Notes on Pricing

Price is the amount of money charged for a product or a service. It is an expression of value -
the sum of all the values that customers give up to gain the benefits of having or using a product
or service. The value rests in the usefulness and quality of the product itself, in the image that
is conveyed through advertising and promotion, in the availability of the product through
wholesale and retail distribution systems, and in the service that goes with it.

A price is the seller’s estimate of what all of this is worth to potential buyers, recognizing the other
options buyers will have for filling the need the product is intended to satisfy. To the extent that
the product or service finds markets and is profitable at given price levels, it provides a
viable economic base for building and maintaining a business. Pricing is an art, a game played
for high stakes; and for marketing strategists, it is the “moment of truth.” All of marketing
comes to focus in the pricing decision.

Price is the one element of the marketing mix that produces revenue; the other elements produce
costs. Prices are perhaps the easiest element of the marketing program to adjust; product
features, channels, and even promotion take more time. Price also communicates to the market
the company’s intended value positioning of its product or brand. A well-designed and marketed
product can command a price premium and reap big profits.

It is important for a firm to get its pricing “right.” Consider the impact of product pricing on
a firm’s net income. If Coca-Cola could increase its prices by an average of 1%, without
affecting consumer demand for its products, it would increase its net income by 6.4%. A price
increase of less than 1¢ on a can of cola would translate to an increase in net income of about
$300 million.

These examples highlight the potential impact on a firm’s net income of optimally setting product
prices — small changes in price can have an enormous impact on income. Before raising (or
lowering) prices in an attempt to improve the bottom line, however, a firm must understand
and anticipate a consumer’s response to a product price change.

Unfortunately, it appears that many firms lack the necessary understanding of a consumer’s
“willingness to pay” to optimally set product prices. When asked whether they were “well-
informed” on six of the potential inputs to the product pricing decision, managers at one well-
respected U.S.-based multinational responded as follows:

• 84% were well-informed on the variable cost of providing their product.

• 81% were well-informed on the fixed cost of providing their product.
• 75% were well-informed on the price of competitors’ products.
• 61% were well-informed on the value of their product to the customer.
• 34% were well-informed on how consumers would respond to price changes.
• 21% were well-informed on consumers’ willingness to pay at various price levels.

These managers were well-informed on the costs of providing its products and on the
price of competitor’s products. They were also well-informed on the value it s products
delivered to consumers. However, when it came to a consumer’s willingness to pay or to a
consumer’s response to potential price changes, these managers were lacking the insight needed
to optimally set prices. Experience suggests that this company is not unique in this regard.

Pricing decisions are clearly complex and difficult, and many marketers neglect their pricing strategies.
Holistic marketers must take into account many factors in making pricing decisions—the company,
customers, competition, and marketing environment. Pricing decisions must be consistent with the
firm’s marketing strategy and its target markets and brand positioning.

Setting the Price

A firm must set a price for the first time when it develops a new product, when it introduces its regular
product into a new distribution channel or geographic area, and when it enters bids on new contract
work. The six step procedures for setting up prices are as follows:

Step 1: Setting the pricing objective:

Pricing is a key element in strategy, and to make strategic pricing decisions it is important to
know what objectives are being served. The range of possibilities is quite large. One may seek
to gain market share or may price to discourage some competitors from entering the market.
Or a seller may seek to maximize short-run profits or to “buy in” with the hopes of making
profits in the long run.

One may price low to meet a competitive attack, or to take an order that offers an
opportunity to gain a new customer. Alternatively, one might price high on some new product
to minimize its impact on the sales of old products in the line (avoid cannibalization). Whatever
the objective, it is important that it be determined explicitly. Otherwise pricing decisions become
aimless responses to the moves of others.

The company first decides where it wants to position its market offering. The clearer a firm’s
objectives, the easier it is to set price. The five major objectives are: survival, maximum current
profit, maximum market share, maximum market skimming, and product-quality leadership.

