What you’ll learn to do: compare common pricing strategies
Thus far we have discussed many pricing considerations: the impact of pricing on value perceptions, the effects of elasticity, and approaches to common pricing objectives. In this section we are going to introduce some very specific, yet standard pricing strategies that organizations use to bring these concepts together. They do not replace the information that we have discussed to this point, but they are important to understand.
The specific things you’ll learn in this section include:
- Explain why a company would use skim pricing
- Explain why a company would use penetration pricing
- Explain why a company would use cost-oriented pricing
- Explain how price discounting is used and why it can be effective
With a totally new product, competition either doesn’t exist or is minimal, and there’s no market data about customer demand. How should the price be set in such a case? There are two common pricing strategies that organizations use for new products: skim pricing and penetration pricing.
The Economics of Price and Demand
In order to understand these pricing strategies, let’s review the demand curve. In a typical economic analysis of pricing, the demand curve shows the quantity demanded at every price. In our graph below, the demand increases by 100 units each time the price drops by $1. Based on this demand, if a company priced its product at $4, consumers would buy 200 units. If the company wanted to raise its prices, it could charge $5, but then consumers would buy only 100 units. This is an oversimplified example, but it shows an important relationship between price and demand.
The key thing to understand about this model is that when all else is equal, demand decreases as price increases. Fortunately, the marketer does not have to regard everything else as fixed. She can make adjustments to product, promotion, or distribution to increase the value to the customer in order to increase demand without lowering price. Still, once the other elements of the marketing mix are fixed, it’s generally true that a higher price will result in less demand for a product, and a lower price will result in more demand for a product.
What Is Skim Pricing?
Price skimming involves the top part of the demand curve. A firm charges the highest initial price that customers will pay. As the demand of the first customers is satisfied, the firm lowers the price to attract another, more price-sensitive segment.
Using our example of the demand curve, the price might be set at $5 per unit at first, generating a demand of only 100 units.
The skimming strategy gets its name from skimming successive layers of “cream”—or customer segments—as prices are lowered over time.
Why Might Skim Pricing Make Sense?
There are a number of reasons why an organization might consider a skimming strategy. Sometimes a company simply can’t deliver enough of a new product to meet demand. By setting the price high, the company is able to maximize the total revenue that it can generate from the quantity of product that it can make available.
Price skimming can also be part of a customer segmentation strategy. Take a look at the graph, above. You’ll remember from our discussion of the product life cycle and customer adoption patterns that the Innovators—the adventurous customers on the left who are game to try new products—are less price sensitive and place a premium on being first to own a new product. A skim-pricing strategy targets these customers and sets a higher price for them. As the product starts to move through the Early Adopters stage, the marketer will often reduce the price to begin drawing Early Majority buyers.
A skimming strategy is most appropriate for a premium product. Today we can see many examples of skim pricing in the electronics industry when new product innovations are introduced. Electronics companies know that many buyers will wait to purchase new technologies, so they use skim pricing to get the highest possible price from the Innovators and Early Adopters.
What Is Penetration Pricing?
Penetration pricing is a pricing strategy in which the price of a product is initially set low to rapidly reach a wide fraction of the market and initiate word of mouth. The strategy works on the assumption that customers will switch to the new product because of the lower price. Penetration pricing is most commonly associated with marketing objectives of enlarging market share and exploiting economies of scale or experience.
Returning to our economic model, below, you can see that penetration pricing focuses at the bottom of the demand curve. If the initial price is set low, at $2, for instance, the quantity demanded will be high: 400 units.
Penetration pricing offers a lower price in order to draw in a higher demand from consumers.
Why Might Penetration Pricing Make Sense?
Like skim pricing, penetration pricing shows an awareness of the dynamics in the product life cycle. The advantages of penetration pricing to the firm are the following:
- It can result in fast diffusion and adoption across the product life cycle. The strategy can achieve high market penetration rates quickly, taking competitors by surprise and not giving them time to react.
