Pricing Methods

Top 6 Pricing Methods (Price Setting Methods)

by S. Jaideep Pricing

Pricing method leads to a specific price. There are various methods used for setting price of the product. Some methods are cost-oriented while some are market-oriented. Each of the methods has its plus and minus points, and applicability. Marketing managers apply the appropriate method for setting the price. The appropriate method can be decided on the basis of the study and analysis of internal and external aspects as well as suitability of the method. Following part describes some widely used pricing methods. See Figure 3.

1. Mark-up Pricing Method:

This is the most commonly used method. The method is also known as cost-plus pricing. In this method, a standard mark-up (or profit margin) is added to the product costs. This method is used in construction business, professions, and even for consumer goods. The method can be used only when company has necessary data about various costs and expected sales. Company may prefer fixed per cent of costs or fixed per cent of selling price.

Let us illustrate the method:

XYZ Company Limited expects annual sales of 100000 units.

Variable cost per unit is Rs. 10.

Fixed cost is Rs. 500000.

Company wishes to earn 20 % mark-up on selling price, or 25% mark-up on costs.

Cost per unit = variable costs + (Fixed costs/ Unit sales)

= Rs. 10 + Rs. 500000/100000

= Rs. 15

Now, company wants 20% mark-up on selling price,

Selling price = unit cost/(1 – desired mark-up)

= Rs. 15/ 0.8

= Rs. 18.75

Alternatively, suppose company wants 25% mark-up on unit cost,

Selling price = unit costs + (15 x 25%)

= Rs. 15 + Rs. 3.75

= Rs. 18. 75.

Naturally, when cost is taken as a base, the rate should be high, as indicated in the example. Company may follow either of approaches, but must know the difference.

Merits:

Keeping in mind a lot of forces affecting market, the mark-up rate may be kept high or low, fixed or variable.

This method is widely used. It offers following merits:

i. It recovers costs as rapidly as possible.

ii. It is relatively a simple method to practice.

iii. If it is used by the entire industry, price tends to be similar. And, price competition can be minimized:’

iv. Experts believe that cost-plus pricing method is fair for both – buyers and sellers.

Demerits:

The method suffers from following limitations:

i. It ignores current demand.

ii. It ignores consumers’ perception of price.

iii. It doesn’t consider competition. (However, mark-up rate may be decided on the basis of competition).

iv. It is difficult to estimate exact sales.

v. The method is meaningful only if price of raw material and other inputs remain unchanged. Otherwise, the method may be misleading.

2. Perceived-value pricing Method:

Perceived-value pricing is a market-oriented method for setting the price. Here, price is based on the consumers’ perceived value of the product. Consumers’ views on price are given priority. Company takes consumers’ perception of value as a key to set the price, and not its own cost and objectives.

Company tries to measure the views of buyers regarding price of the product. Manager explains the consumers about total offers, including core product (key benefits and features), product-related aspects (like brand image, reputation, novelty, etc.), and product- related services (such as after-sales services like free installation, free home delivery, guarantee, etc.) and asks them to estimate price for that product or for total benefits offered by the product.

The key to the perceived-value pricing method is to measure accurately the market’s perception of the offer’s value. The seller with inflated views of his offers will overprice the product while with underestimated views will charge less than what it should be. Market research is needed to estimate market perception of price. Let us take an example,

ABC Company Limited wants to set price for the motorbike by the perceived-value method. Market research officer considers following aspects and takes the views of buyers.

Buyers respond as under:

Rs. 30000 if the bike is similar to competitors’ motorbikes

Rs. 2000 is the price premium for novelty, shape, new getup, and colour.

Rs. 3000 is price premium for the highest mileage per litre petrol.

Rs. 2000 is price premium for replacement guarantee and two extra free services.

Rs. 2000 is price premium for durability and reliability.

Rs. 1000 is price premium for special safety measures.

Rs. 40000 is the normal price as per consumers’ perception.

Rs. 2000 discount is for DIWALI special offer.

