7.2.2. Prices based on competition.
7.2.3. Prices based on customer-value.
7.2.4. Prices based on customer-offering.
7.3 Pricing decision making process.
“Of all the possible prices I can charge for my widgets
which price will maximize my profitability over my planning horizon”
Leonard M. Lodish,
Professor of Marketing and author of Marketing that Works.
7.1 Introduction
Pricing is often said to be the only marketing element that is an actual cash inflow and not a cash outflow, like all other elements in the marketing toolbox of both large companies and SMEs. The opening case is an example of how difficult the pricing of a product can be. Pricing is a way to differentiate a product or service from that of a competitor but also a signal to customers about the value the product can offer; different value means different offers. The price of a yellow Lamborghini Aventador is more than forty times that of a Kia[1], but is a yellow Lamborghini Aventador really more than forty times as expensive to build as a Kia? In this chapter the basics of pricing and the pricing decision making process will be described. Next price testing and alternative pricing strategies are discussed.
7.2 Pricing – the basics
First, the price is more than just a monetary value charged for a product or service (x euro’s for a kilo of cherries) it is “the sum of all values a customer has to give up to gain the benefits of having or using a product or service” (Kotler & Armstrong, 2014: 312). A customer has to give up time and effort next to money in order to have or use an offering. “Free” access to Facebook or Tiktok is paid by giving away private information which is then sold by the company to advertisers. “Cheap” IKEA furniture is paid by customers who now have to transport the products back to their own homes and assemble the cupboards, beds and chairs themselves.
Prices of offerings are somewhere between the costs to make the product or service (minimum price or price floor) and the price a customer is willing to pay (maximum price or price ceiling). Prices lower that the price floor lead to financial losses and prices higher than the price ceiling lead to lower (or no) sales.
Companies determine their prices in one of the following four ways: price based on costs, price based on competition, price based on customer-value, and price based on customer-offering. The first two are relatively easy to determine, the second two are more tricky. Lodish et al. (2016: 79) make the distinction between being “precisely wrong” or “vaguely right”: the first two are easy to calculate but might not be the optimal price to maximize profits whereas the last two are more vague to determine upfront (for entrepreneurs and especially their accountants) but could lead to more profits anyway.
7.2.1. Prices based on costs
The most often used method to calculate a price is by calculating the costs of a product and then adding a mark-up (Carson et al., 1998: 75). Costs attributed to a product or service are manufacturing costs, labour costs, depreciation costs, costs of capital, marketing costs etc. The costs can be divided into fixed costs and direct (or variable) costs and based on that break-even analyses and variance analyses can be made.
This form of pricing is called cost-plus pricing and has a couple of drawbacks. Although it is a simple (accounting) way to calculate the price of a product or service it assumes that entrepreneurs know and understand beforehand what the costs are going to be at any given level of production and demand. It does not take into consideration that the price-elasticity of demand might influence the sales up to a certain degree. And it also does not look at competitors to see if the price sets the company back.
7.2.2. Prices based on competition
Another way to determine a price is by looking at what the competition is asking for their (similar) solution. This is also an easy way of price-setting, companies conform to industry standards and do not have to explain to customers why their prices are different; especially higher prices need explanation. Many SMEs, mainly start-ups, take the industry norm as the price they need to beat. The reasoning behind this has everything to do with the idea that a low price will force an entrance into the market, the backlash is that once customers have accepted this low price they will be less likely inclined to pay a higher price later.
A drawback of basing prices on those of the competition is mainly the difficulty to create a distinctive position in the mind of the customer. If a product has the same price as other products in the market this implies that the product is the same as these other products. A lower price gives customers the impression that the product seems the same but will probably have an inferior value.
7.2.3. Prices based on customer-value
In the previous paragraph the customer has already been mentioned, it is the customer who buys a product and needs to decide which product to choose from the large range of products that are offered in the market. Even if a product is unique, still the customer can choose between buying or not buying.
Customers will only buy a product or service if the value of having or using it is higher than the costs attached to it. In previous chapters we have already seen that the value of an offering essentially boils down to:
- Performance value, the offering does a better job at solving a specific problem a customer has,
- Price value, the offering is cheaper to buy or to use than others,
- Relational value, the offering is personally made for a customer.
Not all customers experience the value of an offering in the same way: a millionaire’s daughter will value a diamond ring in a different way than a beggar’s. The value of something to eat is less to someone who has just had dinner than to someone who is hungry. This is called perceived value, every customer perceives the value of an offering differently.
An interesting video on pricing and customer value can been viewed on TED.com. Joseph Pine, author of “Authenticity” describes the value of coffee and the difference in the price of coffee as a commodity and that of coffee as an experience.
Full video: https://youtu.be/2RD0OZCyJCk
7.2.4. Prices based on customer-offering
This is actually the complete reverse to the other three price-setting techniques, prices based on customer-offering means it is the customer who sets the price. Either through an auction, reverse-auction, pay-what-you-like or name-your-own-price method customers set the price of an offering.
In the auction method the price-bidding starts at a low point and customers bid against each other and the customer willing to pay the highest price gets the product. In the reverse-auction, also known as Dutch auction, the initial price is high and prices decrease until one customer calls out to buy at that price. The main difference between both types of auctions is that in the first it is the last one to call out who gets the product, in the second it is the first one to call out.
