Pricing methods 1 2003

COST PLUS PRICING
It is also known as “Mark –up pricing” “Average cost
Pricing “ or “Full cost pricing.” The general practice
under this method is to add up a fair percentage of
profit margin to AVC. The formula is:
P= AC + m
Hence a firm will consider total cost per unit or
average cost and determine a mark up, depending
upon various considerations such as target rate of
return, degree of competition, price elasticity and
availability of substitutes.

Example: Technologies Pvt. Has invested Rs. 10 crore in
plant and machinery, with a capacity to produce 10,000
units of television per month. TVC is estimated at Rs. 5
crore and the firm expects a return of 20% on total
investment. What should be the price of TV if we suppose
that the firm can sell its entire output?
Solution:
Base Price = TC = 10+5 = Rs. 15 crore
Margin = 20% of 15 = 3 crore
Total Revenue = 15+3 = 18 crore
Price = 18,00,00,000/10,000 = Rs. 18,000 per TV

The method of mark up pricing is very simple and
convenient.
But there is one major limitation of this method, it is
not suitable when competition is tough or when a
new or existing firm is trying to enter a new market.

MARGINAL COST PRICING
When demand is slack and market is highly
competitive, full cost pricing may not be the right
choice; an alternative in such a situation is to fix the
price on the basis of variable cost, instead of full cost.
The method remains same except that only variable
cost is considered instead of total cost for the purpose
of price determination. Marginal cost pricing is also
known as incremental cost pricing.

Determine the price of television on the basis of
marginal pricing:
Solution:
Base price = VC = Rs. 5 crore.
i) Margin = 20% (of TC) 15 = 3 crore;
Total Revenue = 5 + 3 = Rs. 8 crore
Price = 8,00,00,000/10,000 = Rs. 8,000 per TV
ii) Margin = 20% of VC = 1 crore;
Total Revenue = 5+1 = Rs. 6 crore
Price = 6,00,00,000/10,000 = Rs. 6,000 per TV

Thus we can see that the highest price by using
marginal cost pricing method would be Rs. 8ooo
when margin is calculated on total investment, this is
less than half of the price charged under full costing.
If the company charges a margin on variable cost, the
price would be further lower, namely Rs. 6000.
This method is very useful to beat competitors, it is
also used by firms to enter a new market. It is very
useful in case of goods of public utility where
profitability is not the objective.

Penetration Pricing
When a firm plans to enter a new market which is
dominated by existing players, its only option is to charge
a low price, even lower than the ongoing price. This price
is called penetration price.
Reliance brought a kind of revolution in Indian mobile
phone industry by using this strategy in a market which
was dominated by BSNL.
Air Deccan, Nirma.
The principle of marginal costing may be used for this
purpose. However this method is also short term in
perspective and its success largely depends upon the price
elasticity of demand of the product.

ENTRY DETERRING PRICING
Creation of monopoly depends upon entry barriers.
One such barrier may be created by a large player to
eliminate or reduce competition, by keeping the price
low, thus making the market unattractive for other
players. If the prevailing price is already very low, new
entrants with high fixed cost will not be able to enter
the market at a price lower than the prevailing price.
On the other hand, existing small players may not be
able to survive at this price due to higher average
cost. Thus this practice is also known as Limit pricing.

Preventing entry of new players is just opposite to
penetrating a new market, though quite interestingly,
pricing strategy is the same in both, that is charging a
low price.
Success of entry deterring pricing strategy depends
on the fact that the firm earns economies of scale and
hence can afford to charge low price.

GOING RATE PRICING
Have you wondered why all the brands of packaged drinking
water are priced the same? Or packs of fruit juice? Or soft
drinks or milk packets? The answer is simple, all the players are
using going rate pricing strategy. This strategy is adopted when
most of the players do not indulge in separate pricing but prefer
to follow the prevailing market price. Normally the price is fixed
by the dominant firm and other firms accept its leadership and
follow that price. The success of this strategy is dependent on
the fact that most of the firms do not want to enter into a price
war kind of situation. Secondly small or new firms may not be
sure of shift in demand by charging a price different from the
prevailing market price. Thirdly the products sold by the players
are very close substitutes, hence their cross elasticity is very
high

Product life cycle based pricing
Every product passes through many stages starting
from introduction, going through growth and
maturity and leading to saturation and ultimately
reaches decline. Each phase is unique in itself, with
varied features. Moreover a product faces different
demand patterns and consumption levels under
different stages; hence there is a need for revising its
price as it passes through different stages. Charging a
uniform price for a product across all theses stages
would amount to less than optimum revenue for the
firm.

Instead an intelligent firm would devise different
pricing for a product at different stages of its lifecycle.
Ex: First cellular phone with camera and radio, or the
first TV with flat screen.
The most popular strategies under this category are
price skimming, product bundling and perceived
value pricing.

A) Price Skimming: Producers know that there is a
segment of consumers who have deep pockets and
who would like to be among the first few proud
possessors of the latest product. These consumers are
mostly governed by the status symbol factor and not
by the intrinsic value of the product. Hence producers
charge a very high price in the beginning to skim the
market and earn super margins on sales. In the
introduction stage the mark up on cost is normally
very high.

Once the product is established and approaches
maturity, sellers reduce their profit margin and
charge lower price for the same product to attract
large number of consumers who have lower paying
capacity or in other words who have high price
elasticity for the product.
Price skimming strategy deals with a complete
pricing package suitable for different life cycle stages
of a product, i.e., high price at the time of
introduction and lower price during maturity. Nokia
has been successfully using this strategy for its
products.

