What is a Pricing Strategy?
A pricing strategy is how a business firm sets the best price for its product or service. The firm can use one or more pricing strategies to leverage its pricing objectives.
Setting an appropriate price for the product is difficult, but after careful analysis of demand, cost, and competition, one can set the best price. Of the marketing mix components, price generates a profit for the firm.
A good price for a firm’s offerings is essential to attract potential customers as fast as possible and as much to make the firm’s future better.
While pricing one should be based on universally accepted three factors cost, demand, and competition.
The essential pricing strategies can be pointed out as:
- Cost-Based Pricing Strategy
- Demand-Based Pricing Strategy
- Competition-Based Pricing Strategy
Let’s describe those three pricing strategies or techniques and their sub-strategies.
Cost-Based Pricing Strategy
Cost-oriented pricing means pricing based on cost. Companies adopting this pricing strategy set their prices based on cost.
Cost-based pricing strategy argues while setting the price, the particular product’s price must at least cover the cost incurred during production.
In other words, anyhow the price of the product should not be less than the production cost. Under this pricing, one can use different (primary) pricing strategies markup pricing, target return pricing, and breakeven pricing.
Markup or Cost Plus Pricing
Markup pricing is the most simple, most popular, and traditional approach to pricing.
As its name suggests, under cost-plus pricing certain markup (percentage) is added to the total cost which is incurred with the product, promotion, and placement (distribution).
Such markup can be in terms of percentage or value. To be more clear, the cost-plus pricing can be expressed mathematically as,
Markup Price = Total Cost + Profit (certain)
It cannot be said that the markups are the same for all products. The margin percentage varies on different products or services depending upon their nature and type. There is a markup chain, as such even in the same product, markups vary from firm to firm.
It goes on a chain, the producer’s selling price becomes the wholesaler’s cost, and in that cost, a wholesaler may also add some percent of profit.
Similarly, the wholesaler’s selling price becomes the retailer’s cost, and this cost plus a retail markup becomes the retailer’s selling price.
For the following reasons, it is seen that wholesalers and retailers have adopted this spring strategy,
- First, there is less uncertainty about cost than about demand,
- Second, prices based on this strategy are likely to be similar, if cost and markups are similar, in this case, price competitions are maximized,
- Third, there is the feeling that cost markup pricing is fairer to both buyers and sellers because there is a strong justification for pricing.
Target Return Pricing
Another cost-based pricing strategy is target return pricing in which business firms set an average rate of return on the investment as well as total sales.
In both cases, the price setter seeks to obtain a percentage return or specific total value in rupee or dollar.
One can calculate the target return by using its formula, expressed as,
Target Return Pricing = Variable cost per unit + Fixed Cost/Standard production units, = Variable cost per unit + Expected profit rate * Invested capital/Standard production units
Suppose, a cold drink company recently aims to bring its cold drink in 250ml. Where the variable cost per unit is Rs. 8, fixed cost is Rs. 400,000, production is 200,000 units, and invested capital is Rs. 10,00,000. Which, the company expects a profit of 15% – which is the target return. By following the above formula, the expected return is Rs. 10.75.
In the following situations, companies adopt target return pricing than other strategies,
- Companies that have a monopoly position in the market,
- Companies that have a large investment in public utilities, and
- Companies that want to seek a fair rate of return on their costs.
This strategy is not used in practical life because, in this pricing strategy, companies use an estimate of sales volume to derive the price, but the price is a factor that influences sales volume.
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Break-Even Pricing/ Target Profit Pricing
Break-even pricing or target profit pricing is the most popular approach to pricing. The break-even approach of pricing does not help to establish the price, rather in this system price is already assumed.
Since the break-even point is when the cost is equal to revenue. Break-even pricing helps to know the relationship between cost and revenue and find a point where revenue equals the total cost.
According to this approach, price is determined at the point where revenue equals cost. And, that point is called the “break-even point (BEP)”.
The BEP can be calculated in two ways, one way in terms of unit and another in value. BEP in-unit = Fixed cost/Selling price per unit – Variable cost per unit and BEP in value = Fixed cost/1 – Variable cost per unit/Selling cost per unit.
Among the various strategies or approaches of cost-oriented pricing, break-even pricing is the most popular because it can be used as the basic tool for measuring various alternatives of price with sales volume.
