Internal Factors Affecting Pricing Decisions

Internal factors affecting pricing include the company's marketing objectives, marketing-mix strategy, costs and organization.

• Marketing Objectives

Before setting price, the company must decide on its strategy for the product, If the company has selected its target market and positioning carefully, then its marketing-mix strategy, including price, will be fairly straightforward. For example, if Toyota decides to produce its Lexus cars to compete with European luxury cars in the high-income segment, this suggests charging a high price. Travel Lodge positions itself as motels that provide economical rooms for budget-minded travellers; this position requires charging a low price. Thus pricing strategy is largely determined by past decisions on market positioning.

At the same time, the company may seek additional objectives. The clearer a firm is about its objectives, the easier it is to set price. Examples of common objectives are survived, current profit maximization, market-share maximization and product-quality leadership.

Companies set survival as their fundamental objective if they are troubled by too much capacity, heavy competition or changing consumer wants. In Europe and Japan steel-makers sell steel at a loss as demand declines. To keep a plant going, a company may set a low price, hoping to increase demand. In this case, profits are less important than survival. As long as their prices cover variable costs and some fixed costs, they can stay in business. However, survival is only a short-term objective. In the long run, the firm must learn how to add value or face extinction,4

Many companies use current profit maximization as their pricing goal. They estimate what demand and costs will be at different prices and choose the price that will produce the maximum current profit, cash flow or return on investment. In all cases, the company wants current financial results rather than long-run performance. Other companies want to obtain market-share leadership. They believe that the company with the largest market share will enjoy the lowest costs and highest long-run profit. To become the market-share loader, these firms set prices as low as possible.

A variation of this objective is to pursue a specific market-share gain. Say the company wants to increase its market share from 10 per cent to 15 per cent in one year. It will search for the price and marketing programme that will achieve this goal.

Digital television transmission is set to make the current analogue television as outdated as 16mm cine film or vinyl albums. Tt produces cinema quality pictures while cramming hundreds of channels through the wave bands needed for a do?,en analogue transmissions. Seeing the mould-breaking" potential of digital TV satellite television company, BSkyB and terrestrial BOB are set to battle for market leadership of digital television transmission. BSkyB's consortium of BT, IISBC and Matsushita aims to subsidize its TV set-top converters by ecul billion, retailing them at ecu.100, although they will cost at least twice that to manufacture.

A company might decide that it wants to achieve product-quality leadership. This normally calls for charging a high price to cover such quality and the high costofR&D:

For example, Jaguar's limited edition XJ220 sold for £400,000 each, but had wealthy customers queuing" to buy one. Less exotically, Pitney Bowes pursues a product-quality leadership strategy for its fax equipment. While Sharp, Canon and other competitors fight over the low-price fax machine market with machines selling at around $500, Pitney Bowes targets large corporations with machines selling at about 85,000. As a result, it captures some 45 per cent of the large-corporation fax niche.5

A company might also use price to attain other more specific objectives. It can set prices low to prevent competition from entering the market or set prices at competitors' levels to stabilize the market:

In 1994 grocery market leaders Sainsbury and Teseo used 'Essentials' and 'Everyday super value range' campaigns to counter the attack of discounters Aldi and Netto on the UK market. Originally projected to take 20 per cent of the grocery market by the year 2000, forecasters later predicted the discounters would take only 12 per cent.6

Prices can be set to keep the loyalty and support of resellers or to avoid government intervention. Prices can be reduced temporarily to create excitement fora product or to draw more customers into a retail store. One product may be priced to help the sales of other products in the company's line. Thus pricing may play an important role in helping to accomplish the company's objectives at many levels.

Non-profit and public organizations may adopt a number of other pricing objectives. A university aims fmpartial cost recovery, knowing that it must rely on private gifts and public grants to cover the remaining costs. A non-profit hospital may aim for full cast recovery in its pricing. A non-profit theatre company may price its productions to fill the maximum number of theatre seats. A social service agency may set a social price geared to the varying income situations of different clients.

target costing A technique to support pricing decision, which starts with deciding a target cost Jar « new product and works back to designing the product.