- It can create goodwill among the Innovators and Early Adopters, which can generate more demand via word of mouth.
- It establishes cost-control and cost-reduction pressures from the start, leading to greater efficiency.
- It discourages the entry of competitors.
- It can generate high stock turnover throughout the distribution channel, which creates important enthusiasm and support in the channel.
The main disadvantage of penetration pricing is that it establishes long-term price expectations for the product and image preconceptions for the brand and company. Both can make it difficult to raise prices later. Another potential disadvantage is that the low profit margins may not be sustainable long enough for the strategy to be effective.
Cost-plus pricing, sometimes called gross margin pricing, is perhaps the most widely used pricing method. The manager selects as a goal a particular gross margin that will produce a desirable profit level. Gross margin is the difference between how much the goods cost and the actual price for which it sells. This gross margin is designated by a percent of net sales. The percent chosen varies among types of merchandise. That means that one product may have a goal of 48 percent gross margin while another has a target of 33.5 percent or 2 percent.
A primary reason that the cost-plus method is attractive to marketers is that they don’t have to forecast general business conditions or customer demand. If sales volume projections are reasonably accurate, profits will be on target. Consumers may also view this method as fair, since the price they pay is related to the cost of producing the item. Likewise, the marketer is sure that costs are covered.
A major disadvantage of cost-plus pricing is its inherent inflexibility. For example, department stores often find it hard to meet (and beat) competition from discount stores, catalog retailers, and furniture warehouses because of their commitment to cost-plus pricing. Another disadvantage is that it doesn’t take into account consumers’ perceptions of a product’s value. Finally, a company’s costs may fluctuate, and constant price changing is not a viable strategy.
When middlemen use the term markup, they are referring to the difference between the average cost and price of all merchandise in stock, for a particular department, or for an individual item. The difference may be expressed in dollars or as a percentage. For example, a man’s tie costs $14.50 and is sold for $25.23. The dollar markup is $10.73. The markup may be designated as a percent of the selling price or as a percent of the cost of the merchandise. In this example, the markup is 74 percent of cost ($10.73 / $14.50) or 42.5 percent of the retail price ($10.73 / $25.23).
There are several reasons why expressing markup as a percentage of selling price is preferred to expressing it as a percentage of cost. One is that many other ratios are expressed as a percentage of sales. For instance, selling expenses are expressed as a percentage of sales. If selling costs are 8 percent, it means that for each $100,000 in net sales, the cost of selling the merchandise is $8,000. Advertising expenses, operating expenses, and other types of expenses are quoted in the same way. Thus, when making comparisons, there is a consistency in expressing all expenses and costs, including markup, as a percentage of sales (selling price).
As an illustration of the cost-based process of pricing, let’s look at Johnnie Walker Black Label Scotch Whisky. This product sells for about $30 in most liquor stores. How was this price derived? The per-bottle costs are shown below:
$5.00 production, distillation, maturation
+ $2.50 advertising
+ $3.11 distribution
+ $4.39 taxes
+ $7.50 markup (retailer)
+ $7.50 net margin (manufacturer)
Each of the cost elements, including the retailer’s markup, is added to the initial production costs, and the total is the final price.
Cost-Oriented Pricing of New Products
Certainly costs are an important component of pricing. No firm can make a profit until it covers its costs. However, the process of determining costs and setting a price based on costs does not take into account what the customer is willing to pay at the marketplace. This strategy is a bit of a trap for companies that develop products and continually add features to them, thus adding cost. Their cost-based approach leads them to add a percentage to the cost, which they pass on to customers in the form of a new, higher price. Then they are disappointed when their customers do not see sufficient value in the cost-based price.
In addition to deciding about the base price of products and services, marketing managers must also set policies regarding the use of discounts and allowances. There are many different types of price reductions–each designed to accomplish a specific purpose. The major types are described below.