Demand-Oriented Pricing Strategy
Under the demand-oriented pricing strategy, the firm prices its offerings based on the consumer’s perception and the demand intensity rather than on costs. It is also popularly known as market-oriented pricing.
The demand-oriented strategy also has three pricing strategies, they are,
Perceived Value Pricing
Perceived value pricing is when companies set their product’s price by the perceived value of the customers on their offerings. Here the perception of value is the key to pricing.
In this, the firm tries to measure the relative perceived value of its offers and utilize this in setting the price. For this, the firm has to be based on market research to know the market’s perception.
Perceived value pricing is an important tool for market positioning. The firms develop particular products and offer them to the target market with an appropriate market positioning in mind concerning price, quality, and service.
More specifically, the process of setting perceived value price involves 4 steps,
- First, identify product features, performance, and company services.
- Second, conduct a market survey to determine the customer’s response on each product feature, performance, and company service.
- Third, rank their emphasis based on the value they placed.
- Finally, identify the price customers wish to pay for the company’s product or service. This price is called the perceived-value price.
The key to perceived value pricing is to make an accurate determination of the marketer’s perception of the value of the total offer.
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Value Pricing or Value-Based Pricing
Value-based pricing also called value pricing, is defined by offering the product at a fair and reasonable price that makes sense to the purchasing consumer.
In this pricing strategy, the price of the product or service is set according to the value perceived by the customer.
In this case, the customer expects a certain level of quality service or benefit from the seller, for which he pays a certain amount of money, but he does not directly compare with the benefit from the product, rather he expects benefits from the seller or marketer.
The value of the product is the mental estimation a consumer makes of it. It may be conceptualized as the relationship between the consumer’s perceived benefits about the perceived cost of receiving these benefits.
The value is the estimation of the merit of the offering in terms of money, quality, or any other measure of worth. Value is a benefit but a benefit is not necessarily valuable to all consumers.
For example, a vendor offers free installation and free updates of his software. If a particular customer considers “free installation” as “value” because he has no technical knowledge this will save him time and effort.
Another customer may rate the “free installation” as “nice to have” but the value is “free updates” that will save him money in the long run. Customers thus do not assign the value of the same benefit.
The goal of value-based pricing is to better align the price with the value delivered. It is intended to make companies more competitive and more profitable than using other pricing strategies.
It can also be used in product development and product management to configure products to maximize value for specific customers.
Demand Differential Pricing
In demand differential pricing strategy a product is sold at two or more prices that do not reflect a proportional difference in marginal costs. This strategy is also known as price discrimination,
i.e. charging different prices to different customers based on their income, purchasing power, spending power, and so on.
In other words, the price will be discriminated against based on customers paying capacity, product form, place, and time (seasonal).
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Competition-Oriented Pricing
Under competition-oriented pricing, the company sets its offering price based on what competitors are charging.
However, the company doesn’t need to charge the same price as its competitors charge. Price may be determined below the market price depending upon the nature of competition, the nature of the product, market expectations, etc.
In competition-oriented pricing strategy, generally, there are two pricing strategies,
Going Rate Pricing
In simple words, going rate pricing means setting the product price as per the prevailing market price. The firm adopting this strategy tries to keep its price at the average level charged by the competitors.
This pricing strategy is generally adopted for homogeneous products in an extremely competitive market. This pricing is adopted where costs are difficult to measure.
In a market characterized by product differentiation, the companies exercise freedom in price decisions. In such markets, the price of the products may differ from company to company,
i.e. companies may price the product below the market price or above the market price. Because consumers can not compare the prices of differentiated products since their performance may differ from one another.
Sealed Bid Pricing
The sealed bid type of pricing is popularly used where firms compete for jobs based on bids. The bid is the firm’s offer prices, and it is a prime example of pricing based on expectations of how competitors will price rather than a rigid relation based on the firm’s costs or demand.
The objective of the firm in a bidding situation is to get the contract, and this means that it hopes to get its price lower than that set by any of the other bidding firms.
The sealed bid price shouldn’t be below the lower limit (base price) or it should be below the marginal cost (expected), if some unfavorable happens may cause a loss to the firm.
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Sujan Chaudhary holds a BBA degree. He loves to share his business knowledge with the rest of the world.