• Marketing-Mix Strategy

Price is only one of the marketing-mix tools that a company uses to achieve its marketing objectives. Price decisions must be co-ordinated with product design, distribution and promotion decisions to form a consistent and effective marketing programme. Decisions made for other marketing-mix variables may affect pricing decisions. For example, producers using many resellers that arc expected to support and promote their products may have to build larger reseller margins into their prices. The decision to position the product on high performance quality will mean that the seller must charge a higher price to cover higher costs. The perfume houses argue that their high margins, expensive advertising and exclusive distribution are essential to the brands and in the public interest.7

Companies often make their pricing decisions first and then base other marketing-mix decisions on the prices they want to charge. Here, price is a crucial product-positioning factor that defines the product's market, competition and design. The intended price determines what product features can be offered and what production costs can be incurred.

Many firms support such price-positioning strategies with a technique called target costing, a potent strategic weapon. Target costing reverses the usual process of first designing a new product, determining its cost and then asking'Can we sell it for that?' Instead, it starts with a target cost and works back:

Compaq Computer Corporation calls this process 'design to price'. After being battered' t'or vears by* lower-priced rivals, Comp an used this approach to create its highly successful, lower-pric edj Prohnea personal computer line. Starting with a price target set by marketing and with profit-margin goals from management, the Prolinea design ream determined what costs had to be in order to charge the target price. From this crucial calculation all else followed. To achieve target costs, the design team negotiated doggedly with all the company departments responsible for different aspects of the new product and with outside suppliers of needed parts and materials. Compaq engineers designed a machine with fewer and simpler parts, manufacturing overhauled its factories to reduce production costs and suppliers found ways to provide quality components at needed prices. By meeting its target costs, Compaq was able to set its target price and establish the desired price position. As a result, Prolinea sales and profits soared.s

Other companies de-emphasize price and use other marketing-mix tools to create non-price positions. Often, the best strategy is not to charge the lowest price, but rather to differentiate the marketing offer to make it worth a higher price (see Marketing Highlight 16.1).

For example, in the USA Johnson Controls, a producer of climate control systems for office buildings, used initial price as its primary competitive tool. However, research showed that customers were more concerned about the total cost of installing and maintaining a system than about its initial price. Repairing broken systems was expensive, time-consuming and risky. Customers had to shut down the heat or air conditioning in the whole building, disconnect a lot of wires and face the dangers of electrocution. Johnson decided to change its strategy. It designed an entirely new system called Metasys. To repair the new system, customers need only pull out an old plastic module and slip in a new one - no tools required. Metasys costs more to make than the old system and customers pay a higher initial price, but it costs less to install and maintain. Despite its higher asking price, the new Metasys system brought in 8500 million in revenues in its first year.9

Thus the marketer must consider the total marketing mix when setting prices. If the product is positioned on non-price factors, then decisions about quality, promotion and distribution will strongly affect price. Tf price is a crucial positioning factor, then price will strongly affect decisions made about the other marketing-mix elements. In most cases, the company will consider alS the marketing-mix decisions together when developing the marketing programme.

Costs set the floor for the price that the company can charge for its product. The company wants to charge a price that both covers all its costs for producing, distributing and selling the product, and delivers a fair rate of return for its effort and risk. A company's costs may be an important element in its pricing strategy. Many companies work to become the 'low-cost producers' in their industries. Companies with lower costs can set lower prices that result in greater sales and profits (see Marketing Highlight 16.1).

TYPES OF COST. A company's costs take two forms, fixed and variable. Fixed costs (also known as overhead) are costs that do not vary with production or sales level. For example, a company must pay each month's bills for rent, heat, interest and executive salaries, whatever the company's output.

Variable costs vary directly with the level of production. Each personal computer produced by Compaq involves a cost of computer chips, wires, plastic, packaging and other inputs. These costs tend to be the same for each unit produced. They arc called variable because their total varies with the number of units produced.

fixed costs

Costs that do not vary with production or sales level variable costs Costs that vary directly with the level of production.

A Pricing Fable

16.1

Marketing

Highlight

16.1

to-delivery cycle to only one and a half weeks, and had dropped prices to competitors' levels. Encouraged by tliis success, Woodbridge continued its quest to match competitors' processes, efficiency and prices. Soon, the angry phone calls from customers had stopped. Market share, which had fallen at the rate of about 1 per cent per month for six months, stabilized. Everyone celebrated.

An Unhappy Ending

End of the story? Well, not quite. Within a year, a frightening new marketplace pattern had emerged. Lead time was now the same for all competitors: about one week. After waves of product-line pruning by Woodbridge, the competitors' product lines looked alike and customers now ranked the three suppliers about equally on quality and customer service. The term corn-modify raised its ugly head. The three companies took turns initiating price cuts, and each met the others' prices as a matter of policy. Narrowing the Woodbridge product line had taken a heavy toll, 'All we've got to compete on now is price,' complained Woodbridgc's marketers. Industry-wide prices and margins declined steadily. Seven years later, all competitors were struggling to make even meagre profits.