Survival
Companies pursue survival as their major objective when they are plagued with overcapacity,
intense competition, or changing consumer wants. Survival is a short-run objective.
Maximum Current Profit
Many companies try to set a price that will maximize current profits. They estimate the demand
and costs associated with alternative prices and choose the price that produces maximum current
profit, cash flow, or rate of return on investment. Such objective is useful if company use shorter
payback period to recoup investments.
Maximum Market Share / Market Penetration
Penetration pricing is a strategy of low entry prices to get to the mass market quickly. When
there are substantial economies of large production, the low-price/high-volume strategy has very
favorable production cost effects and may be an effective barrier to competitive entry. Some
companies want to maximize their market share. They believe that a higher sales volume will lead
to lower unit costs and higher long-run profit. This practice is called market- penetration pricing.
The following conditions favor setting a low price:
1) The market is highly price-sensitive, and a low price stimulates market growth.
2) Production and distribution costs fall with accumulated production experience.
3) A low price discourages actual and potential competition.
A major risk in penetration pricing is that, with a new product, demand is very difficult to predict.
Consequently, a low initial price may swamp the firm with orders many times its production capacity.
A consideration of penetration pricing brings up the matter of demand elasticity as it relates
to pricing strategy. In economic theory, the lower the price the greater the demand will be for
the product. In developing pricing strategy, however, some modifications of the theory must be
recognized. The demand for many goods, particularly in the industrial sector, is derived demand.
The demand for treadmill motors depends directly on the demand for treadmills, for example.
Price reductions on this component are not likely to increase treadmill motor industry volume.
Maximum Market Skimming
In market skimming pricing, the firm sets a high price initially to obtain high unit contributions.
Price is lowered as time goes on. This initial high-price strategy is effective in segmenting the
market (i.e., those who place a high value on the good buy initially at the high price). Then, as
the price comes down, new market segments open up, theoretically, in order of declining product
value to different customer sets. A strategy of reducing price gradually to broaden the potential
market, in principle, maximizes total profits. The most well-known skimming strategy is with
books—first coming out in hardcover, then the same generic product in paperback form later to
tap the more price-sensitive segment. Similarly when Apple introduced the new Iphone 13 it
was priced around $900 so that Apple could ‘skim’ the maximum amount of revenue from the
various segments of the market, but price was dropped steadily through the years.
Product-Quality Leadership
A company might aim to be the product-quality leader in the market. Many brands strive to
be “affordable luxuries”—products or services characterized by high levels of perceived quality,
taste, and status with a price just high enough not to be out of consumer’s reach. Brands such
as Starbucks, Movenpick have positioned themselves as quality leaders in their categories.
Step 2: Determining Demand
Each price will lead to a different level of demand and therefore have a different impact on a
company’s marketing objectives. The normally inverse relationship between price and demand
is captured in a demand curve.
Price Sensitivity
A relevant consideration in thinking about price as an expression of product value is how sensitive
is the buyer to price. Price sensitivity will vary considerably among purchasers and, for the same
purchaser, it will vary from one time and one set of circumstances to another.
The demand curve shows the market’s probable purchase quantity at alternative prices. The first
step in estimating demand is to understand what affects price sensitivity. We can put price
sensitivity and demand relationship into 3 categories: product characteristics, price
characteristics and buyer characteristics. Price sensitivity will be high:
a. Product.
i. When the product is commodity. Less differences among
competitor’s product means customer can buy from any seller offering a
lower price.
ii. If the product is search vs. experience good. Search good is where you
can identify the benefit before buying, can easily evaluate before
purchase. Customer are price sensitive as they can judge quality before
buying. Common examples are buying clothing, shoes. For experience
goods, customers cannot identify the benefit of the product until
consumed. In such cases, customers are less price sensitive as price is then
can be used as a cue to product quality. Example: spa treatment, dental
care, honeymoon packages, school tuition fees or surgery fees.
iii. If the product is mission critical. If product performance is less
important, customer will be more price sensitive. A home internet buyer
will be more price sensitive compared to airport management buying
internet service.
b. Price:
i. When customer can easily compare prices. The use of internet for
purchasing airline ticket has made customer more price sensitive as they
can easily compare price of different airlines.
ii. If it is high in relative sense – you are less price sensitive when
buying something less than Tk. 10 vs. buying something costing more than
10,000 taka
iii. If you have reference prices. Customers are more price sensitive if
they have previous price experience regarding the product. Products that
are purchased less frequent tend to lead customer to be less price
sensitive. For example, you are more price sensitive to rickshaw fare
between your home and office than buying pens.
c. Buyer:
i. If buyer is sophisticated. If buyers are product expert, they can
evaluate the quality of product and make accurate judgment about what
the product is actually worth.
ii. Bearing the cost. If someone else bears the cost, customers are less
price sensitive. Buyers who can pass on the cost of the purchase are less
sensitive to price than those who cannot. A business person who can
charge expenses to his or her company is less price sensitive to travel
costs than a family vacationer.
 iii. If buyer can switch easily to substitute product. For instance, a trip to
Dhaka by train or bus makes you more price sensitive. The rise in cost of petrol shifts
customer to alternative/substitute – CNG.
iv. If buyer is not motivated by brand / prestige and thus see everything as a
basic product. Don’t understand or want to understand the value of brand.

