Chapter-6

Pricing:
Pricing of Services:

Price policies for the services are quite different from what is called Product pricing. We have seen a
wide variety of terms service organizations use to describe the prices they set. Universities talk
about tuition, professional firms collect fees, and banks charge interest on loans or add service
charges. Some bridges and highways impose tolls, transport operators collect fares, clubs charge
subscriptions, utilities set tariffs, insurance companies establish premiums, and hotels establish room
rates. These diverse terms are a signal that service industries have historically taken a different
approach to pricing than manufacturers. Answering the question, what price should we charge
for our service? is a task that can't be left solely to financial managers. The challenges of
service pricing require active participation from marketers who understand customer needs
and behavior and from operations managers who recognize the importance of matching
demand t o available capacity

What Makes Service Pricing Different?

Let’s consider ho w some of the differences between goods and services marketing that we
discussed in Chapter 1 may affect pricing strategy.

N o O w n er sh ip o f Service s: It's usually harder for managers to calculate the financial

costs involved in creating an intangible performance for a customer than it is to identify the
labor, materials, machine time , storage, and shipping costs associated with producing a
physical good . Yet without a g o o d u n d e r s t a n d i n g o f costs, ho w can managers hope to
price at levels sufficient to achieve a desired profit margin?

H ig h er R a t io of Fixed Cost s to Variable Costs: Because of the labor and

infrastructure needed to create performances , many service organizations have a much
higher ratio of fixed costs to variable costs than is found in manufacturing firms.
Service businesses with high fixed costs include those with an expensive physical facility (e.g., a
hotel , a hospital, a university, or a theater), or a fleet of vehicles (e.g., an airline, a bus
company, or a trucking company) , or a network dependent on company-owned
infrastructure (e.g., a telecommunication s company, an Interne t provider, a railroad, or a gas
pipeline).While the fixed costs may be high for such businesses, the variable costs for serving on
e extra customer may b e minimal.

Variability of B oth Input s a n d Outputs : It's no t always easy to define a unit t of

service , raising question s a s t o what should be the basis for service pricing . An d
seemingly similar units of service may no t cost the same to produce no r may they be of equal
value t o a l l customers. T he potential for variability in service performance s (especially
those that involve interactions with employees and other customers) means that customer s
ma y pay the same price for a service but receive different levels of quality an d value.
Alternatively, the y may be c ha r ge d radically different prices for the same service offering, as
often happens in the hotel industry.

Many Service s Are Hard t Evaluate The intangibility o f service performances and the
invisibility of the backstage facilities and labor make it harder for customers to know what
they are getting or their money than when they purchase a physical good.

Im p o r ta n ce of the T i m e Facto r: T i me o f t e n dr i ve s value. In many instances ,

customers are willing to pay more for a service delivered at a preferred time than for a service
offered at a less convenient time. The y may also choose to pay more for faster delivery of some
services—compare the cost of express mail against that of regular mail.

Availability o f B oth Electron ic an d Physical Distribution Channels : T he use of

different channels to deliver the same service can affect costs an d perceive d value.
Electronic banking transactions are much cheaper f o r a bank than face-to-face contact in a
branch. While some people like the convenience of impersonal but efficient electronic
transactions , other s prefer to deal with a real ban k teller. Thus , a service delivered
through a particular channel may have value for one person but not for another .
Companies must balance customer needs and preferences against the desire to reduce
production costs, because in some cases customers may be willing to accept a price increase
in order to have access to a physical distribution channel.

Factors involved in pricing a service product:

Fixed costs—sometimes referred to as overheads—are those economic costs that a supplier would continue to incur
(at least in the short run) even if no services were sold. These costs may include rent, depreciation, utilities,
taxes, insurance, salaries and wages for managers and long-term employees, security, and interest payments

Variable costs refer to the economic costs associated with serving an additional customer, such as making
another bank transaction, selling an additional seat in a train or theater, serving an extra hotel guest for the night
in a hotel, or completing one more repair job. For many services, such costs are very low. There is, for
instance, very little labor or fuel cost involved in transporting an extra bus passenger. Selling a hotel room for
the night has slightly higher variable costs, since the room will need to be cleaned and the linens sent to the
laundry after a guest leaves.

