Setting the Price of a Product: Policy, Determination ,Methods and Strategies!
Types of Pricing:
Pricing for products or services encompass three main ways to improve profits. These are that the business owner can cut costs or sell more, or find more profit with a better pricing strategy. When costs are already at their lowest and sales are hard to find, adopting a better pricing strategy is a key option to stay viable.
Merely raising prices is not always the answer, especially in a poor economy. Too many businesses have been lost because they priced themselves out of the marketplace. On the other hand, too many business and sales staff leave “money on the table”. One strategy does not fit all, so adopting a pricing strategy is a learning curve when studying the needs and behaviors of customers and clients.
There are various ways of setting prices as outlined in the following:
1. Cost-Plus Pricing:
Cost-plus pricing is the simplest pricing method. The firm calculates the cost of producing the product and adds on a percentage (profit) to that price to give the selling price. This method although simple has two flaws; it takes no account of demand and there is no way of determining if potential customers will purchase the product at the calculated price.
This appears in two forms, Full cost pricing which takes into consideration both variable and fixed costs and adds a % markup. The other is direct cost pricing which are variable costs plus a % markup, the latter is only used in periods of high competition as this method usually leads to a loss in the long run.
2. Creaming or Skimming:
In most skimming, goods are sold at higher prices so that fewer sales are needed to break even. Selling a product at a high price, sacrificing high sales to gain a high profit is therefore “skimming” the market.
Skimming is usually employed to reimburse the cost of investment of the original research into the product- commonly used in electronic markets when a new range, such as DVD players, are firstly dispatched into the market at a high price.
This strategy is often used to target “early adopters” of a product or service. Early adopters generally have a relatively lower price sensitivity this can be attributed to- their need for the product outweighing their need to economize; a greater understanding of the product’s value; or simply having a higher disposable income.
This strategy is employed only for a limited duration to recover most of the investment made to build the product. To gain further market share, a seller must use other pricing tactics such as economy or penetration. This method can have some setbacks as it could leave the product at a high price against the competition.
3. Limit Pricing:
A limit price is the price set by a monopolist to discourage economic entry into a market, and is illegal in many countries. The limit price is the price that the entrant would face upon entering as long as the incumbent firm did not decrease output. The limit price is often lower than the average cost of production or just low enough to make entering not profitable.
The quantity produced by the incumbent firm to act as a deterrent to entry is usually larger and would be optimal for a monopolist, but might still produce higher economic profits than would be earned under perfect competition.
The problem with limit pricing as a strategy is that once the entrant has entered the market, the quantity used as a threat to deter entry is no longer the incumbent firm’s best response. This means that for limit pricing to be an effective deterrent to entry, the threat must in some way be made credible.
A way to achieve this is for the incumbent firm to constrain itself to produce a certain quantity whether entry occurs or not. An example of this would be if the firm signed a union contract to employ a certain (high) level of labor for a long period of time. In this strategy price of the product become limit according to budget.
4. Loss Leader:
A loss leader or leader is a product sold at a low price (i.e. at cost or below cost) to stimulate other profitable sales. This would help the companies to expand its market share as a whole.
5. Market-Oriented Pricing:
Setting a price based upon analysis and research compiled from the target market. This means that marketers will set prices depending on the results from the research. For instance if the competitors are pricing their products at a lower price, then it’s up to them to either price their goods at an above price or below, depending on what the company wants to achieve.
6. Penetration Pricing:
Setting the price low in order to attract customers and gain market share. The price will be raised later once this market share is gained.
7. Price Discrimination:
Setting a different price for the same product in different segments to the market. For example, this can be for different ages, such as classes, or for different opening times.
8. Premium Pricing:
Premium pricing is the practice of keeping the price of a product or service artificially high in order to encourage favorable perceptions among buyers, based solely on the price. The practice is intended to exploit the (not necessarily justifiable) tendency for buyers to assume that expensive items enjoy an exceptional reputation, are more reliable or desirable, or represent exceptional quality and distinction.
9. Predatory Pricing:
Aggressive pricing (also known as “undercutting”) intended to drive out competitors from a market. It is illegal in some countries.
10. Contribution Margin-Based Pricing:
Contribution margin-based pricing maximizes the profit derived from an individual product, based on the difference between the product’s price and variable costs (the product’s contribution margin per unit), and on one’s assumptions regarding the relationship between the product’s price and the number of units that can be sold at that price.
The product’s contribution to total firm profit (i.e. to operating income) is maximized when a price is chosen that maximizes the following- (contribution margin per unit) X (number of units sold).
11. Psychological Pricing:
Pricing designed to have a positive psychological impact. For example – selling a product at $3.95 or $3.99, rather than $4.00.
12. Dynamic Pricing:
A flexible pricing mechanism made possible by advances in information technology, and employed mostly by Internet based companies. By responding to market fluctuations or large amounts of data gathered from customers ranging from where they live to what they buy to how much they have spent on past purchases dynamic pricing allows online companies to adjust the prices of identical goods to correspond to a customer’s willingness to pay.
