Multimedia Marketing/Marketing.iso/market/chapter8.3p

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SECTION 8.3  Cost Based Pricing Strategies

INSTRUCTIONS Try to imagine how costs should be used to set prices. Then
go into this section for insights into this issue.

EXAMPLE

A supermarket chain operating in western states has steadily
outperformed rivals over the past seven years, with an annual sales
growth rate exceeding 15 percent, while the industry grew at a rate
of about 5 percent.

This company caught its competitors off guard when it closed a
number of stores and then reopened them with a low price strategy
that touched off a price war with other supermarkets. The strategy
was effective. This firm had cut its costs to levels below those
of rivals and was able to absorb the price decreases better than
them. The result was large profit gains for the firm.

DETAILS

What variables should management consider when setting prices?
There are several approaches adopted by marketing managers in the
pricing decision making process. These can be categorized into
three types: cost based, competition based, and demand based pricing
strategies. This section examines the cost based strategies.

Cost based pricing strategies are those where management sets prices
specifically in relation to costs--that is, heavy emphasis is not
placed on factors such as demand and competition. The four major
strategies in the category are markup, cost-plus, target return,
and payback period pricing.

Markup pricing is widely-used. Here companies mark up products by a
fixed percentage over costs. This is a very common pricing method
for intermediaries. For instance, clothing retailers traditionally
apply a markup of 40 percent while confectionery wholesalers generally
use a 10 percent margin.

At one time many trade associations issued books or lists of suggested
markups for members of the industry. Basically, items with elastic
demand had smaller percentage markups than did those with inelastic
demand. However, the courts have ruled that the suggested markups
were an illegal form of price collusion. Today, many intermediaries
adhere to markups that are traditional in the industry. Essentially,
they are emulating their competitors and this is legal under the law.
Companies can imitate each other in pricing, but they cannot arrive
at outright agreements.

Many producing and service marketers also use "markup pricing". To
illustrate, accounting and law firms normally bill clients at a
percentage over labor costs and automobile manufacturers mark up
vehicles first in determining their sales prices to dealers, then
again to consumers to establish a suggested retail price.

Some companies that market many different items find standard
markups to be the only feasible way to set prices. Large retail
firms sell thousands of different products. One soon realizes that
complicated pricing methods are impractical, despite other virtues
that they might have, after multiplying the difficulty of using
such methods for a single product by the many items that a firm
might handle. More complicated pricing methods make estimates of
demand, cost, and competition and combine these estimates to
produce sophisticated pricing models.

PROBLEM 1

A major reason why drug stores use markup pricing is that:

A. They have a very wide product line.
B. They tend to be small firms.
C. Most of the products they carry have inelastic demands.
D. Most of the products they carry have elastic demands.

WORKED

A major reason why drug stores use markup pricing is that they have
a very wide product line. Markup pricing is not time consuming, in
that the drug store has only to multiply the invoice cost of each
product by the percentage markup. This is especially useful when
the product line is large and it would be unduly time consuming
to make estimates of demand, cost, and competition for each item
stocked in the store. Further, retailers know that their rivals
use this method and if they all adhere to standard industry markups,
each company will be competitive and not price most of its items
too high to be competitive or too low to return a satisfactory
profit.

ANSWER  A

DETAILS

Intermediaries generally do not have great incentive
to tinker with finding an item's optimal price through complex
methods. They are content to use the markup method. With retailers,
shelf space is a valuable commodity, and items that do not meet
established markup-volume expectations are logical candidates to be
dropped and replaced with new product offerings that meet these
expectations, in an attempt to achieve the organization's overall goals.

Optical scanners at the retail level are very useful in indicating
which products are and are not meeting markup-volume expectations.
Scanner data enable the retailers to determine, on a daily basis if
necessary, the volume of sales for each product and each product
group. If a product is not contributing adequate levels of sales, it
is quickly replaced.

In most industries there are customary markups. Usually these fall in
a range, with more discount oriened companies at the bottom end and
more prestige oriented at the upper end. Most competitors stay within
these boundaries, although departures sometimes occur. Some retailers
have policies of meeting any competitor's prices, which may place them
below the customary markups for very competitive items.

