How does a seller set price?

1) Cost center approach in pricing

2) Demand oriented approach in pricing
3) A combination of cost center and demand oriented approaches.

1) Cost center approach in pricing:

What costs are incurred when you manufacture a product?

Sunk costs –

A cost that has been incurred and cannot be reversed. Also referred to as "stranded cost."

Investopedia explains Sunk Cost

A worn-out piece of equipment bought several years ago is a sunk cost because the cost of
buying it cannot be reversed.

Direct costs

Indirect costs

Non-variable costs

Variable costs

Variable costs Non-variable costs

Direct costs Raw materials Direct workers’ or supervisors’
salaries
Direct maintenance costs
Indirect Costs for production Common staff salaries
Costs for marketing Common rent
Electricity
Managerial compensation
Common stationery expense

(i) Full costing à In monopolistic scenario (all direct, indirect costs) not sunk costs.
(ii) Marginal costing à In highly competitive scenario, a vendor has to bag an order to ensure its
survival and keep the installed machines at least partially occupied.
- Covers at least direct variable costs (set the floor or rock bottom of price)
(iii) Mark-up pricing à Adding a fixed % to the unit cost
- Popular in retail trades (low to high margin) depending on the competitive scenario

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 2) Demand-oriented approach in pricing:

Look at the intensity of demand unlike cost-oriented approach (std mark-up over costs).

- A high price is charged when the demand is intense and low price is charged when the demand
is weak (even though production unit costs may be the same in both cases)

(i) Price discrimination

Price setting is different for different products based on –

- Customer,
- Product version,
- Place (theatre seats, economy or business class air fares)
- Time (peak season or off-season hotel rates for corporate).

(ii) Market penetration pricing à use marginal pricing strategy.

Gain quick entry and capture a large market volume.

For vendor, the larger the production value and volume (long production runs) the lesser will be the
costs of production (fixed costs) per unit due to low lead times.

- Especially for low-value standard industrial products and services.

3) A combination of cost center and demand oriented approaches.

(i) Target pricing

Pricing method whereby the selling price of a product is calculated to produce a particular rate of
return on investment for a specific volume of production. The target pricing method is used most
often by public utilities, like electric and gas companies, and companies whose capital
investment is high, like automobile manufacturers

(ii) RCA – Relative contribution approach

Different products from same vendor may be in different stages of product life cycle (PLC).

- Introductory stageà market entry stage à infancy à Low load-bearing or low sharing of
overheads.
If you have sophisticated and complex industrial products and services, new prospects and even
existing customers may take a long time to be convinced about buying and using product /
services as they are not aware of the benefits.
Free experiments, trial runs, pilot-scale operations. High pricing may scare away prospective
buyers.

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 Over time, the vendors’ marketers have to present all the facts before the buying firm’s DMU
and convince and negotiate for better pricing deal.

- Growth stage à money-making stage à youth à high revenue and high load bearing capacity
- Maturity à stage of established product à middle age à relatively lower capacity to bear load
- Decline à clearing the old stocks is important à old age à very low capacity to bear
overheads.

Buyer-specific and product-specific pricing-

1) Sealed bid pricing / reverse bidding mechanism

Purchasers in each plant set the highest possible bidding price, beyond which offers will not be
accepted.

Each vendor is encouraged to offer its own price below the set figure.

The lower the bid offer, the greater the possibility of getting the contract, without compromising on
product quality considerations.

2) Two-step bidding process (sometimes buyers go for quality or lowest bids)

1st a technical bid and next a commercial bid.

DSP – Durgapur Steel Plant – prefer to have technical bidding by vendors, who have to comply with the
desired technical specifications, spare parts availability, delivery schedules, after sales service.

After these are complied with, their technical wing will agree to allow a few chosen vendors to go for
the next phase of commercial bidding, where as a thumb rule, the lowest bid (L1) with the most
acceptable financial terms will be considered, prior to awarding contracts.

Not true at all times.

Nalco Chemicals – MNC – makes and distributes specialty water treatment chemicals (WTC) to a large
number of cooling tower users. These are application specific specialized (fabricated) WTC products.

PRODUCT – specialty water treatment chemicals (WTC)

SELLER – Nalco Chemicals (India) MNC.

BUYER – Cooling tower users (all over India). They need application-specific specialized (fabricated)
WTC products.

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 These WTCs ensure water purity at the inlet point and also cool the outgoing purified water for
continuous recycling.

The greater the purity and cooling efficiency of the cooling water used in cooling towers, the greater will
be its effect on, say, the quality and quantity of steel production in DSP’s steel melting shop (SMS).

DSP is highly traditional and conservative government organization.

- Usually awarded L1 – lowest bidder contracts

- After trials and tests, Nalco’s management and Betz India Pvt Ltd (another MNC) proved to
DSP’s management that use of superior quality WTC ensured much better quality and quantity
of steel production in their steel melting shops (SMS), as compared to the use of much lower-
quality WTC made and supplied by other vendors (mostly local) whose investment in applied
R&D à negligible or non-existent.
- Free experimentations jointly organized by Nalco and DSP’s technical personnel at steel plant at
Durgapur, DSP officials agreed to officially award a large part of WTC’s yearly rqmt to both Nalco
and Betz – primarily for critical cooling applications.
- Over a 3 year period, a part of contractual offer was awarded at a 30% higher price, as
compared to that awarded to local WTC supplier whose chemicals were of inferior quality.
- Hence, for this fabricated industrial product, better product quality, backed by superior service,
ensured a price level higher than L1.

3) Hiring / Leasing

Fabricated industrial products and capital equipment (like cyrotanks) can also be hired or leased out for
a long period.

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