Step 5: Selecting a Pricing Method
Firms use various methods to set their prices. We will examine a few of them here.
The most elementary method is to add a standard markup to the product’s cost. Reusing the example in Step 3 and suppose that the camera manufacturer expects to sell 100 units per day…
Average unit cost = $500
Now assume that the manufacturer wants to earn a 20 percent markup on sales. The markup price is:
Markup price = unit cost x 1.20 = $500 x 1.20 = $600
Because markup-pricing method does not take into account current demand, perceived value, and competition, it is unlikely to lead to the optimal price.
In target-return pricing, the firm determines the price that would yield its target return on investment (ROI).
Suppose the camera manufacturer has invested $20 million in the business and wants to earn a 20% ROI, i.e. $4 million, over a fixed period of time. The expected unit sales are 50,000 cameras during this period. The target-return price is given by the following formula:
= unit cost + (desired return x invested capital)/unit sales
= $500 + (0.2 x $20,000,000)/50,000
= $500 + $80
In going-rate pricing, the firm bases its price largely on competitors’ prices. It may charge the same, slightly more or slightly less than major competitor(s). The smaller firms follow the leader, changing their prices when the market leader’s prices change.
In oligopoly industries that sell a commodity such as steel or paper, firms normally charge the same price.
In perceived-value pricing, the firm must deliver the values promised by their value proposition, and the customer must perceive these values. They rely on other marketing-mix elements such as advertising and sales force to communicate and enhance perceived value in buyers’ minds.
Perceived value is made up of several elements, such as the buyers’ image of the product, the channel deliverables, the warranty coverage, customer support, supplier’s reputation and trustworthiness. Furthermore, each potential customer places different weights on these different elements, with the result that some will be price buyers, others will be value buyers, and still others will be loyal buyers. For price buyers, firms need to offer stripped-down products and reduced services. For value buyers, firms must keep innovating and aggressively reaffirming their values. For loyal buyers, firms must invest in relationship building and customer intimacy.
Reference: Kotler & Keller, “Marketing Management”, 12th edition