Companies with high markups normally expect that their inventory will
turn relatively slowly. They realize that they will make high profits
on low volumes. Conversely, firms that employ small markups aim for
high turnover, knowing that they must sell a large number of units
in order to make a satisfactory return.

Furniture and jewelry stores tend to have high markups. Their
inventory turnover is slow, sometimes taking 6 months or more to
complete. At the other end of the scale, supermarkets and discount
houses keep markups very slim and can enjoy inventory turnover rates
at as low a level as two weeks. Their lifeblood is store traffic,
which they must gain and retain, in order to stay profitable.

PROBLEM 2

Which of the following is not a reason why a ceramic figurine
retailer would use markup pricing?

A. The retailer may want to use one of the more sophisticated tools
   for determining price.
B. Items with inadequate markup/volume performance will be dropped
   from the product mix.
C. Markup pricing is not difficult to apply.
D. The retailer may have a large product mix.

WORKED

A ceramic figurine retailer may use markup pricing because items with
inadequate markup/volume performance will be dropped, markup pricing
is not difficult to apply, and the retailer has a large product mix.
This is not one of the more sophisticated tools for determining price,
however. More sophisticated methods make estimates of demand,
competition, and costs and combine the estimates for developing
pricing models. These methods can require considerable time and
expense, however. A particular problem is estimating demand at various
prices. There are both quantitative and judgmental tools for estimating
demand, but these are very complex and are often subject to error.

ANSWER  A
INSTRUCTIONS Try to imagine how costs should be used to set prices. Then
go into this section for insights into this issue.

EXAMPLE

A supermarket chain operating in western states has steadily
outperformed rivals over the past seven years, with an annual sales
growth rate exceeding 15 percent, while the industry grew at a rate
of about 5 percent.

This company caught its competitors off guard when it closed a
number of stores and then reopened them with a low price strategy
that touched off a price war with other supermarkets. The strategy
was effective. This firm had cut its costs to levels below those
of rivals and was able to absorb the price decreases better than
them. The result was large profit gains for the firm.

DETAILS

Cost-plus is somewhat similar to markup pricing. Typically contracts
involving custom construction or manufacturing work require these
methods. A defense contractor, for instance, billed the federal
government on a cost-plus basis for much of its work in building
space capsules for the National Aeronautics and Space Administration
(NASA). With this method, management does not specify an item's
price until it knows all associated costs. Then it adds on an agreed
upon percentage or a fixed amount, depending on the contract, to
provide a profit.

While it may not be readily apparent, cost-plus pricing is a more
comprehensive technique than is markup pricing. This is because
management considers demand implications when establishing profit
margins to be included in the price.

Usually, cost-plus contracts result only after considerable
negotiation between buyer and seller. If sellers insist on
excessively high margins or overly extensive profits, they
may lose contracts to competitors. Consequently, the method indirectly
takes both cost and demand characteristics into consideration.

Further, it provides sufficient flexibility to both buyer and seller
to alter a project, as necessary, practically up to the completion date.
If costs turn out to be higher than expected, or if other unanticipated
events take place, the contract may be renegotiated on the eleventh
hour.

Cost-plus is common for government contracts, but it also is used
for private industry. When companies have major projects which
they want completed, they often negotiate with other firms on a
cost-plus basis. This is especially common in large-scale contracts,
involving substantial expenditures.

Some cost-plus pricing arrangements have brought negative publicity
to companies. There are a number of cases where firms have billed
governmental agencies at costs which far exceeded original estimates.
Some of these have come to the attention of the media and, as a
result, have alienated the public. Companies who are caught up in
such arrangements should realize that they may lose goodwill in
the eyes of the public, as a result.

PROBLEM 3

A producer of newsprint might use cost-plus pricing because it is
more comprehensive than markup pricing. This means that cost-plus:

A. Is negotiated by a larger number of people than is markup.
B. Uses differential calculus, whereas markup does not.
C. Takes demand into consideration, whereas markup does not.
D. Takes federal regulations of pricing into consideration, whereas
   markup does not.