Rs. 38000 is final ex-showroom price as per consumers’ views (or perception).

Merits:

This method offers following merits:

i. Perceived-value method matches with consumer orientation.

ii. It considers indirectly competitors’ offers.

iii. It is more realistic than any other method.

iv. Perceived-value can be taken as base, with little adjustment in costs and objectives, the most suitable price can be set.

Demerits:

However, there are certain practical problems in setting price via this method.

Main limitations include:

i. It is practically difficult to measure perception of the market. Unless relatively a large sample of consumers is contacted, views may be misleading.

ii. A lot depends on the person who estimates buyers’ perception of price. Possibility of bias cannot be ignored.

iii. The method is based on the trust. If their response is not normal, it is a wasteful exercise.

iv. All the limitations of marketing research are equally applicable to this method.

v. It is, compared to the first method, difficult and complex to understand and apply.

3. Going-rate Pricing Method:

This is also said as competitive parity method. Even, sometimes, it is called as competition- oriented pricing. The method is, normally, followed by small firms, said as ‘the followers’ In going- rate pricing method, the company gives less attention to its own costs, objectives, or product demand. But, pricing decision is largely based on competitors’ prices.

The company may charge the same, more, or less than major competitors. The notion is “follow the leader,” or “leader is right.” One must note that company doesn’t select a price, which is far below or much higher than the real. However, competitors’ pricing is taken as a base. And, final price may be set slight high or low depending upon objectives, qualities of product, and services offered.

Merits:

The method can be justified on the following grounds:

i. It is the only way to set the price when costs are difficult to measure and competitors’ response is uncertain.

ii. It considers competitors pricing policies as a base. In contemporary marketing practices, it is more relevant method.

iii. Going rate pricing brings uniform pricing in the industry. It ensures fair return to sellers and harmony in industry.

iv. It may protect consumers’ from cheating and misguiding. They can buy the similar product at a, more or less, same price.

Demerits:

Going-rate pricing method has been criticized as under:

i. This is not an ideal method for pricing because it is one-sided, i.e., only competition factor is considered.

ii. Company’s objectives, costs, qualities, services, and consumers’ perception of value have been ignored.

iii. It is senseless to follow blindly the leaders or strong competitors as every firm has its special problems, opportunities, situations, and capabilities.

iv. Temporary pricing of competitors may lead to erroneous decision.

4. Sealed-bid Pricing Method:

Sealed-bid pricing is followed in construction or contract business. It is also a competitive pricing method. Here, price is selected on the basis of sealed bids (quotation or estimated price) for the jobs.

The firm sets its price on expectations of how competitors will price the product. The firm wants to win the contract requires submitting the lower price than competitors. However, costs and profits are not totally ignored. The firm cannot set price below the costs.

It is called as tender pricing also. In response to the proposal of jobs or works, interested parties (businessmen or marketers) have to fill the tender (send quotation or estimated costs) stating price and conditions of work and send in forms of sealed-bids.

The bid is an offer of price for particular work or product. Generally sealed-bids (sealed envelops containing a bid) are invited for a competitive work. Offers or proposals come from charitable trusts, companies, organisations, or governments. In our country, we say this method as “tender,” and proposal of jobs as a “tender notice.”

Mostly, the tender notice is published in newspapers or circulars. The offer or proposal for work contains type of work or job, time to complete the work, quality of work, and other similar conditions.

In response to the tender or proposal, interested parties have to send sealed-bids stating their prices and conditions within the permitted time. In this method, the party inviting the sealed-bids is customer and those who bid by sealed quotations are the marketers (because they will serve the inviting party).

On a due date – either publicly or otherwise – the sealed-bids (or quotations) are opened, and the bid with lower price and more favourable conditions is selected. Rate of selected bid is the price for the job. The selected bid is given the business. The method has its plus and minus points.

5. Target Return Pricing:

This is one of the cost-oriented methods for setting price of the product. Here, the firm determines that level of price at which it can yield the target return on investment. Here, return on investment is taken as a base for price determination.