The airline industry is often cited as a dynamic pricing success story. In fact, it employs the technique so artfully that most of the passengers on any given airplane have paid different ticket prices for the same flight.
13. Price Leadership:
An observation made of oligopolistic business behavior in which one company, usually the dominant competitor among several, leads the way in determining prices, the others soon following. The context is a state of limited competition, in which a market is shared by a small number of producers or sellers.
14. Target Pricing:
Pricing method whereby the selling price of a product is calculated to produce a particular rate of return on investment for a specific volume of production. The target pricing method is used most often by public utilities, like electric and gas companies and companies whose capital investment is high, like automobile manufacturers.
Target pricing is not useful for companies whose capital investment is low because, according to this formula, the selling price will be understated. Also the target pricing method is not keyed to the demand for the product, and if the entire volume is not sold, a company might sustain an overall budgetary loss on the product.
15. Absorption Pricing:
Method of pricing in which all costs are recovered. The price of the product includes the variable cost of each item plus a proportionate amount of the fixed costs and is a form of cost plus pricing.
16. High-Low Pricing:
Method of pricing for an organization where the goods or services offered by the organization are regularly priced higher than competitors, but through promotions, advertisements, and or coupons, lower prices are offered on key items.
The lower promotional prices are designed to bring customers to the organization where the customer is offered the promotional product as well as the regular higher priced products.
17. Premium Decoy Pricing:
Method of pricing where an organization artificially sets one product price high, in order to boost sales of a lower priced product.
18. Marginal-Cost Pricing:
In business, the practice of setting the price of a product to equal the extra cost of producing an extra unit of output. By this policy, a producer charges, for each product unit sold, only the addition to total cost resulting from materials and direct labor. Businesses often set prices close to marginal cost during periods of poor sales.
If, for example – an item has a marginal cost of Rs. 49 and normal selling price is Rs. 53, the firm selling the item might wish to lower the price to Rs 50. The business would choose this approach because the incremental profit of 1 rupee from the transaction is better than no sale at all.
19. Value-Based Pricing:
Pricing a product based on the value the product has for the customer and not on its costs of production or any other factor. Value-based pricing sells the product at the price based on the customer’s perceived value of the product. A good example where such a pricing system is used is on luxury items where the actual value is quite different from the perceived value.
For Example – A luxury item may not actually cost nearly as much to make as what people are prepared to pay for it. It is important to note that this method of pricing is based on a sound understanding of how customers judge value and may only be possible after a product has a strong reputation.
20. Pay What You Want:
Pay what you want is a pricing system where buyers pay any desired amount for a given commodity, sometimes including zero. In some cases, a minimum (floor) price may be set, and/ or a suggested price may be indicated as guidance for the buyer. The buyer can also select an amount higher than the standard price for the commodity.
Giving buyers the freedom to pay what they want may seem to not make much sense for a seller, but in some situations it can be very successful. While most uses of pay what you want have been at the margins of the economy, or for special promotions, there are emerging efforts to expand its utility to broader and more regular use.
21. Freemium:
Freemium is a business model that works by offering a product or service free of charge (typically digital offerings such as software, content, games, web services or other) while charging a premium for advanced features, functionality, or related products and services. The word “freemium” is a portmanteau combining the two aspects of the business model-“free” and “premium”. It has become a highly popular model, with notable success.
22. Odd Pricing:
In this type of pricing, the seller tends to fix a price whose last digits are odd numbers. This is done so as to give the buyers/consumers no gap for bargaining as the prices seem to be less and yet in an actual sense are too high.
A good example of this can be noticed in most supermarkets where instead of pricing at $10, it would be written as $9.99. This pricing policy is common in economies using the free market policy.
23. Mark-Up Pricing:
Mark-up is the difference between the costs of producing and selling a product (fixed costs plus variable costs) and the market selling price of the product. It is the difference between what you spend to produce the product and what the customer spends to purchase if.
It is calculated as follows:
Fixed Cost per unit = Total Fixed Cost/Units Produced
Variable Cost per unit = Total Variable Costs/Units Produced
Selling Price = Fixed Cost per unit Variable Cost per unit Desired Profit Margin
Desired profit margin is the amount of profit you would like your business to make above your production costs. It can be expressed as a percentage of the total costs.
24. Target Return Pricing:
Using this strategy, a business first determines what level of demand there is for the product and then identifies the desired profit the business would like to make from the product.
The price is calculated by dividing the total desired profit by the expected level of sales. Therefore, by meeting the level of expected sales, a certain amount of profit will be received.
25. Going-Rate Pricing:
In the situation where the business is in a competitive market, the business charges the average price of what its competitors are charging for a similar or the same product. This may be the case where there is only a small amount of competition and the product is a necessity. It is sometimes in a business’s best interest to not compete by undercutting their competition.
Introduction to Pricing Policy:
Pricing policy refers to the policy by which a company determines the wholesale and retail prices for its products or services. It is the method of decision making used for setting the prices for a company’s products or services. A pricing policy is usually based on the costs of production or provision with a margin for profit, for example, cost-plus pricing.
