10.1 Strategies for Setting Prices
Cost-Plus Pricing
With a cost-plus approach, a firm first determines its own costs to generate each unit of a particular good or service, and then adds another amount to that first figure. This additional amount is often referred to as the markup, and expressed as a percentage value.
This method may seem simple and straightforward, but the process a firm uses to determine its indirect costs can be quite complicated. If overhead costs are shared among several business lines, it can be challenging to properly allocate those costs to each component of the business.
Cost-plus pricing is often used by service professionals such as accountants and lawyers.
A downside of cost-plus pricing is that it ignores the possible complexities of a given situation (such as changes in consumer demand, and the prices charged by competitors).
Break-Even Pricing
Break-even analysis is used to determine the unit volume and dollar sales that a company must attain to avoid a loss, given a particular cost structure.
Break-even volume is typically found by taking fixed costs, and then dividing by the difference between price and the per-unit variable cost.
Using this methodology, if we assume that fixed costs and unit variable cost cannot be changed, then higher prices mean that less sales volume will be required to break even.
Since a firm’s long-term goal should be to achieve profitability – not to barely break even – this pricing strategy may seem unorthodox. However, it might be used by a company that is experimenting with a new product line. Perhaps they are “testing the waters” to see if their consumer base will be interested in the product, and they wish to introduce the product at the lowest possible sustainable price.
Going-Rate Pricing
When a firm employs going-rate pricing, which is often referred to as competition-based pricing, it looks to the market first. Who else is selling similar products? What are they charging? After answering those questions, the firm determines its own pricing structure.
The Internet has greatly boosted price transparency, making it far easier than ever before to determine market prices. Someone starting a business out of a dorm room or garage can quickly use this approach to find a baseline price to set; years ago, this would have been far more challenging.
The first major advantage of going-rate pricing is that it is simple to implement, yet already incorporates a tremendous amount of information. If the product exists in an already-established market, the competitors selling the good have likely arrived at their pricing structure after many years of trial-and-error. Their collective experience with the market, their own cost structure, and the feedback that they have received through the customer public have all led to the pricing structure in place today.
Second, a firm that uses going-rate pricing will already know that it is priced well for competition in the market. Eventually, this company may decide that its unique value proposition justifies a higher price, or that its low production costs enable it to undercut the competition. Either way, a new market entrant using this approach can be reasonably certain that their prices are not out-of-line with the target market’s expectations.
Going-rate pricing is akin to the ensemble approach that was introduced in Chapter 9. Since an established, competitive market already includes a large number of buyers and sellers, it is both safe and reasonable to assume that the “wisdom of the crowd” is reflected in the current market-rate prices.
Prestige Pricing
With a prestige pricing strategy, a company intentionally sets its prices high, usually as a way to signal to the market that its goods or services are more valuable than those of the competition.
The price that a firm sets for a good or service can have a powerful psychological effect on consumers. In some cases, high prices could be viewed as a proxy for high quality; after all, if markets set prices, and if other buyers are willing to pay up for something good, then there must be a rationale behind their decision. Some consumers might feel a stronger emotional connection to something that they have paid dearly for – after all, they are more invested in such an item than in something acquired cheaply.
Take a look at the screenshot shown below. The per-night prices shown here are for suites at the Four Seasons Hotel in Boston, MA during Memorial Day weekend in late May.
Clearly, the Four Seasons is not appealing to bargain hunters here! This company is charging four-figure sums for a night’s stay at its property, with the prices displayed prominently on the homepage. There is no mention of discounts, sales promotions, or other ways to save on these rooms. Implicitly, that sends an important message to consumers — this elite brand is offering something special, and it is meant for a particular clientele. Irrespective of the Four Seasons’ famously-excellent customer service, these sky-high prices may actually stimulate demand among certain types of guests, who appreciate the exclusivity that such prices create.
Most products face a downward-sloping demand curve (we will see an example later in this chapter). This means that as the price goes down, consumer demand for the product will increase. For rare categories of luxury goods, this will not always be the case.
Skimming Pricing
The seller employing a skimming strategy aims to “skim the cream” off the top of the market, by capturing the willingness to pay the market segment that is more interested in obtaining the latest tech gadget than in saving money.
Perhaps the best known contemporary example of a firm using this approach is Apple. When Apple releases a new version of the iPhone, it sets a high price initially. Apple’s most loyal, die-hard consumers will line up early, and sometimes literally camp out beforehand, in order to obtain that brand new model. Meanwhile, Apple offers slightly older, previous generation models for much lower prices, thereby capturing more bargain-conscious consumers, too.
A potential risk associated with this strategy is “version fatigue” among the buying public. At some point, even the most ardent Apple phone enthusiast may grow tired of new product releases. Especially if the incremental differences from one version to another are not substantial, consumers may reach a point where they simply decide that their current version is good enough.
Penetration Pricing
Firms employ a penetration pricing strategy when they offer a low price upon market entry, usually with the aim of building consumer loyalty or of selling a complementary product.
Mobile phone companies and cable TV companies frequently advertise near college campuses. They typically offer a low introductory rate, sometimes known as a teaser rate, in order to draw sign-ups. After some period of time, the teaser rate period expires, and the customer would then pay the regular fee. In such a scenario, the service provider hopes that the customer has developed an affinity for the product, and will remain a subscriber at the standard rate.
