Pricing is the simplest way to communicate the product value to customers. As price significantly influences both the profitability and the strategy of a company as well as those of its competitors, it is necessary to strategically set the price while thoroughly understanding the actions of customers, competitors, as well as the company’s internal actions.
1 Factor that Influence Price
The price of a product is affected by a variety of elements. However, among these, the three factors representing internal costs, the competitive environment, and customer value are essential.
Company (Costs)
The price of a product should be set above its costs in order to generate profit. Cost generally consists of fixed costs (expenses independent of sales) and variable costs (expenses that are proportional to sales). A business organization should accurately grasp its cost structure, as it reveals the number of products needed to be sold in order to generate profit.
Competitors (Competitive Environment)
In a competitive environment, a business organization will not be able to set product prices solely based on internal circumstances, and its pricing decisions will inevitably be affected by competitor prices. If a company wants to minimize the impact on the competitive environment, it should clearly differentiate its product from those of its competitors in terms of design, function, brand, services, etc. In addition, the market position of a company may also limit its ability to set prices. A leading business organization generally refrains itself from initiating price wars (although it may be feasible to do so if it foresees it will crush the competitors) as to prevent the market from shrinking. Whereas, companies below the market leader will be forced to either follow the market leader or to differentiate its products without pursuing the No. 1 position in the market.
Customers (Customer Value Proposition)
Customer value represents “the price that customers acknowledge as being just” and serves as the upper limit in price setting. Customer value is difficult to determine, but it is also a concept that puts to test research and other marketing skills. A business organization should first recognize the difference between the technical value (the value estimated through internal calculations) and the customer value. And, it should approach customers through accurate communication of the product features and other similar actions.
2 Standard Pricing Methods
Standard pricing methods can be categorized according to which factors that they most emphasized on, whether it is cost, customer value (demand) or the competitive environment.
Cost-Based Pricing
This category includes in turn several types of pricing methods, such as: “cost-plus pricing” in which case the final price is determined after the desired profit is added to the total production costs; “mark-up pricing:”, determined by adding a certain amount of money to the cost price of a product; and “target pricing”, which refers to setting the price in order to ensure that a certain rate of profitability is maintained, based on the projected scope of the business.
Customer Value-Based Pricing
This category includes the “perceived value pricing” method, according to which the price is determined based on measuring how users perceive the value of the product and the “differential pricing” method, in which case the price of the same product is set differently for each customer segment, are part of this category.
Competition-Based Pricing
This category includes the “going-rate pricing” method, which refers to setting the price to match the average price of the company’s business industry, the “bid pricing” method, according to which the purchase is made from the manufacturer with the lowest price among all competitors, as well as various other methods.
3 Pricing and Profitability
Relation between Price and Demand (Price Elasticity)
A product with a market demand that is significantly influenced by changes in its market price is described as having “high price elasticity”. Meanwhile, a product whose demand remains relatively unaffected by price changes has “low price elasticity”. Price elasticity is generally considered to be low for essential commodities and high for easy-to-replace items but it can vary depending on the customer segment. In addition, in certain circumstances price elasticity may vary even within the same customer segment.
Profitability Analysis (Break-Even Analysis)
In general, product costs determine the lower limit of price setting. However, the sales levels, at which the “marginal profit” (sales minus variable costs) is equal to the fixed costs of the product, are referred to as “break-even sales”. Whether sales are able to exceed the break-even point or not is an important criterion in price setting, especially for the cases in which fixed costs (such as manufacturing equipment) account for the majority of the overall cost.
4 Setting the Launch Price
The launch price of a new product affects how fast the product can penetrate the market. Therefore, forecasts of price elasticity, future market share, etc. must be taken into consideration when setting the price for a new product.
Skimming Pricing
Skimming Pricing is intended to quickly recover the investment by setting a high price during the early stages of the product launch. This method is applied in areas where the target market is limited in scope, the price elasticity is expected to be low with respect to target customer demand, and there are few, if any, competitors.
Penetration Pricing
Penetration pricing involves launching the product at a price low enough to discourage competitors from matching it, and is meant for customer segments with a high price elasticity of demand. It is based on the premise that the cost per unit will decline dramatically in line with growing sales volume, due to economies of scale and experience curve effects. This pricing method is applied when launching a new product on a market where existing competitors are unaware of the considerably large amount of potential needs, which have not been tapped into yet.