PRICING AND SALES PROMOTION:TYPES OF PRICING DECISIONS

4. TYPES OF PRICING DECISIONS

As shown in Table 1, there are many kinds of pricing decisions that a firm must make. There is the decision on the specific price to set for each product and service marketed. But this specific price depends on the type of customer to whom the product is sold. For example, if different customers purchase in varying quantities, should the seller offer volume discounts?

The firm must also decide whether to offer discounts for early payment and, if so, when a customer is eligible for a cash discount and how much to allow for early payment. Should the firm attempt to suggest retail or resale prices, or should it only set prices for its immediate customers? When a firm uses other business firms as intermediaries between itself and its customers, it does not have direct contact with its ultimate customers. Yet the way customers respond to prices depends on how they perceive the prices and the relationships between prices. Hence, the manufacturer is very interested in having the prices that the final customer responds to correspond to its strategic objectives.

Normally, the firm sells multiple products and these questions must be answered for each product or service offered. Additionally, the need to determine the number of price offerings per type of product and the price relationships between the products offered make the pricing problem more complex. Further, different types of market segments respond differently to prices, price differences, and price changes.

The firm must also decide on whether it will charge customers for the transportation costs incurred when shipping the products to them. Customers located at different distances from the manufacturer will pay a different total price if they are charged for the transportation costs. Yet if the seller quotes a uniform price that includes the transportation costs regardless of distance from the manufacturer, some buyers may receive the products at a total price that is less than the costs incurred to the manufacturer while other customers will pay a price that exceeds the total costs incurred by the manufacturer. Such differences in prices to similar types of customers may lead to some concerns about the legality of the pricing policy.

Pricing New Products

One of the most interesting and challenging decision problems is that of determining the price of a new product or service. Such pricing decisions are usually made with very little information on demand, costs, competition, and other variables that may affect the chances of success. Many new products fail because they do not provide the benefits desired by buyers, or because they are not available at the right time and place. Others fail because they have been incorrectly priced, and the error can as easily be in pricing too low as in pricing too high. Pricing decisions usually have to be made with little knowledge and with wide margins of error in the forecasts of demand, cost, and competitors’ capabilities.

The core of new product pricing takes into account the price sensitivity of demand and the incremental promotional and production costs of the seller. What the product is worth to the buyer, not what it costs the seller, is the controlling consideration. What is important when developing a

new product’s price is the relationship between the buyers’ perceived benefits in the new product relative to the total acquisition cost (i.e., financial value), and relative to alternative offerings available to buyers.

It has been generally presumed that there are two alternatives in pricing a new product: skimming pricing, calling for a relatively high price, and penetration pricing, calling for a relatively low price. There are intermediate positions, but the issues are made clearer by comparing the two extremes.

Skimming Pricing

Some products represent drastic improvements upon accepted ways of performing a function or filling a demand. For these products, a strategy of high prices during market introduction (and lower prices at later stages) may be appropriate. Skimming is not always appropriate and does have drawbacks. A skimming strategy is less likely to induce buyers into the market and does not encourage rapid adoption or diffusion of the product. Moreover, if skimming results in relatively high profit margins, competitors may be attracted into the market.

Penetration Pricing

A penetration strategy encourages both rapid adoption and diffusion of new products. An innovative firm may thus be able to capture a large market share before its competitors can respond. One disadvantage of penetration, however, is that relatively low prices and low profit margins must be offset by high sales volumes. One important consideration in the choice between skimming and penetration pricing at the time a new product is introduced is the ease and speed with which com- petitors can bring out substitute offerings. If the initial price is set low enough, large competitors may not feel it worthwhile to make a big investment for small profit margins. One study has indicated that a skimming pricing strategy leads to more competitors in the market during the product’s growth stage than does a penetration pricing strategy (Redmond 1989).

Pricing During Growth

If the new product survives the introductory period, as demand grows, usually a number of compet- itors are producing and selling a similar product and an average market price begins to emerge. Normally there is a relatively wide range of market prices early in the growth stage, but this market price range narrows as the product approaches maturity.

In regard to pricing products during the growth stage, three essential points should be noted: (1) the range of feasible prices has narrowed since the introductory stage; (2) unit variable costs may have decreased due to the experience factor; and (3) fixed expenses have increased because of in- creased capitalization and period marketing costs. The pricing decision during the growth stage is to select a price that, subject to competitive conditions, will help generate a sales dollar volume that enables the firm to realize its target profit contribution.

Pricing During Maturity

As a product moves into the maturity and saturation stages, it is necessary to review past pricing decisions and determine the desirability of a price change. Replacement sales now constitute the major demand, and manufacturers may also incur regional competition from local brands. Market conditions do not appear to warrant a price increase, hence the pricing decision usually is to reduce price or stand pat.

When is a price reduction profitable? We know that when demand is price elastic it is profitable to reduce prices if costs do not rise above the increase in revenues. But since it can be expected that any price decrease will be followed by competitors, it is also necessary that the market demand curve be elastic within the range of the price reduction. Moreover, the requirements for a profitable price reduction strategy include beginning with a relatively high contribution margin (i.e., relatively high PV ratio), opportunity for accelerating sales growth and a price-elastic demand (Monroe and Mentzer 1994). When a product has reached the maturity stage of its life cycle, it is most likely that these conditions will not exist.

