Pricing Decisions

Chapter 8
Many marketing texts compare and contrast the approaches of the marketer and the economist to pricing decisions. This
implies that the two disciplines have, virtually, irreconcilable perspectives on ‘best practice’ with respect to pricing. Neither
the value nor the validity of these comparisons has ever been convincingly established. Marketing is an eclectic discipline of
which the much older science of economics is a principal component. Thus, within this text, marketing is presented as a
natural extension of economics, whose fundamental precepts remain intact. Whilst markets rarely behave in precise
conformity with the theories of price expounded by economists, it remains the case that our understanding of market
behaviour, and our ability to predict it, depend greatly upon those same theories and therefore marketing managers need to
be familiar with them. At the same time, marketers must be capable of applying alternative approaches when deterministic
economic models prove inconsistent with the realities of a complex marketplace better explained by probabilistic behavioural
models.

Chapter Objectives
This chapter seeks to explain:

 The wide range of objectives that organisations seek to achieve through their pricing decisions
 How producer and consumer sensitivity to price changes affect supply and demand
 The nature of cost-revenue-supply relationships and their influence upon pricing decisions
 Consumers' perceptions of price and how these are used in making purchase decisions
 The differences between cost-oriented and market-oriented pricing strategies, and
 How controlled prices are administered.

Structure Of The Chapter

Pricing decisions
All of the decisions made with respect to the elements of the marketing mix are of critical importance and not least the
decisions as to what price to ask for the product or service. The task of pricing is reiterative because it takes place within a
dynamic environment: shifting cost structures affect profitability, new competitors and new products alter the competative
balance, changing consumer tastes and disposable incomes modify established patterns of consumption. This being the
case, an organisation must not only continually reassess its prices, but also the processes and methods it employs in
arriving at these prices.

Perhaps a logical starting point is for an organisation to clearly articulate what objectives it seeks to achieve through its
pricing policies and then to evaluate the factors likely to impinge upon the strategies which it seeks to adopt in pursuit of
those objectives.

As figure 8.1 shows, enterprises have a hierarchy of objectives. At the apex of this hierarchy are the corporate objectives
and it is from these that the organisation's marketing objectives are derived. Price is an element of the marketing mix, and
so pricing objectives are defined in terms of their role within the marketing mix strategy.
Figure 8.1 The process of price determination

It can happen that an enterprise designs its marketing mix around its prices. It may be, for instance, that marketing research
identifies a market segment for inexpensive instant coffee. The company might set a target selling price and then select
ingredients and roasting processes which will keep the product within this target. In such circumstances price is the principal
determinant of product positioning, product formulation, packaging, promotional strategy and, perhaps, distribution. On other
occasions, price will be determined by the other elements of the marketing mix. The company may decide that in order to
achieve a given level of market penetration the product must be promoted through the mass media. The price of the product
would have to be set to cover the cost of this relatively expensive channel of communication. Similarly, if the company's
initial decisions centred around creating a particular product image or gaining access to a specific channel of distribution or
in making use of an innovative form of packaging, then the price would be greatly influenced by these decisions. Whatever
the starting point, marketers have to take into account all of the elements of the marketing mix when developing marketing
strategies and it is invariably the case that pricing decisions will be central to those strategies.

However, pricing decisions are not made by organisations operating within some kind of vacuum. When making pricing
decisions marketers have to take into account a range of factors. Some of these are internal to the company, such as its
marketing objectives, its marketing mix strategy and the structure of its costs. Factors which are external to the company,
and that are likely to impinge upon pricing decisions, include the state of market development, the pattern of supply and
demand, the nature and level of competition and a host of environmental considerations (e.g. legislation, political initiatives,
social norms and trends within the economy)
Pricing objectives
Whilst pricing objectives vary from firm to firm, they can be classified into six major groups: (1) profitability, (2) volume, (3)
competition, (4) prestige, (5) strategic and (6) relationship objectives. The way in which each of these objectives is
expressed can take different forms as figure 8.2 illustrates.

Figure 8.2 Pricing objectives

Profitability objectives

Commercial enterprises, and their management, are judged by their ability to produce acceptable profits. These profits may
be measured in monetary values and/or as a percentage of sales and/or as a percentage of total capital employed. In
addition to the overall profitability of the organisation, the profitability of strategic business units(SBUs), product lines and
individual products are also often monitored. The principal approach to ascertaining the point at which profits will be
maximised is marginal analysis, which is described later in this chapter.

Prudent managers are likely to take the strategic view when making pricing decisions. That is, they will not necessarily seek
to maximise profits in the short-term at the expense of long-term objectives. For instance, profits may be low, or even
negative, during a period when the company is seeking to penetrate a new market. Again, heavy investments in capital
equipment and/or R&D may adversely affect the short-term profitability of an enterprise, but are likely to provide a foundation
for longer term commercial success.

Target return on investment (ROI) goals are common in commerce and these can be either short or long run goals, stated
as profit as a percentage of either sales or assets. This is a cost-oriented approach to pricing decisions. The targets set will
depend very much upon the economy within which the organisation operates. If one views organisations as competing for
limited funds from prospective shareholders, financial institutions and perhaps even government, then the rate of return
achieved by an organisation must be competitive with the sorts of returns others in the economy are able to achieve.
Potential investors have to consider the opportunity cost they incur by investing in one organisation rather than another.
Typical pricing objectives might be a 20–25% annual rate of return on investment (after tax) and a 5–8% return on sales.
Individual targets are likely to be set for strategic business units, product lines and individual products.