Semi variable costs fall in between fixed and variable costs. They represent expenses that rise or fall in stepwise
fashion as the volume of business increases/decreases. Examples include adding an extra flight to meet increased
demand on a specific air route, or hiring a part-time employee to work in a restaurant on busy weekends.

Contribution is the difference between the variable cost of selling an extra unit of service and the money received for
that service. It goes to cover fixed and semi variable costs before creating profits.

Determining and allocating economic costs can be a challenging task in some service operations. For example, it's
difficult to decide how to assign fixed costs in a multi-service facility like a hospital. There are certain fixed costs
associated with running the emergency unit. Beyond that there are fixed costs for running the entire hospital. How
much of the hospital's fixed costs should be allocated to the emergency unit? A hospital manager might use one of
several approaches to calculate the unit's share of overheads. These could include (1) the percentage of total floor
space that it occupies, (2) the percentage of employee hours or payroll that it accounts for, or (3) the percentage
of total patient contact hours involved. Each method is likely to yield a
totally different fixed-cost allocation. One method might indicate that the
emergency unit is very profitable, another might make it seem like a
break-even operation, and a third might suggest that the unit is losing money.

Break-even analysis. Managers need to know at what sales volume a service

will become profitable. This is called the break• even point. The necessary
analysis involves dividing the total fixed and semi variable costs by the
contribution obtained on each unit of service. For instance, if a 100-room hotel
needs to cover fixed and semi variable costs of $2 million a year and the
average contribution per room-night is $100, then the hotel will need to sell
20,000 room-nights per year out of a total annual capacity of 36,500. If prices are cut by an average of $20 per
room night (or variable costs rise by $20), then the contribution will drop to $80 and the hotel's break-even
volume will rise to 25,000 room nights.

FOUNDATIONS OF PRICING STRATEGY:

The foundations underlying pricing strategy can be described as a tripod, with costs to the
provider, competition, and value to the customer as the three l e g s (see Figure). The costs that
a firm needs to recover usually impose a minimum or floor price for a specific service offering.
The perceived value of the offering to customers sets a maximum, or ceiling. The price charged
by competitors for similar services typically determine s where , within the floor-to-ceiling
range, the price should actually be set. Let's look at each leg of the pricing tripod in more
detail.

Cost-Based Pricing:

Cost-based pricing involves setting prices relative to financial costs. Companies seeking to
make a profit must set a price sufficient to recover the full costs—variable, semi- variable, an d
fixed—of producing and marketing a service. A sufficient margin must also be added to provide
the desired level of profit at the predicted sales volume. W h en fixed costs are high and the
variable costs of serving an additional customer are very low, manager s may feel that the
y have tremendous pricing flexibility an d be tempted to price low in order to make an
extra sale. However, there can be no profit at the en d of the year unless all relevant costs have
been recovered. Firms that compete on the basis of lo w prices nee d to analyze their cost
structure and identify the sales volume needed to break even at particular prices.

A ctiv it y - B as ed C ost ing: It's a mistake t look at costs from just an accounting perspective
. Progressive managers view them as an integral part of their company's efforts to create
value for customers. Customer s aren't interested in what it costs the firm to produce a
service; instead, they focus on the relationship between price and value. Activity-based
costing (ABC) provides a structured way of thinking about activities and the resources that
they consume.
Competition-Based Pricing:

If customers see little or no difference between the services offered in the marketplace, they
may just c h oos e t he c h e a p e s t a l t e r na t i ve . Un d er conditions of co m p e t i t i o n - base d
pricing , the fir m with the lowest cost per unit of service enjoys an enviable marketing
advantage . It has the option o f either competing o n price a t levels that higher-cost
competitor s cannot afford to match , or charging the going market rate and earning larger
profits than competing firms.

Value-Based Pricing:

Service pricing strategies are often unsuccessful because they lack any clear association
between price and value. There are three strategies for capturing and communicating the
value of a service: uncertainty reduction , relationship enhancement , and cost leadership.

Pricing Strategies to R e d u ce Uncertain ty: If customers are unsure about how much
value they will receive from a particular service, they may remain with a know n supplier or
not purchase at all. Benefit-driven pricing helps reduce uncertainty by focusing on that
aspect of the service that directly benefits customer s (requiring marketers to research
what aspects of the service the customers do and do not value). Flat-rate pricing involves
quoting a fixed price in advance of service delivery so that there are no surprises. This
approach transfers the risk from the customer to the supplier in the event that service
production costs more than anticipated.

