Pricing Policy

Determining the appropriate price for a product or service is an intricate problem. Three factors need to be considered: The lowest price that can be charged for the product or service without sustaining a loss, the value of the product or service to the potential customer, and the price charged by the competition for similar products or services. These factors are complicated by whether or not a product is durable or consumable as well as whether or not the target market is able to pay. Optimal pricing is also affected by vertical differentiation (i.e., perceived higher quality goods or services) and horizontal differentiation (i.e., different characteristics within a single product line). Prices are not necessarily set in stone, however. It is often advantageous to offer discounts to attract customers and maintain customer loyalty.

Keywords Consumer; Customer Relationship Management (CRM); Customer Value; Gross Margin; Markov Chain; Price Band Analysis; Strategy; Target Market

Marketing > Pricing Policy

Overview

There is an old adage that cautions that one should not charge more than the market will bear. This is, of course, sound advice. Although one wants to make as much money as possible from a transaction for a number of reasons, it is not feasible to simply set a high price. First, no matter how specific one's market niche, there is virtually no business that is without competition. If a business prices its product or service too high, it is relatively easy for a competitor to set their prices lower and take over a larger portion of the market share. In addition, most consumers have a good idea of what a product or service is worth and what they are willing to pay. For example, although I might be willing to invest a significant amount when purchasing a solid wood dresser, it is unlikely that I would be willing to pay the same amount for a fiberboard replica of the dresser because I know the various advantages and disadvantages of each and what their relative price ranges are. Similarly, although I might like to have an expensive new piece of electronic equipment for my business, if the price is such that the equipment will not save me at least a comparable amount of time and money, I am unlikely to make the purchase no matter how reasonably the price is set vis a vis the value of the item.

From the business's point of view, pricing is as complicated as the buying decision is for the consumer. Sometimes, for example, it is cost effective for a business to make little or no profit in the short term in order to bring in a larger customer base and higher profits in the long term. This marketing philosophy can be seen illustrated in the Sunday supplement of most major newspapers every week which carries coupons for products both old and new. Similarly, most days one can find advertisements and coupons in the mail offering first-time customers discounts for trying a product or service. By not making as much profit on the first sale, the businesses offering the products or services hope to earn customer loyalty and continued higher profits over the long term.

Determining Best Price

To enable a business to best price its goods or services, three factors need to be considered and understood. First, as a general rule, the lowest price one can offer a product at is the cost of that product to the business. (There are occasional exceptions where a business prices an item or service below cost to harm a competitor or gain new customers. However, this approach tends to be successful only as a short term strategy.) This low price limit must include other factors such as the costs associated with the personnel, equipment, and administration associated with selling and delivering the product or service. Pricing must take into account the salaries of all the personnel involved with that product line such as production, management, human relations, shipping and receiving, and accounting personnel. In addition, pricing needs to take into consideration overhead costs such as the cost to rent facilities, pay for utilities, taxes, and so forth. The second factor that needs to be taken into consideration when setting a price for a product or service is its value — in other words, what is it worth to the customer? This is one of the reasons that purchasing a drink at the movies is more expensive than purchasing a drink at the grocery store. Since the customer cannot bring in his/her own soda or water to the theatre, the value of the drink rises. In the grocery store, however, there are more choices not only within the store but at other stores to which the customer can go. So, value places a cap on how much a business can charge for a product or service. Somewhere in the middle between the cost of the product or service to the business and its value to the customer is typically where the actual price of the item will fall. This actual price is influenced by a third factor: The price charged by the competition. Even if one sets the price lower than the value, if a competitor offers the same or a similar product or service at a lower price, it is more likely that the customer will choose the competitor's product or service.

In addition to the old adage about setting prices that the market will bear, there is another old adage that cautions that one gets what one pays for. Indeed, research has found that many consumers do not do sufficient research to differentiate between similar products but often use price as an indicator of quality. There are, of course, limits to this philosophy. Carried to an extreme, this would mean that the higher the price, the more likely people would be to buy a product or service. Although this may be true in some instances, it is not a universal truth. Some purchasing decisions are made not on getting the "best," but on getting the "good enough." Also, some people are out to get a bargain. If offered the same item at two different prices, most people would opt for the less expensive of the two.

