Basic methods of price determination

Basic methods of price determination


Following points must be taken into consideration before fixing the price of a product.

Costs
Competition
Demand
Legal Considerations
Elements of Marketing Mix etc.

However, major determinants of price are - Costs, competition and demand. Based on this there are three major approaches to setting the price of a product. They are:

1. Cost oriented pricing
2. Competition oriented pricing
3. Demand oriented pricing

Cost oriented pricing


In Cost oriented approach to pricing or cost based pricing the selling price of a product is determined by adding a percentage of profit to the product cost. There are two methods in cost oriented pricing. They are

1. Cost plus pricing and
2. Target profit pricing or break-even analysis.

Cost plus Pricing


Selling price of a product is calculated by aggregating all the costs of the product such as manufacturing cost, marketing cost and distribution cost plus a predetermined margin of profit. Giving below an example of cost plus pricing:

Particulars
Amount $
 
Manufacturing Cost
60
 
Administration cost
6
 
Distribution Cost
6
 
Promotional and selling cost
8
 
Total Costs
80
 
Profit margin
10
 
Selling price
90
 

In this method the product cost include fixed and variable costs. It can be represented as follows:

Selling price = Variable Costs + Overhead Costs (Fixed Cost) + Profit.

Changes in the cost while changing the volume of production also needs to be taken into consideration before fixing the selling price. This method will help the manufacturer to secure his position in the market without any loss to the business. This method protect the interests of both the seller as well as the buyer and can be justifiable. The rate of profit margin vary from industry to industry and seller to seller. This method is useful when pricing the government contracts, where pricing of a contract needs to be estimated in advance. It can reduce the risk and uncertainties. This method is mostly used for pricing services.

Break even analysis and Target profit pricing.


It is to be noted that as the production increases the fixed cost reduce. For example the fixed cost of a production unit is USD 100 per month.

If the manufacturing unit produce 10 units/products in a month then the cost per unit is USD 10.
If the manufacturing unit produce 100 units/products in a month then the cost per unit is USD 1.

From the above we can understand that as the production increases the fixed cost reduce. Fixing the price by assuming that the production for the month is 10 units, then the cost will be high and price also will be on the higher side. On the other hand fixing the price by assuming that the production for the month is 100 units then the cost and price of the product will be low. A marketer needs to balance this issue while fixing the price. Keeping this truth in mind certain manufacturers fix the prices accordingly. Here the firm has to determine the volume of sale through which it can cover the fixed as well as variable cost. This point of sale or revenue is called break even point. What ever revenue comes above this point will generate profit.

A break even analysis relates to total cost to total revenue. A break even point is that level of production at which the total sales revenue (TR) equals the total cost (TC). In other words, a break-even point is the level of production or supply where the firm neither earns any profit nor suffers any loss. There are different break even points for different selling prices. Any amount of sale below the break even point gives loss to the firm. If the amount of sale is above the break even point, the business will be profitable.

We can calculate the break even point by using the following equation

Break Even Point =

F
P - V

F is the Total fixed Cost per month, P is the selling price per unit and V is the average variable cost per unit.

Suppose Adidas is making shoe and selling it for $ 12 in the market. The total fixed cost for manufacturing the finished shoe is $ 800 which is irrespective of the amount of sale volume. Average variable cost per shoe is $8 then the break even point is

800
12 - 8

= 200 shoes.

The firm must sell at lease 200 shoes to break even i.e. total revenue to the total cost. To find out the revenue or sale value you can multiply the number of shoes into selling cost ie. 200 x 12 = $2400. If the firm has to make $400 profit, it has to sell 300 shoes (Total revenue = 300 x 12 = $ 3600)

If the firm increase the price of the product to $13 then the break even point will be 160 shoes. And if it reduce the price to $11 the the break even point will be 266 shoes.

For pricing decisions and financial analysis, this technique is very useful. Marketing manager can ascertain the financial implication of pricing decision by using this technique. It is useful when the demand and coast of production are stable. For fixing up the price of a new product, this method is very useful. The firm must consider different price level to earn the desired profit. Possible sale volume also must be taken in to consideration while fixing the price.

To some products the fixed cost will be same for different volume of production. But to some other products, the fixed cost may increase as the volume increases. In such causes, this technique is useless. Other limitation is that the company cannot predict the sale volume of the product in advance. Lower level of production or sales may occur in adverse conditions. However, many firms use this method to fix the price of their products.

