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Pricing Strategies and Strategic Pricing Considerations
Business Essentials · Chapter 15: Pricing and PromotionSection 15.1 · lesson 68 of 10514 min · free with a free account
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In this lesson
Objectives, approaches, and the numbers behind a price.
- Name the 5 objectives a price can serve
- Compare cost-, value-, and competition-based pricing
- Use break-even analysis as a question, not an answer
- Explain elasticity, new-product pricing, and legal limits
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Pricing and Promotion
Pricing Strategies and Strategic Pricing Considerations
Every other part of the marketing mix spends money. Price is the part that brings it in. This section is about setting that number well. We'll start with what a price is meant to achieve, because the same product can deserve different prices. Then three ways to arrive at a price: from cost, from customer value, and from competitors. We'll work through break-even analysis, and why its answer is really a question. Then price elasticity, pricing a new product, and pricing a whole product line. We'll cover discounts, the legal limits on pricing, and how competitors react. And we'll meet a leather maker whose formula priced her bags far too cheaply.
Price and Its Purpose
The Only Element That Brings Money In
Price is the amount exchanged for a product. Within the marketing mix from section twelve point one, it holds a distinctive position. It's the only element that generates revenue. Product, place, and promotion all generate cost. So a pricing mistake, either way, hits the bottom line faster than any other. But a price can't be set sensibly until you decide what it's meant to accomplish. Profit maximization seeks the greatest possible profit, weighing units sold against the margin on each. Target return aims at a specific, predetermined return on the investment, not the highest one possible. Market share prices lower, to win the largest possible share of category sales. It accepts less margin now, for a stronger position later. Survival prices near cost, or briefly below it, to get through a demand collapse or a glut of competing supply. Status quo matches prevailing prices, to avoid disrupting the competitive balance. Stability comes before gain. These objectives can call for very different prices on the same product. So the objective comes first.
Cost-Based Pricing
Cost Plus a Markup, and Its 2 Defects
Cost-based pricing adds a markup to the cost of producing and delivering the product. It's straightforward. Calculate the full cost per unit, then add a percentage, or a fixed amount, on top. Here's an illustration with figures constructed for the exercise. A fictional desk lamp maker, Corvane Lighting, calculates a full cost of thirty dollars per lamp. That combines materials, labor, and an allocated share of fixed costs like rent and equipment. A forty percent markup on cost gives thirty times one point four, or forty-two dollars. The method has two defects. First, it ignores what customers will pay. It never asks if customers value the lamp at forty-two. If they'd pay sixty, money is left on the table. If they see it as worth only thirty-five, the business has priced itself out of the market. Second, it needs a volume assumption just to spread fixed cost across units. That creates a genuine circle. Cost per unit depends on assumed volume. Volume depends on price. And price depends on cost per unit. Assume high volume, price low, sell less, and your real unit cost was higher all along.
Break-Even Analysis
How Many Units Before Profit?
Break-even analysis relates cost, price, and volume, without assuming a lower cost-plus price is wise. Fixed cost doesn't change with the number of units produced. Rent, salaried staff, and equipment are examples. Variable cost rises with each additional unit, like materials and piece-rate labor. Contribution per unit is the price of one unit, minus its variable cost. It's what each sale contributes toward covering fixed cost, and once that's covered, toward profit. The break-even volume is the number of units at which total revenue equals total cost. You find it by dividing fixed cost by contribution per unit. Back to Corvane Lighting, again with constructed figures. Fixed cost is eighteen thousand dollars, and variable cost is twenty-two dollars per lamp. At a price of forty-eight dollars, each lamp contributes twenty-six dollars. Eighteen thousand divided by twenty-six is about six hundred ninety-two units. At sixty-two dollars, each lamp contributes forty dollars. Eighteen thousand divided by forty is four hundred fifty units.
Figure 15.1.1
Break-Even at 2 Prices
Picture both cases on one chart, with units sold along the bottom. Total cost starts at the eighteen-thousand-dollar fixed cost, and climbs by twenty-two dollars per lamp. Each revenue line starts at zero, and climbs by the price per lamp. Where a revenue line crosses total cost, the business breaks even. The steeper sixty-two-dollar line crosses at four hundred fifty units. The forty-eight-dollar line needs about six hundred ninety-two. That's because each lamp sold at the higher price contributes more toward fixed cost. Now the discipline this analysis demands. Treat the break-even volume as a question to investigate, not a conclusion. Needing four hundred fifty sales at sixty-two dollars says nothing about whether four hundred fifty such buyers exist. That judgment means looking outward at the market, not further into the cost accounting.
Value and Competition
Pricing From the Customer, or From Rivals
Value-based pricing starts from what the offering is worth to the customer, and takes a share of that. It directly fixes the first defect of cost-based pricing, by putting customer valuation at the center. Its central difficulty is that value is genuinely hard to estimate. Cost can be measured from internal records. Value lives in the customer's own judgment, and must be inferred. One method uses the market research from section twelve point two. Ask customers directly what they'd pay, or watch how demand responds to different prices in a controlled test. Another compares the offering with the customer's next-best alternative, and values the advantage over it, in dollars. Competition-based pricing sets price mainly by what competitors charge. It dominates where offerings are hard to differentiate, like the undifferentiated markets in section two point two. There, many sellers offer close substitutes, and no one has much power to set price independently. Price meaningfully above the going rate, and customers go to a rival offering the same thing for less. Price meaningfully below it, and you give up margin without enough extra volume. Competitors will often just match the cut.
