What is Pricing?
Pricing is used as a term in finance and economics, pricing is the process of fixing a value for a product or a service. Pricing establishes a value for a product or service that the customer has to pay. A business can choose from different strategies while deciding to set prices.
Pricing is a method to adjust the cost of the manufacturer’s offerings so that it is suitable for the producer and the consumer. Pricing is decided by the average prices of the business and the customer’s perceived value of a product as compared to a competitor’s product. Every business has the primary objective of making profits. This can be achieved by the method of pricing a firm chooses. Some points a business considers before deciding on the price of a product or a service are –
- The category of goods and services
- Competitor’s pricing of similar goods and services
- The identified target audience
- The total cost of production inclusive of raw materials, machinery cost, labor cost, inventory cost, and other fixed and variable costs
- Changes in the external environment like changes in legal issues, economy, government policies, and regulations
The pricing objectives chart out a path for the business and clearly states the purpose of its existence. Some of the pricing objectives are –
Survival – Though a short-term objective, survival is the primary pricing objective of any company that helps the product or service to survive the intense competition and the rapidly evolving customer preferences. This pricing objective calls for setting a price to cover the fixed and variable costs without considering any profit margin. The objective is to get a hold of the market before trying to get additional profits. Start-ups often adopt this type of pricing strategy.
Expanding current profits – Companies try and optimize profits by evaluating the demand and supply of products and services. Pricing is set based on the demand for the product as far as customers are concerned and the substitutes available in the market. Demand and supply of seasonal goods and services is a good example of this type of strategy.
Ruling the market – Companies often set low prices for their goods and services to capture greater market share. Low prices can be a result of Economies of Scale, where a higher volume of sales leads to a lower cost of production. This low price strategy is also called Market Penetration Pricing. Such a pricing strategy comes into play when competition is severe and the customer is price sensitive. FMCG industry is a very good example to corroborate this strategy.
Market Skimming – An enterprise charges a high price for goods and services that are innovative and use advanced technology. High production costs incurred to produce these offerings lead to high prices to the customers. Electronic gadgets are an example of skimming pricing as they are launched at a high cost but get cheaper with time.
Product – Quality Leadership – Firms like to price their products and services according to the customer’s perception of the quality. Customers are willing to pay a higher price if they associate the product with high quality and status image.
For example, Mercedes or BMW are brands that customers are willing to pay a high price to buy into the image.
Therefore, pricing is dependent on the production costs and the benefits to customers with the ultimate goal of making profits.
A pricing strategy looks at factors like market conditions, competition, consumer trends, and such variable costs to arrive at a value for the goods and services. A business needs a fix on the pricing of products before the company can start promoting them in the market. Some of the approaches to pricing strategy are as below -
Competition-based pricing – Companies base their pricing strategy on competition’s pricing data instead of taking into account the cost of production and the item’s value. This strategy utilizes market data to derive its offering’s price.
However, this pricing strategy will be sustainable only if enterprises produce quality products and add value to their customer’s life. Competitive-based pricing is mostly used by small businesses like E-commerce.
Cost-plus pricing – This strategy considers the total cost of production and adding a mark-up to arrive at the price of the offering. This pricing strategy is a long-term strategy.
To calculate pricing via the cost-plus pricing method, the total production cost is calculated. This amount is divided by the number of units produced to get the unit cost.
Finally, the unit cost is multiplied by the mark-up percentage to determine the price of the product. So, if a product .costs $ 20, and the markup percentage is 10, then the profit margin will be, $20 X 10/100 = $2. Therefore the product will be priced at $20 + $2 = $22
This strategy is mostly used by retail enterprises as they can incorporate different mark-ups.
Dynamic pricing – Dynamic pricing strategy states that prices cannot be static and change based on segments and time. This strategy is partially a technology-based system where prices get altered as per different customer segments and their eagerness to pay.
For example, Uber will hike up prices for locations with a plethora of bars, or car dealers offering cheap rates in a rush to sign deals before the end of the month. Some examples of companies that use dynamic pricing are Airline companies, Amazon, and Uber.
Penetration pricing – Companies use this kind of pricing strategy and set prices below the market level to capture market share and gain customers. Once the enterprise has achieved its objective of gaining a substantial market share, it adjusts the price of the offering to suit the circumstance.
For example, Company ABC sells sunscreen lotion for $10.
A new entrant from the international shores, Company XYZ enters the market with a similar product priced at $5. At the cost of not making much profit, XYZ uses penetrative pricing to drive ABC out of the market. This kind of extreme pricing is also known as predatory pricing. For example, Walmart has led the retail segment for decades with unmatchable prices.
Price Skimming – New product launches see companies using price skimming to introduce a product at a higher price and later readjusting or lowering the price depending on the demand.
For example, Celebrity product lines like Rihanna’s Fenty Beauty, PlayStation, or Kanye’s Clothing Line use price skimming to sell to willing customers who are ready to pay a higher price to be the first in line to use the product. These prices drop in a few months.
Many pricing strategies are based on the understanding of human psychology. Ending an amount with 9 or 5, like 99 cents or $25, is called charm pricing.
Another strategy that helps optimize the perceived extent of discount is the rule of 100. Firms offer a discount in percentage amount for products below $100 and a discount in dollar amount for products over 100. Apart from the scientific methods of breaking down elements and fixing a price, human psychology plays an important role in pricing.
Summarization of Pricing Quiz-let
Buyer’s view of pricing:
The buyer is the final customer and pays a price to receive benefits. Most such transactions are financial with the buyer payer paying money to acquire a product or service. Sometimes it can be a barter situation with a farmer exchanging crops for a cow.
Seller’s view of pricing:
For a seller, pricing shows the revenue generated from the sale of products and is significant to evaluating profits made. Pricing is an important marketing tool as well with sellers promoting the product by highlighting its price.
Target Rate of Return
Companies decide on the pricing strategy in a way that sales will bring in the desired return on investment or ROI. The amount attained when net profits earned are divided by capital investment is called the rate of return.
The set target leads to companies using cost-plus pricing to determine the expected profit margin and adding it to the production & distribution cost.
Common Mistake and Pitfalls
Cost and price mean two different things when it comes to financial statements in accounting though they are used interchangeably at times. It is important to realize the difference between price and cost while taking investment decisions or while conducting financial analysis.
Cost is the incurred expenditure to produce goods or services. The cost of manufacturing a product has a direct impact on the price and profits earned. Price is the amount that a customer is ready to pay for the good or service bought. The difference between the incurred costs and the price paid is the profit earned.
Context and Application
This topic is significant in the professional exams for both undergraduate and graduate courses –
- B. Com
- BA Economics Honors
- Chartered Accountancy
- International Trade
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