Relationship between Price & Purchase Probability

The literature on consumer buying habits reflects the same complicated relationship between price and purchase probability. Recent research into this phenomenon examined three levels of products: A durable product (specifically, a color television set), a semi-durable product (specifically, a T-shirt), and a non-durable product (specifically, toothpaste). It was found that the relationship between price and consumer buying decisions was complex. For durable goods, the study found that too low a price negatively affected the customer's impression of the product's quality and the probability that the customer would purchase the item. For this level of product, customers tended to purchase a mid- to high-priced product, on the assumption that the price was an indicator of the quality of the item. In fact, customers surveyed in the study believed that it was risky to buy a low-priced product. Another reason that customers hesitated to buy a low-priced product is because they thought it would negatively affect their image. These results imply that pricing for durable goods such as television sets should not be set too low in order to give the product a higher image. However, this approach is not without its limits. When setting the price of such goods, it is also important to take into consideration competitors' prices on similar products as well as the purchase power of the target market. Whether or not they think that an item is a good value, if it is out of their price range most people will not purchase it.

Semi-Durable Products

For the semi-durable product, price was again found to be a factor. Once again, those consumers surveyed believed that the lower the price of the T-shirt, the lower the quality of the garment. However, customers purchasing semi-durable goods were more skeptical about the relationship between price and value than were those who were purchasing durable goods. For this type of item, purchasing decisions were more likely to be made based on the perceived value of the item (e.g., strength, texture, colorfastness) than on price alone. This makes pricing items of this nature more difficult than pricing for durable goods such as television sets. Part of the problem with pricing T-shirts is that the customers tend to be young and have limited purchasing power. Therefore, even though they might like to purchase a name-brand product, they often chose a less expensive item instead. From a marketing perspective, therefore, it is helpful to select the appropriate segment of the target market and price the item accordingly.

Non-Durable Products

Finally, it was found that customers tended to pay less attention to price when buying the non-durable product than the other types of products. Other factors such as brand loyalty, reputation, and features were more important in the purchase decision than was the price. Although the customers surveyed did believe that there was a relationship between price and product quality, this belief was not as strong as for the durable and semi-durable goods. For non-durable products such as toothpaste, this means that the product should be priced according to the reputation of the brand. However, as with the other types of products studied, pricing the product too low could negatively impact sales and create the impression of an inferior product in the consumer's mind.

Differential Pricing within Multiple Product Lines

Businesses are not only interested in pricing relative to their competitors' products; sometimes they need to determine differential prices for their own multiple product lines. The number of consumer goods offered has been steadily rising for several decades. For example, in the early 1970s, Colgate only offered two varieties of toothpaste; today they offer 19. Similarly, Häagen Dazs only offered three flavors of ice cream when they first started operations in 1961; by 2004 they offered 36 flavors. Even credit card companies differentiate their offers. The industry offered only a small number of cards in the 1960s. Today, tens of thousands of distinct card offers go out daily.

Vertical Presentation

One of the ways that businesses differentiate between their various product lines is to present them vertically; offering different quality levels at different prices. As in the example of T-shirts, above, moderately priced garments with fewer features are more likely to be purchased by young people with limited disposable income than are higher priced garments. However in some businesses or industries, product lines do not differ by quality but by features. For example, Coca Cola offers regular Coke, classic Coke, Diet Coke, decaffeinated Diet Coke, Coke Zero, Cherry Coke, and so forth. This is an example of horizontal differentiation. Items that only differ along this dimension are priced the same.

Horizontal & Vertical Presentation

Sometimes, however, product lines are differentiated both horizontally and vertically. Yoplait, for example, offers numerous product lines including original, light, whips, and thick and creamy as well as smoothies, Yoplait for Kids, etc. (vertical differentiation). Within each product line is a range of flavors (horizontal differentiation). Research into pricing in such situations shows that consumers tend to be more interested in the characteristics of the product line (i.e., the vertical differentiation) than in the flavors (i.e., the horizontal differentiation) offered. In fact, the addition of flavors to a product line does not always increase the worth of the line in the customer's eyes. The standard practice of pricing all items within a line the same is, therefore, optimal.

Applications

Discount Pricing

Sometimes an effective pricing strategy is to permanently lower the price on a product or service with the expectation of making up the loss in increased sales volume. For example, the industry average markup on wine purchased by customers in restaurants is typically 100 to 150 percent above wholesale. Many restaurants find, however, this price was often more than the market would bear. However, one restaurant found that when they lowered their markup on wine to 50 percent, they doubled their sales volume in wine, thus retaining their profitability on it.