Table 15.1.1
3 Approaches, 3 Blind Spots
Here are the three approaches side by side. Cost-based pricing needs the full cost per unit and a chosen markup. It ignores what customers will actually pay. It suits internal cost control, and a quick starting estimate. Value-based pricing needs customer valuation, estimated indirectly. It ignores the business's own cost structure entirely. It suits differentiated offerings, where value clearly exceeds cost. Competition-based pricing needs the prices rivals charge. It ignores both the business's own cost and its customers' specific valuation. It suits undifferentiated markets with many close substitutes. Each approach needs a different kind of information, and is blind to something the others capture. So the right approach depends on your information and your market, not on which is easiest.
Price Elasticity
Will a Price Rise Raise Revenue?
Price elasticity of demand is how responsive the quantity customers buy is to a change in price. Demand tends to be more elastic, meaning more responsive, when close substitutes are readily available. Also when it's a large share of the budget, or the buyer has time to search. Demand tends to be less elastic when there are few or no close substitutes. Also when it's a small share of the budget, or so urgent there's no time to shop around. Here's why it matters. A price increase raises revenue in one case, and lowers it in the other. Total revenue is price multiplied by quantity. If demand is inelastic, quantity falls by a smaller percentage than price rises. So total revenue goes up. If demand is elastic, quantity falls by a larger percentage than price rises. So total revenue goes down. Each unit brings in more, but too few units sell to make up for it. A business that raises price with no sense of its elasticity is guessing between two opposite outcomes.
New Product Pricing
Skim the Top, or Penetrate the Market
A newly launched product, developed through the process in section twelve point six, faces a specific choice. Price skimming sets a high initial price, to capture the customers most willing to pay first. Then the price comes down over time, reaching progressively more price-sensitive segments. It assumes a meaningful segment values the product highly, and will pay a premium to have it early. It assumes the high price won't draw competitors too fast, and that quality or novelty supports a premium image. It fits genuinely new, hard-to-imitate products, with limited early competition and customers who aren't too price-sensitive. Penetration pricing sets a low initial price, to capture as much of the market as possible, quickly. The aim is to build volume before competitors can respond. It assumes demand is fairly price-sensitive, and that efficient high-volume production makes the low price profitable. It assumes early share builds a durable advantage, like switching costs or brand position, from section twelve point one. It fits an easily imitated product, facing likely fast competitive entry. There, an early, dominant position matters more than maximizing margin on the first sales.
Product Lines and Discounts
Pricing Beyond the Single Item
When a business sells related products, pricing reaches beyond any single item. Line pricing sets distinct price points across a line, such as good, better, and best. The price gaps themselves signal quality differences, and steer customers toward a tier. Optional feature pricing charges separately for add-ons and accessories. Customers pay only for what they want, while those who value extras pay more. Captive product pricing prices a core product low, sometimes near cost. The companion items customers must keep buying carry higher margins, like refills for a cheap device. Bundling prices a combination together, usually below the separate total, encouraging customers to buy more. By-product pricing sells what would otherwise be production waste, and that revenue offsets some of the main product's cost. Discounts and allowances are reductions from list price, granted under specific conditions. A quantity discount rewards larger purchases. A cash discount rewards prompt payment. A seasonal discount rewards buying in a slower period. A trade allowance pays channel members, from section fourteen point one, for local advertising or shelf placement. Each is a deliberate, targeted departure from the standard price, buying a specific behavior. None is arbitrary.
Limits and Reactions
The Law, and the Competitor Who Answers
Pricing operates within a legal framework, and two prohibitions deserve particular attention. Price discrimination charges different buyers different prices for the same product, in comparable circumstances, harming competition. It's restricted under federal law, including the Robinson-Patman Act, with exceptions that need careful legal analysis. Price fixing is an agreement among competitors to set or coordinate prices, instead of setting them independently. It's prohibited under federal antitrust law, chiefly the Sherman Act, and treated as a serious violation. State law adds further layers that can differ from the federal floor. And how these rules apply to a real pricing plan depends on the facts. In practice, that needs counsel. Price changes also rarely happen in isolation. Competitors watch, and often respond. A price increase risks losing customers to rivals who hold steady, unless the whole market moves together. That might happen with a shared rise in input costs. A price cut risks rivals matching or undercutting it. That can spiral into a price war that leaves every seller worse off. So a responsible price decision asks how competitors will react, and whether the business can sustain that reaction.
Case Vignette
The Price That Was Too Cheap
A final composite case. The organization and the person are fictional. Talia owns Fennimore Leatherworks, a maker of handcrafted leather bags. She prices with a cost-plus formula. Materials and labor, plus a thirty-five percent markup. That puts her signature bag at ninety-five dollars. At a craft fair, she notices a nearby competitor with a comparable, similarly well-made bag. She estimates it costs about the same to make. It's priced at two hundred forty dollars, and selling briskly. She could keep her formula, raise her price sharply, or first investigate what her own customers value. The constraint is that a sudden, sharp increase could alienate customers who expect her current price. The trade-off is the certainty of her familiar formula, against a possibly much larger margin from value-based pricing. The reasoning turns on the first defect of cost-based pricing. It ignores what customers will pay. Her formula showed what the bags cost, not their worth. The rival's price is direct evidence of far higher value. The sound decision isn't necessarily to jump straight to two hundred forty dollars. It's to research her customers' actual valuation, as in section twelve point two, before trusting her current price.
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