Relationship E nh an cem e nt: In general, discounting to win new business is not the best way
t o attract customers w ho will remain loyal over time , since those who are attracted by
cut-rate pricing are easily enticed away by competing offers. However , offering discounts
when customers purchase two or more services together may be a viable relationship-
building strategy. The g r e a t e r the n u m b e r of different services a customer purchases from a
single supplier, the closer the relationship is likely to be.

Cost Leadership: This strategy is based on achieving the lowest costs in an industry. Low-
price d services have particular appeal to customers who are on a tight financial budget .
They may also lead purchasers to buy in larger volumes.

Pricing and Demand

Demand Variation & Capacity Constraints:

Fluctuating demand for service, like that experienced by the retailers, movie theaters, motels,
restaurants etc is found everywhere. It's a problem for a huge cross-section of businesses serving
both individual and corporate customers. These demand fluctuations—which may be as long as a
season of the year or as short as an hourly cycle—play havoc with efficient use of productive
assets. Unlike manufacturing, service operations create a perishable inventor y that cannot be
stockpiled for sale at a later date. That's a problem for any capacity-constrained service that
faces wide swings in demand. T he problem is most comm on ly found among services that process
people or physical possessions, like transportation, lodging, food service, repair and
maintenance, entertainment, and health care. It also affects labor-intensive information-
processing services that face cyclical shifts in demand. University education and accounting
and tax preparation are cases in point.

From Excess Demand to Excess Capacity:

At any given moment,a fixed-capacity service may face on e of four condition s( See figure below)

 Excess demand—the level of demand exceeds maximum available capacity, with the
result that some customers are denied service and business is lost
 Demand exceeds optimum capacity—no on e is actually turned away, but conditions are
crowded and all customer s are likely to perceive a decline in service quality
 Demand and supply are well balanced at the level of optimum capacity—staff and facilities
are busy without being overtaxed, and customers receive good service without delays.
 Excess capacity—demand is below optimum capacity and productive resources are
underutilized , resulting in lo w productivity. In some instances, this poses a risk that
customer s may find the experience disappointing or have doubts about the viability of
the service

Fig: Implication of variations in demand relative to capacity

W h en demand exceeds the maximum available capacity, some potential customers may be
turned away and their business could be lost forever. When the demand level is between
optimum and maximum capacity, all customers can be served but there's a risk that they may
receive inferior service and thus become dissatisfied.

There are two basic solution s to the problem o f fluctuating demand . O ne is to adjust the
level of capacity to meet variations in demand. This approach , which involves cooperation
between operations and human resource management ,requires an understanding of what
constitute s productive capacity and how it may be increased or decreased on an
incremental basis. The second approach is to manage the level of demand, using marketing
strategies to smooth out the peaks and fill in the valleys to generate a more consistent flow
of requests for service. Astute firms employ a mi x of both strategies, which requires close
collaboration between operations and marketing.

Measuring and Managing Capacity:

Many service organizations are capacity constrained .There's an upper limit to their capacity
to serve additional customers at a particular point in time . They may also be constrained in
terms of being unable to reduce their productive capacity during period s of low demand. In
general, organizations that engage in physical processes like people processing and
possession processing are more likely to face capacity constraints than those that engage in
information-base d processes. A radio station, for instance, may be constrained in its
geographic reach by the strength of its signal. Bu t within that radius, any number of listeners
can tune in to a broadcast.

There are various ways of managing capacity. Some of important are being discussed here.

Stretching and Shrinking the Level of Capacity:

Measures of capacity utilization include the number of hours (or percentage of total
available time) that facilities, labor, and equipment are productively employed in revenue
operation , an d the percentage o f available space (e.g., seats, cubic freight capacity,
telecommunication s bandwidth ) that is actually utilized in revenue operations . Some
capacity is elastic in its ability to absorb extra demand.