The general considerations involved in formulating a pricing policy are as follows:
1. The number, relative size, and product lines of competitors, i.e., degree of closeness of substitute products supplied by the rivals.
2. The likelihood of potential competition. This depends on the possibilities of entry of new firms in the market and the relative entry barriers. The 1st stage of consumer acceptance of the product. The degree of patronization of the buyers towards the given product is manufactured by the firm.
3. The degree of potential market segmentation or sub-division and chances of price discriminations.
4. The degree of product differentiation adopted by the concerned firm in comparison to the rivals in the market.
5. The opportunities and possibilities for variation in the product service bundle.
6. The richness of the mixture of service, advertisement and sales propaganda and the reputation of the firm and qualitative improvement in the product bundle.
7. The cross elasticity of demand provides a unique dividing line between differentiated products and homogeneous products and an idea of the market condition and its relative competitiveness.
8. Pricing should normally aim at stimulating profitable combination sales. Sometimes, the firm may also seek profit maximisation. Sometimes, the firm may want to capture the market through sales maximisation. But, in any case, sales should also be more profit oriented and never be loss oriented, under normal circumstances.
9. Prices should be set to promote the long range welfare and well-establishment of the firm in the market. The firm may seek to discourage entry of the rivals through its low price policy.
10. Pricing policy should be flexible enough to meet the changes in the demand pattern and market situation.
11. The firm has to set a clear vision of its business objective such as survival, growth, etc.
12. Prices should be adapted and individualized in accordance with the diverse competitive situations encountered by different varieties of products produced by the firm.
13. Provision may be made for a predetermined and systematic method of pricing new products which may be introduced by the firm in course of time, under its business planning for expansion.
14. Determination of replacement parts prices form an organized classification of parts by type and manufacture.
15. Determination of the price discount structure, i.e., price discount differentials for distribution channels quantity-wise, territory-wise, terms of payments wise, etc.
16. Prices have to be viewed in relation to the quality and quantity of the firm’s product and its promotional policies and sales expenditures.
Objectives of Pricing Policy:
The common pricing objectives are:
(i) To maximize long-run profit.
(ii) To maximize short-run profit.
(iii) To increase sales volume.
(iv) To increase monetary sales.
(v) To increase market share.
(vi) To obtain a target rate of return on investment (ROI).
(vii) To obtain a target rate of return on sales.
(vii) To stabilize market or stabilize market price.
(viii) To ensure company growth.
(ix) To maintain price leadership.
(x) To desensitize customers to price.
(xi) To discourage new entrants into the industry.
(xii) To match competitors prices.
(xiii) To encourage the exit of marginal firms from the industry.
(xiv) To avoid government investigation or intervention.
(xv) To obtain or maintain the loyalty and enthusiasm of distributors.
(xvi) To enhance the image of the firm, brand or product.
Importance of Good Pricing Policies:
The importance of good pricing policies can be summarized as follows:
(a) Market Shares:
By adopting a price policy the firm may wish to capture a larger share in the market and acquire a dominating leadership position. In oligopoly market, this is quite common.
(b) Target Return on Investment:
The firms may have a predetermined target return of their investment.
(c) Preventing Competition:
In pricing its product, the firm may keep an eye on rival’s entry. So, it may fix up the price such that would prevent competition.
(d) Survival:
Basically, in these days of monopolistic competition or dynamic changes and business uncertainties, a firm is always interested in its continued survival first. For the sake of assuring continued existence, generally, a firm is ready to tolerate all kinds of upheaval in product lines, organizational and even personnel changes.
(e) Rate of Growth and Sales Maximization:
A firm may be interested in setting a price policy which will permit a rapid expansion of the firm’s business and its sales maximization.
(f) Making Money:
Some firms are interested in making a fast buck taking their monopoly advantage into account and try to sell their goods at premium.
(g) Service Motive:
A firm may set pricing policy such as to serve the community and improve its welfare.
(h) Regular Income:
Some firms are interested in maintaining regular flow of income, so would set their price policy accordingly.
(i) Price Stabilization:
The firms may be generally interested in keeping their prices stable within certain range over a period of time, irrespective of marginal changes in demand and costs.
Determination of Pricing Policy:
The following are the important factors deserving special attention in determination of a pricing policy of any firm:
1. Examine Market Pricing and Economics:
A paid, ad-free site should generate more revenue than a free ad-supported one, for example. In considering this option, remember to incorporate the cost of forgone revenue, especially as advertisers find paying customers more attractive.
2. Costs:
Cost is an important element in price determination. Cost data serve as the base. Price has to be along cost. If price is below the cost of production it would mean losses. Thus, cost analysis is important. Along the total costs, average and marginal costs are to be determined.
For business decisions in the short run, direct or variable costs have greater relevance. The firms seek to cover full allocated costs. Economy in cost is also important for setting a lower price for the product. A high cost of production obviously calls for a higher price.
3. Demand:
In pricing policy, demand can never be overlooked. Rather, demand is more important for the effective sales. Demand for a firm’s product depends on consumer’s preferences. So, the consumer psychology is very important.
Through appropriate advertising and sales campaign, consumers’ psychology can be influenced and their preferences may be altered, thus, demand can be manipulated.
