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Pricing Solution Navetti: Boost your profitability in a sustainable way

pricing - introduction
Setting the right price is an important part of effective marketing . It is the only part of the marketing mix that generates revenue (product, promotion and place are all about marketing costs). Price is also the marketing variable that can be changed most quickly, perhaps in response to a competitor price change. Put simply, price is the amount of money or goods for which a thing is bought or sold. The price of a product may be seen as a financial expression of the value of that product. For a consumer, price is the monetary expression of the value to be enjoyed/benefits of purchasing a product, as compared with other available items. The concept of value can therefore be expressed as: (perceived) VALUE = (perceived) BENEFITS (perceived) COSTS A customers motivation to purchase a product comes firstly from a need and a want:e.g. Need: "I need to eat Want: I would like to go out for a meal tonight") The second motivation comes from a perception of the value of a product in satisfying that need/want (e.g. "I really fancy a McDonalds"). The perception of the value of a product varies from customer to customer, because perceptions of benefits and costs vary. Perceived benefits are often largely dependent on personal taste (e.g. spicy versus sweet, or green versus blue). In order to obtain the maximum possible value from the available market, businesses try to segment the market that is to divide up the market into groups of consumers whose preferences are broadly similar and to adapt their products to attract these customers. In general, a products perceived value may be increased in one of two ways either by: (1) Increasing the benefits that the product will deliver, or, (2) Reducing the cost.

For consumers, the PRICE of a product is the most obvious indicator of cost - hence the need to get product pricing right. Factors affecting demand Consider the factors affecting the demand for a product that are (1) within the control of a business and (2) outside the control of a business: Factors within a businesses control include: Price (assuming an imperfect market i.e. not perfect competition) Product research and development Advertising & sales promotion Training and organisation of the sales force Effectiveness of distribution (e.g. access to retail outlets; trained distributor agents) Quality of after-sales service (e.g. which affects demand from repeat-business) Factors outside the control of business include: The price of substitute goods and services The price of complementary goods and services Consumers disposable income Consumer tastes and fashions Price is, therefore, a critically important element of the choices available to businesses in trying to attract demand for their products.

pricing - full cost plus pricing


Full cost plus pricing seeks to set a price that takes into account all relevant costs of production. This could be calculated as follows: Total budgeted factory cost + selling / distribution costs + other overheads + MARK UP ON COST Budgeted sales volumes An illustration of applying this method is set out below: Consider a business with the following costs and volumes for a single product: Fixed costs: Factory production costs Research and development Fixed selling costs Administration and other overheads Total fixed costs Variable costs Variable cost per unit Mark-Up Mark-up % required Budgeted sale volumes (units) What should the selling price be on a full cost plus basis? The total costs of production can be calculated as follows: Total fixed costs Total variable costs (8.00 x 500,000 units) Total costs Mark up required on cost (5,625,000 x 35%) 1,625,000 4,000,000 5,625,000 1,968,750

750,000 250,000 550,000 325,000 1,625,000 8.00 35% 500,000

Total costs (including mark up) Divided by budgeted production (500,000 units) = Selling price per unit The advantages of using cost plus pricing are: Easy to calculate - Price increases can be justified when costs rise

7,593,750 15.19

- Price stability may arise if competitors take the same approach (and if they have similar costs) - Pricing decisions can be made at a relatively junior level in a business based on formulas The main disadvantages of cost plus pricing are often considered to be: This method ignores the concept of price elasticity of demand - it may be possible for the business to charge a higher (or lower) price to maximise profits depending on the responsiveness of customers to a change in price The business has less incentive to cut or control costs - if costs increase, then selling prices increase. However, this might be making an "inefficient" business uncompetitive relative to competitor pricing; It requires an estimate and apportionment of business overheads. For example, total factory overheads need to be calculated and then allocated in some way against individual products. This allocation is always arbitrary. If applied strictly, a full cost plus pricing method may leave a business in a vicious circle. For example, if budgeted costs are over-estimated, selling prices may be set too high. This in turn may lead to lower demand (if the price is set above the level that customers will accept), higher costs (e.g. surplus stock) and lower profits. When the pricing decision is made for the next year, the problem may be exacerbated and repeated. Amongst the factors that influence the choice of the mark-up percentage are as follows: Nature of the market - a mark-up should reflect the degree of competition in the market (what do the close competitors do?) - Bulk discounts - should volume orders attract a lower mark-up than a single order?

