PRICING POLICIES AND PRACTICES

 INTRODUCTION

Price is an important element of the marketing mix. It can be used as a strategic marketing variable to meet competition. It is also a direct source of revenue for the firm. It must not only cover the costs but leave some margin to generate profit for the firm. However, price should not be so high as to frighten the customers. Price is also an element, which is highly perceptible to customers and significantly affects their decisions to buy a product. In general, price directly determines the quality to be sold. That is why electric fans are sold at lower prices and hotels reduce their tariffs during off-season periods to attract customers. This unit examines pricing policies and some strategies adopted by company executives.

 OBJECTIVES

At the end of this unit, you should be able to:

1. state the factors affecting the pricing decision 
2. state the importance and role of cost in pricing 
3. identify the different methods used in pricing 
4. explain how pricing can be used to achieve the objectives at each stage of the products life-cycle
5. state the difference in pricing of customer and industrial products 
6. outline how pricing can help position a product in relation to other competing products. 

MAIN CONTENT

Determinants of Pricing

Pricing decisions are usually determined by cost, demand and competition. We shall discuss each of these factors separately. We take demand first.

Demand

The popular ‘Law of Demand’ states that “the higher the price; the lower the demand, and vice versa, other things remaining the same”. In season, due to plentiful supplies of certain, agricultural products, the prices are low and because of low price, the demand for them increases substantially. You can test the validity of this law yourself in your daily life. There is an inverse relationship between price and quantity

demanded. If price rises, demand falls and if the price falls, the demand goes up. Of course, the law of demand assumes that there should be no change in the other factors influencing demand except price. If any one or more of the factors, for instance, income, the price of the substitutes, taste and preferences of the consumers, advertising, expenditures, etc. vary, the demand may rise in spite of a price rise, or alternatively, the demand may fall in spite of a fall in price. However, there are important exceptions to the law of demand.


There are some goods, which are purchased mainly for their ‘snob appeal’. When prices of such goods rise, their snob appeal increases and they are purchased in larger quantities; therefore, their demand falls. Diamonds provide a good example.

In the speculative market, a rise in price is frequently followed by larger purchases and a fall in prices by smaller purchases. This is especially applicable to purchases of industrial raw materials.
More important than the law of demand is the elasticity of demand. While the law of demand tells us the direction of change in demand, elasticity of demand tells us the extent of change in demand. Elasticity of demand refers to the response of demand to a change in price.

It is necessary for the marketer to know what would be the reaction of the consumers to the change he wishes to make in the price. Let us take some examples. Smokers are usually so addicted to smoking that they will not give up smoking even if prices of cigarettes increase. So also the demand for salt or for that of wheat is not likely to go down even if the prices increase. Another example of inelastic demand is the demand for technical journals, which are sold mainly to libraries. On the other hand, a reduction in the price of television will bring in more than a proportionate increase in demand. Some of the factors determining the price-elasticity of demand are the nature of the commodity, whether it is a necessity or luxury, extent of use, range of substitutes, urgency of demand and frequency of purchase of the product.


The concept of elasticity of demand becomes crucial when a marketer is thinking of lowering his price to increase the demand for his product and to get a larger market share. If the increase in sales is more than proportionate to the decline in price, his total sale proceeds and his profits might be higher. If the increase in sales is less than proportionate, his total sales proceeds will decline and his profits will definitely be less. Thus, knowledge of the elasticity of demand for his products will help a marketer to determine whether and to what extent he can cut the price or pass on the increase in cost to the consumer.


It may also be noted that the price elasticity of demand for a certain commodity and the price elasticity of demand for a certain brand of that commodity may be radically different. For example, while cigarettes as such, may be highly inelastic, the price elasticity of demand for ‘Capstan’ or ‘Charms’ may be highly elastic. The reasons for these are weak brand loyalty and the availability of substitutes.

Competition

The degree of control over prices, which the sellers may exercise, varies widely with the competitive situation in which they operate. Sellers operating under conditions of pure competition do not have any control over the prices they receive. A monopolist, on the other hand, may have some pricing discretion. The marketer; therefore, needs to know the degree of pricing discretion enjoyed by him. Let us take up each of these cases individually.

