There are several different pricing strategies that can be used and these are broadly categorized into: cost-based methods, competition-based methods, market-based methods, perception-based methods and pricing strategies for introducing new products.
Cost-based pricing methods
Four different approaches to setting prices when a firm assesses costs of production and then adds a percentage (%) or an amount ($) on top of the calculated cost can be found in this category depending on the marketing objectives of the business. The pricing strategies include mark-up pricing, target pricing, full-cost (absorption-cost pricing) and contribution-cost (marginal cost) pricing.
1. Mark-up pricing
Mark-up pricing, or cost-plus pricing, involves adding either a fixed percentage mark-up (%) or specified amount ($) to the cost per unit of output to determine the selling price. The size of this mark-up depends on demand for the product, the number of other suppliers, the age and stage of life of the product, traditional practice in the industry, etc.
When is mark-up pricing used?
Mark-up pricing is often used by retailers who take the price that they pay the producer or wholesaler for the product and then just add a percentage mark-up (%) when deciding on the final price displayed to the consumer.
When the cost of producing and selling the product on average is USD$30 and the business wants to add 50% mark-up on cost which is USD$45, then the selling price should be USD$60. If a coffee shop estimates the average cost of its products to be USD$6 and wants to have a 50% mark-up, then the price should be set at USD$9. Alternatively, if the firm wanted to earn USD$2 profit on each unit sold, the selling price would be USD$8.
✅ Advantages of mark-up pricing:
Mark-up pricing is a simple, quick and easy way to calculate the final price of a product. Additionally, the business makes sure that the price covers all of the costs per unit on average of producing and selling the product.
❌ Disadvantages of mark-up pricing:
Mark-up pricing, often relies too much on intuitive decision-making rather than on real needs of the customers. Also, the price might be set higher than competitors, or much higher than what customers are able or willing to pay, which might potentially reduce sales and profits.
2. Target pricing
Target pricing involves setting a desired price that gives a required rate of return (%) at a certain level of output produced and then sold.
When is target pricing used?
Target pricing is often used in industries with high levels of competition, where businesses need to be able to price their products competitively in order to remain profitable. Mainly, when a new product is being developed, so the company wants to ensure that it can be priced competitively while still generating a profit. Or, when a company is facing increased competition from new entrants into the market, so it needs to find ways to reduce its costs in order to remain competitive. Or, when trying to increase market share, so being willing to accept a lower profit margin in order to do so.
When producing 10,000 units of output, the company incurs Total Costs (TC) of USD$400,000. It also wishes to earn the expected rate of return of 20% which is USD$80,000 in profits. Then, the total sales revenue needed is USD$480,000. Therefore, the final price per unit sold will be determined by dividing total costs plus the expected return by the output. In this case the final price will be USD$48.
✅ Advantages of target pricing:
Target pricing can help businesses to remain competitive in highly competitive markets by increasing market share. It can also help to reduce costs when increasing sales is not longer possible.
❌ Disadvantages of target pricing:
It can be difficult to accurately determine the target price. Also, firms might be required to accept lower profit margins when neither selling more nor decreasing costs is possible. Target pricing can also lead to businesses being less responsive to changes in the market once managers become obsessed about achieving a specific rate of return.
3. Full-cost (absorption-cost) pricing
Full-cost (absorption-cost) pricing involves using all relevant Variable Costs (VC) and a full share of Fixed Costs (FC) directly attributable to a particular product in setting its selling price. The final price covers all of the costs of producing the product, plus a fixed profit margin. It is different from mark-up pricing, or cost-plus pricing, as Fixed Costs (FC) had already been allocated among all of the various products being sold by the business.
When is full-cost (absorption-cost) pricing used?
Full-cost pricing is often used in industries where there is little competition such as utilities or government services. It can also be used in industries where the product is complex or customized, so it is difficult to compare prices with competitors.
A business has annual Fixed Costs (FC) of USD$10,000 and Variable Cost (VC) of USD$5 for producing the product. It currently produces 5,000 units per year. Total Costs (TC) of this product each year is USD$35,000 as USD$10,000 + USD$5 x 5,000. Hence, the average unit cost of making each product is USD$7 as USD$35,000 / 5,000. The business must charge at least USD$7 for one product in order to cover the costs per unit. If the firm now adds a 100% profit margin, then the total selling price will become USD$14.
✅ Advantages of full-cost (absorption-cost) pricing:
Full-cost pricing ensures that the company will not lose money on each sale. Second, it can help to maintain a consistent price over time which can be important for customers who rely on the product. Also, it can help to build customer loyalty, as customers know that they are paying a fair price for that product.
❌ Disadvantages of full-cost (absorption-cost) pricing:
It is not always easy to allocate or divide all of the costs in a large business to a specific product, especially when the firm makes a huge range of different products. It is especially difficult to allocate the Fixed Costs (FC) among different cost centers.
4. Contribution-cost (marginal-cost) pricing
Contribution-cost (marginal-cost) pricing involves setting the price based on the Variable Costs (VC) of making a product in order to make a contribution towards paying Fixed Costs (FC). Instead of allocating Fixed Costs (FC) to specific products, Variable Cost (VC) per unit is calculated. The price of a product is set to cover Variable Costs (VC) of producing or buying the product, plus a contribution margin that will help to cover Fixed Costs (FC). When enough units are sold, the total contribution covers Fixed Costs (FC), and then a profit is generated in addition.
When is contribution-cost (marginal-cost) pricing used?
There are many firms that have excess capacity and hence use contribution-cost pricing to attract extra business that will absorb the excess capacity. Train companies, electricity providers and telephone companies all have substantial excess during non-rush hours such as late at night or very early in the morning. When this problem arises, businesses are able to use price discrimination to increase demand during those low-use periods.
A firm produces a single product which has Variable Costs (VC) of USD$2 per unit. The annual Fixed Costs (FC) for this product are USD$40,000. The company is able to produce and sell 10,000 units per year. Hence, it must set the price of the product at USD$6 in order to cover entirely the Fixed Costs (FC) as the contribution will be USD$4. If the company sells more than 10,000 products, then it will make the profit. Thus, if the firm sells 20,000 units, not only Fixed Costs (FC) will be covered, but there will be USD$40,000 profit made.
✅ Advantages of contribution-cost (marginal-cost) pricing:
Contribution-cost pricing can help companies to remain competitive in industries with a lot of competition by generating a profit while still offering lower prices to customers. Additionally, it can help companies to avoid losing money on each sale. When a firm produces a range of products where all make a positive contribution to Fixed Costs (FC), then each product is ‘doing its job’ covering Fixed Costs (FC). In this case all products should continue to be produced as long as there is spare capacity in the firm.
❌ Disadvantages of contribution-cost (marginal-cost) pricing:
Contribution-cost pricing can lead to lower prices for consumers which may not be sustainable in the long run. When products are not popular, it can make it difficult for companies to cover their Fixed Costs (FC) which may lead to financial problems. Additionally, it can discourage innovation as companies may be less likely to develop new products, if they know that the current products entirely cover Fixed Costs (FC).
