Today, we shall look at critical inputs that inform pricing decisions. In the long run, no company can survive that cannot cover costs. As we noted in our last post, accountants are particular about costs because they know that costs must be recovered for a firm to stay afloat. Even marketers are aware of the fact that costs set the floor below which prices must not fall.
When the accountant provides information on different types of costs, the firm is able to see the relationship between costs and price. The marketer is also able to use the relationship as the basis for setting the price of a new product.
Let us, consider the different types of costs and thereafter look at some useful tools of cost analysis.
- Total Cost: Fixed costs plus variable costs,
- Average cost: Total cost divided by units produced.
- Fixed costs: Costs that do not vary with the number of units produced or sold.
- Variable costs: Costs that vary as the units produced or sold vary.
- Marginal cost: The-addition to total cost from producing one extra unit of the product.
- Economy of scales: The potential reduction in average costs as output or sales increase.
- Experience curve: The potential reduction in average cost occasioned by learning or experience based on cumulative output.
Simple Methods of Analyzing Costs
Let us now consider two interrelated tools that enable us analyze cost. One of these tools is contribution and the other breakeven analysis.
Contribution is defined as what is left after variable cost has been deducted from selling price. This notion is called contribution because it contributes to the covering of fixed cost.
Contribution = Selling price – Variable cost.
A company will continue to stay in business, at least in the short run, if it can cover variable costs as fixed costs are incurred no matter the quality produced.
The breakeven point is defined as the level of output at every given price where total revenue is equal to total cost (cost of production and marketing).
The breakeven quantity,
BEQ = Fixed costs/Contribution
In order to price its products intelligently, management must know how costs vary with different levels of production.
Typically, the cost is higher if fewer units are produced. As production level increases, average cost falls because the fixed costs are spread over more units, with each incurring a smaller fixed cost.
As production level increases further, average cost increases because the plant becomes inefficient as a result of clutter, frequent breakdown, expanding market and other factors. In order to increase efficiency, another plant has to be built. This happens in the long run when fixed costs must of necessity vary.
As the company gathers more experience in production, workers learn more shortcuts, there is improved flow of materials, and procurement costs are cut leading to a fall in average costs. This trend is called the experience curve or the learning curve.
We have seen that costs set the lower limit below which a marketer would not want to sell his product if he wants to continue in business. Now we shall consider the demand or customer consideration which determines the upper limit of pricing, that is, what the market can bear. This means that demand has a powerful influence on pricing as we cannot set prices beyond what customers are willing to pay.
At the introductory stage, the firm sets a high price for its product. This is called skimming strategy and it is used to cover the costs of research and development especially if the product is innovative. At this stage, profit is likely to be low due to high fixed costs. Demand is likely to be highly price inelastic.
Alternately the company may enter the market with a low price (penetration strategy) in order to gain a high share or to discourage competitors from entering.
Price is reduced in order to further penetrate the market. Demand is likely to be more price-elastic due to the activities of competitors.
Prices are set to match or beat competitors. High prices can be retained in segments that are less price sensitive. Demand is less price elastic due to brand loyalty.
There is a likely return to price elasticity where consumers are likely to react sharply to price changes due to the fact that they already have substitutes to the declining product. The firm may cut prices to attract more customers or even hike prices to meet rising cost at the tail end of the decline stage.
Thus far, we have seen that a firm, for several reasons, may have to adopt different pricing policies at different stages of the product life cycle. One example readily comes to mind. At the inception of GSM telephone price in Nigeria in 2001, it cost about N20,000 to be connected to the MTN network and N18,000 to the Vmobile (then Econet) network. Now it costs well under N300 to be connected to any telephone network.
Apart from the effect of price on the consumer (demand) that we have outlined above, consumers may take cognizance of other factors before they decide to purchase a product. A thorough understanding of these factors is critical to evolving an effective pricing strategy.
Some of these factors include:
If the product has been able to deliver what it promised, a repeat purchase can be expected.
The Perceived Risk Associated With the Product
A consumer may opt for a more expensive brand if the brand will minimize the certain risks. A buyer may opt for a more expensive television, such as Sony, believing that its quality makes it a cheaper long-term option.
The consumer may weigh available options based on factors like price and other product characteristics.
This factor is often an important consideration for many buyers and they are quite ready to pay a premium price for quality. Many consumers would readily choose Peak Milk above other brands because of the perceived quality.
The image of the product acquired through careful positioning, quality, design, packaging or a combination of these attributes also contributes to buyers’ preference .
The general outlook of the consumer will influence his preferences. A sports enthusiast is likely to be familiar with brands like Nike and Adidas and may consider purchasing them in spite of their relatively high prices.
Value for money
In the eyes of the consumer, does the product offer value for money? Since price is the monetary value of a product, value is critical in the perception of the consumer. Is the product worth the price charged for it?
The objective for purchasing a product may determine its utility to the consumer. For regular lunch a consumer may patronize a “bukateria” and go to Mr. Bigg’s for a special treat.
Price or quality discount have effect on the consumer’s buying decision. According to Jack Trout, a firm should take the following into consideration: don’t do it just because others are doing it; use it to clear stock or generate extra business; put time limits on the deal; ensure the ultimate customer is the beneficiary; discount only to survive in a mature market; stop it as soon as you can.