Attempts are made to recover the cost of investment. Mostly, government Companies, public utilities, cooperative societies, and the similar organisations fix pricing for their products on this basis to ensure minimum return on investment.

For example, Jai Hind Private Limited company expects to sell 10000 school bags of premium quality in the current year. Fixed costs allocated to this line is Rs. 5, 00000. Variable costs estimated for each bag is Rs. 100. Total investment (covering development, production and marketing) on this line is Rs. 50, 00000. Company wants 20% return on investment.

Return on Investment (ROI) = Rs. 5000000 x 20% = Rs. 1000000

Costs per unit = variable cost per unit + fixed cost per unit

= Rs. 100 + (Rs. 500000 ÷ 10000 units)

= Rs. 100 + Rs. 50

= Rs. 150.

Target return (profit) per unit = Rs. 1000000 + 10000 units = Rs. 100.

Selling price per unit = cost of product + Return on Investment.

= Rs. 150 + 100

= Rs. 250.

If company wants to earn 20% ROI (Return on Investment), the selling price should be Rs. 250. If RIO is more, definitely selling price will go up and vice versa.

This method can be used only when company is capable of estimating accurately the sales, variable costs, and fixed costs. The price so determined will be meaningful only if the company can achieve expected sales. Here, we assume that company might have estimated sales keeping in mind quality of product on one hand, and competition on the other hand.

6. Break-even Analysis Method:

Some companies set the price for their products by Break-Even Analysis (BEP method). It is a managerial tool that establishes relationship among costs, volume of sales, and profits. It is also known as cost-volume-profit analysis.

It involves developing tables and/or charts that help a company to determine at what level of sales, the revenue will be equal to the total costs. Under this method, attempts are made to find out volume of sales at which total costs are just equal to the sales revenue. This is such a level of sales at which there is no profit, no loss.

Sales Revenue = Total Costs.

This level is called BEP (break-even point), at which the firm has neither profits nor losses. The firm just covers its total costs. When sales revenue exceeds the total costs, the result is profit; and when sales revenue is less than total costs, the result is loss. Thus, BEP is the position of sales at which sales revenue is just equal to total costs. BEP can be calculated either by a formula or by a chart.

Formula Method:

BEP can be calculated using formula as under:

For example,

Hindustan Products Pvt. Ltd. gives following details:

Selling price is = Rs. 200 per unit.

Variable cost is = Rs. 100 per unit.

Fixed cost is = Rs. 500000.

Contribution is = selling price – variable costs

= (Rs. 200 – Rs. 100) = Rs. 100

Let’s calculate BEP by using the Formula

BEP = Fixed Cost + Contribution

= Rs. 500000 + Rs. 100

= 5000 units.

Or

Sales Revenue is (5000 units x Rs. 200) Rs. 1000000. If the company achieves sales of 5000 units, there is no profit, no loss position. Pricing is the decisive or critical factor in the break-even analysis. An increase in selling price enables the firm to reach break-even point much rapidly, that is, at less sales volume; and, lowering price needs to achieve more sales volume, assuming costs will be equal.

Based on ability of the firm to achieve sales, the price is set accordingly. By trial and error method, a table can be prepared with different level of price to see how much sales a company must achieve to offset costs against sales revenue. And, suitable price can be picked up.

Graphic Method:

By trial and error method, a table can be prepared to find out the break­even point and can be presented graphically; the same result can be arrived at. We may take different level of sales at fixed price to find out break-even point.

BEP is essentially a tool for mark-up or cost-plus pricing. It can be said as an extension of mark-up pricing method. Here, it is assumed that sales will remain stable at different level of the selling price. (This is hardly possible). Similarly, fixed and variable costs remain unchanged.

This method is used only when data on sales, costs, etc., are accurately available. While estimating sales, apart from the BEP at particular price, market forces should also be considered. But, all depends on the estimates. It is a useful tool. However, for setting price of the product, it should be used with care and caution. It may be used along with other price setting methods.