, their business; they must work extremely hard, and often
be very tough, with debtors who do not pay as they agreed to.

15. What are the most commonly used methods to purchase online using credit? What reasons
can you give for consumer uncertainty when giving credit card information online as
opposed to via the telephone?
Answer – When it comes to online business transactions, currently the most common way to
make a payment is via credit cards. Debit cards that authorize merchants to electronically
debit your bank account are also being used. Debit card may be automated teller machine
(ATM) card and may require using a personal identification number (PIN). It may be a card
that requires only some form of signature or other identification; or it may have a
combination of these features. While using a debit card is similar to using a credit card, there
is one important difference: when using a debit card, the money for the purchase is
transferred almost immediately from your bank account to the merchant's account.
The Internet is a dynamic environment and forms of payment are rapidly evolving. So it's no
wonder that a number of electronic payment systems - sometimes referred to as "electronic
money" - are under development for simplifying purchases online. Some new Internet-based
payment systems would allow value to be transmitted through computers. Consumers can use
them to make "micro-payments". Micro-payments are extremely small payments - for an
item like a sheet of music or a short article. When consumers use electronic money to make a
purchase, they decrease the balance on their card or computer by the amount of the purchase.
Some cards can be "reloaded" with additional value, say, at a cash machine; other cards are
"disposable" - you can throw them away after you use them.
Internet vendors are constantly challenged by the need to provide secure ways to transact
business in a safe environment. Many potential consumers are hesitant about online
transactions for reasons of security and privacy. Because of merchant and consumer
vulnerability, credit card processing companies have developed a variety of ways to
compensate for the exposure to risk. E-commerce requires the business to integrate a variety
of electronic services into a seamless shopping experience. While this is not currently a
perfected process, nor is it one without inherent hassles for the merchant – the payoff of a
small local entrepreneur being able to tap into a global market is often well worth the trouble.

16. What advantages does accepting credit cards provide a small business? What costs are
involved?
Answer – In today’s business environment, it has become essential to link the firm’s pricing
strategy with its credit strategy. In excess of 8 million American households have credit
Chapter 10 - Pricing and Credit Strategies 217

cards and the estimate of the number of credit cards per person is between 4 and 5.
Individuals on the eastern seaboard have more credit cards and the highest credit limits. In
contrast, the most conservative credit card users were located in the Midwest. Interest
payments on credit card balances have now become a significant part of our monthly budget.
American consumers have racked up $462 billion in bank and credit card debt and an
additional $88 billion in retail credit card debt. More small businesses also are equipping
their stores to handle debit-card transactions, which act as electronic checks, automatically
deducting the purchase amount from a customer’s checking account. The equipment is easy
to install and to set up, and the cost to the company is negligible. The payoff can be big,
however, in the form of increased sales. Although it has become an essential element of
business, credit card sales have many associated fees. Not all merchant account providers
charge all of these fees, but expect to see some of these: a) application fee (usually waived),
b) equipment fee, c) licensing fee, d) transaction fee, e) holdbacks and chargebacks.

17. What steps should a small business owner take to earn merchant status?
Answer - See "Gaining a Competitive Edge,". A few tips include:
• Recognize that business start-ups and companies that have been in business
less than three years face the greatest obstacles in gaining merchant status.
• Apply with your own bank first.
• Know what information the bank or ISO is looking for and be prepared to
provide it.
• Make sure you understand the costs involved.
• Shop around.
• Have a knowledgeable attorney to look over your contract before you sign it.

Step into the Real World

1. Interview two successful small retailers in your area and ask the following questions: Do you
seek a specific image through your prices? What role do your competitors play in pricing?
Do you use specific pricing techniques such as odd pricing, price lining, leader pricing, or
geographic pricing? How are discounts calculated? What markup percentage does the firm
use? What is your cost structure?

2. Select an industry that has several competing small firms in your area. Contact these firms
and compare their approaches to determining prices. Do prices on identical or similar items
differ? Why?

3. Contact two local small businesses: one that does accept credit cards and one that doesn’t.
Ask the owner of the business that does accept credit cards why he or she does. What role do
customers’ expectations play? Does the owner believe that accepting credit cards leads to
increased sales? What does it cost the owner to accept credit cards? How difficult was it to
gain merchant status? Does the business sell products to consumers or other businesses
online? If so, what method of payment is used and how satisfied is the owner with this
method? Ask the owner of the business that does not accept credit cards why he or she does
not. Has the business lost sales because it does not accept credit cards? What would it take
and how much would it cost for the owner to be able to accept credit cards?