 Cost–Plus or Full–Cost Pricing

This is the most common method used in pricing. Under this method, the price is set to cover costs (materials, labour and overhead) and a predetermined percentage for profit. The percentage differs strikingly among industries, among member–firms and even among products of the same firm. This may reflect differences in competitive intensity, differences in cost base and differences in the rate of turnover and risk. In fact, it denotes some vague notion of just profit. What determines the normal profit? Ordinarily margins charged are highly sensitive to the market situation. They may, however, tend to be inflexible in the following cases:

1. They may become merely a matter of common practice. 
2. Mark–ups may be determined by trade associations either by means of advisory price lists or by actual lists of mark–ups distributed to members. 
3.  Profits sanctioned under price control as the maximum profit margins remain the same even after the price control is discontinued. These margins are considered ethical as well as reasonable. Their inadequacies are a) It ignores demand – there is no necessary relationship between cost and what people will pay for a product. b) It fails to reflect the forces of competition adequately. Regardless of the margin of profit added, no profit is made unless what is produced is actually sold. c) Any method of allocating overheads is arbitrary and may be unrealistic. Insofar as different prices would give rise to different sales volumes, unit costs are a function of price, and therefore, cannot provide a suitable basis for fixing prices. The situation becomes more difficult in multi-product firms. d) It may be based on a concept of cost which may not be relevant for the pricing decision. 

Explanation for the widespread use of Full–cost Pricing

A clear explanation cannot be given for the widespread use of full–cost pricing, as firms vary greatly in size, product characteristics and product range, and face varying degrees of competition in markets for their products. However, the following points may explain its popularity:

1.  Price based on full–cost looks factual and precise and may be more defensible on moral grounds than prices established by other means. 
2. Firms preferring stability, use full-cost as a guide to pricing in an uncertain market where knowledge is incomplete. In cases where costs of getting information are high and the process of trial and error is costly, they use it to reduce the cost of decision-making. 
3. In practice, firms are uncertain about the shape of their demand curve and about the probable response to any price change. This makes it too risky to move away from full–cost pricing. 
4. Fixed costs must be covered in the long run and firms feel insecure if they are not covered in the long run either. 
5. A major uncertainty in setting a price is the unknown reaction of rivals to that price. When products and production processes are similar, cost-plus pricing may offer a source of competitive stability by setting a price that is more likely to yield acceptable profit to most other members of the industry also. 
6.  Management tends to know more about product costs than factors which are relevant to pricing. 
7. Cost-plus pricing is especially useful in the following cases: a) Public utilities such as electricity supply, and transport, where the objective is to provide basic amenities to society at a price which even the poorest can afford. b) Product tailoring, i.e. determining the product design when the selling price is predetermined. The selling price may be determined by government, as in the case of certain drugs, cement, and fertilizers. By working back from this price, the design and the permissible cost is decided upon. This approach takes into account the market realities by looking from the viewpoint of the buyer in terms of what he wants and what he will pay . c) Pricing products that are designed to the specification of a single buyer as applicable in case of a turnkey project. The basis of pricing is estimated cost plus gross margin that the firm could have got by using facilities otherwise. d) Monophony buying – where the buyers know a great deal about suppliers’ costs as in the case of an automobile maker buying components from its ancillary units. They may make the products themselves if they do not like the price. The more relevant cost is the cost that the buying company, say the automobile manufacturer, would incur if it made the product itself. 

 Pricing for a Rate of Return

An important problem that a firm might have to face is one of adjusting
the prices to changes in costs. For this, popular policies that are often

followed are as:

1. Revise prices to maintain a constant percentage mark-up over costs. 
2. Revise prices to maintain profits as a constant percentage of total sales. 
3. Revise prices to maintain a constant return on invested capital 

 Marginal Cost Pricing

Under full-cost and rate-of -return pricing, prices are based on total costs comprising fixed and variable costs. Under marginal cost pricing, fixed costs are ignored and prices are determined on the basis of marginal cost. The firm uses only those costs that are directly attributable to the
output of a specific product.

