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Principles of Marketing Unit 7: Pricing Strategy

Price is the only element of the marketing mix that produces revenue; the others create costs. This unit covers how firms set prices, the math behind markups and break-even, and the strategies firms use to adjust prices.

Covers: Value-based, cost-based and competition-based pricing, Markups and cost-plus pricing, Break-even analysis, Price elasticity of demand, New-product pricing: skimming and penetration, Product mix pricing, Price adjustments and legal issues

Study guide

Price is the amount of money charged for a product, or more broadly, the sum of values customers give up to gain its benefits. Firms usually set prices between two limits. Customer perceptions of value set the ceiling: if price is higher than perceived value, buyers will not buy. Product costs set the floor: below cost, the firm loses money on every sale. Within that range, competitors' prices and other internal and external factors guide the choice. Customer value-based pricing starts with what buyers will pay and works backward to design a product and cost that can deliver at that price. Good-value pricing and value-added pricing are two common forms.

Cost-based pricing adds a standard markup to cost. A markup can be stated on cost or on selling price, and tests often mix them up. Markup on cost = (price − cost) ÷ cost. Markup on selling price = (price − cost) ÷ price. To find a price from a desired markup on price, use price = unit cost ÷ (1 − markup). For example, a unit cost of $16 with a 20% markup on price gives $16 ÷ 0.8 = $20. Cost-plus pricing is simple and seems fair, but it ignores demand and competition. Competition-based pricing sets prices largely on rivals' prices, which is common in markets with similar products.

Break-even analysis finds the sales volume at which total revenue equals total cost. Fixed costs (rent, salaries, ad campaigns) do not change with output; variable costs (materials, packaging) change directly with output. Each unit sold contributes price minus variable cost toward fixed costs. Break-even volume = fixed costs ÷ (price − unit variable cost). To find the volume needed for a target profit, add the profit to fixed costs before dividing. Price elasticity of demand measures how responsive demand is to price: elasticity = % change in quantity ÷ % change in price. If the absolute value is above 1, demand is elastic, and a price cut raises total revenue; below 1, demand is inelastic, and a price rise raises revenue.

New products call for special strategies. Market-skimming pricing sets a high initial price to skim maximum revenue from segments willing to pay, then lowers it over time; it works when quality and image support the price and competitors cannot enter easily. Market-penetration pricing sets a low initial price to win a large share quickly; it works when the market is highly price sensitive and costs fall as volume grows. For a product mix, firms use product line pricing (price steps between items), optional-product pricing (accessories), captive-product pricing (razor blades, printer ink), by-product pricing and product bundle pricing, which combines items at a reduced price.

Firms adjust base prices for different customers and situations. Discounts include cash, quantity, functional (trade) and seasonal discounts, while allowances include trade-in and promotional allowances. Segmented pricing charges different prices to different groups, such as student fares. Psychological pricing uses price to signal quality or uses odd endings like $9.99. Promotional, geographical, dynamic and international pricing are other adjustments. Some practices are illegal in the United States: price fixing (competitors agreeing on prices), predatory pricing (selling below cost to drive out rivals), deceptive pricing and certain kinds of price discrimination between business buyers under the Robinson-Patman Act.

Key ideas

• Customer perceived value sets the price ceiling, and costs set the price floor.
• Value-based pricing starts with the customer, while cost-plus pricing starts with the product's cost.
• Markup on cost and markup on selling price use different bases and give different percentages.
• Break-even volume equals fixed costs divided by contribution per unit.
• Elastic demand means a price cut raises revenue; inelastic demand means a price rise raises revenue.
• Skimming starts high for less price-sensitive buyers, while penetration starts low to build share fast.
• Price fixing and predatory pricing are illegal in the United States.

Formulas and rules

Common mistakes

• Computing a markup on cost when the question asks for markup on selling price, or the reverse.
• Dividing fixed costs by price instead of by price minus variable cost in break-even problems.
• Thinking a price cut always raises revenue; it does so only when demand is elastic.
• Mixing up skimming (start high) with penetration (start low).
• Calling captive-product pricing bundling; captive pricing is cheap main product, profitable supplies.

Before the test, make sure you can

• Explain why customer value sets the price ceiling and cost sets the floor.
• Calculate markups on cost and on selling price, and convert between them.
• Calculate unit cost, break-even volume and the volume needed for a target profit.
• Calculate price elasticity and predict how a price change affects revenue.
• Choose between skimming and penetration pricing for a given situation.
• Identify product mix pricing strategies and price adjustment strategies.
• Recognize illegal pricing practices such as price fixing and predatory pricing.

Words to know

Price

The amount of money charged for a product or service, or the sum of values customers give up for the benefits of having or using it.

Customer value-based pricing

Setting price based on buyers' perceptions of value rather than on the seller's cost.

Good-value pricing

Offering the right combination of quality and good service at a fair price.

Value-added pricing

Attaching value-added features and services to differentiate offers and charge higher prices.

Cost-plus pricing (markup pricing)

Adding a standard markup to the cost of the product.

Fixed costs

Costs that do not vary with production or sales level, such as rent and salaries.

Variable costs

Costs that vary directly with the level of production, such as materials.

Break-even pricing

Setting price to break even on the costs of making and marketing a product, or to make a target return.

Price elasticity

A measure of the sensitivity of demand to changes in price.

Market-skimming pricing

Setting a high price for a new product to skim maximum revenues layer by layer from segments willing to pay.

Market-penetration pricing

Setting a low price for a new product to attract a large number of buyers and a large market share.

Captive-product pricing

Setting a price for products that must be used along with a main product, such as razor blades or printer cartridges.

Product bundle pricing

Combining several products and offering the bundle at a reduced price.

Segmented pricing

Selling a product at two or more prices where the difference is not based on differences in costs.

Psychological pricing

Pricing that considers the psychology of prices, not simply the economics, such as $9.99 endings or prestige prices.

Dynamic pricing

Adjusting prices continually to meet the characteristics and needs of individual customers and situations.

Price fixing

An illegal agreement among competitors to set prices at a certain level.

Predatory pricing

Selling below cost with the intention of punishing a competitor or driving it out of the market.

Sample practice questions

30 more questions like these, from level 1 to 5, are in the practice set.