PRICING STRATEGIES (SL & HL Content) IB BUSINESS & MANAGEMENT A COURSE COMPANION P210-212

PRICING STRATEGIES There are 3 main categories: Cost-based pricing Cost-plus Pricing Marginal-cost pricing Contribution Pricing Competition-based pricing Price Leadership Predatory Pricing Going Rate Pricing Market-Based pricing Price Penetration Price Skimming Price Discrimination Loss Leaders Psychological Pricing Promotional Pricing

COST BASED STRATEGIES Cost Plus Pricing This method is very commonly used by businesses as it is easy to calculate and understand. It simply involves working out the average cost per unit produced (total cost divided by output) and then adding a percentage mark up. Eg: The average cost per unit is $100 for a product. It may decide that it wants a profit margin of 25%, meaning the selling price would be $125. The higher the percentage mark up, the more profit per unit. This strategy is also known as full cost pricing or absorption pricing.

COST BASED STRATEGIES Marginal Cost Pricing The marginal cost is the addition to the total cost for producing one extra unit of output. Some businesses have very high fixed costs (costs that do not vary with output) and very low variable costs (costs that do vary with output >> therefore once their fixed costs have been recovered, they can sell at any price above the variable (now the marginal cost) This is because the extra units sold will only add small amount to their total costs, so the business can still be profitable as along as these costs are covered.

COST BASED STRATEGIES Marginal Cost Pricing Utilities companies such as gas and water suppliers may do this as long as they have very low marginal costs of increasing output to one home or business. However, it is important that the price is not well publicized as a business can’t afford to sell its output at this low price – low prices for everyone would mean an overall loss.

COST BASED STRATEGIES Contribution Pricing This is similar to marginal-cost pricing in that it mainly considers the variable costs of production. Businesses will want to make sure that their variable costs, such as raw materials, are covered, but also need a contribution towards the fixed costs of the business, such as rent on the factory.

COST BASED STRATEGIES Contribution Pricing Example The fixed costs for a product are $400. The variable costs are $6 per unit. 100 units are sold. The business decides to price the product at $11. This means $5 per unit sold will go towards the fixed costs. The fixed costs of $400 will be covered by the first 80 units sold. $400/ $5 = 80. Any more sold beyond 80, will each add $5 to profits. If 100 are sold the total profit would be 20 x $5 = $100.

COST BASED STRATEGIES Contribution Pricing A business cannot guarantee profit using this pricing method – it needs to sell enough units to cover its fixed costs before making profit. This method can be very useful when making one-off decisions, such as a special for a particularly large order. As long as the price contributes to fixed costs, it may be worth offering a special price, but if there is no contribution then the business unlikely to take the order.

COMPETITION BASED PRICING Price Leadership Price leadership exists where a dominant organization in a market sets a price for its products and its rivals feel compelled to match that price. This may be because there is one large business in the industry coupled with lots of smaller competitors with far less market power to set prices. It can also be seen in oligopolistic markets (markets with a few large businesses) where the leaders all tend to match each other’s prices.

COMPETITION BASED PRICING Price Leadership Example Petrol/gas stations will often have policies where they agree to match local rivals prices. This practice has brought about claims of illegal agreements by businesses to fix prices at an artificially high level and exploit customers. However, it is very hard to prove that this collusion has actually occurred.

COMPETITION BASED PRICING Predatory Pricing Predatory pricing is deliberately selling a product at below average cost with the intention of forcing a competitor out of the market. In many countries this is illegal, but it is very hard to prove the intention of an organization’s behaviour – it could be simply running a loss leader. Businesses often strongly contest accusations of this in the courts – and even if they lose, they may not change their behaviour.

COMPETITION BASED PRICING Going Rate Pricing Going-rate pricing is where businesses price their products at whatever the prevailing market price may be. This is likely to be because the market is highly transparent and the business would lose most of its sales by trying to charge a higher price.

MARKET BASED PRICING Price Penetration Price penetration is where a business sells it products at a low price to try to break into a market and gain market share quickly. The aim of this policy is to gain enough market share to be able to raise prices in the future once the business has become established.

MARKET BASED PRICING Price Skimming This is most commonly seen with new and innovative products, such as new mobile phones and games consoles. The price is set high initially to gain those customers who will pay almost any price to get their hands on the latest gadget. Once the business has profited from selling to those customers, it drops the price to tempt other customers who may have been put off by the high price originally. It is only able to do this because there is likely to be almost no competition in the market due to the cutting edge nature of the product.

MARKET BASED PRICING Price Discrimination Most markets can be broken down into different sub groups. It is likely that customers in some of these groups may be prepared to pay slightly higher prices than those in other groups. Ideally the business would like to sell its product at different prices in the various segments, by charging higher prices to customers who are prepared to pay more.

MARKET BASED PRICING Price Discrimination Examples of Price Discrimination Phone calls – it is usually more expensive to make a call during the day (Monday to Friday) that the evenings or weekend. This is because some users will have no choice but to use the phone a lot in their work) and are therefore more likely to pay higher prices. Conversely, those people who just wish to call for social purposes are often prepared to wait to make their calls and so only pay a lower price.

MARKET BASED PRICING Price Discrimination Price discrimination is only possible if the product cannot be easily traded. Eg: Selling footballs in one town at a higher price than in another town would tempt entrepreneurs to buy up the cheap footballs and drive them to the first one to sell at a profit.

MARKET BASED PRICING Loss Leaders Loss leaders are products sold at very low prices to tempt customers into a store. Most supermarkets offer a low cost range, which in itself may not be profitable. The supermarket know that someone coming in is unlikely only to buy products in the low cost range and as a result the supermarket will be able to earn profit overall on consumers weekly shopping. A business can use these loss-leading products as part of its promotional activity – they will also give the business a reputation for good value which may in turn also increase sales and profits.

MARKET BASED PRICING Loss Leaders Walmart Example In the US Walmart has managed to combine its huge buying power with a loss-leading strategy to offer new CD albums for sale at half their recommended retail price. The headline grabbing strategy allows Wal-Mart to attract customers from far and wide, but it has resulted in accusations of unfair market practices by music retailers where sales have been badly hit.

MARKET BASED PRICING Psychological Pricing Psychological pricing considers the fact that price gives a customer information about the characteristics of a product. Eg. You would expect a luxury product to be priced at the higher end of the market. If a perfume is priced too cheaply, its sales may suffer as potential consumers perceive it as of poorer quality than the higher priced rivals.

MARKET BASED PRICING Psychological Pricing Psychological pricing also refers to the practice of setting prices at just under the currency unit such as $19,99 rather than $20. This is based on a number of assumptions: Customers only take account of the “big number” rather than the proper rounding. If a product is $19,99 it appears that it is offered at the lowest possible cost rather than being priced up to the nearest full currency unit. Psychological pricing pushes products into cheaper price bands. Examples of this are cars and property.

MARKET BASED PRICING Psychological Pricing Whatever the reason, pricing at amounts ending .99 or .95 has become common place. Most bizarre are petrol and gas prices that often end in fractions of a penny or cent – a price that is impossible to pay as we don’t have small enough coins – so the prices quoted need to be rounded up before we can pay.

MARKET BASED PRICING Promotional Pricing Special offer or promotional pricing is used to clear excess stock quickly or to try to gain market share. The best example is “buy one get one free” (“BOGOF”) offers, which are now common place across the world. This enables a business effectively to halve the price without it seeming that the product is of lower quality. It also ensures that those customers who would only have bought one product at half price have to buy twice as much. Promotional pricing can also be used to boost sales in times of low demand, or to boost customer awareness of a new outlet that has opened in an area.