There are three pricing methods that can be adopted by a firm: 1. Cost Oriented Pricing 2. Demand Based Pricing 3. Competition-Based Approach 4. Marketing Oriented Pricing 5. Perceived Value Pricing 6. Differentiated Pricing.
1. Cost Oriented Pricing:
Cost oriented pricing can be divided into full cost pricing and marginal cost pricing, mark up pricing and target rate return pricing.
(a) Full Cost Pricing (Absorption Cost Pricing):
This method is adopted by manufacturing firms. In this method a firm determines the direct and fixed costs for each unit of product at normal level of production and sales a profit margin is added to this unit cost. The selling price is arrived. This method is known as full cost pricing science. It envisages the realization of full cost from each unit sold by adding the required margin toward profit to such total cost.
(b) Direct (or Marginal) Pricing:
This involves the calculation of only those costs, which are likely to increase as output increases. Indirect or fixed costs (plant, machinery etc.) will remain unaffected whether one unit or one thousand units are produced. Like full cost pricing, this method will include a profit margin in the final price.
Direct cost approach is useful pricing of services. It aims at maximizing the contribution towards fixed cost. The main difference between absorption cost pricing and marginal cost pricing is that the latter gives the flexibility to recover a share of fixed cost form a certain market segment.
(c) Mark-Up Pricing (Cost Plus Pricing):
In markup pricing, the selling price of the product is fixed by adding a particular margin or mark-up to its total cost. Mark-up pricing is most common in retailing, where a retailer buys a product for resale. A percentage of mark up on cost is added to the total cost.
The choice of the mark-up percentage depends on nature of the market, bulk discounts, pricing strategy and stage of the product in its life cycle. This method focuses upon the internal costs of the firm as opposed to the prospective customers’ willingness to pay.
This could be calculated as follows:
Total budgeted factory cost + selling/distribution costs + other overheads + mark up on cost.
The advantages of using cost plus pricing are:
(i) Easy to calculate
(ii) Price increases can be justified when costs rise
(iii) Pricing decisions can be made at low level in a business based on formulas.
The main disadvantages of cost plus pricing are:
(i) This method ignores the concept of price elasticity of demand – it may be possible for the business to charge a higher (or lower) price to maximize profits depending on the responsiveness of customers to a change in price.
(ii) It requires an estimate and apportionment of business overheads, over heads may change in future.
(iii) If budgeted costs are over-estimated, selling prices may be set too high.
(d) Target Return Pricing:
The target return pricing is set by marketers to attain a particular rate of return on their investments. The companies, which fix a return on their investment, are usually the leaders in their industry. General Motors have linked the prices of their products to this objective. A marketer can fix the prices of products on the basis of target returns that he is expecting on the investment.
2. Demand Based Pricing:
Mainly demand based pricing is divided into two categories Skimming Pricing and Penetration Pricing:
(a) Skimming Pricing:
The practice of price skimming 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. High prices can be enjoyed in the short term where demand is relatively inelastic.
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. Skimming pricing can be seen in computers and technology dependent products like cell phones, television etc.
There are several advantages of price skimming like when a highly innovative product is launched, research and development costs are likely to be high, as 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.
By charging high prices initially, a company can build a high-quality image for its product. 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. In prestige goods, the practice of price skimming can be particularly successful, since the buyer tends to be more ‘prestige’ conscious than price conscious.
(b) Penetration Pricing:
Penetration pricing involves the setting of lower, rather than higher prices in order to achieve a large, if not dominant market share. This strategy is most often used businesses wants to enter a new market. This will only be possible where demand for the product is believed to be highly elastic, i.e. demand is price-sensitive and either new buyer will be attracted, or existing buyers will buy more of the product as a result of a low price. A successful penetration pricing strategy may lead to large sales volumes/market shares and therefore lower costs per unit.
The effects of economies of both scale and experience lead to lower production costs, which justify the use of penetration pricing strategies to gain market share. Companies like HUL, ITC, Godrej, Dabur are having large scale production capabilities they practice penetration pricing in various products.
Before implementing a penetration pricing strategy, a supplier must — be certain that it has the production and distribution capabilities to meet the anticipated increase in demand. Disadvantage is the impact of the reduced price on the image of the offering, particularly where buyers associate price with quality.
3. Competition-Based Approach:
(a) Going-Rate Pricing:
In going-rate pricing, the firm bases its price largely on competitor’s prices, with less attention paid to its own costs or to demand. The firm might charge the same, more, or less than its major competitors. Going rate pricing is a simple method in which a company simply follows the prevailing pricing patterns in the market. The company adopts a pricing strategy similar to those adopted by the major players in the market or may slightly adjust its prices to suit the company’s systems and processes.
Generally, in this method, marketers give importance to price changes made by the market leader and alter their own prices accordingly, rather than changing the prices according to the demand patterns of the company’s product in the market.
(b) Competitive Bidding:
Large firms calls for competitive bidding when they want to purchase certain products. The most usual process is the drawing up of detailed specifications for a product and putting the contract out for tender. Potential suppliers quote a price, if all other things being equal the buyer will select the supplier that offers the lowest price; this method is used by government organizations.
4. Marketing Oriented Pricing:
The price of a product should be set in line with the marketing strategy. The danger is that if price is viewed in isolation (as would be the case with full cost pricing) with no reference to other marketing decisions such as positioning, strategic objectives, and promotion, distribution and product benefits.
The way around this problem is to recognize that the pricing decision dependent on other earlier decisions in the marketing planning process. For new products, price will depend upon positioning, strategy, and for existing products price will be affected by strategic objectives.
5. Perceived Value Pricing:
In this type (perceived value) of pricing, marketers set the prices of the products on the basis of their perceived value in the minds of customers. Perceived value is calculated as a weighted average of the products’ perceived attribute scores. Marketers normally use advertising and sales promotional activities to enhance the perceived value of the product in the market. Firms may conduct market surveys to analyze customers’ perceptions about the value of the product.
This will help marketers efficiently set the prices for their products. However, there is an inherent risk in using this method. If the marketer underestimates the value of the product based on the customer’s belief of the perceived value of the product, he will charge less than what he actually can from the customers and he will not be able to maximize his profits. Similarly, if the marketer overestimates the value of the product, the customers will not buy the product and it will be difficult for him to survive in the market.
In some markets, business is carried out on the basis of sealed bids rather than on the basis of openly setting prices for products. This type of pricing is more suitable for industrial products. Many companies compete in this process, where the price of the product or service is usually quoted in a sealed cover. This method is adopted for the products that do not possess a market price or for products for which it is difficult to fix the price owing to attributes like varying levels of quality and specifications.
The sealed bid method is usually followed in government organizations. Whenever a government organization needs to purchase a product or service, it is required to call for bids and several companies are invited to quote their prices in a sealed form. After receiving the sealed bids, the organization will normally purchase the product or service from the company, which has bid the least price.
6. Differentiated Pricing:
In differentiated pricing, marketers adopt different prices for the same product at different locations or for different types of customers. For example, pricing of electricity differs in rural consumer, urban consumers and for industries.
For instance, the cost of a cold drink differs in a supermarket, in a cinema hall and in a restaurant. Thus, even though the product is the same, it is sold at different prices at different locations. This pricing method, if used effectively, will help a company increase its profits.