Step 3: Estimating costs

The second component of the profit calculation involves the cost to produce the products being
sold. In this regard, there are two types of costs typically incurred by a firm—fixed costs and
variable costs.

Fixed costs remain constant, regardless of the amount of a product produced and sold. These costs
could include expenses such as rent for administrative office space, management salaries, and
advertising. In the short term, such costs remain constant, regardless of whether the factory is
running at 50% or 90% of capacity—that is, they remain fixed.

In contrast, variable costs change depending on the amount of product produced and sold. For a
manufacturing firm, these costs include the costs of raw materials and direct manufacturing labor.
For instance, if the materials used to make a clock included a movement for $10, a housing for $5,
a dial and hands for $3, and a glass front for $2, and the labor required to assemble that clock
amounted to one-quarter of an hour for a worker earning $20 per hour, the unit variable cost to
make a single clock is $25 ($20 in materials + $5 in labor). In turn, if the firm were to produce 10
clocks at a constant unit variable cost, the total variable cost for those 10 clocks would be $250.
Combining fixed and variable costs, total costs measure the amount of money a firm must spend
to produce the quantity of goods it makes and sells. In its simplest form, total costs are calculated
as follows:

Exhibit 1 shows these costs graphically. In the base case, where the unit variable cost remains
constant across the number of units produced, total costs can be captured as reflected in Exhibit
1(a). Here, the fixed costs are shown as a flat line, reflecting the fact that fixed costs do not vary
in the number of units produced. In turn, the total cost line, which is the sum of the fixed costs
and total variable cost, is an angled straight line, reflecting the fact that total variable costs
increase at a constant rate with increases in volume.

Exhibit: 1
In contrast, unit variable costs often vary depending on the number of units produced, as reflected
in Exhibit 1(b). This could happen for a number of reasons—for example, the firm achieves some
economies of scale in the production process or it negotiates some volume discounts for raw
materials. As a result, fixed cost is shown as a flat line, but now the shape of the total cost curve
is concave—that is, it increases at a decreasing rate with volume. This means the unit variable
costs decrease the more the firm produces.

Regardless of whether total cost takes the simpler shape of Exhibit 1(a) or the more complex shape
of Exhibit 1(b), the basic concept is the same. That is, one needs to add the fixed and variable costs
incurred by the firm to produce a product to arrive at the total costs used to assess profitability.

If fixed costs make up a large portion of total costs, pricing to get maximum capacity utilization
is crucial. Until the seller covers fixed costs, money is lost. After fixed costs are covered each
incremental sale contributes proportionally large amounts to profits. If variable costs are a
relatively high percentage of total costs, pricing to maximize unit contribution (i.e., the difference
between unit variable cost and price) on each item produced will be critical to profitability.
Under these cost conditions, the manufacturer would naturally work to maximize unit prices and
to reduce variable costs.