A low or high price policy is to be set in view of the elasticity of demand. If demand for the product is highly inelastic, then only rising price policy would be a paying proposition to the businessman.
4. Competition:
The nature of pricing policy largely depends on the degree of competition prevailing in the market. Under perfect competition, there is a uniquely determined ruling price in the market; also the firm has no scope to design its own price policy. Under monopoly, oligopoly or monopolistic competition, the firm can determine its own price policy.
5. Profits:
In determining price policy, profit consideration is also significant. In practice, however, rarely is there a goal of profit maximization. Usually, pricing policy is based on the goal of obtaining a reasonable profit.
Further, most of the businessmen would prefer to hold constant price for their products rather than going for a price rise on a price cut, as far as possible.
6. Government Policy:
Pricing policy of a firm is also affected by the government policy. If the government resorts to price control, the firm has to adopt the price as per the formula and ceiling prescribed by the Government and then there is little scope to pursue its own pricing.
7. Monitor the Competitor’s Pricing:
Market dynamics and new products can influence and change consumer needs.
Methods/Types of Pricing Policies:
Types of pricing methods which are:
1. Cost-Oriented Pricing Policy:
Following are the some of the methods of pricing based on cost:
(a) Cost-Plus Method:
This pricing method assumes that no products are sold at a loss since the price covers the full cost incurred. Definitely costs furnish a good point from which the computation of price could begin.
Fixing a tentative price under this policy is easier. The price under this method is determined by adding a desired percentage profit on cost to the total cost of the product taking into account, the margins for middlemen.
But the disadvantage of this policy is that it ignores completely the use of retail traders and in manufacturing industries where the production is not standardized. The method of pricing is based on simple mathematics adding a fixed percentage to the unit cost.
Thus the retail price of a particular item might be the manufacturer’s cost plus his gross margin. This method is therefore, also known as sum of margins methods.
Advantages of Cost-Plus Method:
(i) Where it is difficult to forecast the future demand this method is appropriate.
(ii) If there are few buyers of the products, pricing can be justified.
(iii) Public utility services like railways, post office, electricity etc. are priced through this method.
(iv) It is a long-term policy.
Disadvantages of Cost-Plus Method:
(i) The demand and supply forces and competition-the two important factors in fixing the prices- are ignored.
(ii) This method is totally based on cost-concept. But the reality is that it does not influence the prices whereas prices influence the cost.
(iii) The costs of joints products are only estimated. Correct cost cannot be calculated.
(b) Rate of Return or Target Pricing:
Under this method, first of all, an arbitrary desired rate of profit on the capital employed/invested is determined by the enterprise. The total desired profit is then calculated on the basis of this rate of return. Total desired profit is then added to the total cost of production and thus, the price per unit of the product is determined. In short-
(c) Break- Even Pricing:
The break even analysis helps a firm to determine at what level of output the revenues will equal the costs assuming a certain selling price. For this purpose the cost of manufacture is also divided into two- fixed and variable costs. Fixed cost (Rent, Rates, Insurance, etc.) theoretically remain constant over all levels of output, Variable costs (labor and material) vary with changes in the output level.
Fixed costs naturally decrease per unit when production increases. Variable costs, on the other hand change as production varies, i.e., no production no variable cost, more production more variable cost.
The break-even point therefore, is a point where there is neither loss nor profit.
This is found out by using the following equation:
Margin of contribution = Unit selling price – unit variable costs.
This could also be expressed graphically-
FC = Fixed Cost
SP = Selling Price
VC = Variable Cost
Break-even analysis helps to establish prices only when the costs of production remain reasonably constant. Another trouble is found in accurately forecasting demand at various prices.
(d) Marginal Cost or Incremental Cost Pricing:
In this method the price is fixed on the basis of additional variable cost associated variable cost associated with an additional unit of output. The cast of producing and selling on or more units, i.e., the last unit is taken as the base for the pricing under this method. Only variable cost is considered and recovered. Consideration of fixed cost is ignored.
Advantages of Marginal Cost/Incremental Cost Pricing:
(i) This method is useful in introductory campaigns, i.e., for introducing a new product should not bear its share in fixed cost.
(ii) In order to protect the shut down and keeping the labor force busy in slack seasons this method is also helpful.
(iii) If the product is perishable or when the competitors are weak this method is useful.
(iv) This method can be used where break-even point has been achieved.
(v) This method is particularly useful in quoting for competitive tenders and export marketing.
Limitations of Marginal Cost/Incremental Cost Pricing:
(i) This method cannot be followed indefinitely as its share of fixed costs remains to be unabsorbed and if other products are made to absorb all the fixed costs involved in an organization, the seller is selling a proportion of their output at incremental cost and the customers of the other products are paying a higher price.
(ii) The producer may lose the market of other products because of the high cost and competitors may drive away the customers.
2. Demand-Oriented Pricing Policy:
Under this method of pricing, the demand is pivotal factor. Price is fixed by simply adjusting it to the market conditions. Price is fixed by simply adjusting it to the market conditions. A high price is charged when or where the demand is intense and a low price is charged when the demand is low. The following methods belong to this charged of demand is low.