As illustrated by this example, offering discounts can sometimes be a worthwhile venture. However, this tactic should only be implemented as part of a well thought-out strategy as a way to help the organization reach its goals and objectives. The decision as to whether or not to offer a discount should be made based on rigorous analysis of several factors including market needs and trends, competitor capabilities and offerings, and the organization's resources and abilities. For example, a discount can help the business attain such strategic goals as securing customer loyalty (e.g., giving the customer a discount if s/he signs a long-term contract) or customizing products (e.g., giving the customer a discount if s/he bundles several services tailored to his/her needs). In such cases, the business is forcing the customer to decide which products or services are of value and make tradeoffs in determining which products or services s/he most desires. In addition, this approach to discounting requires the customer to work closely with the sales representative. This situation, in turn, will tend to make the customer see the sales representative as a partner helping to determine which products or services to purchase. This gives the business further opportunities to sell to the customer.

Discounting Policy

However, in order for discounting to be an effective way to increase profits, it is important for the business to have a consistent discounting policy made at a level higher in the organization than direct sales. If such a policy is not in place, a discount may aid in the individual sale but will also probably hurt the next several sales. For example, if an individual salesperson offers a customer a discount, the salesperson may make the sale, but when the customer returns, s/he will expect a discount again. Or, if other people find out about the discount, the next several customers will also expect a discount to the disadvantage for the company either in terms of lost revenue or from decreased customer satisfaction. However, discounts are not always necessary to attract and keep customers. A product or service that is easily distinguishable from those offered by the competition may add value for which the customer is willing to pay. Superior salespersons who give excellent customer service are another factor that will keep a customer coming back despite a somewhat higher price.

Discount Amount

In addition to deciding whether or not to offer a discount, the organization must also decide how much the discount should be. There are two factors to be considered in this decision. First, one must carefully analyze the gross margin. This is the ratio of gross income divided by net sales expressed as a percentage. Gross margin is a measure of the retailer's markup over wholesale. Gross margins are an expression of earnings adjusted for costs associated with producing the product or service. Most businesses attempt to have a gross margin as large as possible, although discount retailers attempt to keep operations efficient so that they can afford a smaller markup. If the business's gross margin is ten percent and it discounts a product by five percent, its income is cut in half and it must double its sales to keep the same profit. If, on the other hand, the gross margin is 50 percent and the business offers a five percent discount, income is only reduced by a tenth, and sales will only need to increase its sales by ten percent to make up for the difference. Any increased sales over that amount will mean higher overall profits. The second consideration in whether or not to offer a discount is price band analysis. This is a statistical model that measures what customers should pay within a band of prices as opposed to those prices that fall outside of the band. Using these two indicators, a business can set pricing and discounting policies that help increase long-term sales, market share, and customer loyalty rather than merely helping the business meet short-term sales goals or quotas.

Customer Relationship Management

One of the ways that businesses can customize their marketing approaches to the needs of individual customers is through the practice of customer relationship management. This is the process of identifying prospective customers, acquiring data that concerns these prospective and current customers, building relationships with customers, and influencing their perceptions of the organization and its products or services. These systems can help businesses develop dynamic marketing policies that will adjust to the changing dynamic between with the customer over time. These approaches also seek to increase customer value, an estimate of how much a customer will spend with a business or brand. Analysis of customer value should include consideration of the depth, breadth, and duration of the customer's relationship with the business or brand as well as the cost to acquire, serve, and retain each customer.

A recent study performed by Lewis investigated the effect of discounting on customer relationship pricing in offering discounts for a major metropolitan newspaper. In practice, many newspapers offer new customers a one-time steep discount for starting a new subscription that is not extended to current customers. A dynamic programming model was created that uses customer transaction history from over 1300 customers to develop a Markov chain that determines a way to maximize long term customer value. As opposed to current practice, however, it was found that such businesses can increase profitability by offering a series of decreasing discounts as customer tenure with the business grows, rather than using a traditional single steep discount to acquire new customers.

Terms & Concepts

Consumer: A person or organization that acquires goods or services for direct use rather than for resale or use in a manufacturing process.