Unit Margins

The profitability framework just outlined is relevant in the aggregate—that is, it enables the firm
to assess the profit of selling x units of a good for y dollars each, when it incurs fixed costs of w
and unit variable costs of z.

However, almost any pricing discussion also considers the financial contribution of a single unit of
a good. We call the difference between the per- unit revenue received by a firm and the per-unit
variable cost of production the unit margin. If it is clear from the context, we sometimes drop the
word unit and simply call this the margin. Another term sometimes used to represent the same
quantity is unit contribution.

Consider our clockmaker. If the firm sells this clock to its nearest downstream channel partner,
say a wholesaler, for $40 and the unit variable cost, as previously stated, is $25, then the unit
margin is $15. Sometimes, it is useful to state this $15 unit margin in percentage terms. To do so,
you simply divide the dollar margin by the selling price (e.g., $15/$40 = 0.375) and multiply by 100
to arrive at a percentage margin of 37.5%.

Step 4: Analyzing Competitors’ Costs, Prices, and Offers

Within the range of possible prices determined by market demand and company costs, the firm
must take competitors’ costs, prices, and possible price reactions into account. The firm should
first consider the nearest competitor’s price. The introduction of any price or the change of any
existing price can provoke a response from customers, competitors, distributors, suppliers, and
even the government.
Step 5: Selecting a Pricing Method
Given the customers’ demand schedule, the cost function, and competitors’ prices, the company
is now ready to select a price. There are three main pricing strategy that marketers can choose
from. The first one is customer value-based pricing. Pricing according to the value of the product
to the customer is more difficult and speculative. How does one determine what the value of the
product is in the customer’s mind?

First, it is useful to distinguish between perceived value and potential value or true economic
value. There are several important features of perceived customer value:
1. It varies across customers.
2. For a given customer, it will vary over time as perceptions of the product
and competitive prices change.
3. It is to some extent controllable by the marketer.

Perceived value is what the buyer now recognizes. Potential value is what the buyer can be
educated to see in the product. That is a task of marketing. It may be accomplished through
advertising, personal selling, and getting the buyer to try the product.

In customer’s value-based pricing, the price is set based on the benefit the customer perceives
to get from the product and is not directly related to the cost of producing it. So, it deals with
buyer’s perception of value and is thus customer driven. A pricing thermometer can be used to
determine customer value and price setting (see below figure).

The traditional economic approach to product pricing is driven by a small handful of factors,
as shown in below Figure. One of these factors is the “objective value” or true economic value
the product delivers to the consumer. This is a measure of the benefits that the product delivers
to the consumer, regardless of whether the consumer recognizes those benefits. When 61% of
managers claim they are well- informed on the value of their product to the consumer, they are
most likely referring to this “objective value.”
A second factor in the economic approach to pricing is the “perceived value” of the product
to a consumer. Perceived value is the value the consumer understands the product to deliver.
Sometimes, a product’s benefits are readily apparent to the consumer and “perceived value”
approaches “objective value” with little effort by the firm. Other times, a product’s benefits
are less obvious and need to be communicated by the firm to the consumer (e.g., via advertising,
personnel selling). In such cases, the “perceived value” of a product typically falls below its
“objective value.”
The perceived value of a product also can be influenced by the price of competing products
or “substitutes.” Company A may develop a product that creates great objective value for
consumers. Consumers may recognize this value and be willing to pay a high price to obtain the
product. However, if Company B introduces an identical product at a much lower price, the
perceived value of Company A’s product would be reduced to the price of Company B’s
product.
It is important to note that the “perceived value” of a product to a consumer should equal
the maximum price that consumer is willing to pay for the product. Imagine a consumer who
perceives the value of a modem to be $100. If priced above $100, the consumer has no incentive
to buy the modem. If priced at $100 or less, however, the consumer always stands to gain from
purchasing.

