Price Setting (Pricing)

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Contributed by: Devendra Vyavaharkar

 

Price Setting (Pricing)

What is Price Setting (Pricing)? Meaning.

When firms develop new products or services, it is necessary to set the price correctly in order to target the right customer segment, to correctly position the product with respect to price & quality, and to maximize the profits.


Pricing is one of the four Ps of the marketing mix, the other three aspects being Product, Promotion, and Place. Of these 4, price is the only revenue generating element; the other 3 are cost centers.


Price Setting (a.k.a. Pricing) is the process/procedure firms are following for setting the price. This procedure can be used when a firm develops a new product/service, when introducing an existing product into a new distribution channel or geographical area, and when bidding on a new contract. Of course a firm may also adapt an existing price. This is formally not considered as price setting, but called "Price Adaptation".


Process of Price Setting. Steps

  1. SELECTING THE PRICING OBJECTIVE: The firm needs to have a clear objective as to why the new product/service is being introduced. There are six pricing objectives:
    • Survival (when faced with overcapacity, intense competition, or changing customer wants)
    • Maximizing the current Profit
    • Maximizing the current Revenue
    • Maximizing the current Sales Growth (when using a Market Penetration Strategy)
    • Maximizing Market Skimming (using Price Skimming and initially setting the highest initial price the customers are willing to pay, and then reducing it over time to attract the price-sensitive customer segment)
    • Achieving Product-Quality Leadership in the Market
  2. DETERMINING THE DEMAND: Every price level leads to a different level of demand from the market. Typically, price and demand have an inverse relationship (indicated by the Demand Curve). The firm has to focus on the following issues when estimating the demand:
    • Price Sensitivity: Different customer segments have different price sensitivities. Customers tend to be less price-sensitive when: (1) there are few/no substitutes, (2) they don't easily notice the price differences, (3) they are slow in changing buying habits, (4) they feel that the high price is justified, etc.
    • Estimating the Demand Curves: Firms attempt to estimate the demand curves for their products using (1) Surveys, (2) Price Experiments (studying the changing in sales due to changing the price of different products or same products in similar regions), and (3) Statistical analysis of past prices, quantities sold, and other similar factors.
    • Determining Price Elasticity of Demand: Firms try to estimate how elastic the demand for their product is, to changes in prices. Two types of Demand are observed: (1) Inelastic demand (when demand barely changes with change in price) and (2) Elastic demand (when demand reduces substantially to an increase in price).
  3. ESTIMATING COSTS: While the demand sets the upper limit to the Price, the underlying costs set the lower limit for the Price. Firms aim to set a price which covers the manufacturing, distribution, and selling cost, and yet obtain a fair margin over it. The Total Cost of a firm be broken down into Fixed Costs or Overheads (don't vary with the production levels or revenue) and Variable Costs (vary with the production levels).
    Firms achieve a decrease in the product costs via:
    • Economies of Scale: The average cost decreases with the increase in production level
    • Experience curve or Learning curve: The average cost reduces when firm accumulates production experience over a period of time
    • Target Costing: Firms try to bring down the costs by focusing on the cost elements  design, engineering, manufacturing, sales, etc. in order to reach the target cost (refer to Target Pricing).
  4. ANALYZING COMPETITOR'S COSTS/PRICES/OFFERS: Along with the price band obtained by estimating the market demand and the company costs, the firm must take into consideration the competitor's costs, prices, offers, and possible reactions to the firm's product launch.
    If the firm's product has an additional feature over the competitor's product, the value from the additional feature can/should be added to the price. If the competitor's product has an additional feature, then it's associated value can/should be subtracted from the product's price.
  5. SELECTING THE PRICING METHOD: As already mentioned, the market segment demand establishes the price ceiling, the company cost establishes the price floor, while analyzing the competitor's prices establishes an orienting point in between the two. The following pricing methods take one or more of the above points into consideration:
    • Cost-plus Pricing or Mark-up Pricing: Adding a mark-up to the costs to obtain the price
    • Target Return Pricing: Setting a price which yields a target rate of return on investment.
    • Perceived Value Pricing or Value-based Pricing: Setting the price based on the value perceived by the customer
    • Value Pricing: Charging a fairly low price for a high-quality product/service (e.g. IKEA, Target, Southwest Airlines)
    • Everyday Low Pricing (EDLP): Setting a constant low price with little or no price promotions or sales (e.g. Walmart)
    • Going-rate Pricing: The prices are set based on competitor's prices. Usually observed in oligopolistic industries like steel, fertilizers, and paper
    • Auction-type Pricing: There are three major types of auctions  (1) English Auctions (ascending bids), (2) Dutch Auctions (descending bids), and (3) Sealed-bid Auctions
  6. SELECTING THE FINAL PRICE: The pricing methods narrows down the price band for the new product. Additionally, the firm must also take the following factors into account while setting the final price:
    • Impact of other Marketing Activities (Branding, Corporate Reputation, Advertising, etc.)
    • Company pricing policies (the prices set must be consistent with the company's policies)
    • Impact of the price on other stakeholders and parties (distributors and dealers, sales force, competitors, suppliers, government & regulatory bodies, etc.)

Now, having set the initial price for the product/service, the firm can launch the product/service into the new market/region/segment. Later on, the firm may decide to adapt the price (instead of maintaining a static price) based on changing market conditions. The firm may undertake Price Adaptation strategies such as Geographical Pricing, Price Discounts and Allowances, Promotional Pricing, or Differentiated Pricing.


Source: Kotler, P. & Keller, K. L. (2016), "Marketing Management", 2016, pp. 506-522, G10


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