A Happier Ending

Wait, let's rewind the tape and consider another ending, one based on the actual experiences of a US paper company that is now one of the world's most profitable. Here's what really happened. When it learned that its competitor was delivering products faster and at lower prices, Woodbridge invited the unhappy soup manufacturer and the local printer to a meeting to diseuss their concerns. They learned that the soup manufacturer faced problems in handling promotions. 'We never know how successful we'll be until the promotion hits the stores,' commented one soup executive. 'When the promotion is successful, we run out of stock, costing us big money in lost sales and profits. The problem is that the printer can't print packages fast enough to avoid stock-outs.'

'That's true,' the printer conceded, 'but we aren't the problem. We have old printing presses which we could use if we could get paper faster. But Woodbridge takes four weeks to deliver.' Woodbridge's manufacturing vice president offered a solution. 'You know,' he said, 'we have an old paper machine we don't use any more. It's not the fastest or cheapest machine. But it could help us in these situations.' The three managers quickly sketched out a system for handling stock-out emergencies.

The Woodbridge managers also learned that the manufacturer faced an increasingly competitive and fragmented market. 'The trick is to make our products stand out on the shelf,' noted the soup executive. 'In addition, we need to tailor our packages to the preferences of different markets. For example, consumers in Holland love red cans. In France, they prefer dark green, Dealing with this fragmentation is a nightmare.' Woodbridge's manufacturing vice president nodded. 'We have a similar problem.' he said. 'Our shiny vermilion, which must be for your Dutch market, is very hard to make. 80 is shamrock green. Actually, we're losing our shirt on those papers and arc thinking about dropping them.'

'If you do that,' the soup maker warned, 'you'll be like every other supplier. We might as well buy from whichever supplier charges the lowest price.' After a few moments of reflection, he added, 'But maybe we and the printer can agree on a higher price that makes these low-volume items more profitable for you.'

Within the next few months, Woodbridge redesigned its manufacturing system around the newly discovered customer needs. First, it set up the old paper machine for rush jobs. Next, it dedicated one of its smaller machines to making special, small-volume papers. Everyone involved agreed that Woodbridge would charge a premium price for these rush orders and special papers. Finally, Woodbridge devoted the rest of its machines to large-volume items, allowing it dramatically to reduce lead times and prices on these items.

Three years later, Mountain View announced that it was selling its coloured-pack aging-pa per business. Woodbridge had successfully stripped Mountain View of its only weapons - lower prices and shorter delivery times on high-volume products. At the same time, Woodbridge had bettered Mountain View by offering a fuller product line -now numbering 520 items - that closely matched the needs of soup manufacturers facing highly fragmented markets. Woodbridge succeeded not by matching Mountain View's prices and products, but by differentiating its offer to create greater value, even though many of its prices were higher. Woodbridge had beaten the competition by understanding its customers and they all lived happily ever after.

Lesson: if you do not know your customers, you will end. up giving them something tor nothing.

SOURCES: Based on portions of Francis J. Goulllart and Frederick D Sturdivant. 'Spend a day in the life of your customers', Harvard Business Reiiiew: (January—February 1994), pp. 116-35; see also Minda Zetlin, 'Kicking the discount liabit', Sales tend Marketing Management {May 1994), pp. 102-5.

Fart of the cost of a CD is an agreed amount paid to artists for each unit sold. When CDs were introduced, recording companies renegotiated a lower rate than for vinyl recordings to allow them to recoup their costs. George Michael mounted an nnsuccessful legal case against Sony Music, complaining that the rates were too low. The lingering resentment of many artists over this 'deal' is now becoming important as recording companies try to agree rates to apply to electronically distributed music where customers play music on demand or download albums on to their PC. With the possibility of no packaging, manufacturing, wholesaling or retailing costs, the artists' share of the asking price for this format could be high. The issue will have to be resolved by summer 199') when Deutsche Telekom is due to launch a music-on-demand service to 1 million German homes.10

Figure 16.2

Cost per unit at different levels of production total costs

The sum of the fixed and variable costs for any given level of production.

Total costs are the sum of the fixed and variable costs for any given level of production. Management wants to charge a price that will at least cover the total production costs at a given level of production. The company must watch its costs carefully. If it costs the company more than competitors to produce and sell its product, the company will have to charge a higher price or make less profit, putting it at a competitive disadvantage.