The last major component to the economic approach to pricing involves the firm’s cost of goods
sold (i.e., COGS). Just as the consumer requires an incentive to purchase a product, the firm
requires an incentive to sell the product. In order to stay in business and make a positive return,
a firm must charge a price that covers both its cost of production.
By pricing above COGS and below perceived value, the firm has an incentive to sell the product,
measured as [price – COGS], and the consumer has an incentive to purchase the product,
measured as [perceived value – price]. In value pricing terminology, the firm has “created”
value by offering a product that the consumer values at a price greater than the firm’s COGS.
In turn, by pricing between perceived value and COGS, the firm has “captured” some of that
value for itself and has allowed consumers to capture the remainder.
All of these economic factors come together to form the “value pricing” approach to pricing.
In optimally pricing a product, a firm is bound at the upper end by the consumers’ “perceived
value” for the product. This “perceived value” is influenced by the “objective value” of the
product to the consumer, by the firm’s marketing effort to communicate that objective value,
and by the price of substitute products. At the same time, the firm is bound on the lower end
by its COGS.
There are two common types of value-based pricing: good value pricing & value added pricing.
It is necessary to understand that good value is not same as low price. It just means the price is
right for the amount of benefit you get from the product. Therefore, it is the right combination
of quality and good service at a fair price. Good value pricing can be again of two types
1. Every day low price: Everyday low pricing sets prices a certain percent lower than
competitors’ regular list prices, and does not offer sales or promotions to further lower
the prices. In practice, very few retailers use a pure EDLP strategy.
2. High-low pricing: The high-low pricing strategy is a form of price discrimination
that allows customers to express their different willingness to pay for the same item.
Items have an initial high price, but the store offers promotions or time-limited sales
events that bring the price down, often significantly. A customer who is not price sensitive
will buy at the original price, while price sensitive customers will wait for sales. Most
department stores use a high-low pricing strategy. In our country context, Pebbles,
Artisian, Aarong, etc. will fit the description when they offer 30% - 70% discount offers.
Below figure shows a graph of high-low and EDLP pricing.

Apart from good value pricing, some companies adopt value-added pricing. Instead of cutting
prices, companies add more features and services to the product and differentiate it that help
them to charge higher prices. For example, Amex charge their platinum customer over Tk 25,000
per year. But instead of reducing annual fees, Amex is known to create bundle of benefits for
customers from free access to airport lounges to buy 1 get 1 free in Radisson to host of other
facilities and benefits.
The 2nd type of pricing is cost based pricing. Some business managers set prices simply by adding
a percentage over costs to provide an acceptable profit. That approach has two advantages.
Price is simple to calculate and if a firm is a low-cost producer, relative to competitors, so-called
“cost-plus” pricing may seem to provide some protection from competitive attack.
The trade-off for simplicity and security may be lost profits. In theory the amount of profit
that is sacrificed is the difference between what customers actually paid and what they would
have been willing to pay.
Companies should also understand that profit maximizing price based on cost based pricing
depends on the level of demand, variable cost and capacity and they are all interrelated. For
example, fixed cost is important because it affects capacity decision, and hence also entry/exit
decisions (exit=zero capacity). However, given a preexisting capacity, fixed cost does not affect
the pricing decision. To decide on capacity expansion, contribution per unit (Price – Variable
cost) is more important as if contribution per unit can cover the fixed cost of capacity expansion,
companies should go ahead and expand the capacity as it will increase total profit contribution.
We can also have competition based pricing. In competition based pricing, the firm bases its price
largely on competitor’s prices. The firm might charge the same, more, or less than major
competitor(s). Competitor based pricing is quite popular where costs are difficult to measure or
competitive response is uncertain. Competitive market price levels usually impose a tight discipline
on value pricing. They reflect not so much what the product is worth to the customer in some
absolute sense as the availability of supply relative to demand. The greater the supply relative to
demand, the lower the price.
For so-called commodities (i.e., virtually undifferentiated products), all competitors generally charge
identical prices. If one goes above the market price, sales will drop off sharply; if one goes below,
all others are likely to follow or risk significant reductions in market share.
How much any individual firm is constrained by competitors’ prices, therefore, depends largely
on how differentiated its product is. A product that is set apart from other market offerings by its
functional design, appearance, brand image, and the supplier’s reputation for service and
availability in ways that have value to customers can command a price premium. Apple, for example,
has typically charged prices for computers over what its competitors have charged for comparable
equipment. Its customers are persuaded that Apple offers superior systems design and field service
and is in the forefront of computer technology.