The following methods belong to this category of demand based pricing:
(a) What the Traffic can Bear Pricing/Purchasing Power Pricing Method:
Under this method the price of the product is determined on the basis of what the purchaser can bear or pay. What purchasers can pay depends upon their purchasing power. Generally, luxury goods or fashion goods, cosmetics, are price on this basis. It is more used by retailers rather than by manufacturing firms.
This method brings high profits in short run. But in the long run, this concept is not safe. Chances of errors in judgment are high. It can be used where monopoly/oligopoly conditions exist and where demand is quite inelastic with respect to price.
(b) Skimmed Pricing:
The skim of Pricing Strategy’ uses a very high introductory price to skim the cream of demand at the very outset. This strategy is adopted when there is no competition in the e-market or the new product has some exclusive characteristics.
Such prices continue to be high till the competitors begin to enter the field. As soon as competitors enter the market, the producer reduces the prices of his product. This is a method of recovering the product development cost very soon.
(c) Penetration Pricing:
This is the opposite of ‘skim the cream’ technique. It offers a very low introductory price to speed up its sales and therefore widening the market base. Low price is used as a major tool for rapid penetration of a mass market and is based on a long-term viewpoint.
It aims at capturing the market, if there is already a competing product. Its aim may be to capture a share of the market from a company product which new product it is hoped will replace. It discourages competitors from entering the market.
3. Competition-Oriented Pricing Policy:
Most of the companies fix prices of their products after a careful consideration of the competitors’ price structure. Deliberate policy may be formulated to sell its products in the competitive market.
Three policy alternatives are available to the firm under this method:
(a) Parity Pricing or Going Rate Pricing:
Under this method, the price of the product is determined on the basis of the price of competitor’s products. This method is used when the firm is new in the market or when the existing firm introduces a new product in the market. This method is used when there is tough competition in the market.
This method is based on the assumption that a new product will create demand only when its price is competitive. In such a case, the firm follows the market leader.
(b) Pricing above Competitive Level or Discount Pricing:
Discount pricing means when the firm determines the price of its products below the competitive level, i.e., below the price of the same products of the competitors.
(c) Pricing above Competitive Level or Premium Pricing:
Premium pricing means where the firm determines the price of its product above the price of the same products of the competitors. Price of the firm’s product remains higher showing that quality is better. The price policy is adopted by the firms of high repute only because they have created the image of quality producer in the minds of the public.
They become the market leader. All the above three competitive based methods are not rigid in price cost relations. Its cost or demand may change but the price of the product remains unchanged. Conversely, the firm changes its price even when there is no change in cost or demand of firm’s product.
Price Determination Process:
Pricing is the process of determining what a company will receive in exchange for its products. Pricing factors are manufacturing cost, market place, competition, market condition, and quality of product. Pricing is also a key variable in microeconomic price allocation theory.
Pricing is a fundamental aspect of financial modeling and is one of the four Ps of the marketing mix. The other three aspects are product, promotion, and place. Price is the only revenue generating element amongst the four P’s, the rest being cost centers.
Pricing is the manual or automatic process of applying prices to purchase and sales orders, based on factors such as a fixed amount, quantity break, promotion or sales campaign, specific vendor quote, price prevailing on entry, shipment or invoice date, combination of multiple orders or lines, and many others.
Automated systems require more setup and maintenance but may prevent pricing errors. The needs of the consumer can be converted into demand only if the consumer has the willingness and capacity to buy the product. Thus pricing is very important in marketing.
Pricing Strategies:
The various pricing strategies are as follows:
1. Value based pricing
2. Cost based pricing
3. Customer-based pricing
4. Competitor-based pricing
1. Value Based Pricing:
Pricing a product based on the value the product has for the customer and not on its costs of production or any other factor. Value-based pricing sells the product at the price based on the customer’s perceived value of the product.
A good example where such a pricing system is used is on luxury items where the actual value is quite different from the perceived value.
For Example, A luxury item may not actually cost nearly as much to make as what people are prepared to pay for it. It is important to note that this method of pricing is based on a sound understanding of how customers judge value and may only be possible after a product has a strong reputation.
2. Cost Based Pricing:
This involves setting a price by adding a fixed amount or percentage to the cost of making or buying the product. In some ways this is quite an old-fashioned and somewhat discredited pricing strategy, although it is still widely used. After all, customers are not too bothered what it cost to make the product they are interested in what value the product provides them.
Cost-plus (or “mark-up”) pricing is widely used in retailing, where the retailer wants to know with some certainty what the gross profit margin of each sale will be. An advantage of this approach is that the business will know that its costs are being covered. The main disadvantage is that cost-plus pricing may lead to products that are priced un-competitively.
The main advantage of cost-based pricing is that selling prices are relatively easy to calculate. If the mark-up percentage is applied consistently across product ranges, then the business can also predict more reliably what the overall profit margin will be.
3. Customer-Based Pricing:
(a) Skimming Pricing Strategy:
Skimming pricing is a pricing strategy in which a marketer sets a relatively high price for a product or service at first then lowers the price over time. This strategy is often used to target “early adopters” of a product or service.