Strategy for stretching capacity within a given time frame is to utilize the facilities for longer
periods. Examples of this include restaurants that are open for early dinners and late meals,
universities that offer evening classes and summer semester programs, and airlines that extend
their schedules from 14 to 20 hour s a day. Alternatively, the average amount of time that
customer s (or their possessions) spend in the process may be reduced . Sometime s this is
achieved by minimizing slack time , as when the bill is presented promptly to a group of
diners relaxing at the table after a meal. In other instances, it may be achieved by cutting back
the level of service—like offering a simpler men u at busy times of day

Changing Demand: Another set of options involves tailoring the overall level of capacity to
match variations in demand. This strategy is known as chase d e m a n d . There are several actions
that managers can take to adjust capacity as needed.

 Schedule downtime during periods of low demand.

 Use part-time employees.
 Rent or share extra facilities and equipment.
 Cross-train employees: employees can be cross-trained to perform a variety of tasks, they
can be shifted to bottleneck point s as needed to help increase total system capacity.
Creating Flexible Capacity:

Sometimes the problem is no t in the overall capacity but in the mi x that's available to serve
the needs of different market segments. For example, on a given flight, an airline may have to
few seats in economy even though there are empty places in the business- class cabin.

good example of highly flexible capacity comes from an eco-tourism operator in the
South Island of N ew Zealand . During the spring, summer , and early autumn months the
firm provides guide d walks and treks, and during the snow season it offers cross-country
skiing lessons an d trips. Bookings all year round are processed through a contracted telephone-
answering service. Guides and instructors are employed on a part-time basis as required. The
firm has the capacity to provide a wide range of services, yet the owners ' capital
investment in the business is remarkably low..

Strategies for Managing Demand:

In a well-designed, well-managed service operation, the capacity of the facility, supporting

equipment and service personnel will be in balance. Sequential operation s will be designed to
minimize the risk of bottlenecks at any point in the process. This ideal, however, may prove
difficult to achieve. The level of demand may vary, often randomly, and the time and effort
required to process each person or thing may vary widely at any point in the process.

Various approaches are used to manage the demand and the shaping demand using effective
pricing.

Managing Demand under Different Conditions: There are five basic approaches t o managing
demand.

 Taking no action and leaving demand to find its own levels.

 Reduce demand in peak periods
 Increase demand when there is excess capacity
 Inventorying demand until capacity becomes available by introducing reservation system.
 Creating formalized queuing systems

Using Marketing Strategies to Shape Demand Patterns: Price is often the first variable companies
use to bring demand and supply into balance, but changes in product , distribution strategy,
and communication efforts can also play an important role. Although we discuss each
element separately here , effective demand management efforts often require changes in
two or more elements simultaneously.

 Price and Other User Outlay s: O ne of the most direct ways of reducing excess
demand at peak period s is to charge customers more money to use the service during
those times. Increases in nonfinancial outlays may have a similar effect. For instance, if
customers learn that they are likely to spend more time and physical effort during peak
periods, this information may lead those who dislike waiting in crowded and unpleasant
conditions to try later (or to use an arm's length delivery alternative like the Internet or
self-service machines) . Similarly, the lure of cheaper prices and an expectation of
 no waiting may encourage at least some people to change the timing of their
consumption behavior
 Changing Product Elements: Although pricing is often a c om m o nl y a d v oc a t e d
method of balancing supply and demand, it is no t quite as universally feasible for services
as for goods.
 Modifying the Place an d T i m e o f Deliver y:
 Some firms attempt to modify demand for a service by changing the time and place
of delivery by choosing one of two basic options. The first strategy involves varying the
times when the service is available to reflect changes in customer preference by day of week,
by season, and so forth. Theaters and cinema complexes often offer matinees on
weekends when people have more leisure time. During the summer, cafes and restaurants
may stay open later because of daylight savings time and the general inclination of people
to enjoy the longer, warmer evenings outdoors. Retail shops may extend their hours in the
pre-holiday season or during school holiday periods. A second strategy involves offering
the service to customers at a new location. One approach is to operate mobile units that take
the service to customers rather than requiring them to visit fixed-site service locations.
 P r o m o t i on an d Ed ucat i on: Communication efforts alone may b e able t o help
smooth demand even if the other variables of the marketing mix remain unchanged .
Signage, advertising, publicity, and sales messages can be used to educate customers
about the timing of peak periods and encourage the m to use the service at off-peak
times when there will be fewer delays