Pricing strategy - e.g. skimming, penetration (see more on pricing strategies further below) - Stage of the product in its life cycle; products at the earlier stages of the life cycle may need a lower mark-up percentage to help establish demand.

Pricing Strategy

One of the four major elements of the marketing mix is price. Pricing is an important strategic issue because it is related to product positioning. Furthermore, pricing affects other marketing mix elements such as product features, channel decisions, and promotion. Pricing Strategy

While there is no single recipe to determine pricing, the following is a general sequence of steps that might be followed for developing the pricing of a new product: 1. Develop marketing strategy - perform marketing analysis, segmentation, targeting, and positioning. 2. Make marketing mix decisions - define the product, distribution, and promotional tactics. 3. Estimate the demand curve - understand how quantity demanded varies with price. 4. Calculate cost - include fixed and variable costs associated with the product. 5. Understand environmental factors - evaluate likely competitor actions, understand legal constraints, etc. 6. Set pricing objectives - for example, profit maximization, revenue maximization, or price stabilization (status quo).

7. Determine pricing - using information collected in the above steps, select a pricing method, develop the pricing structure, and define discounts. These steps are interrelated and are not necessarily performed in the above order. Nonetheless, the above list serves to present a starting framework.
Marketing Strategy and the Marketing Mix

Before the product is developed, the marketing strategy is formulated, including target market selection and product positioning. There usually is a tradeoff between product quality and price, so price is an important variable in positioning. Because of inherent tradeoffs between marketing mix elements, pricing will depend on other product, distribution, and promotion decisions.
Estimate the Demand Curve

Because there is a relationship between price and quantity demanded, it is important to understand the impact of pricing on sales by estimating the demand curve for the product. For existing products, experiments can be performed at prices above and below the current price in order to determine the price elasticity of demand. Inelastic demand indicates that price increases might be feasible.
Calculate Costs

If the firm has decided to launch the product, there likely is at least a basic understanding of the costs involved, otherwise, there might be no profit to be made. The unit cost of the product sets the lower limit of what the firm might charge, and determines the profit margin at higher prices. The total unit cost of a producing a product is composed of the variable cost of producing each additional unit and fixed costs that are incurred regardless of the quantity produced. The pricing policy should consider both types of costs.
Environmental Factors

Pricing must take into account the competitive and legal environment in which the company operates. From a competitive standpoint, the firm must consider the implications of its pricing on the pricing decisions of competitors. For example, setting the price too low may risk a price war that may not be in the best interest of either side. Setting the price too high may attract a large number of competitors who want to share in the profits. From a legal standpoint, a firm is not free to price its products at any level it chooses. For example, there may be price controls that prohibit pricing a product too high. Pricing it too low may be considered predatory pricing or "dumping" in the case of international trade. Offering a

different price for different consumers may violate laws against price discrimination. Finally, collusion with competitors to fix prices at an agreed level is illegal in many countries.
Pricing Objectives

The firm's pricing objectives must be identified in order to determine the optimal pricing. Common objectives include the following:

Current profit maximization - seeks to maximize current profit, taking into account revenue and costs. Current profit maximization may not be the best objective if it results in lower long-term profits. Current revenue maximization - seeks to maximize current revenue with no regard to profit margins. The underlying objective often is to maximize long-term profits by increasing market share and lowering costs. Maximize quantity - seeks to maximize the number of units sold or the number of customers served in order to decrease long-term costs as predicted by the experience curve. Maximize profit margin - attempts to maximize the unit profit margin, recognizing that quantities will be low. Quality leadership - use price to signal high quality in an attempt to position the product as the quality leader. Partial cost recovery - an organization that has other revenue sources may seek only partial cost recovery. Survival - in situations such as market decline and overcapacity, the goal may be to select a price that will cover costs and permit the firm to remain in the market. In this case, survival may take a priority over profits, so this objective is considered temporary. Status quo - the firm may seek price stabilization in order to avoid price wars and maintain a moderate but stable level of profit.