These early adopters are relatively less price sensitive because either their need for the product is more than others or they understand the value of the product better than others. In market skimming goods are sold at higher prices so that fewer sales are needed to break even.
The practice of skimming pricing involves charging a relatively high price for a short time where a new, innovative, or much-improved product is launched onto a market.
The objective with skimming is to “skim” off customers who are willing to pay more to have the product sooner; prices are lowered later when demand from the “early adopters” falls.
The success of a price-skimming strategy is largely dependent on the inelasticity of demand for the product either by the market as a whole, or by certain market segments. High prices can be enjoyed in the short term where demand is relatively inelastic.
In the short term the supplier benefits from ‘monopoly profits’, but as profitability increases, competing suppliers are likely to be attracted to the market (depending on the barriers to entry in the market) and the price will fall as competition increases.
The main objective of employing a price-skimming strategy is, therefore, to benefit from high short-term profits (due to the newness of the product) and from effective market segmentation.
Advantages of Skimming Pricing:
(i) Where a highly innovative product is launched, research and development costs are likely to r e high, as are the costs of introducing the product to the market via promotion, advertising etc. In such cases, the practice of price skimming allows for some return on the set-up costs.
(ii) By charging high prices initially, a company can build a high-quality image for its product. Charging initial high prices allows the firm the luxury of reducing them when the threat of competition arrives. By contrast, a lower initial price would be difficult to increase without risk in the loss of sales volume.
(iii) Skimming can be an effective strategy in segmenting the market. A firm can divide the market into a number of segments and reduce the price at different stages in each, thus acquiring maximum profit from each segment.
(iv) Where a product is distributed via dealers, the practice of price skimming is very popular, since high prices for the supplier are translated into high mark-ups for the dealer.
(v) For ‘conspicuous’ or ‘prestige goods’, the practice of price skimming can be particularly successful, since the buyer tends to be more ‘prestige’ conscious than price conscious. Similarly, where the quality differences between competing brands is perceived to be large, or for offerings where such differences are not easily judged, the skimming strategy can work well. An example of the latter would be for the manufacturers of ‘designer-label’ clothing.
Disadvantages of Skimming Pricing:
(i) It is effective only when the firm is facing an inelastic demand curve. If the long run H’ schedule is elastic (as in the diagram to the right), market equilibrium will be achieved quantity changes rather than price changes.
Penetration pricing is a more suitable strategy in this case. Price changes by any one firm will be matched by other firms resulting in a rapid growth in industry volume. Dominant market share will typically be obtained by a low cost producer that pursues a penetration strategy.
(ii) A price skimmer must be careful with the law. Price discrimination is illegal in many jurisdictions, but yield management is not. Price skimming can be considered either a form of price discrimination or a form of yield management.
Price discrimination uses market characteristics (such as price elasticity) to adjust prices, whereas yield management uses product characteristics.
Marketers see this legal distinction as quaint since in almost all cases market characteristics correlate highly with product characteristics. If using a skimming strategy, a marketer must speak and think in terms of product characteristics to stay on the right side of the law.
(iii) The inventory turn rate can be very low for skimmed products. This could cause problems for the manufacturer’s distribution chain. It may be necessary to give retailers higher margins to convince them to handle the product enthusiastically.
(iv) Skimming encourages the entry of competitors. When other firms see the high margins available in the industry, they will quickly enter.
(v) Skimming results in a slow rate of stuff diffusion and adaptation. This results in a high level of untapped demand. This gives competitors time to either imitate the product or leap frog it with an innovation. If competitors do this, the window of opportunity will have been lost.
(vi) The manufacturer could develop negative publicity if they lower the price too fast and without significant product changes. Some early purchasers will feel they have been ripped off.
They will feel it would have been better to wait and purchase the product at a much lower price. This negative sentiment will be transferred to the brand and the company as a whole.
(vii) High margins may make the firm inefficient. There will be less incentive to keep costs under control. Inefficient practices will become established making it difficult to compete on value or price.
(b) Penetration Pricing:
Penetration pricing is the pricing technique of setting a relatively low initial entry price, often lower than the eventual market price, to attract new customers. The strategy works on the expectation that customers will switch to the new brand because of the lower price.
Penetration pricing is most commonly associated with a marketing objective of increasing market share or sales volume, rather than to make profit in the short term.
Advantages of Penetration Pricing:
The advantages of penetration pricing to the firm are:
(i) It can result in fast diffusion and adoption. This can achieve high market penetration rates quickly. This can take the competition by surprise, not giving them time to react.
(ii) It can create goodwill among the early adopters segment. This can create more trade through word of mouth.
(iii) It creates cost control and cost reduction pressures from the start, leading to greater efficiency.
(iv) It discourages the entry of competitors. Low prices act as a barrier to entry.
(v) It can create high stock turnover throughout the distribution channel. This can create critically important enthusiasm and support in the channel.
