Basic Methods of Price Determination

 

Price Determination

Exploring Pricing Strategies: Factors to consider - costs, competition, demand, legal considerations, and marketing mix. Choose wisely for profitability and market success.

Basic methods of price determination

Before determining the price of a product, several factors should be considered, including:

• Costs
• Competition
• Demand
• Legal Considerations
• Elements of Marketing Mix, etc.

However, major determinants of the price are - Costs, competition, and demand. Based on this there are three major approaches to setting the price of a product. They are:

1. Cost-oriented pricing

2. Competition-oriented pricing

3. The demand-oriented pricing

Cost-oriented Pricing

In the cost-oriented approach to pricing, also known as cost-based pricing, the selling price of a product is determined by adding a profit percentage to the product cost. There are two methods within cost-oriented pricing.

1. Cost-plus pricing and
2. Target profit pricing or break-even analysis.

Cost Plus Pricing

Particulars	Amount $
Manufacturing Cost	60
Administration cost	6
Distribution Cost	6
Promotional and selling cost	8
Total Costs	80
Profit margin	10
Selling price	90

Cost Plus Pricing

The selling price of a product is determined by adding up all the costs associated with the product, including manufacturing, marketing, and distribution costs, along with a predetermined profit margin. An example of this pricing approach, known as cost-plus pricing, is provided below:

In cost-plus pricing, the product cost comprises both fixed and variable costs, which can be expressed as follows:

Selling price = Variable Costs + Overhead Costs (Fixed Costs) + Profit.

Before setting the selling price, it is important to consider any cost changes that may occur when adjusting the production volume. This method encourages manufacturers to establish their position in the market without incurring losses. It safeguards the interests of both the seller and the buyer, making it a justifiable approach. The profit margin rate may vary across industries and sellers. This method proves valuable when pricing government contracts, where contract pricing needs to be estimated in advance, helping to mitigate risks and uncertainties. Additionally, this method is commonly employed for pricing services.

Price Determination

Price Determination

Break even analysis and Target profit pricing.

It should be noted that as production increases, the fixed cost decreases. For instance, let's consider a production unit with a fixed cost of USD 100 per month.

If the manufacturing unit produces 10 units/products in a month, the cost per unit is USD 10.

If the manufacturing unit produces 100 units/products in a month, the cost per unit is USD 1.

From the examples above, we can observe that as production increases, the fixed cost decreases. When setting the price, assuming a production of 10 units would result in a higher cost and a higher price. Conversely, assuming a production of 100 units would lead to lower costs and a lower price for the product. Marketers need to find a balance when determining the price, considering this aspect. In light of this, certain manufacturers set their prices accordingly. The firm must calculate the sales volume required to cover both the fixed and variable costs, known as the break-even point. Any revenue above this point will generate profit.

Break-even analysis relates to the comparison between total cost and total revenue. The break-even point represents the production level at which total sales revenue (TR) equals total cost (TC). In other words, it is the level of production or supply where the firm neither earns a profit nor incurs a loss. Different selling prices result in different break-even points. If the amount of sales falls below the break-even point, the firm incurs a loss, while sales above the break-even point result in profitability.

The break-even point can be calculated using the following equation:

Break-Even Point = F ÷ (P - V)

Here, F represents the total fixed cost per month, P is the selling price per unit, and V is the average variable cost per unit.

For example, let's consider Adidas, a shoe manufacturer selling shoes for $12 each. The total fixed cost for manufacturing the shoes is $800, regardless of the sales volume. The average variable cost per shoe is $8. Using the formula, the break-even point is calculated as follows:

= 800 ÷ (12 - 8) = 800 ÷ 4 = 200 shoes

Therefore, the firm must sell at least 200 shoes to break even, where total revenue equals total cost. To determine the revenue or sales value, multiply the number of shoes by the selling price, i.e., 200 x 12 = $2400. If the firm aims to make a $400 profit, it would need to sell 300 shoes (Total revenue = 300 x 12 = $3600).