Pay-what-you-like means exactly that: after the customer has consumed the product he/ she pays any amount of money he/ she thinks is acceptable for the offering. The problem with a method like this one is that customers tend to pay less if they are familiar with the prices and feel uncomfortable with products or services they are less familiar with. The entrepreneur also has a problem when too many customers pay too little for the offering. Name-your-own-price is an alternative customer-centred pricing method, customers have to indicate the price that they would be willing to pay beforehand and the entrepreneur can then take the offer or leave it.
7.3 Pricing decision making process
Price is too important to simply set based on gut feeling or intuition. Prices set the position a product or service has in the market. A product with a higher price is often seen as a product with a higher quality (BMW versus VW?) and lower priced products or services need a higher throughput to make an equal amount of money (RyanAir versus AirFrance-KLM?). When deciding on prices SMEs need to consider the following (Shipley and Jobber, 2001):
- The role price will play in their strategy or how important is the price to the customer?. For some products or services the price is less an issue than other customer values or product characteristics like availability and design. In that case it is more important to focus on these elements than on price.
- The pricing objectives or what is the purpose of the price? Some companies value revenues more than profits, whereas others use the price to signal the (higher) quality of the product or to keep competition out through low prices.
- The pricing determinants or what or who sets out price? It has been mentioned earlier that costs, customers, and competition determine the lowest and highest price a company can set.
- The pricing strategy or what is the (perceived) price-benefit claim the company makes? Basically a customer can perceive the price of any offering as being higher, the same or lower than expected and at the same time he/ she can perceive the benefit of the offering as being higher, the same or lower than expected (figure 5.1). Of the nine claims a company can make only five are viable, offering the same benefits at the same price is risky, and offering less benefit for the same price or higher or the same benefit at a higher price seem strategies likely to fail.
Figure 7.1 – price-benefit claim
- The pricing method or how to determine the price? As mentioned before a company can select their price based on costs, customers, or competitors.
- The implementation and control. The final stage in the decision making process is to publicly announce the prices and evaluate the outcomes. The company has set objectives and needs to make sure the decision made leads to these pricing goals.
7.4 Price testing
The most difficult thing in pricing is setting the right price: too high and the company will not sell enough, too low and the company will sell a lot but still not make enough profits. The price decision is mainly a management decision and many managers or SME owners base their decision on intuition next to considerations concerning costs and competition. Carson et al. (84) mention that through experiential learning and a deep understanding of the market management’s decision making process can be improved. Testing is one way to learn about the “right” price.
One way to test the price in the market is to do a pre-market test. Before entering the market a company can show the product concept to a potential customer and ask if he/she would buy at a certain price. The more people say yes the better informed management is when deciding what price to set. Internet has made it easier to do pre-market tests; by offering a product online in a web-shop environment, customers can click through to an ordering page and actually start the buying process. If a company uses different prices for different customers entering the site, the entrepreneur can see what prices attract most customers who want to order the product. Companies can also choose to offer pre-order opportunities and count the number of orders at different prices to find out at what price to sell.
In-market testing can be done for products already being offered on the market. Again by offering similar products or services to different customers at different prices, companies can test what prices work best. The only point of concern with in-market tests are to be careful that people do not feel cheated. Increasing or decreasing prices to find out an optimum price can best be done for all customers at the same time; increase prices on a Monday to see if sales or profits go up compared to last week’s Monday is better that offering Mrs. Brown a cheaper loaf of bread than Mr. Black on the same day… Of course, larger companies with several outlets can more easily compare price differences on a daily basis.
7.5 Conclusion
Pricing is the only element within the marketing mix that doesn’t lead to additional costs but that actually adds to the bottom-line. A higher price means more profits… if a company can actually sell at that price! Prices are determined by costs, competition, customer-value, and customer-offerings but in order to set prices an SME also needs to know what price-benefit position it wants to claim.
Although a lot of managers and SME-owners rely on intuition, the “right” price is set through understanding the market and customers and also by experimenting with different prices in order to get to the price that fits the pricing objectives best.
References
Carson D., A. Gilmore, D. Cummins, A. O’Donnell & K. Grant (1998). Price setting in SMEs: some empirical findings. Journal Of Product & Brand Management, Vol. 7 (1), p. 74 – 86.
Kim, J. Y., Natter, M., & Spann, M. (2009). Pay what you want: A new participative pricing mechanism. Journal of Marketing, 73(1), pp. 44 – 58.
Kotler, P. & G. Armstrong (2014). Principles of Marketing, Global Edition (15th ed.), Harlow, Essex: Pearson Education Limited.
Lodish, L.M., H.L. Morgan, S. Archambeau, and J.A. Babin (2016), “Marketing That Works, How Entrepreneurial Marketing Can Add Sustainable Value To Any Sized Company, second edition”. Old Tappan, New Jersey: Pearson Education Inc..
Shipley D. & D. Jobber (2001). Integrative Pricing via the Pricing Wheel. Industrial Marketing Management, Vol. 30 (3), pp. 301 – 314.
[1] A Lamborghini Aventador 6.5 lp 700-4 4wd automatic costs € 420 thousand in the Netherlands, a Kia Picanto € 10 thousand. Both have four wheels, five when the steering wheel is included, and both can take you from your home to somewhere else.