(vi) It can be based on marginal cost pricing, which is economically efficient. Disadvantages
Disadvantages:
(i) Penetration pricing is limited to the growth and declining phases of the product because implementation during the introductory or mature phases of the cycle will lead to a cycle of competition driving prices continually lower and causing a drop in profits.
While often profitable, penetration pricing has some major drawbacks including customer dissatisfaction, and false loyalty.
The penetration pricing is that it establishes long term price expectations for the product, and image preconceptions for the brand and company. This makes it difficult to eventually raise prices.
Some commentators claim that penetration pricing attracts only the switchers (bargain hunters), and that they will switch away as soon as the price rises. There is much controversy over whether it is better to raise prices gradually over a period of years (so that consumers don’t notice) or employ a single large price increase. The low profit margins may not be sustainable long enough for the strategy to be effective.
(c) Loss Leaders:
The use of loss leaders is a method of sales promotion. A loss leader is a product priced below cost-price in order to attract consumers into a shop or online store. The purpose of making a product a loss leader is to encourage customers to make further purchases of profitable goods while they are in the shop. Pricing is a key competitive weapon and a very flexible part of the marketing mix.
If a business undercuts its competitors on price, new customers may be attracted and existing customers may become more loyal. So, using a loss leader can help drive customer loyalty.
One risk of using a loss leader is that customers may take the opportunity to “bulk-buy”. If the price discount is sufficiently deep, then it makes sense for customers to buy as much as they can (assuming the product is not perishable).
Using a loss leader is essentially a short-term pricing tactic for any one product. Customers will soon get used to the tactic, so it makes sense to change the loss leader or its merchandising every so often.
(d) Predatory Pricing:
With predatory pricing, prices are deliberately set very low by a dominant competitor in the market in order to restrict or prevent competition. The price set might even be free, or lead to losses by the predator. Whatever the approach, predatory pricing is illegal under competition law.
(e) Psychological Pricing:
The aim of psychological pricing is to make the customer believe the product is cheaper than it really is. Pricing in this way is intended to attract customers who are looking for “value”.
4. Competitor-Based Pricing:
If there is strong competition in a market, customers are faced with a wide choice of who to buy from. They may buy from the cheapest provider or perhaps from the one which offers the best customer service. But customers will certainly be mindful of what is a reasonable or normal price in the market.
Most firms in a competitive market do not have sufficient power to be able to set prices above their competitors. They tend to use “going-rate” pricing i.e. setting a price that is in line with the prices charged by direct competitors. In effect such businesses are “price-takers” they must accept the going market price as determined by the forces of demand and supply.
An advantage of using competitive pricing is that selling prices should be line with rivals, so price should not be a competitive disadvantage. The main problem is that the business needs some other way to attract customers. It has to use non-price methods to compete e.g. providing distinct customer service or better availability.
New Product Pricing Strategy:
Pricing strategy for a new product depends on how distinct the product is and how long the distinctiveness remains. The more the distinctiveness, the higher is the freedom to determine the price. If the product is highly distinctive with no substitute, the firm can set a price which maximized the profit in the short period.
If the product is slightly different from the existing products, freedom for pricing is also restricted. If a product remains distinctive for a long period, the firm enjoys more freedom to set the price.
New product however distinctive will enjoy their distinctiveness for a limited period till the competitors start manufacturing similar products. The imitation by the competitors depends on their capacity to develop alternatives and expectation of sales potential of the product.
Though a firm enjoys freedom to set a price of its new product, the choice of pricing may broadly be classified into two viz., skim the cream pricing and penetration pricing.
(a) Skimming Price Policy:
Many firms set a high price for the new product to skim the market. This strategy is adopted when there is no competition in the market and the new product has some distinctive characteristics.
High price strategy at the introduction stage will help the firm to recover its research and development costs and also the high promotion expenditure incurred within a short period before the competitors come out with substitute products.
This price policy first attracts those customers who are willing to pay a premium price for the product to have the satisfaction of owing the product first. After exhausting the creamy layer the prices are reduced slowly to attract customers who are willing to pay that price.
Over a period, all the possible layers of the customers are exhausted. This policy also matches the production capacity of the firm i.e. the firm may have little production capacity in the beginning which matches the low demand because of the high price and firm increases its production capacity over a period which again matches the increased demand as a result of reduction in price.
(b) Penetration Pricing Policy:
Some of the firms set a relatively low price for their new product. This is done hoping to attract large number of customers and gain a large market share. Penetration pricing is advised when the firm finds it difficult to find sufficient number of customers who would purchase the product at a higher price.
Choice between skimming price policy and penetration pricing policy depends on several factors such as the rate of market growth desired, erosion of the distinctiveness of the product, cost structure of the product and the nature of the product.
When a high market growth is expected in a short period of time; the product losses its distinctiveness very soon; cost of manufacturing is less; and the product is a consumer non-durable, penetration policy is preferred otherwise, skimming price policy is adopted.
Discount and Allowances:
Discounts and allowances are reductions to a basic price of goods or services. They can occur anywhere in the distribution channel, modifying either the manufacturer’s list price (determined by the manufacturer and often printed on the package), the retail price (set by the retailer and often attached to the product with a sticker), or the list price (which is quoted to a potential buyer, usually in written form).
