Cost-based pricing involves setting prices on the basis of the costs of producing, distributing, and selling the product plus an appropriate rate of return for its risk and effort. A firm’s costs might be an important element in its pricing strategy. Some firms, such as Ryanair and Walmart, work for becoming the “low-cost producers” in their industries. Firms with lower costs could set lower prices which result in smaller margins but greater sales and profits. Other firms—such as Apple, Steinway, and BMW—intentionally pay higher costs so that they could claim higher prices and margins. The key is to manage the spread between costs and prices—how much the firm makes for the consumer value it delivers.
Cost-based pricing is simply the act of pricing based on what it costs an organization to make a product.In addition, a company should also consider factors such as its competition, the cost of production, applicable government regulations and the customers. Cost-based pricing is about setting a price such that:
Price = (1+ Percent Markup)(Unit Variable Cost + Average FixedCost) .
Costs are simply a function of sales, which are in turn a function of prices. This will make the calculations of costs, sales, and prices circular. Imagine a company whose average costs decrease with sales. If it sells less, its costs will rise up. A remedy would be to increase prices in this condition, but a time of decreasing sales is hardly the right environment for a move such as this. Next, imagine a company that runs at small-scale capacity. If it can sell more, its costs will go down. However, pricing at an average cost for small-scale capacity means that the company may never discover this. Rather than asking what prices the company need to charge in order to cover their costs and gain their profit objectives, company must ask how their pricing strategy will affect their cost structure.
Beyond consumer value perceptions, costs, and competitor strategies, the firm must consider several additional internal and external factors. Internal factors affecting pricing is related to the firm’s overall marketing strategy, objectives, and marketing mix, as well as other organizational considerations. External factors refer to the nature of the market and demand and other environmental factors.
Overall Marketing Strategy, Objectives, and Mix
Price is only one component of the firm’s broader marketing strategy. Thus, before setting the price, the firm should decide on its overall marketing strategy for the product or service. If the firm has selected its target market and positioning carefully, then its marketing mix strategy, including the price, will be fairly straight forward. For example, when Honda developed its Acura brand for competing with European luxury-performance cars in the higher income segment, this prescribed charging a high price. But when it introduced the Honda Fit model—billed as “a pint-sized fuel miser with feisty giddy up”—this positioning prescribed charging a low price. Hence, pricing strategy is mostly determined by decisions on market positioning.
Pricing might play a significant role in helping to accomplish organization objectives at several levels. A company could set prices to attract new customers or profitably retain existing ones. It could set prices low to prevent competition from entering the market or set prices at competitors’ levels for stabilizing the market. It can price to keep the support and loyalty of resellers or avoid government intervention. Prices could be reduced temporarily for creating excitement for a brand. Or one product might be priced to help the sales of other products in the firm’s line.
Price is only one of the marketing mix tools that an organization uses for achieving its marketing objectives. Price decisions should be coordinated with product design, distribution, and promotion decisions in order to form a consistent and effective integrated marketing program. Decision which is made for other marketing mix variables might affect pricing decisions. For example, a decision to position the product on high-performance quality will mean that the seller should charge a higher price in order to cover higher costs. Producers whose resellers are expected to support and promote their products might have to build larger reseller margins into their prices.
Management should decide who within the company should set prices. Organizations handle pricing in a variety of ways. In a small firm, prices are usually set by top management rather than by the marketing or sales departments. But in a large firm, pricing is typically handled by divisional or product line managers. In the case of industrial markets, salespeople might be allowed for the negotiation with customers at certain price ranges. Even so, top management sets the pricing objectives and policies, and it generally approves the prices proposed by lower level management or salespeople. In industries in which pricing is a key factor (airlines, steel, aerospace, oil companies, railroads,) companies usually have pricing departments to set the best prices or may help others in setting them. These departments will report to the marketing department or top management. Others who have an influence on pricing include sales managers, finance managers production managers, and accountants.
The Market and Demand
As we all know, good pricing begins with an understanding of how consumers’ perceptions of value affect the prices they are willing to pay. Both consumer and industrial buyers balance the price of any product or service against the benefits of owning it. Hence, before setting prices, the marketer should understand the relationship between price and demand for the organization’s product.
Economic conditions may have a strong impact on the company’s pricing strategies. Economic factors such as recession or boom, inflation, and interest rates affect the decisions of pricing as they affect customer spending, customer perceptions of the product’s price and value, and the firm’s costs of producing and selling a product.
The most obvious response to the new economic realities is about cutting prices and offering deep discounts. And thousands of organizations have done just that. Lower prices will make products more affordable and help to increase short-term sales. However, such price cuts might have undesirable long-term consequences. Deep discounts might cheapen a brand in customers’ eyes. And once a firm cuts prices, it will be difficult for raising them again when the economy recovers. Many organizations are shifting their marketing focus to more affordable items in their product mixes rather than cutting prices.
Other External Factors
Beyond the economy and the market, the organization should consider various other factors in its external environment while setting prices. It should know what impact its prices would have to other parties in its environment. How will resellers react to various prices? The firm should set prices which give resellers a fair profit, motivate their support, and help them for selling the product effectively. The government is another essential external influencing factor that affects pricing decisions. Finally, social concerns might need to be taken into account. While setting prices, a firm’s short-term sales, market share, and profit goals might require being tempered by broader societal considerations.
Kotler, P., & Armstrong, G. (2013).Principles of Marketing.Chennai: Pearson India Education Services Pvt Ltd.