Demand oriented pricing


Some firms fix the price of a product based on the demand, instead of fixing the price on the basis of competitors price or costs. Demand oriented pricing is based on an estimate of how much sales volume can be expected at various prices which can be paid by different types of buyers. If the demand is high the price will be higher and if the demand is low the price will be lower. In such situation, price is fixed neither based on the cost nor on the price of competitors. There are two methods adopted for fixing the price in such situations. They are:

1. Differential Pricing
2. Perceived value pricing.

Differential Pricing


Different customers have different desires and wants. Intensity of their demand for the product would also be different. Following four factors affect the differential pricing method. They are time of purchase, location of the customer (Place), Product version and the Customer.

In a theater, there are different class for viewing the same film. But the film is same for all the customers. Here some customers are willing to pay more for a comfortable seat. At the same time some customers are not willing to pay that much money for the same film. Bargaining ability of the customer is another factor for low and high price of a product. Those who have the ability to bargain well can get the product at a lower cost and others will have to shell out more money for the same product. Level of the knowledge of product features also affect the price paid by the customer. Another factor is the availability of a product. When there are many customers for one piece of product, the seller can demand a high price. The one who is willing/able to pay more will get the product.

In different places, the similar products can be sold at different prices. Factor of place is the determinant of price in such situation. One has to travel a lot to get the same product at a lower rate which is time consuming and may not be economically desirable. Hotels charge different amount for different seasons. Telephone call rates are different for working days and non working days. There is night call charges and day call charges. This pricing is demand oriented and time dependent.

A book can be sold for different prices. By binding the book with attractive leather cover, the seller can demand a higher price than the ordinary book. The cost of the product will have a slight variation but the price could have huge variation in such situations. Slightly different versions of products could be sold on high prices in the market.

Perceived Value Pricing

Different buyers often have different perceptions of the same product on the basis of its value to them. A cup of coffee is priced differently by hotels and restaurants of different categories. Because the buyers will assign different value to the same item. You have to ascertain how different buyers perceive the product in terms of its features, quality and attributes before you follow this 'perceived value' method.

Competition oriented pricing


When the price is determined based on the price of the product of the competitors or the industry leader and not on the basis of cost of production or the different perceptions of the product by different buyers, then the pricing approach is called Competition oriented pricing.

Going rate pricing

Fixing the price as per the market trend is known as going rate pricing. This method practiced in such products which is easily available in the market and has no variants. In such situations the marketer would not analyses the market for its intensity of demand or the perceptions of the value of the products in the mind of buyers. It is not necessary that the price should be same as the competitor or the industry leader. It could be little higher or little lower than the price of industry leader. As the industry leader changes the price, the firm can increase or decrease the price accordingly. This is a popular method of pricing the product among the retailers. In such situations it is very difficult to ascertain the customer reaction as the price change is for everyone throughout the industry.

This is an easy method as there is no need to estimate the price elasticity, demand or various product costs. It is also felt that the adoption of the going rate pricing method prevents price wars among competitors. This method is practiced mainly in the case of homogeneous products, under conditions of pure competition and oligopoly. The firm selling an undifferentiated product in a purely competitive market actually has very little choice in setting its price. Those who adopt the going rate method of pricing argue that the rate prevailing is the collective wisdom of the industry.

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Comments 8 comments

yeagerinvestments profile image

yeagerinvestments 4 years ago from Wisconsin

Very detailed and organized information. It is helpful to learn these methods and I never realized how detailed it can get.


umeraziz profile image

umeraziz 4 years ago

useful information and good explanations for pricing approaches


girishpuri profile image

girishpuri 4 years ago from NCR , INDIA

Yes you are right, thanks for giving detailed information on pricing components and various factors influencing pricing, i think these days marketing a particular brand, the pricing factor mainly depends upon the competitors and the psychology of consumers, useful hub.


AKASH 4 years ago

USEFUL INFORMATIONS


shivangi wadhwani 4 years ago

thanku soo very much.. i was going to skip this topic coz the notes i had were very difficult to undersatnd... now i am all prepared with this topic... :)


otaj zam 4 years ago

helpful information indeed,


csmiravite-blogs profile image

csmiravite-blogs 2 years ago from Philippines

Setting the selling price is something that would be done differently by the finance group, marketing group, and the stockholders. Accountants or finance people normally compute prices based on the recovery of all expenses, cost of money, and average industry rate of returns. The outcome can be a few percentage higher or lower than what is computed.

The marketing group would do pricing vis-a-vis prices of competitors in the market. They would gauge on how strong the product is as compared to its nearest rivals. If they want to enter the market dramatically, this group would opt to go into competitive pricing to do away with the competition. Once entrenched, they may increase prices to take care of profit margins.

On the other hand, the stockholders would always want prices that would give them a fair return on their investments. So they tend to look at prevailing rates of interest and cost of money more than the other concerns.

As an accountant, this is one topic that always fascinate me. However, this is more fun to do in the real work arena than in the academe.

Good post! Interesting!


maha 17 months ago

i am still not getting it.this topic is difficult to understand. :(

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