With marginal cost pricing, the firm seeks to fix its prices so as to maximise its total contribution to fixed costs and profit. Unless the manufacturer’s products are in direct competition with each other, this objective is achieved by considering each product in isolation and fixing its price at a level, which is calculated to maximise its total contribution.

Advantages

1. With marginal cost pricing, prices are never rendered uncompetitive merely because of a higher fixed overhead structure. The firm’s price will be rendered uncompetitive by higher variable costs, and these are controllable in the short run while certain fixed costs are not. 
2. Marginal cost pricing permits a manufacturer to develop a far more aggressive pricing policy than does full-cost pricing. An aggressive pricing policy should lead to higher sales and possibly reduced marginal costs through increased marginal physical productivity and lower input factor prices. 
3.  Marginal cost pricing is more useful over the life-cycle of a product, which requires short-run marginal cost and separable fixed data relevant to each particular state of the cycle, not long- run full-cost data. 

Marginal cost pricing is more effective than full-cost pricing because of two characteristics of modern business:

1.  The prevalence of multi-product, multi-process and market concerns makes the absorption of fixed costs into product costs absurd. The total costs of separate products can never be estimated satisfactorily, and the optimal relationships between costs and prices will vary substantially both among different products and between markets. 
2. In many businesses, the dominant force is innovation combined with constant scientific and technological development, and the long-run situation is often highly unpredictable. There is a series of short runs. When rapid developments are taking place, fixed costs and demand conditions may change from one short run to another, and only by maximising contribution in each short run will profit be maximized in the long-range. 

Limitations

1. The encouragement to take on business, which makes only a small contribution to the business arises. Such business may have to be foregone because of inadequate free capacity, unless there is an expansion in organisation and facilities, with the attendant increase in fixed costs. 
2. In a period of business recession, firms using marginal cost pricing may lower prices in order to maintain business and this may lead other firms to reduce their prices, leading to cut-throat competition. With the existence of idle capacity and the pressure of fixed costs, firms may successively cut down prices to a point at which no one is earning sufficient total contribution to cover its fixed costs and earn a fair return on capital employed. 

In spite of its advantage, due to its inherent weakness of not ensuring the coverage of fixed costs, marginal cost pricing has usually been confined to pricing decision relating to special orders.

Going-Rate Pricing

Instead of the cost, the emphasis here is on the market. The firm adjusts its own price policy to the general pricing structure in the industry. Where costs are particularly difficult to measure, this may seem to be the logical first step in a rational pricing policy. Many cases of this type are situations of pricing leadership. Where price leadership is well established, charging according to what competitors are charging may be the only safe policy. It must be noted that ‘going-rate pricing’ is not quite the same as accepting a price impersonally set by a near perfect market. Rather it would seem that the firm has some power to set its own price and could be a price maker if it chooses to face all the consequences. It prefers, however, to take the safe course and conform to the rice of others.

Customary Pricing

Prices of certain goods become more or less fixed, not by deliberate action on the seller’s part but as a result of their having prevailed for a considerable period of time. With such goods, changes in costs are usually reflected in changes in quality or quantity. Costs change significantly only when the customary prices of these goods are changed.

Customary prices may be maintained even when products are changed. For example, the new model of an electric fan may be priced at the same level as the discontinued model. This is usually so even in the face of lower costs. A lower price may cause an adverse reaction on the competitors leading to a price war so also on the consumers who may think that the quality of the new model is inferior. Perhaps, going with the prices as long as possible is a factor in the pricing of many products.
If a change in customary prices is intended, the pricing executive must study the pricing policies and practices of competing firms and the behaviour and emotional make-up of his opposite number in those firms. Another possible way out, especially when an upward move is sought is to test the new prices in a limited market to determine the consumer reaction.

Objectives of Pricing Policy

Before a marketer fixes a price, he should keep in mind certain basic considerations. The pricing policy he adopts is closely related to his other policies, like production programme, advertising policy, and selling methods. For example, it may be necessary to reduce the price to
offset the probable loss of sales from a lower advertising budget or to enable fuller utilisation of plant capacity more quickly. Aggressive sales campaign may be necessary to meet the advent of a new competitor. Your price should not be so high that it attracts others to compete with you. A low price may result in such a high volume of sales and low unit costs that profits are maximised even at low prices.