Companies may also use penetration pricing as a way to draw a consumer in with a product sold at a bargain price (perhaps even below the manufacturing cost!), with the expectation that the consumer will be likely to spend on related products. Inkjet printers provide one of the best such examples – major office supply retailers will draw consumers in with very low prices for such printers, knowing that the ink cartridges need to be replaced regularly. Any consumer who has been lured into an inkjet purchase after seeing some fabulously low sticker price for a printer knows how this story goes – the total cost of ownership skyrockets due to the ink cartridge purchases.
Penetration pricing could backfire if consumers expect the company to maintain the original low price. Customers who do not read the fine print may feel surprised, or even betrayed, when the teaser rate on a subscription expires. Subscribers who do read the fine print, and who pay attention to their monthly billing statements, may simply cancel at the first opportunity, once the regular rate sets in.
Promotional Pricing
A firm employing promotional pricing is offering some type of time-limited deal. The time limitation associated with a short-term sale appeals to something primal among buyers – if we do not act soon, the opportunity may pass us by!
As consumers, we may be drawn to a sale by the “thrill of the chase.” Indeed, the feeling that we get after obtaining a desired item at a great price may release endorphins,
Sales often coincide with major holidays – and in some cases, retailers have even created their own promotional days. The most famous such example is Alibaba, whose annual Singles’ Day event on November 11 has become the biggest shopping day of the year, worldwide.1
Amazon launched its first “Prime Day” in 2015, to celebrate its 20th “birthday” as an e-commerce retailer. During this 24-hour event, Amazon sold more than 34 million items. Since that time, Prime Day has expanded into a two-day event.2
Other companies have followed suit. Target has launched Deal Days, while Walmart and JD.com have attempted to establish their own summertime equivalent to Alibaba’s Singles’ Day.3
Clever promotions can be an effective form of marketing in and of themselves – they can build buzz among consumers and the media. In winter, the Pancake Parlour in Australia offers special price discounts based on the temperature; as the mercury drops further, pancake lovers can take solace in knowing that better deals can be had. In a similar spirit, restaurants may offer discounts tied to the performance of local sports teams, such as a percentage discount on Monday for each point scored by a professional football team on Sunday.
Everyday Low Pricing
A company offering everyday low pricing attempts to serve consumers with goods or services at the lowest possible price, on a consistent basis.
The implicit value proposition to the consumer here is “We will cut through all the gimmicks associated with coupons, rebates, discounts, etc. and just give you the best possible price, every single day.”
From the company’s perspective, a benefit of everyday low pricing is that it saves on “menu costs” – the company does not need to continually readjust its displays, promotional material, and the tags on its shelves.
A possibly-surprising way in which everyday low pricing can backfire is when consumers grow bored with the lack of sales promotions. Although consumers may say that they appreciate the straightforwardness of this type of pricing, some may find that they miss the thrill that comes with discovering a wanted item at a deep discount.
Value-Based Pricing
With value-based pricing, a firm sets its prices for goods and services based on customers’ perceived value of those offerings.
A value-based approach can work well for a small business that does not operate at a large scale. For instance, a landscaping business that works in a town whose properties range from multi-acre estates to tiny two-bedroom homes could set prices uniquely for each customer. Since each property is unique, and since each client’s wishes are unique, the company could start by talking to each of the homeowners in order to get a sense of their needs. Then, the company could set a price that reflects both the level of service requested and the homeowner’s perception of the service.
Loss Leader Pricing
At times, a firm may set the price for an item so low that the company loses money with each transaction; in other words, the firm is enabling consumers to purchase the item for less than it cost the company to acquire the item and bring it to market.
Supermarkets routinely employ loss leader pricing in order to increase in-store foot traffic. A store might use its weekly advertising flier to loudly proclaim a great deal on one particular item. This deal may be so good, in fact, that the store is offering the item below its own cost. The logic behind such a decision is that it brings customers into the store, many of whom are likely to purchase other items once there.
While loss leader pricing may sound like penetration pricing, there is an important distinction between them. With penetration pricing, a company is ultimately looking to generate future sales either on the same product (such as a cable TV subscription), or on a complementary product (as with the printer and ink example). A firm using a loss leader strategy, by contrast, is expecting to lose money on the item sold below cost, with offsetting revenues to come from the sale of unrelated items.
One potential drawback associated with loss leader pricing is that customers may not buy other items – in such a scenario, the loss from the promoted item would not be offset by other consumer purchases, and it would backfire.
1 Lee, Xin En. CNBC, 04DEC2018. “The world’s biggest shopping holiday is in China — not the US. Here’s how Singles Day became No. 1”
https://www.cnbc.com/2018/12/04/how-chinas-singles-day-became-the-worlds-biggest-shopping-holiday.html
2 Molina, Brett. USA Today, 11JUL2022, “Amazon Prime Day 2022: What to know about two-day shopping event
3 Howland, Daphne. Retail Dive, 26JUL2017 https://www.retaildive.com/news/walmart-jd-announce-shopping-holiday-to-rival-singles-day/447894