B) Price Bundling (or Packaging): In this method
two or more products are bundled together for a
single price. This strategy is often used as a double
edged weapon, for propagating a new product, as well
as for selling a product in its stage of decline.
When a product is new and needs to be popularised,
sellers adopt packaging of various products together
and charge one price for the same.
Ex: Hotels provide free breakfast or drinks as part of
room tariff.

C) Perceived value pricing: The underlying
philosophy of this pricing is that a product is as good
as a consumer finds it. Value of goods for different
consumers depends upon their perception of utility of
the good. Therefore the price a consumer is willing to
pay would reflect the value of that product to him. A
segment of buyers believe that higher the price, better
the quality; hence they would be willing to buy
anything that is tagged at high price. It is also termed
as Psychological Pricing.

Perceived value pricing is normally adopted during
the growth and maturity stage so as to differentiate
the product from that of competitors’ and retain the
quality conscious customers. Titan watches, Philips
products, Tanishq jewellery and Parker pens are some
of the brands which have consistently resorted to
perceived value pricing by creating hype about high
quality. Here the price of the product is not at all
governed by the cost of production.

Value Pricing
Value Pricing: A variant of perceived value pricing is
value pricing, in which sellers try to create a high value of
the product to keep the price low. The assumption is that
price should represent value for money to consumers, in
other words price charged should be lower than perceived
value of product for the consumers. Thus in this method
of pricing the seller allows some consumer surplus to the
buyer.
This is a strategy suitable for the maturity and saturation
stage when demand can be maintained by keeping focus
on higher quality and lower cost. Ex: Koutons

Loss Leader Pricing
An interesting strategy adopted by companies which
produce or sell multiple products is to sell one product at
a low price and compensate the loss by other products of
the same firm. However the success of this strategy largely
depends upon a combination of goods which are
complementary in nature and one product cannot be
utilised without the other product.
Ex: printer and cartridge
In this case the firms charge low price for the good which
is durable and has high value and high price for the
product which is consumable and has low value and hence
has recurring demand.

Multi Product Pricing
In order to understand the complexity of pricing of multi
product company it is desirable that you understand the
possible relationships among the products of the same
company. The interdependence between the products can
be of three types viz. demand interdependence; supply
interdependence; and input output relationship.
In case of substitutes: The seller has to options-i) charge
the same price for the two goods, as Coca Cola has
adopted for Coke and Thums Up brands, or ii)
differentiate the products from each other and take
advantage of perceived value pricing as in case of Surf
Excel (premium segment) and Surf (economy segment) by
HLL.

In case of complements an increase in demand for
one product increases demand for the other as well;
therefore optimal output is greater than when there
was no demand interdependence. Here an increase in
price of one good would result in fall in demand of
both the goods. Therefore a suitable strategy would
be either product bundling or loss leader.

Supply Interdependence: The case of production
interdependence is when the same equipments and
technology are used to produce multiple products, there is
no increase in fixed cost and the firm makes use of
economies of scope. Ex: cars like Maruti 800, Alto, Zen,
WagonR etc. from Maruti are produced with the same
plant and machinery; overheads are distributed and the
same distribution network is utilised. In such a case the
company adopts a combination of various pricing
strategies by categorising its own products under different
segments on the basis of the stage of product life cycle,
consumers’ perceived value, distribution of costs and so
on.
One of the strategies for such companies is RAMSAY
PRICING

Input-output Relationship: There may be the case when a
company undertakes all the stages of production involved
in bringing out the final product. For example, Tata Sons
produce iron and steel; it also manufactures cars, trucks
and other vehicles. Steel is produced in a separate plant
managed as an autonomous division (TISCO) and vehicles
are manufactured in another similar autonomous division
(Tata Motors). The product of TISCO is used as an
intermediary product in TELCO (and is sold to other users
as well). Thus products(steel and automobiles) of these
units bear input output relationship; pricing in this case is
called TRANSFER PRICING

RAMSAY PRICING: Economist Frank Ramsay gave a
model for taxation which became very useful for
pricing decisions of a multi product firm. He
suggested that the govt. should levy high tax on the
goods which had low price elasticity and low tax on
goods which had high price elasticity.

TRANSFER PRICING: Transfer prices are the charges
made when a company supplies goods, services or
financials to another company to which it is related as
its subsidiary or sister concern. When a multi product
firm is engaged in production of such goods where
one product is an intermediary for the other, i.e., it is
vertically integrated. The firm now encounters the
problem of fixing the price of a product demanded for
internal use. Since use of these goods is part of total
cost of final product but involves no cash outflow
rather is only a transfer of accounts from one
subsidiary to another, this is called transfer pricing.

Peak Load Pricing: This is a kind of price
discrimination in which consumers are segregated on
the basis of time segments; different prices are
charged for the same facility used at different points
of time by the same consumers. The time zone is
divided into peak load and off peak load, consumers
using the product at peak load time pay a higher price
and users at off peak period pay a lower price. Ex:
BSNL, Airlines provide various discounts on tickets
purchased at different points of time.

RETAIL PRICING: Some of the popular techniques
followed are discussed here:
Every Day Low Pricing (EDLP) Strategy: As per EDLP,
a low price is charged throughout the year and none
or very few special discounts are given on special
occasions. This method can be successful only when
retailer is very large in size to avail economies of scale
and has very low overhead expenses. In India, Big
Bazaar has tried the same strategy.

High-low Pricing – This method involves high prices
on regular basis, coupled with temporary discounts
on promotional activity. How is this different from
EDLP? On all days the price is higher than EDLP, but
on discount days it is lower than

Pricing methods 1 2003

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