WORKED

A producer of newsprint might use cost-plus pricing because it
is more comprehensive than markup pricing. This means that cost-
plus takes demand into consideration, whereas markup does not.

The newsprint marketing executives will have to think of the effect
on demand for their product when they establish the profit margin
which they will include in the price. The producer will want to
set the margins at a level that will provide the company with an
adequate return. On the other hand, if the profit margin is perceived
to be too large, the intended customer may award the contract to a
rival. Executives who have experience in dealing with buyers develop
insights into what profit margins they are likely to accept as
reasonable. They also develop insights that allow them to predict the
profit margins that rivals will seek. Their experience, then, can
be invaluable in setting final prices.

ANSWER  C
INSTRUCTIONS Try to imagine how costs should be used to set prices. Then
go into this section for insights into this issue.

EXAMPLE

A supermarket chain operating in western states has steadily
outperformed rivals over the past seven years, with an annual sales
growth rate exceeding 15 percent, while the industry grew at a rate
of about 5 percent.

This company caught its competitors off guard when it closed a
number of stores and then reopened them with a low price strategy
that touched off a price war with other supermarkets. The strategy
was effective. This firm had cut its costs to levels below those
of rivals and was able to absorb the price decreases better than
them. The result was large profit gains for the firm.

DETAILS

Another common cost-related strategy is to set prices in an attempt
to attain a desired target return on investment. This is called
"target return" pricing. Here, management calculates the return on
invested capital (profit divided by investment) for each price that
is under consideration. In order to estimate the profit, management
must have forecasts of both demand and cost at each level of price.
The price that the firm will charge is the one that is estimated
to produce the largest return on invested capital.

A number of firms use this method. Normally it is best for
companies that do not produce large numbers of products, because
the forecasts needed to perform the calculations require considerable
time and effort and this would be prohibitive if numerous products
were involved. Further, large companies use the method more extensively
than do their smaller counterparts. Small companies normally do
not have the skilled specialists needed to make forecasts of demand
and costs.

Payback period pricing requires calculating the price that will
enable the firm to cover all costs and capital investment for an
item within a specified time period, such as five years. Management
calculates the total investment required for the product. Then it
estimates the costs and revenues that would result for each price.
This makes it possible to determine when the company would be
able to cover all costs and capital investment. Those prices producing
a longer payback than management desires are rejected. It is expected
that management will select the price producing the shortest payback.

Target return and payback period pricing methods can yield identical
prices because the approaches are quite similar. They are also subject
to similar criticisms.  However, payback period pricing is especially
useful in dynamic industries where substantial environmental change
is common. This is true within several industries, including high
tech and consumer packaged goods--industries where it is difficult
to accurately forecast returns for new products. Rapid change injects
uncertainty into decision making and this approach forces management
to realize the need to recover all costs in a relatively short period
of time.

To illustrate, electronic digital watches have experienced dramatic
technological breakthroughs over the past decade, which means that
related investments tend to be very short-lived. In order to earn
a profit, companies foresee the need to recover all developmental
costs within a reasonably short period of time before being confronted
with some new breakthrough by competitors.

PROBLEM 4

A small hair salon probably would not use return on investment
pricing because:

A. Its invested capital is not of sufficient size to permit reasonable
   estimates of return on investment.
B. It does not have the technical expertise needed to forecast
   demand and cost.
C. Its fixed costs are much larger than its variable costs.
D. Management normally is more interested in acquiring a positive
   cash flow than it is in maximizing profits.

WORKED

A small hair salon probably would not use return on investment
pricing because it does not have the technical expertise needed
to forecast demand and cost. In order to employ this technique,
management needs accurate estimates of future revenues and costs.

Costs may not be difficult to forecast, but this is not the case
for revenues. And it is necessary to have an estimate of revenue
for every price that is being considered. Experts in this field
use quantitative methods, such as regression analysis (which uses
the historical behavior of one variable to predict the behavior
of another variable), computer simulation, surveys, and test
markets. The skills required to employ these methods are normally
not under the command of small hair salons, where management is
more likely to have skill in treating hair than in forecasting.

ANSWER  B