PRICING STRATEGY

CHAPTER 2
The Starting Point in Setting an
Initial Price
 OBJECTIVE:

In this chapter, we will first discuss how

an item’s costs and competitors’ prices
can serve as starting points for
determining an item’s initial price.

Then we will discuss an alternative place

to begin—the value of the benefits that
the item creates by satisfying the needs
of the customer.
COST-BASED PRICING
When the setting of an item’s initial price begins
with a consideration of the item’s costs, the
process is known as cost-based pricing. The logic
of cost-based pricing is very simple. An item’s
selling price should be greater than what it costs
to produce or acquire that item. Thus, the price
can be calculated by adding an amount of money
to the item’s costs. There are many ways in
which this could be done.
Perhaps the simplest form of cost-based pricing
is the procedure referred to ascost-plus pricing.
This pricing method involves determining the
amount to be added to an item’s cost and then
adding that amount to arrive at the item’s price.
If C is an item’s cost, then its price (P) is
calculated as follows:

P = C + added amount
Markup Pricing
Some organizations sell such a large number of
different products that it becomes difficult to
determine the added amount separately for each
product. In particular, organizations that buy goods
and resell them, such as wholesalers and retailers, may
carry tens of thousands of separate items and are
constantly dropping items and adding new ones.
The standard percentage used in markup
pricing is called the markup. It is the amount
added to an item’s cost (C) expressed as a
percentage of that cost. A markup (M will be
used in to represent markup in the equations)
could be calculated as follows:

M = (added amount/C) × 100

To determine a price based on a markup, the
markup must first be converted into a proportion
(by dividing it by 100) and then multiplied by the
cost. The result of this multiplication is then added
to the cost. This method of calculating a price is
expressed symbolically as follows:

P = C + [(M/100) × C]
Gross-Margin Pricing
A gross margin is the amount of a company’s sales
revenue that remains after subtracting the “cost of
goods sold,” a standard accounting measure of the costs
of manufacturing or acquiring the items that are sold.
The percent gross margin is the gross margin as a
percentage of the sales revenue. An example of the use
of gross margins for pricing was described by
researchers who interviewed executives of a company
that built automated workstations for businesses.
In contrast to a markup, which is the amount added to
an item’s cost as a percentage of that cost, a percent
gross margin is the amount added to an item’s cost
expressed as a percentage of the item’s price. In
symbols, a percent gross margin (%GM) could be written
as follows:

%GM = (added amount/P) × 100

Thus, to convert a percent gross margin to a markup, we
must do something to increase the %GM side of the
equation that relates the two. The formula that
accomplishes this is as follows:

M = %GM × [100 / (100 − %GM)]

The second method of using a gross margin for price
setting is to compute the product’s price directly from the
gross margin percentage. The formula for doing this is as
follows:

P = C / [1 − (%GM/100)]
Determinants of Gross
Margin Goals
For many companies, gross margin
goals, like markups, are based on
tradition and rules of thumb. However,
it is also possible to look to industry
norms for this type of guidance.
Advantages of Cost-Based
Pricing
One advantage of cost-based pricing is its simplicity.
The idea of starting with costs is intuitive, and cost-
based prices are relatively easy to calculate. Such
simplicity is particularly important in situations where
there are large numbers of prices to determine on a
continuing basis. This is often the case among product
resellers, which at least partly explains why cost-based
pricing is particularly widespread in wholesaling and
retailing.
A second advantage of cost-based pricing stems from
the common practice of using standard markup or
margin levels in an industry or for a particular type of
product. Because per-item costs are often similar
among competitors, applying a standard markup or
margin reduces the need to carry out research on
competitors’ prices. Use of such cost-based standards
could serve as an economical means of keeping one’s
prices from being substantially out of line with those
of competitors.
Disadvantages of Cost-
Based Pricing
A major disadvantage of cost-based pricing is
perhaps related to what is often considered an
advantage. There is frequently the presumption
that by looking first at costs and then setting
the price sufficiently above those costs that
one can insure a good profit on what one sells.
Although this might be so for each item sold, it
is not so for the far more important measure of
total profits.
This disadvantage of cost-based pricing, then, is
that it turns out to not be particularly useful in
efforts to maximize total profits. For example, a
markup set to yield a good profit on each item
might result in a price so high that few items are
sold. The total profits made from that item might
then be quite disappointing. Alternatively, a
markup set to yield a good profit on each item
could result in a price that is substantially lower
than customers would be willing to pay. The result
of this could be a level of total profits far lower
than could otherwise have been made.
COMPETITION-BASED
PRICING
Estimating the Value to
the Customer
The first step is to identify what the customer perceives
as the next closest substitute for your product. In other
words, if the customer were not to buy your product,
what competing product would the customer be likely to
buy? The price of this alternative product could be
referred to as the reference value of your product.

The second step is to identify all of the differentiating

factors, the factors that differentiate your product from
this next closest substitute.
The third step in VTC estimation is to determine what is, for the
customer, the monetary value of each of these differentiating
factors. If your product is superior to the next closest substitute on
a factor, then this differentiating factor’s monetary value is a
positive differentiation value. If your product is inferior to the next
closest substitute on a factor, then this differentiating factor’s
monetary value is a negative differentiation value.

The fourth step in this process is to sum the reference value and the
differentiation values. Each positive differentiation value would be
added to the reference value. Each negative differentiation value
would be subtracted from the reference value. The resulting total,
your product’s VTC, is a monetary representation of the value
created by the product for that customer. It is the maximum
amount that the customer, when fully informed of the product’s
benefits, would be willing to pay for the product.
THE POTENTIAL OFCUSTOMER-
BASED PRICING
This discussion of how a product’s VTC can be
estimated and how such an estimate can be
used as a means of capturing a larger amount of
a product’s value illustrates an important
benefit of customer-based pricing. However,
this is certainly not only way that customer-
based pricing can be used. Starting the pricing
process with a consideration of customer needs
has a much wider range of potential benefits.
REFERENCES:

Pricing Strategy by Schindler, Chapter 2