At the maturity stage of the life cycle, the firm probably should attempt to maximize short-run direct product contribution to profits. Hence, the pricing objective is to choose the price alternative leading to maximum contribution to profits. If competition reduces prices, the firm may, however reluctantly, match the price reduction. On the other hand, it may try to reduce costs by using cheaper materials, eliminating several labor operations, or reducing period marketing costs. All or any of these actions may allow the firm to match competitively lower prices and still maintain target con- tributions to profit.

Pricing a Declining Product

During the declining phase of a product’s life, direct costs are very important to the pricing decision. Normally, competition has driven the price down close to direct costs. Only those sellers who were able to maintain or reduce direct costs during the maturity stage are likely to have remained. If the decline is not due to an overall cyclical decline in business but to shifts in buyer preferences, then the primary objective is to obtain as much contribution to profits as possible.

So long as the firm has excess capacity and revenues exceed all direct costs, the firm probably should consider remaining in the market. Generally, most firms eliminate all period marketing costs (or as many of these costs as possible) and remain in the market as long as price exceeds direct variable costs. These direct variable costs are the minimally acceptable prices to the seller. Thus, with excess capacity, any market price above direct variable costs would generate contributions to profit. Indeed, the relevant decision criterion is to maximize contributions per sales dollar generated. In fact, it might be beneficial to raise the price of a declining product to increase the contributions per sales dollar. In one case, a firm raised the price of an old product to increase contributions while phasing it out of the product line. To its surprise, sales actually grew. There was a small but profitable market segment for the product after all!

Price Bundling

In marketing, one widespread type of multiple products pricing is the practice of selling products or services in packages or bundles. Such bundles can be as simple as pricing a restaurant menu for either dinners or the items a` la carte, or as complex as offering a ski package that includes travel, lodging, lift and ski rentals, and lessons. In either situation, there are some important principles that need to be considered when bundling products at a special price.

Rationale for Price Bundling

Many businesses are characterized by a relatively high ratio of fixed to variable costs. Moreover, several products or services usually can be offered using the same facilities, equipment, and personnel. Thus, the direct variable cost of a particular product or service is usually quite low, meaning that the product or service has a relatively high profit–volume (PV) ratio. As a result, the incremental costs of selling additional units are generally low relative to the firm’s total costs.

In addition, many of the products or services offered by most organizations are interdependent in terms of demand, either being substitutes for each other or complementing the sales of another offering. Thus, it is appropriate to think in terms of relationship pricing, or pricing in terms of the inherent demand relationships among the products or services. The objective of price bundling is to stimulate demand for the firm’s product line in a way that achieves cost economies for the operations as a whole, while increasing net contributions to profits.

Principles of Price Bundling

Underlying the notion of bundling is the recognition that different customers have different perceived values for the various products and services offered (Simon et al. 1995). In practical terms, these customers have different maximum amounts they would be willing to pay for the products. For some customers, the price of the product is less than this maximum acceptable price (upper price threshold), resulting in some consumer surplus. However, for these customers, the price of a second product or service may be greater than they are willing to pay and they do not acquire it. If the firm, by price bundling, can shift some of the consumer surplus from the highly valued product to the less valued product, then there is an opportunity to increase the total contributions these products make to the firm’s profitability.

The ability to transfer consumer surplus from one product to another depends on the comple- mentarity of demand for these products. Products or services may complement each other because purchasing them together reduces the search costs of acquiring them separately. It is economical to have both savings and checking accounts in the same bank to reduce the costs of having to go to more than one bank for such services. Products may complement each other because acquiring one may increase the satisfaction of acquiring the other. For the novice skier, ski lessons will enhance the satisfaction of skiing and increase the demand to rent skis. Finally, a full product-line seller may be perceived to be a better organization than a limited product-line seller, thereby enhancing the perceived value of all products offered.

5.6. Yield Management

A form of segmentation pricing that was developed by the airlines has been called yield management. Yield management operates on the principle that different segments of the market for airline travel have different degrees of price sensitivity. Therefore, seats on flights are priced differently depending on the time of day, day of the week, length of stay in the destination city before return, when the ticket is purchased, and willingness to accept certain conditions or restrictions on when to travel. Besides the airlines, hotels, telephone companies, rental car companies, and banks and savings and loans have used yield management to increase sales revenues through segmentation pricing. It seems likely that retail firms could use yield management to determine when to mark down slow-moving merchandise and when to schedule sales, or how to set a pricing strategy for products with short selling seasons.

The unique benefits of the yield-management pricing program is it forces management to contin- uously monitor demand for its products. Further, changes in demand lead to pricing changes to reflect these changes. If the product is not selling fast enough, then price reductions can be initiated to stimulate sales. Because of a relatively high fixed costs to total variable costs cost structure, these focused price reductions can provide leverage for increasing operating profits, by the effect on sales volume. With relatively high contribution margins (high PV ratios), small price reductions do not require large increases in volume to be profitable.