Step 6: Setting the final price

Pricing methods narrow the range from which the company must select its final price. In selecting
the price, the company must consider additional factors, including the impact of other marketing
activities, company pricing policies, and the impact of price on other parties such as retailers,
distributors and final consumers. Below figure shows the two feasible strategies with respect to
pricing and marketing efforts.

The first feasible option, in the lower left, is to follow a low-price (relative to objective value) and
low-marketing-expenditure strategy. The product’s value in this case must speak for itself, and
such a soft voice may not push PV near TEV. But because of the low price, the hurdle for a
consumer to purchase may not be high. The second option is to follow high/high strategy, in the
upper right quadrant of the exhibit. In particular, a firm can invest in marketing to boost PV, price
high to capture the perceived value thereby created, and attain the margins necessary to fund the
high marketing effort.

Conversely, the other two price/expenditure combinations are not feasible in the long term. High
price/low marketing, in the upper left quadrant, fails because the organization doesn’t use enough
resources to convince potential consumers of the product’s value. And low price/high marketing,
in the lower right quadrant, is not feasible because, while the high number of consumer purchases
may help create unit sales, the low unit margins resulting from the low price amount to minimal
contribution to the organization.
Price Changes
Once the price has set, companies might require adjusting prices as they go along. Sometimes
companies might need to increase the price or cut it. Let’s focus on different scenarios
 Initialing price cuts: Several circumstances might lead a firm to cut prices: an excess
plant capacity or if demand is falling. In such cases price is reduces to increase demand.
The disadvantage is if competitors also initiate a price cut, you end up with price war.
Some companies however have achieved low cost structure and can charge lower price
because of their low cost. Such companies seem to be quite successful. Prime examples are
Walmart, or Lenovo laptop or Symphony phone.
 Initiate price increase: Increasing price can greatly improve profits. This might
happen when demand exceeds supply and company can sustain price increase. In our
country, commodity prices are increased during Ramadan or the sudden increase in price
for masks and sanitizers during Covid-19. Sometimes price increase is done because the
cost has increased. Coca Cola has increased price from Tk 10 to currently Tk 20 over the
last decade.

Given strong consumer resistance, marketers go to great lengths to find alternate approaches
that avoid increasing prices when they otherwise would have done so. Here are a few popular
ones:
 Shrinking the amount of product instead of raising the price. (Hershey Foods
maintained its candy bar price but trimmed its size. Nestlé maintained its size but raised
the price.)
 Substituting less-expensive materials or ingredients. (Many candy bar companies
substituted synthetic chocolate for real chocolate to fight cocoa price increases. Juice
companies substitute real pulps with syrups)
 Reducing or removing product features. (Sears engineered down a number
of its appliances so they could be priced competitively with those sold in discount stores.)
 Removing or reducing product services, such as installation or free delivery.

How should a firm respond to a price cut initiated by a competitor? You have number of
options:
1. You can maintain price if you think that the competitors’ price drop is temporary
or if you think your firm will not face significant drop in sales due to competitors’ price cut.
2. You can match it. This will only be done if you expect significant drop in sales
from competitors’ low price. This is done if customer’s price sensitivity is high
3. Maintain price but add value: Instead of lowering prices, Dell has extended the
warranty period from 1 year to 3 year in response to cut in prices by the competitors.
4. Increase price and increase quality. This will increase the perceived value of the
product. Customer will put the brand at higher price / value position
5. Given resources, you can always launch a low-cost fighter brand.