If a marketing manager is to make effective pricing decisions, he should be clear about the firm’s long-term marketing objectives for the entire range of products and services. If the firm is interested in increased market share, it would have to resort to penetration pricing. If it is interested in short-term profitability, it may have a higher price even at the expense of sales volume and market share.

Consumer Psychology and Pricing

Sensitivity to price change will vary from consumer to consumer. In a particular situation, the behaviour of one individual may not be the same as that of the other. Some important characteristics of the consumer as revealed by research and experience are detailed below:

1.  From the point of view of the consumer, prices are quantitative and precise whereas product quality, product image, customer service, promotion and similar factors are qualitative and ambiguous. It is easier to speculate about what consumers would do if prices rose by 5 per cent than if the quality improved by 5 per cent. 
2. Price constitutes a barrier to demand when it is too low just as when it is too high. Above a particular price, the article is regarded as too expensive and, below another price, as constituting a risk of not giving adequate value. If the price is too low, consumers will tend to think that a product is of inferior quality. 

Nature and Use of Price Discounts

There are two popular types of discounts:

1. Quantity discounts 
2. Cash Discounts. 

Quantity Discounts

Quantity discounts are price reductions related to the quantities purchased. Quantity discounts may be related to the size of the order being measured in terms of physical units of a particular commodity. This is practicable where the commodities are homogeneous or identical in nature, or where they may be measured in terms of truck-loads. However, this method is not possible in case of heterogeneous commodities which are hard to add in terms of physical units or truck- load. The drug industry and the textile industry offer examples of these types. Here, quantity discounts are based upon the money value of the quantity ordered. Money becomes a common denominator of value.

Quantity discounts based on physical units become important where cost of packing is a significant factor and orders of less than standard qualities, say, less than a case of 6 pressure cookers, may involve higher packing charges per cooker since the space remains unutilised. Thus, quantity discounts may be employed to induce full carton purchasing.


In some cases, quantity discounts may be based on the cumulative purchases made during a particular period, usually a year or a season, e.g. Christmas discounts may be given on the basis of cumulative purchases made during the Christmas season spread over October to December.

One important objective of quantity discounts is to reduce the number of
small orders and thereby avoid the high cost of servicing them. Quantity discounts can facilitate economic size order in three ways:

1. A given set of customers is encouraged to buy the same quantity but in bigger lots. 
2. The customers may be induced to give the seller a larger share of their total requirements by giving preference over competitors. 
3. Small size purchasers may be discouraged and bigger size customers may be attracted. 

In many cases, discounts have become a matter for trade customers.
Quantity discounts are most useful in the marketing of materials and supplies but are rarely used for marketing equipment and components.

Cash Discounts

Cash discounts are price reductions based on promptness of payment.

An example of discount can be 2 per cent off if paid in ten days, full invoice price min 30 days. In practice, the term cash discounts may vary widely.
Cash discount is a convenient device to identify and overcome bad
credit risks. In certain trades where credit risk is high, cash discounts would be high. If a buyer decides to purchase goods on credit, this reflects his weak bargaining position, and he has to pay a higher price by foregoing the cash discount.

By prompt collections, manufacturers reduce their working capital

requirements and thus save their interest costs. However, allowing discounts may involve paying 36.5 per cent in order to save 18 per cent. On the basis of 2 per cent off if paid in 10 days, full involve price in 30 days, the seller’s cost comes to 36.5 per cent (for getting the money 20 days before he has to lose 2 per cent which amounts to 36.5 per cent per year). He could get accommodation from any bank at about 18 per cent.
Thus, it is the reduction in collection expenses and in risks rather than
savings on interest, which should be the guiding consideration for cash discounts.

Product Positioning and Price

By ‘positioning’ we mean the way a product is viewed by the customers in comparison with similar products. Price is just one element of the marketing mix and it must reflect the product’s position in the market. A toilet soap meant to be a novelty to attract the elite must be sold at a higher price. This is the basic idea behind product differentiation, i.e. to avoid a situation where the product has to compete only on the basis of price.