For new products, the pricing objective often is either to maximize profit margin or to maximize quantity (market share). To meet these objectives, skim pricing and penetration pricing strategies often are employed. Joel Dean discussed these pricing policies in his classic HBR article entitled, Pricing Policies for New Products. Skim pricing attempts to "skim the cream" off the top of the market by setting a high price and selling to those customers who are less price sensitive. Skimming is a strategy used to pursue the objective of profit margin maximization. Skimming is most appropriate when:

Demand is expected to be relatively inelastic; that is, the customers are not highly price sensitive. Large cost savings are not expected at high volumes, or it is difficult to predict the cost savings that would be achieved at high volume. The company does not have the resources to finance the large capital expenditures necessary for high volume production with initially low profit margins.

Penetration pricing pursues the objective of quantity maximization by means of a low price. It is most appropriate when:

Demand is expected to be highly elastic; that is, customers are price sensitive and the quantity demanded will increase significantly as price declines. Large decreases in cost are expected as cumulative volume increases. The product is of the nature of something that can gain mass appeal fairly quickly. There is a threat of impending competition.

As the product lifecycle progresses, there likely will be changes in the demand curve and costs. As such, the pricing policy should be reevaluated over time. The pricing objective depends on many factors including production cost, existence of economies of scale, barriers to entry, product differentiation, rate of product diffusion, the firm's resources, and the product's anticipated price elasticity of demand.
Pricing Methods

To set the specific price level that achieves their pricing objectives, managers may make use of several pricing methods. These methods include:

Cost-plus pricing - set the price at the production cost plus a certain profit margin. Target return pricing - set the price to achieve a target return-on-investment. Value-based pricing - base the price on the effective value to the customer relative to alternative products. Psychological pricing - base the price on factors such as signals of product quality, popular price points, and what the consumer perceives to be fair.

In addition to setting the price level, managers have the opportunity to design innovative pricing models that better meet the needs of both the firm and its customers. For example, software traditionally was purchased as a product in which customers made a one-time payment and then owned a perpetual license to the software. Many software suppliers have changed their pricing to a subscription model in which the customer subscribes for a set period of time, such as one year. Afterwards, the subscription must be renewed or the software no longer will function. This model offers stability to both the supplier and the customer since it reduces the large swings in software investment cycles.
Price Discounts

The normally quoted price to end users is known as the list price. This price usually is discounted for distribution channel members and some end users. There are several types of discounts, as outlined below.

Quantity discount - offered to customers who purchase in large quantities.

Cumulative quantity discount - a discount that increases as the cumulative quantity increases. Cumulative discounts may be offered to resellers who purchase large quantities over time but who do not wish to place large individual orders. Seasonal discount - based on the time that the purchase is made and designed to reduce seasonal variation in sales. For example, the travel industry offers much lower off-season rates. Such discounts do not have to be based on time of the year; they also can be based on day of the week or time of the day, such as pricing offered by long distance and wireless service providers. Cash discount - extended to customers who pay their bill before a specified date. Trade discount - a functional discount offered to channel members for performing their roles. For example, a trade discount may be offered to a small retailer who may not purchase in quantity but nonetheless performs the important retail function. Promotional discount - a short-term discounted price offered to stimulate sales.

What Is the Relationship Between Value-ofservice Pricing & Cost-of-service Pricing?


By Alex Shadunsky, eHow Contributor , last updated September 01, 2011

Businesses price products in many different ways, but and correct pricing provides better profits and returns for their shareholders. There are many different tools and strategies companies uses to figure out how to price a service. Two of the strategies to price services include value-ofservice pricing and cost-of-service pricing. The differences between the two are subtle but may make a huge differences in the price of the product and the profits received.

Relationship

The two different pricing strategies are completely unrelated because they are based on two different variables. Sometimes they can lead to similar prices but more often than not, they will be different. The cost-of-service pricing is a lot easier to figure out because all a company needs to know is the cost of the service and the markup they want on the service.

Tips

It is best to use a combination of tools and strategies to price your product. You have to see the environment you are in. Just basing your strategy on one concept may drive you out of business. If you are in a very competitive environment, it might not make any sense to do value-of-service pricing. Doing cost-of-service pricing does not make much sense in any environment because it doesn't matter to anyone what the cost of your service is.

