Cost Based Pricing t Cost Plus Pricing

The simplest pricing method is cost-plus pricing - adding a standard mark-up to the cost of the product. Construction companies, for example, submit job bids by estimating the total project cost and adding a standard mark-up for profit. Lawyers, accountants and other professionals typically price by adding a standard mark-up to their costs, Some sellers tell their customers they will charge cost plus a specified mark-up: for example, aerospace companies price this way to the government.

cost-plus pricing Adding a standard mark-up to [he cost of the product.

in ark- it p/n iark- down The difference between selling price and cost as a percentage of selling price or cost.

Figure 16.5

Primary considerations in price settings

To illustrate mark-up pricing, suppose a coaster manufacturer had the following costs and expected sales:

Variable cost $10

Fixed cost $300,000

Expected unit sales 50,000

Then the manufacturer's cost per toaster is given by;

„ fixed costs à $300,000 Unit cost = Variable cost + -.-.— = $10 + —■-= $16

unit sales

50,000

Now suppose the manufacturer wants to earn a 20 per cent mark-up on sales. The manufacturer's mark-up price is given by:

The manufacturer would charge dealers §20 a toaster and make a profit of 14 per unit. The dealers, in turn, will mark up the toaster. If dealers want to earn 50 per cent on sales priee, they will mark up the toaster to S40 ($20 + 50 per cent of $40). This number is equivalent to a mark-up on cost of 100 per cent (820/$20).

Does using standard mark-ups to set prices make logical sense? Generally, no. Any pricing method that ignores demand and competitors' prices is not likely to lead to the best price. Suppose the toaster manufacturer charged §20 but only sold 30,000 toasters instead of 50,000. Then the unit cost woxild have been higher, since the fixed costs are spread over fewer units and the realised percentage mark-up on sales would have been lower. Mark-up pricing works only if that price actually brings in the expected level of sales.

Still, mark-up pricing remains popular for a number of reasons. First, sellers are more certain about costs than about demand. By tying the price to cost, sellers simplify pricing - they do not have to make frequent adjustments as demand changes. Second, when all firms in the industry use this pricing method, prices tend to be similar and priee competition is thus minimized. Third, many people feel that cost-plus pricing is fairer to both buyers and sellers. Sellers earn a fair return on their investment, but do not take advantage of buyers when buyers' demand becomes great.

Figure 16.6

Break-even chart for determining target price

• Break-Even Analysis and Target Profit Pricing

Another cost-oriented pricing approach is break-even pricing or a variation called target profit pricing. The firm tries to determine the price at which it will break even or make the target profit it is seeking. Target pricing is used by General Motors, which prices its cars to achieve a 15-20 per cent profit on its investment. This pricing method is also used by public utilities, which are constrained to make a fair return on their investment. Target pricing uses the concept of a break-even chart. A break-even chart shows the total cost and total revenue expected at different sales volume levels. Figure 16.6 shows a break-even chart for the toaster manufacturer discussed here. Fixed costs are 8300,000 regardless of sales volume. Variable costs are added to fixed costs to form total costs, which rise with volume. The total revenue curve starts at zero and rises with each unit sold. The slope of the total revenue cun'e reflects the price of K20 per unit.

The total revenue and total cost curves cross at 30,000 units. This is the break-even volurtK. At §20, the company must sell at least 30,000 units to break even; that is, for total revenue to cover total cost. Break-even volume can be c alculated using the following formula:

fixed cost $300,000

Break-even volume S

If the company wants to make a target profit, it must sell more than 30,000 units at $20 each. Suppose the toaster manufacturer has invested 81,000,000 in the business and wants to set a price to earn a 20 per cent return or $200,000. In that case, it must sell at least 50,000 units at $20 each. If the company charges a higher price, it will not need to sell as many toasters to achieve its target return. But the market may not buy even this lower volume at the higher price. Much depends on the price elasticity and competitors' prices.

The manufacturer should consider different prices and estimate break-even volumes, probable demand and profits for each. This is done in Table 16.2. The sable shows that as price increases, break-even volume drops (column 2). But as price increases, demand tor the toasters also falls off (column 3). At the $14 price.

break-even pricing (target profit pricing) Setting price to break even on the costs of making and marketing a product; or setting price to make a target profit.

target profit pricing See Break-even pricing.

Table 16.2

Breakeven volume and profits at different prices

Table 16.2

(1)

UNIT DEMAND

EXPECTED UNIT

(4) TOTAL

(5)

(6)

NEEDED TO

DEMAND AT

REVENUES {$)

total

PROFIT

PRICE (S)

BREAK EVEN

GIVEN PRICE

(1) * (3)

COSTS ($)°

(4) - (5)

14

75,000

71,000

994,000

1,100,000

-106,000

16

50,000

67,000

1,072,000

970,000

102,000

18

37,500

60,000

1,080,000

900,000

180,000

20

30,000

42,000

840,000

720,000

120,000

22

25,000

23,000

506,000

530,000

-24,000

Note:* Assumes fixed costs of Si300,000 and constant unit variable costs of 810.

