In Management Lite & Ezy 27, I mentioned that pricing strategies involve 6 steps. Step 1 is selecting the pricing objective. Step 2 is determining demand.
Step 3: Estimating Costs
- Fixed costs – costs that do not vary with production or sales revenue; also known as overhead.
- Variable costs – costs that vary directly with the level of production
- Total costs – sum of the fixed and variable costs
- Average cost – cost per unit at certain level of production; it is equal to total costs divided by production
Economies of scale is an important concept in lowering the total costs.
Assuming that a camera factory has an optimum capacity for producing 100 units per day. Fixed costs are $10,000. Variable costs are $400 per units.
If the factory is running on its optimum capacity…
= fixed costs + variable costs
= $10,000 + $400 x 100
= $10,000 + $40,000
If the factory only produces 50 cameras per day…
= $10,000 + $400 x 50
= $10,000 + $20,000
= $ 30,000
As we can see, average cost drops when the production level goes up. However, average cost increases after the optimum level of 100 units, because the plant becomes inefficient: workers have to line up for machines, machines break down more often, and workers get in each others’ way.
Step 4: Analyzing Competitors’ Costs, Prices, and Offers
Within the range of possible prices determined by market demand and company costs, a firm must take competitors’ costs, prices, and possible price reactions into account. If the firm’s offer contains features not offered by the nearest competitor, their worth to the customers should be evaluated and added to the competitor’s price. If the competitor’s offer contains some features not offered by the firm, their worth to the customers should be evaluated and subtracted from the firm’s price. Now the firm can decide whether it can charge more, the same, of less than the competitor. Do note that competitors can change their prices in reaction to the price set by the firm.
Reference: Kotler & Keller, “Marketing Management”, 12th edition