To determine price levels, companies often make use of simple decision procedures that focus on one dimension of the pricing problem. We first discuss these simplified methods, and then touch on complex optimisation, simulation methods and price adjustments.
Simplified decision methods
Among the simplified decision procedures, cost-based methods are the most widely used approaches to pricing.
Cost-based methods have a common denominator: they start out from information on unit costs for the product, and take this as a ‘floor’ above which a pre-specified
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remuneration is charged by the company. In mark-up (MU) pricing, the company sets a price per unit equal to the cost per unit plus a pre-specified ‘MU’. MUs are often specified as a percentage of unit cost, and vary widely between sectors and product categories. An alternative cost-based method is target return pricing. Here, the company starts out from a desired return on investment (ROI), and then calculates the premium to be charged over unit cost to realise this ROI. In break-even pricing, finally, the company computes the minimum price needed to cover fixed and variable costs (and, eventually, a pre-specified ROI) in view of the forecast demand level. Cost-plus pricing is used in a wide range of consumer and industrial settings, and is adopted by almost all retailers.
Competition-oriented rules of thumb concentrate on competitive price levels to determine the company’s own price. The most simple procedure is that of going rate pricing, where the company simply aligns its own prices with those prevailing in the marketplace. A similar procedure is followed by some international companies, which try to maintain a ‘global’ competitive position by setting prices relative to competitors’
price levels in each export market.
Demand-oriented methods take the customers’ willingness to pay as the basis for pricing. A popular approach, especially in industrial settings, is perceived-value pricing.
The basic idea is to set price in such a way that the ratio of perceived value to price for the company’s product equals that of competitors. Perceived value can be calculated as a weighted average of the products’ perceived attribute scores.
While the simplified pricing methods are extremely popular, they suffer from basic defects. Cost-plus pricing rules forgo the link between price and demand: they start out from estimated volume (and associated unit cost) to set price, but ignore the crucial impact that this price will have on ultimately realised volume. Competition-oriented approaches ignore differences in cost and demand between the company and its competitors. These methods rely upon the ‘collective wisdom of the market’, and their outcomes depend on the selection of competitors whose prices will be mirrored.
Perceived-value pricing resolves some of these problems by allowing differences in perceived value to affect prices, yet it does so in a simplified manner. Multi-product and channel considerations, as well as market heterogeneity and dynamics, are ignored in each of the ‘simplified’ approaches discussed in this section.
Each of these procedures concentrates on one major environmental factor (cost, demand, competition), and basically ignores the others. As a result, each method separately yields only partial insights at best. At the same time, though, the approaches are complementary. Applied in combination they may provide an indication of the range of acceptable prices within which a specific price has to be selected.
Optimisation methods
Optimisation methods take on a different approach: they try to derive an optimal price level analytically or numerically. Optimisation methods start out with the specification and estimation of demand and cost functions. Occasionally, competitive and channel intermediary response functions are also formulated. Next, the pricing objective is identified. In a last step, optimal prices are derived using mathematical techniques.
Optimisation methods can deal with a variety of complex situations. They can set prices for single products as well as product lines, and for single periods as well as
multiple period sequences (trajectory models and optimal control theory). Competitive reactions and channel inter-dependencies (game theory) may be explicitly incorporated.
Other complicating factors such as demand heterogeneity and uncertainty, asymmetric or limited information, and psychological effects can also be accounted for.
Yet in order to allow for analytical solutions, many optimisation methods rely on simplified models and assumptions. Others pursue numerical optima for less restrictive settings, but necessitate the use of extremely complex optimisation routines. In any of these approaches, one is confronted with the problem of a priori model specification.
As pointed out by Kalyanam (1996): ‘Demand functions are latent constructs whose exact parametric form is unknown. Estimates of price elasticities, profit maximising prices, etc. are conditional upon the parametric form employed in estimation. In practice, many forms maybe found that are not only theoretically plausible, but also consistent with the data, yet lead to different (optimal) pricing implications.’ Solutions are currently suggested to reduce the impact of specification error, but none of these is widely applicable yet.
Simulation methods
Simulation methods are similar to optimisation methods, except that the price recommendations are obtained in a different fashion. No ‘optimal’ prices, but near-optimal or satisfying prices are derived from a comparison of alternative scenarios.
Simulation methods are often used in combination with conjoint analysis, a technique for estimating ‘utility’ functions for existing or new products. Conjoint analysis is the basis for simulating demand in various price settings. Combined with cost functions, it can yield overall insights into profit implications of alternative price levels. Simulation may be applied to complex problems and settings. Yet, as for optimisation, simulation applied to comprehensive settings may become complex, and necessitate the collection of a large amount of information.
Price adjustments
While the previous methods, alone or in combination, help determine the appropriate amount to be charged to consumers, small adaptations may be needed to translate them into price levels. These adaptations are in line with practical requirements and originate from psychological pricing issues. In particular, principles of odd pricing and of price lining (the practice of using a limited number of price points to price products in a line) may be highly relevant here. As indicated earlier, both have psychological as well as practical implications, and therefore deserve managerial attention.
Problem
Illustration of cost-based pricing rules
A manufacturer of toothbrushes considers the following costs and demand level:
Production costs £1,000,000 Fixed costs per month
£20 Variable costs per unit Expected demand 20,000 units per month
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1 To earn an MU of 20 per cent on price, the following unit price should be charged:
MU price AC/(1 MU)
MU is specified as a percentage of the selling price. Alternatively, MU can be defined as the margin by which price exceeds average costs (MU price average cost (1MU)).
2 A target return of 8 per cent on investments (INV £2,000,000) per month results in the following price level:
3 The break-even price level at which total returns cover total costs, finally, equals:
Break-even price total cost/sales Questions
1 In the case example, if the manufacturer wishes to earn a MU of 20 per cent on price, what would be the unit price that should be charged?
2 What would be the resulting price level if the company wanted to achieve a target return of 8 per cent on investment?
3 Calculate the break-even price level at which total returns cover total costs.
4 Comment on the role of optimisation methods in the determination of price levels.
(M) Problem 6.2 Perceived value pricing Introductory comments
Price is the value that is placed on something. What is someone prepared to give in order to gain something else? Usually, price is measured in money, as a convenient medium of exchange that allows prices to be set quite precisely. This is not necessarily always the case, however. Goods and services may be bartered (‘I will help you with the marketing plan for your car repair business if you service my car for me’), or there may be circumstances where monetary exchange is not appropriate, for example at election time when politicians make promises in return for your vote. Any such transactions, even if they do not directly involve money, are exchange processes and thus can use marketing principles. Price is any common currency of value to both buyer and seller.
Even money-based pricing comes under many names, depending on the circum-stances of its use: solicitors charge fees; landlords charge rent; bankers charge interest;
railways charge fares; hotels charge a room rate; consultants charge retainers; agents charge commission; insurance companies charge premiums; and over bridges or through tunnels tolls may be charged. Whatever the label, it is still a price for a good or a service, and the same principles apply.
Price does not necessarily mean the same things to different people, just because it is usually expressed as a number. You have to look beyond the price, at what it represents to both the buyer and the seller if you want to grasp its significance in any transaction. Buyer and seller may well have different perspectives on what price means.
We now turn to that of the buyer.
Taret return price AC INV ROI Sales