Note:* Assumes fixed costs of Si300,000 and constant unit variable costs of 810.

because the manufacturer clears only $4 per toaster ($14 less $10 in variable costs), it must sell a very high volume to break even. Even though the low price attracts many buyers, demand still falls below the high break-even point and the manufacturer loses money. At the other extreme, with a $22 price the manufacturer clears #12 per toaster and must sell only 25,000 units to break even. Rut at this high price, consumers buy too few toasters and profits are negative. The table shows that a price of Si 8 yields the highest profits. Note that none of the prices produces the manufacturer's target profit of 8200,000. To achieve this target return, the manufacturer will have to search for ways to lower fixed or variable costs, thus lowering the break-even volume.

value-based pricing Setting price based fin buyers'perceptions of product values rather than on cost.

Value-Based Pricing

An increasing number of companies are basing their prices on the product's perceived value. Value-based pricing uses buyers' perceptions of value, not the seller's cost, as the key to pricing. Value-based pricing means that the marketer cannot design a product and marketing programme and then set the priee. Price is considered along with the other marketing-mix variables before the marketing programme is set.

Figure 16.7 compares cost-based pricing with value-based pricing. Cost-based pricing is product driven. The company designs what it considers to be a good product, totals the costs of making the product and sets a price that covers costs plus a target profit. Marketing must then convince buyers that the product's value at that price justifies its purchase. If the priee turns out to be too high, the company must settle for lower mark-ups or lower sales, both resulting in disappointing profits.

Value-based pricing reverses this process. The company sets its target priee based on customer perceptions of the product value. The targeted value and price then drive decisions about product design and what costs can be incurred. As a result, pricing begins with analyzing consumer needs and value perceptions and a price is set to match consumers1 perceived value:

rjfíJMiV M^KS'IL?- ,n iRgniraiiíS-w cvn ik ÍWWTi r~ ÎB®—¿ „.--—^ ' K ->■

* " t PARKER DUHFOLD

H.inianpiwHiittfKIIWtumiTmni i i i i

Perceived -val ue : a les s expensive pen might inrite as well, but some consumers wiU pay much more the intangibles. This Parker model runs at 8i85, Others are priced as high as 8.3,500.

Consider Thorn selling its 10\V 2D energy-saving electric light bulbs to a hotel manager. The SL18 coses far more to make than a conventional 60-watt tungsten light bulb, so a higher price has to be justified. Value pricing helps by looking at the hotel manager's total cost of ownership rather than the price of electrie light bulbs. The life-cycle costs of the manager using a tungsten bulb tor the 1,000 hours that they last includes the price of the bulb (60p), the labour cost of replacing it (SOp) and electricity (£4.80). The life-cycle cost of the tungsten bulb is therefore £5.90. The Thorn 10W 2D bulb uses a sixth of the electricity of a conventional bulb and lasts eight times longer. Its lite-cycle cost must therefore be compared with the cost of owning eight tungsten bulbs: 8 x £5.90 = S47.20. To work out the value of the Thorn bulb, its cost of ownership is also considered: changing the bulb 50p and electricity £6.40 (one-sixth the electricity costs of eight tungsten bulbs). The maximum value-based price of the Thorn bulb to the hotel manager is therefore:

Maximum value-based price = competitor's cost of ownership - own operating eosts - £47.20 - (£6.40 + SOp) = £40.30

Using this evidence, Thorn can argue that it is worth the hotel manager paying a lot more than 60p to buy the energy-saving bulb. It is unrealistic to think that the manager would pay the full £40.30, but based on these figures, the actual price of £10.00 for the Thorn energy-saving bulb looks very reasonable. At first sight it seems hard to justify replacing a 60p tungsten bulb with a £10.00 energy-saving one, but value-based pricing shows the hotel manager is saving £30.00 by doing so. The value-based pricing using life-cycle costs can be used to justify paying a premium price on products: from low energy-condensation boilers as domestic boilers to low maintenance jet fighters.1"

Figure 16.7

Cost-based versus value-based pricing

A company using perceived-value pricing must find out what value buyers assign to different competitive offers. However, measuring perceived value can be difficult. Sometimes consumers are asked how much they would pay for a basic product and for each benefit added to the offer. Or a company might conduct experiments to test the perceived value of different product offers. If the seller charges more than the buyers' perceived value, the company's sales will suffer. Many companies overprice their products and their products sell poorly. Other companies underprice. Uuderpriecd products sell very well, but they produce less revenue than they would if prices were raised to the perceived-value levels.

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