Does Demand Always Increase When Price Decreases?


1. Relationship of Demand and Price
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Generally, the price of a product and the demand for it are inversely related. This means that as the price of the product goes down, the demand for it goes up and vice versa. This is in keeping with common sense: as a product becomes less expensive, more people will likely want it. However, sometimes demand will not rise much when a price drops -- and, in some instances, it will even fall.

Pricing Methods
Four models for calculating your pricing
As we said earlier, there is no "one right way" to calculate your pricing. Once you've considered the various factors involved and determined your objectives for your pricing strategy, now you need some way to crunch the actual numbers. Here are four ways to calculate prices:

Cost-plus pricing - Set the price at your production cost, including both cost of goods and fixed costs at your current volume, plus a certain profit margin. For example, your widgets cost $20 in raw materials and production costs, and at current sales volume (or anticipated initial sales volume), your fixed costs come to $30 per unit. Your total cost is $50 per unit. You decide that you want to operate at a 20% markup, so you add $10 (20% x $50) to the cost and come up with a price of $60 per unit. So long as you have your costs calculated correctly and have accurately predicted your sales volume, you will always be operating at a profit. Target return pricing - Set your price to achieve a target return-on-investment (ROI). For example, let's use the same situation as above, and assume that you have $10,000 invested in the company. Your expected sales volume is 1,000 units in the first year. You want to recoup all your investment in the first year, so you need to make $10,000 profit on 1,000 units, or $10 profit per unit, giving you again a price of $60 per unit. Value-based pricing - Price your product based on the value it creates for the customer. This is usually the most profitable form of pricing, if you can achieve it. The most extreme variation on this is "pay for performance" pricing for services, in which you charge on a variable scale according to the results you achieve. Let's say that your widget above saves the typical customer $1,000 a year in, say, energy costs. In that case, $60 seems like a bargain - maybe even too cheap. If your product reliably produced that kind of cost savings, you could easily charge $200, $300 or more for it, and customers would gladly pay it, since they would get their money back in a matter of months. However, there is one more major factor that must be considered. Psychological pricing - Ultimately, you must take into consideration the consumer's perception of your price, figuring things like:
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Positioning - If you want to be the "low-cost leader", you must be priced lower than your competition. If you want to signal high quality, you should probably be priced higher than most of your competition.

Popular price points - There are certain "price points" (specific prices) at which people become much more willing to buy a certain type of product. For example, "under $100" is a popular price point. "Enough under $20 to be under $20 with sales tax" is another popular price point, because it's "one bill" that people commonly carry. Meals under $5 are still a popular price point, as are entree or snack items under $1 (notice how many fast-food places have a $0.99 "value menu"). Dropping your price to a popular price point might mean a lower margin, but more than enough increase in sales to offset it. Fair pricing - Sometimes it simply doesn't matter what the value of the product is, even if you don't have any direct competition. There is simply a limit to what consumers perceive as "fair". If it's obvious that your product only cost $20 to manufacture, even if it delivered $10,000 in value, you'd have a hard time charging two or three thousand dollars for it -- people would just feel like they were being gouged. A little market testing will help you determine the maximum price consumers will perceive as fair.

Now, how do you combine all of these calculations to come up with a price? Here are some basic guidelines:

Your price must be enough higher than costs to cover reasonable variations in sales volume. If your sales forecast is inaccurate, how far off can you be and still be profitable? Ideally, you want to be able to be off by a factor of two or more (your sales are half of your forecast) and still be profitable. You have to make a living. Have you figured salary for yourself in your costs? If not, your profit has to be enough for you to live on and still have money to reinvest in the company. Your price should almost never be lower than your costs or higher than what most consumers consider "fair". This may seem obvious, but many entrepreneurs seem to miss this simple concept, either by miscalculating costs or by inadequate market research to determine fair pricing. Simply put, if people won't readily pay enough more than your cost to make you a fair profit, you need to reconsider your business model entirely. How can you cut your costs substantially? Or change your product positioning to justify higher pricing?

Pricing is a tricky business. You're certainly entitled to make a fair profit on your product, and even a substantial one if you create value for your customers. But remember, something is ultimately worth only what someone is willing to pay for it.