There are many purposes for discounting, including; to increase short-term sales, to move out-of-date stock, to reward valuable customers, to encourage distribution channel members to perform a function, or to otherwise reward behaviors that benefit the discount issuer. Some discounts and allowances are forms of sales promotion.
The role of discount offering discounts can be a useful tactic in response to aggressive competition by a competitor. However, discounting can be dangerous unless carefully controlled and conceived as part of your overall marketing strategy.
Discounting is common in many industries or in some it is so endemic as to render normal price lists practically meaningless. This is not to say that there is anything particularly wrong with price discounting provided that you are getting something specific that you want in return.
The trouble is that, all too often, companies get themselves embroiled in a complex structure of cash, quantity and other discounts, whilst getting absolutely nothing in return except a lower profit margin. Let us look briefly at the main types of discounts common today.
Discount and allowances are a form of indirect price competition. The common forms of discounts and allowance are as follows:
(i) Trade Discount:
Trade discount refers to that kind of functional discount which is given to the buyers buying for resale.
(ii) Cash Discount:
Cash discount refers to the discount which is given to the trader or consumer to encourage him to pay in full by cash or by cheque within a short period of the date of the bill or invoice.
(iii) Quantity Discount:
Quantity discount is given to encourage a customer to make bulk or larger purchases at a time or concentrate his purchase with the seller.
(iv) Seasonal Discount:
The manufacturer may offer additional discount of some percentage to a dealer or a customer who place an order during the slack season.
Allowance:
The manufacturer may offer promotional allowance like advertising allowance, window display allowance, free sample, free display materials, free training in sales demonstration and etc.
(v) Cash and Settlement Discounts:
These are intended to bring payments in faster. However, since such discounts need to be at least 25% per month to have any real effect, this means paying your customer an annual rate of interest of 30% just to get in money which is due to you anyway. What is more, customers frequently take all the discounts on offer and still do not pay promptly, so that you lose both ways.
Much better, we believe, are either to eliminate these discounts altogether and introduce an efficient credit control system or change your terms of business so that you can impose a surcharge on overdue accounts instead.
Whilst you may lose some business by doing this, these will probably is the worst payers anyway. If some customers will not pay you for months you are probably better off trying to win others who will.
(vi) Quantity Discounts:
The trouble with these is that, when formalized on a published price list, they become an established part of your pricing structure and as a result their impact can be lost. If you are not very careful, although they may have helped you win the business to start with, in the long run the only effect they have is to spoil your profit margin.
As a general rule, only publish the very minimum of quantity discounts very largest customers will probably try to negotiate something extra anyway. Also keep quantity discounts small, so that you hold something in reserve for when your customers do something extra for you, such as offering you sole supply, or as part of a special promotion.
(vii) Promotional Discounts:
These are the best kind of discounts because they enable you to retain the power to be flexible. There may be times when you want to give an extra boost to sales to shift an old product before launching an updated one for example. At times like these special offers or promotional discounts can be useful.
But try to think of unusual offers a larger pack size for the same price or a five for the price of four can often stimulate more interest than a straight percentage discount. They also make sure that the end user gets at least some of the benefit, which doesn’t always happen with other types of discounts.
Two other points to remember are:
(i) To make sure to retain control over special promotions, with a specific objective, a beginning and an end point.
(ii) Be sure to terminate them once they have outlived their usefulness.
Ensure that offers are linked to sales and not simply to orders. Otherwise the company may find that orders to you are up for a while, only to be followed by a barren period whilst your customer supplies the end user from his accumulated stocks.
Clearly the role of discounts will vary from one type of business to another and not all of the comments above will apply to you. In part your ability to minimize discounts or eliminate them altogether, will depend on the non-price benefits of your product.
But, whatever business you are in, you should always ask yourself what your discounts are supposed to achieve, whether they are effective and how long they are expected to last. In general, keep standard discounts low to retain maximum flexibility and ensure that they are consistent with your overall marketing and pricing strategy.
Types of Price Discounts:
The normally quoted price to end users is known as the list price. This price usually is discounted for distribution channel members and some end users.
There are several types of discounts, as outlined below:
1. Quantity Discount:
Quantity discount offer to customers who purchase in large quantities.
2. Cumulative Quantity Discount:
This a discount that increases as the cumulative quantity increases. Cumulative discounts may be offered to resellers who purchase large quantities over time but who do not wish to place large individual orders.
3. Seasonal Discount:
This discount is based on the time that the purchase is made and designed to reduce seasonal variation in sales. For example, the travel industry offers much lower offseason rates.
Such discounts do not have to be based on time of the year; they also can be based on day of the week or time of the day, such as pricing offered by long distance and wireless service providers.
4. Cash Discount:
This is extended to customers who pay their bill before a specified date.
5. Trade Discount:
This is a functional discount offered to channel members for performing their roles. For example, a trade discount may be offered to a small retailer who may not purchase in quantity but nonetheless performs the important retail function.
6. Promotional Discount:
This is a short-term discounted price offered to stimulate sales.