Pricing Strategies

Chapter Two
The Starting Point in Setting an Initial Price

@ SAGE Publications, 2011

Situations when a Price Must Be Set
 The item is a new product.
 The item is a new version of an existing
product.
 The item is an existing product but is
being offered in a new market.
 The item is an existing product not
previously sold by the organization.

@ SAGE Publications, 2011

Starting Points in Determining Price
 The item’s cost

 The price of similar items sold by

competitors

 The value of the benefits that the item

creates by satisfying the needs of the
customer

@ SAGE Publications, 2011

 Cost-Based Pricing
 The most common form
 Simple logic: The selling price should be
greater than what it costs to produce or
acquire that item.
 Methods:
◦ Cost-plus pricing
◦ Markup pricing
◦ Gross-margin pricing

@ SAGE Publications, 2011

 Cost-Plus Pricing
 Is the simplest form of Cost-Based Pricing
 Must determine the amount to be added to
an item’s cost, and then add that amount to
arrive at the item’s price:
P = C + added amount
 Is particularly common among companies
that sell customized products

@ SAGE Publications, 2011

 Markup Pricing

 Is used when it is difficult to determine

the added amount due to large numbers
of different products
 Is common among wholesalers and
retailers

The item’s cost is “marked up” by some

standard percentage of that cost.

@ SAGE Publications, 2011

 Calculating the Markup Price
 The standard percentage used in markup
pricing is called the markup:
M = (added amount / C) x 100
 The method of calculating the price is:
P = C + [(M / 100 x C)]

When a good changes hands more than once

before reaching the consumer, successive
markups are applied.
@ SAGE Publications, 2011
Determining Markup Levels
 Based on tradition or rules of thumb
Wholesaling: 20%
Retailing: keystone pricing or doubling the
item’s cost (100%)
Restaurants: tripling the food costs
(200%) and quadrupling the costs of
served alcoholic beverages (300%)

@ SAGE Publications, 2011

@ SAGE Publications, 2011
Gross-Margin Pricing
 Is used when the amount added to the
item’s cost is heavily influenced by the
profit goals of the organization
 Gross Margin: the amount of a company’s
sales revenue that remains after
subtracting the costs of the items sold
 Is more difficult to use than markup
pricing

@ SAGE Publications, 2011

 Establishing Gross-Margin

 The percent gross margin is the amount

added to an item’s cost expressed as a
percentage of the item’s price:

%GM = (added amount / P) x 100

@ SAGE Publications, 2011

Two Ways to use Percent Gross Margin
to set a Price
 Convert the percent gross margin to the
more intuitive markup percentage:
M = %GM x [100 / (100 - %GM)]

 Compute the product’s directly from the

gross-margin percentage:
P = C / [ 1 - (%GM / 100)]

@ SAGE Publications, 2011

@ SAGE Publications, 2011
Determinants of Gross-Margin Goals
 Based on tradition and rules of thumb

 Based on industry norms found in publicly

available reports

@ SAGE Publications, 2011

Advantages and Disadvantages
of Cost-Based Pricing
Advantages Disadvantages
 Simple to use  Not useful in
 Standard markup efforts to
or margin levels maximize total
reduces the need profits
for research on
competitor’s
prices

@ SAGE Publications, 2011

Competition-Based Pricing
 Is the setting of an item’s initial price by
examination of competitors’ prices
 Parity pricing: matching the item’s price
to the level of a competitor’s price
 Can be challenging due to the number of
competitors, including those online

@ SAGE Publications, 2011

 Ways to Overcome
Competitive Pricing Challenges
 Focus on only the highest marketplace
prices
 Focus on only the lowest marketplace
prices
 Focus on the middle
 Focus on the prices of one particular
competitor
 In business markets, the company must
focus on salesperson knowledge and
competitive intelligence.
@ SAGE Publications, 2011
Advantages and Disadvantages
of Competition-Based Pricing
Advantages Disadvantages
 Intuitive  Not useful in
 Relatively easy to efforts to
carry out maximize total
profits
 Lack of price-
setting rationale if
all competitors
are using this
method
@ SAGE Publications, 2011
Customer-Based Pricing
 The initial price is set by considering the
customer’s needs and the ability of the
seller’s product to satisfy those needs.

 This method makes possible a rational

basis for price setting – how much of the
product’s value can be captured by its
price.

@ SAGE Publications, 2011

Estimating the Value to the Customer
 The value created by the product,
distribution and promotion elements is
known as the product’s value to the
customer (VTC).

 The process of estimating this value can

be broken down into four steps.

@ SAGE Publications, 2011

Steps One and Two
 Identify what the customer perceives as
the next closest substitute for your
product - the price of this product is the
reference value

 Identify all of the differentiating factors, the

factors that differentiate your product
from the next closest substitute

@ SAGE Publications, 2011

Steps Three and Four

 Determine the value of each of the

differentiating factors – positive or
negative differentiation value

 Sum the reference value and the

differentiation value – the total is the
value to the customer, the maximum
amount the customer when fully informed
of the benefits would be willing to pay
@ SAGE Publications, 2011
Translating a VTC Estimate into a Price
 The product’s price should not be set
equal to the VTC estimate, but at a level
below it.
 If at the same level, there is no net benefit
to the customer. Costs equal benefits.
 How far below the VTC estimate depends
on how fast you want to sell the item.

@ SAGE Publications, 2011

Identification of the Reference Value
 Provides a means of combining
information about competitors with
customer-need information
 Considers the amount of the closest
substitute product that is equivalent
 Does not include the prices of items used
along with the alternative product but are
actually separate products

@ SAGE Publications, 2011

Two Approaches to Determining
Differentiation Values
 Translate the factor into monetary terms
by identifying additional monetary
expenditures and/or savings that result
from the factor
 Use market research to estimate how
customers weigh money against their
preferences and feelings for the
differentiating factor

@ SAGE Publications, 2011

 The Potential of
Customer-Based Pricing
 Capture a larger amount of a product’s
value
 Communicate the product’s value over that
of the competitor’s products
 Avoid parity pricing
 Guide product development
 Determine different customer values for
different market segments

@ SAGE Publications, 2011

Reasons Why Customer-Based Pricing
is a Less Common Method
 Certain industries or certain conditions
use cost-based methods as a matter of
practice, particularly when costs are high.
 Customer-based pricing requires research
on customer needs rather than on costs
or competitive price information
(seemingly less extensive).
 Lack of interest by the price-setter

@ SAGE Publications, 2011