COSTS AT DIFFERENT LEVELS OF PRODUCTION. To price wisely, management needs to know how its costs vary with different levels of production. Glen Dimplex, the Irish domestic appliance company that owns Morphy Richards, Dimplex and Belling, has taken over Roberts, the United Kingdom's maker of high-quality radios. As part of its plan to add new and innovative products to the Roberts range, it could build a plant to produce 1,000 Roberts luxury travel clocks per day. Figure 16.2A shows the typical short-run average cost curve (SRAC). It shows that the cost per clock is high if Roberts' factory produces only a few per day. But as production moves up to 1,000 clocks per day, average cost falls. This is because fixed costs are spread over more units, with each one bearing a smaller fixed cost. Roberts can try to produce more than 1,000 clocks per clay, but average costs will increase because the plant becomes inefficient. Workers have to wait for machines, die machines break down more often and workers get in each other's way.

If Roberts believed it could sell 2,000 clocks a day, it should consider building a larger plant. The plant would use more efficient machinery and work arrangements. Also, the unit cost of producing 2,000 units per day would be lower than the unit cost of producing 1,000 units per day, as shown in the long-run average cost (LRAC) curve (Figure 16.2B). In fact, a 3,000-capacity plant would he oven more efficient, according to Figure 16.2B. But a 4,000 daily production plant would be less efficient because of increasing diseconomies of scale - too many workers to manage, paperwork slows things down and so on. Figure 16.2R shows that a 3,000 daily production plant is the best size to build if demand is strong enough to support this level of production.

COSTS AS A FUNCTION OF PRODUCTION EXPERIENCE. Suppose Roberts runs a plant that produces 3,000 clocks per day. As Roberts gains experience in producing hand-held clocks, it learns how to do it better. Workers learn short cuts and become more familiar with their equipment. With practice, the work becomes better organized and Roberts finds better equipment and production processes. With higher volume, Roberts becomes more efficient and gstins

100.000 200,000 400,000 soo.ooo

Accumulated production

Figure 16.3

100.000 200,000 400,000 soo.ooo

Accumulated production

Cost per iinh as a function of accumulated production: the experience curve economies of scale. As a result, average cost tends to fall with accumulated production experience. This is shown in Figure 16.3.u Thus the average cost of producing the first 100,000 clocks is [£10 per clock. When the company has produced the first 200,000 clocks, the average cost has fallen to IS9. After its accumulated production experience doubles again to 400,000. the average cost is IS7, This drop in the average cost with accumulated production experience is called the experience curve (or learning curve).

If a downward-sloping experience curve exists, this is highly significant for the company. Not only will the company's unit production cost fall; it will fall faster if the company makes and sells more during a given time period. But the market has to stand ready to buy the higher output. And to take advantage of the experience curve. Roberts must get a large market share early in the product's life cycle. This suggests the following pricing strategy. Roberts should price its clocks low; its sales will then increase and its costs will decrease through gaining more experience, and then it can lower its prices further.

Some companies have built successful strategies around the experience curve. For example, during the 1980s, Bausch & Lomb consolidated its position in the soft contact lens market by using computerized lens design and steadily expanding its one Soflens plant. As a result, its market share climbed steadily to 65 per cent. Yet a single-minded focus on reducing costs and exploiting the experience curve will not always work. Experience curves became somewhat of a fad during the 1970s and, like many fads, the strategy was sometimes misused. Experience-curve pricing carries some serious risks. The aggressive pricing might give the product a cheap image. The strategy also assumes that competitors are weak and not willing to fight it out by meeting the company's price cuts.

An 'experience curve war' broke out between the Japanese makers of DRAM (dynamic random-access memory) chips, the semiconductor memory devices used in computers. Hitachi, Toshiba, NEC and Mitsubishi reduced the price of their 4-megabyte DRAMs from ¥12,000 to ¥2,500 within a year of its launch, at the same time spending heavily to develop the next generation's 16-megabyte DRAM. Within two years 1-megabyte DRAM sold for ¥1,600, probably too low to recoup the cost of the production lines needed to make them.12

Finally, while the company is building volume under one technology, a competitor may find a lower-cost technology that lets it start at lower prices than the market leader, who still operates on the old experience curve.

experience curve

(learning curve)

The drop in the average par-unit production cost that comes with accumulated production experience.

Continue reading here: Cost Based Pricing t Cost Plus Pricing

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