If the firm increases the product price to $13, the break-even point would be 160 shoes. Conversely, if the price is reduced to $11, the break-even point would be 266 shoes.

This technique is highly useful for pricing decisions and financial analysis. The marketing manager can assess the financial implications of pricing decisions using this method, especially when demand and production costs remain stable. It is also valuable for setting the price of a new product, where the firm must consider different price levels to achieve the desired profit. However, this technique may not be suitable when fixed costs increase with higher production volumes. Additionally, it is challenging to predict sales volumes in advance, as adverse conditions may result in lower production or sales levels. Despite these limitations, many firms still rely on this method to determine their product prices.

Demand oriented pricing

Some firms choose to set the price of a product based on its demand, rather than considering competitors' prices or production costs. This approach, known as demand-oriented pricing, involves estimating the expected sales volume at various price points that different types of buyers are willing to pay. When demand is high, the price is set higher, and when demand is low, the price is set lower. In such cases, the price is not determined by either the cost or the competitor's price. There are two methods commonly used for pricing in these situations: differential pricing and perceived value pricing.

Differential Pricing:

Different customers have different preferences and needs, leading to varying levels of demand for the product. Four factors influence the differential pricing method: the time of purchase, customer location, product version, and the individual customer.

For example, in a movie theater, there may be different seating classes available for the same film. While some customers are willing to pay more for a comfortable seat, others may not be willing to spend that much on the same film. The bargaining power of the customer also plays a role in determining whether they pay a lower or higher price for a product. Customers with strong bargaining skills may obtain the product at a lower cost, while others may have to pay more. The customer's level of product knowledge and awareness of its features also impact the price they are willing to pay. Additionally, product availability can influence pricing, with high demand allowing sellers to charge higher prices and those willing to pay more securing the product.

In different locations, similar products may be sold at different prices. The factor of location determines the price in such situations. Customers would have to travel extensively to obtain the same product at a lower price, which can be time-consuming and economically undesirable. Hotels charge varying amounts based on different seasons, and telephone call rates differ between working days and non-working days, including night and day call charges. This type of pricing is demand-oriented and dependent on time.

Products can be sold at different prices by offering slight variations. For instance, a book with an attractive leather cover may command a higher price compared to an ordinary version, even though the production cost may only have a slight difference. Slightly different product versions can be sold at higher prices in the market.

Perceived Value Pricing:

Buyers often have differing perceptions of the same product based on its value to them. Hotels and restaurants of different categories may price a cup of coffee differently, as buyers assign different values to the same item. To utilize the perceived value pricing method, it is essential to understand how different buyers perceive the product in terms of its features, quality, and attributes. This approach requires evaluating and understanding the product's perceived value from the perspective of various buyers before determining the pricing strategy.

Competition Oriented Pricing

Competition-oriented pricing refers to a pricing approach where the price of a product is determined based on the prices set by competitors or the industry leader, rather than considering the production costs or varying perceptions of the product by different buyers.

Going Rate Pricing

One specific method of competition-oriented pricing is called going rate pricing. It involves setting the price according to the prevailing market trend. This pricing strategy is commonly employed for products that are readily available in the market and lack variations. In such cases, marketers do not extensively analyze the market's demand intensity or the perceived value of the product among buyers. The price does not necessarily have to match that of the competitor or industry leader exactly; it can be slightly higher or lower. As the industry leader adjusts their price, the firm can also make corresponding adjustments, increasing or decreasing the price accordingly. This approach is particularly popular among retailers. However, it is challenging to determine customer reactions since price changes affect the entire industry.

Going rate pricing is a straightforward method as it does not require estimating price elasticity, demand, or various product costs. Moreover, proponents of this pricing method argue that it helps prevent price wars among competitors. It is commonly employed for homogeneous products in conditions of pure competition and oligopoly. For firms selling undifferentiated products in a purely competitive market, there is limited flexibility in setting prices. Supporters of the going rate pricing method believe that the prevailing rate represents the collective wisdom of the industry.