Customer Relationship Management (CRM): The process of identifying prospective customers, acquiring data that concerns these prospective and current customers, building relationships with customers, and influencing their perceptions of the organization and its products or services.

Customer Value: An estimate of how much a customer will spend with a business or brand. Analysis of customer value should include consideration of the depth, breadth, and duration of the customer's relationship with the business or brand as well as the cost to acquire, serve, and retain each customer.

Gross Margin: The ratio of gross income divided by net sales expressed as a percentage. Gross margin is a measure of the retailer's markup over wholesale. Gross margins are an expression of earnings adjusted for costs associated with producing the product or service. Most businesses attempt to have a gross margin as large as possible, although discount retails attempt to keep operations efficient so that they can afford a smaller markup.

Markov Chain: A random process comprising discrete events in which the future development of each event is either independent of past events or dependent only on the immediately preceding event. Markov chains are often used in marketing to model subsequent purchases of products (i.e., the probability of the customer making a purchase from a particular business or brand is dependent only on his/her last purchase of that brand or independent of the brand).

Price Band Analysis: A statistical model that measures what customers should pay within a band of prices as opposed to those prices that fall outside of the band.

Strategy: In business, a strategy is a plan of action to help the organization reach its goals and objectives. A good business strategy is based on the rigorous analysis of empirical data, including market needs and trends, competitor capabilities and offerings, and the organization's resources and abilities.

Target Market: The people or businesses to whom the entrepreneur wishes to sell goods or services.

Bibliography

Cai, X., Feng, Y., Li, Y., & Shi, D. (2013). Optimal pricing policy for a deteriorating product by dynamic tracking control. International Journal of Production Research, 51, 2491-2504. Retrieved November 15, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=85879208&site=ehost-live

Class, J.N. (2012). Emerging markets and differential pricing policies: A question of global health?. Journal of Commercial Biotechnology, 18, 40-43.Retrieved November 15, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=84433070&site=ehost-live

Hosford, C. (2006). The value of good pricing policies. B to B, 91, 16. Retrieved June 5, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=23358742&site=ehost-live

Lewis, M. (2005). Research note: A dynamic programming approach to customer relationship pricing. Management Science, 51, 986-994. Retrieved June 5, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=17531714&site=ehost-live

Obadia, C. (2013). Competitive export pricing: the influence of the information context. Journal of International Marketing, 21, 62-78. Retrieved November 15, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=87742601&site=ehost-live

Verma, D. P. S.; Gupta, S. (2004). Does higher price signal better quality? The Journal for Decision Makers, 29, 67-77. Retrieved June 5, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=14024729&site=ehost-live

Voelckner, F. (2006). An empirical comparison of methods for measuring consumers' willingness to pay. Marketing Letters, 17, 137-149. Retrieved June 5, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=20743072&site=ehost-live

Walkup, C. (2005). Restaurateurs enjoy higher sales with lower markups on bottled wine. Nation's Restaurant News, 39, 4-82. Retrieved June 5, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=18954638&site=ehost-live

Suggested Reading

Cattani, K., Gilland, W., Heese, H. S., & Swaminathan, J. (2006). Boiling frogs: Pricing strategies for a manufacturer adding a direct channel that competes with the traditional channel. Production & Operations Management, 15, 40-56. Retrieved June 5, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=22404181&site=ehost-live

Draganska, M. & Jain, D. C. (2006). Consumer preferences and product-line pricing strategies: An empirical analysis. Marketing Science, 25, 164-174. Retrieved June 5, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=20944037&site=ehost-live

Kehoe, K. (2004). Make your price fit. Landscape Management, 43, 46-52. Retrieved June 5, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=14775606&site=ehost-live

Rusmevichientong, P., Van Roy, B., & Glynn, P. W. (2006). A nonparametric approach to multiproduct pricing. Operations Research, 54, 82-98. Retrieved June 5, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=19949376&site=ehost-live

Saleh, S. H. (2005). How do you stop a disastrous service pricing practice? Services Revenue, 3, 1-10. Retrieved June 5, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=23631642&site=ehost-live

Swami, S. & Khairnar, P. J. (2006). Optimal normative policies for marketing of products with limited availability. Annals of Operations Research, 143, 107-121. Retrieved June 5, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=20743058&site=ehost-live