Setting Price

Price-setting: Art or Science?
By Paul A. Herbig

.

Price. Our old nemesis. How do you set a price? Is it art or science? Pricing must first be derived from the previously determined pricing objective before you can seriously discuss setting a price. If you are intent on rapid market share, you can use a penetration pricing, or price considerably underneath your competitors so as to preempt their efforts. If you are intent on quality or prestige, you price high to create the correct image. If you wish to maximize profitability, if the conditions were right, you could use price skimming. The final price strategy is totally dependent upon the marketing objective specified. I repeat, until you know what you wish to accomplish, do not attempt to set a price.
Pricing can also be demand based, cost based, or competitively based. Demand based is backwards pricing, examining what the customer is willing to pay, setting the price accordingly and working backwards to ensure the cost is such you will have sufficient profits. Examples of demand-based pricing is penetration pricing and price skimming. Penetration pricing is initially pricing a product extremely low to quickly gain market share. Price skimming is pricing high and cherry picking customers who desire your good and lowering your price periodically to ensure demand. This is only applicable when the market perceives significant advantages to your product and you have a sustainable competitive advantage (this could be patent protection or a special process or a lock on the distribution channel but you need to have a clear edge the competition cannot duplicate near-term.). Cost-based is determining cost first then adding a markup or margin. Competitive pricing is using your competition as a benchmark then meeting, being higher or lower than the competition.

Another consideration with pricing theory is the stage of the life cycle. During the introductory stage, management usually sets prices high in the hopes of quickly recovering its development costs. Usually the innate demand is high resulting in inelastic prices and the initial customers (who are usually the early adopters) are willing to pay for the product to be the first. Since few competitors exist for the device, such prices can be established and will be paid.
Allow me to provide several examples from my own experience in business to business marketing. The cost of the good from a manufacturing viewpoint (generally the cost of parts and the labor required to directly assemble them) was the starting point for calculating a price (say $100). The company had a Overhead factor of 50%. This means the MLO (or fully burdened cost) would have been $150. Our multiplier was 5 times the cost to the suggested list price ($500) or three times the MLO ($450). However, we dealt only exclusively with industrial distributors whom we routinely gave steep discounts (averaging 40%). Therefore, our Average Selling Price (ASP), or the actual revenue received was only 60% of the suggested list price (or $300). This would create the margin ($150) from which all other marketing costs, administrative costs, and profit must be derived. Was the 20% product cost to final product price excessive? We had plenty of customers and price was rarely an issue. We reported healthy profits (but not at Microsoft levels). Was our story unique. No, not at all.