Quantity discounts are reductions in base price given as the result of a buyer purchasing some predetermined quantity of merchandise. A noncumulative quantity discount applies to each purchase and is intended to encourage buyers to make larger purchases. This means that the buyer holds the excess merchandise until it is used, possibly cutting the inventory cost of the seller and preventing the buyer from switching to a competitor at least until the stock is used. A cumulative quantity discount applies to the total bought over a period of time. The buyer adds to the potential discount with each additional purchase. Such a policy helps to build repeat purchases.
Both Home Depot and Lowe’s offer a contractor discount to customers who buy more than $5,000 worth of goods. Home Depot has a tiered discount for painters, who can save as much as 20 percent off of retail once they spend $7,500.
Seasonal discounts are price reductions given for out-of-season merchandise—snowmobiles discounted during the summer, for example. The intention of such discounts is to spread demand over the year, which can allow fuller use of production facilities and improved cash flow during the year.
Seasonal discounts are not always straightforward. It seems logical that gas grills are discounted in September when the summer grilling season is over, and hot tubs are discounted in January when the weather is bad and consumers spend less freely. However, the biggest discounts on large-screen televisions are offered during the weeks before the Super Bowl when demand is greatest. This strategy aims to drive impulse purchases of the large-ticket item, rather than spurring sales during the off-season.
Cash discounts are reductions on base price given to customers for paying cash or within some short time period. For example, a 2 percent discount on bills paid within 10 days is a cash discount. The purpose is generally to accelerate the cash flow of the organization and to reduce transaction costs.
Generally cash discounts are offered in a business-to-business transaction where the buyer is negotiating a range of pricing terms, including payment terms. You can imagine that if you offered to pay cash immediately instead of using a credit card at a department store, you wouldn’t receive a discount.
Trade discounts are price reductions given to middlemen (e.g., wholesalers, industrial distributors, retailers) to encourage them to stock and give preferred treatment to an organization’s products. For example, a consumer goods company might give a retailer a 20 percent discount to place a larger order for soap. Such a discount might also be used to gain shelf space or a preferred position in the store.
Calico Corners offers a 15 percent discount on fabrics to interior designers who are creating designs or products for their customers. They have paired this with a quantity-discounts program that offers gift certificates for buyers who purchase more than $10,000 in a year.
Personal allowances are similar strategies aimed at middlemen. Their purpose is to encourage middlemen to aggressively promote the organization’s products. For example, a furniture manufacturer may offer to pay some specified amount toward a retailer’s advertising expenses if the retailer agrees to include the manufacturer’s brand name in the ads.
Some manufacturers or wholesalers also give retailers prize money called “spiffs,” which can be passed on to the retailer’s sales clerks as a reward for aggressively selling certain items. This is especially common in the electronics and clothing industries, where spiffs are used primarily with new products, slow movers, or high-margin items.
When employees in electronics stores recommend a specific brand or product to a buyer they may receive compensation from the manufacturer on top of their wages and commissions from the store.
Trade-in allowances also reduce the base price of a product or service. These are often used to help the seller negotiate the best price with a buyer. The trade-in may, of course, be of value if it can be resold. Accepting trade-ins is necessary in marketing many types of products. A construction company with a used grader worth $70,000 probably wouldn’t buy a new model from an equipment company that did not accept trade-ins, particularly when other companies do accept them.
Price bundling is a very popular pricing strategy. The marketer groups similar or complementary products and charges a total price that is lower than if they were sold separately. Comcast and Direct TV both follow this strategy by combining different products and services for a set price. Similarly, Microsoft bundles Microsoft Word, Excel, Powerpoint, OneNote, and Outlook in the Microsoft Office Suite. The underlying assumption of this pricing strategy is that the increased sales generated will more than compensate for a lower profit margin. It may also be a way of selling a less popular product—like Microsoft OneNote—by combining it with popular ones. Industries such as financial services, telecommunications, and software companies make very effective use of this strategy.
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