Maximising revenues: When it is difficult to calculate cost functions (e.g. when costs are indirect and/or are shared by
different products) marketing managers often seek to maximise revenues when setting prices. They do so because they
need only estimate the patterns of demand and they believe that if current revenues are maximised then, in the long run,
profits will be maximised.

Volume objectives

On occasion, the pricing decisions of managers have more to do with sales maximisation than profit maximisation. In these
cases, organisations set a minimum acceptable profit level and then set out to maximise sales subject to this profit
constraint. This is common where, as a matter of policy, a company commits itself to mass marketing, as opposed to serving
narrow market segments. Minimum sales volumes can be more important than profit maximisation in another situation.
Agricultural machinery manufacturers, for instance, will seek to keep volumes up, even if it means sacrificing potential
profits, if their factories and skilled work force are kept employed as a result. This frequently happens if the firm believes that
a downturn in business is short to medium term, since production facilities and a skilled work force are difficult to reinstate
once they have been retrenched.

Maximising market share: Another volume-related pricing objective is the maximisation of market share. The
organisation's specific goals may be either to maintain its share of a particular market or to increase its market share. There
is frequently a positive relationship between high market share and profitability since the additional volumes help lower unit
production costs.

In practice, commercial firms are likely to set prices in the context of the company portfolio and corporate strategy. Each
product, product line and SBU within the company's portfolio will have a distinct contribution to make towards corporate
objectives. But, whilst the prices set for individual products, product lines and SBUs will, in the short term, take account of
their individual circumstances, e.g. stage in the product life cycle, degree of competition in the market, relative competitive
strength in the market, average prices prevailing in the particular market, in the longer term their prices must be set in
accordance with corporate strategy so as to contribute to corporate objectives.

Competitive objectives

As with any other marketing decision, pricing decisions must take into account the current behaviour of competitors and
seek to anticipate the future behaviour of those competitors. In particular, a company will wish to anticipate competitors'
likely reactions if the pricing strategies and tactics it is considering are actually implemented.

Going-rate pricing: Competing firms will sometimes set out to match the industry leader's prices. The net result is to take
the emphasis away from price competition and refocus competition on to other elements of the marketing mix. Although
pricing is an effective tool for gaining a differential advantage over competitors, a price move is easily imitated. In certain
cases, if the competing firms in a market allow pricing to be the chief basis of competition, the profitability of the whole
industry can suffer. Competitors may attempt to promote stable prices by focusing upon product/service strategies,
promotion and distribution, i.e. the non-price elements of the marketing mix.

Anti-competitive pricing: On occasion, a firm will price its products with a view to discouraging competitors from entering
the market or to force them out of the market. This is done by maintaining relatively low prices and profit margins. The extent
to which this sort of pricing can be practised depends upon the firm's own return-on-investment requirements and the vigour
with which anti-competitive actions are policed within a country.

Prestige objectives

Prestige objectives are unrelated to profitability or volume objectives. These involve establishing relatively high prices to
develop and maintain an image of quality and exclusiveness that appeals to status-conscious consumers. Such objectives
reflect a recognition of the role of price in creating the image of an organisation and its products or services.

Strategic marketing objectives

Price stabilisation: The objective of stabilising prices is met in the same way as that of removing price as the basis of
competition. That is, the company will seek to maintain its own prices at or around those of competitors. However, the aim is
not to negate price as a possible marketing advantage, but to narrow the range of price differentials and fluctuations 1.

Supporting other products: Pricing decisions are often focused upon the aim of maximising total profits rather than
maximising profits obtained from any single product within the portfolio. To this end, some products may be designated as
loss leaders whereby their price is set at a level that produces low or even negative returns in order to improve the sales and
profitability of others within the range. Thus, for instance, a manufacturer of crop protection products may sell a knapsack
sprayer at or below cost in an attempt to stimulate sales of the high-margin chemicals which it is designed to apply.

Maintaining cash flow: Many businesses fail not so much because there is an inadequate demand for their products and
services, but due to cash outflows running ahead of cash inflows. It follows that the maintenance of a sound cash flow
position is an important management objective. Much of a company's trade will be on the basis of credit rather than cash
sales. The pricing mechanism can be used to manage cash flow. Prices can be structured in such a way that customers are
encouraged either to pay cash or to repay credit earlier than they might otherwise do.

Target markets: The sensitivity of buyers to prices can vary across different market segments. Some consumers will view
products as commodities and therefore purchase mainly, or wholly, on price. Others will perceive differences between
competing brands and will perhaps make their choice on the basis of characteristics such as quality, freshness and
convenience rather than on price.

Prospective buyers also differ in their perceptions of what the actual price is that they are being asked to pay. Some farmers,
for instance, will focus on the retail price of a piece of agricultural equipment when considering a purchase. Others will take
into account the credit terms available on the item. Yet others will calculate the trade-in value for used equipment that one
dealer is offering in competition with another dealer.
Product positioning: The category into which a product is placed by consumers, and its relative standing within that
category, is referred to as its position within the market. The same product can hold different positions depending upon
which segments of its market are under consideration. An example would be Hodzeko, a brand of fermented milk marketed
in Zimbabwe. This product is popular among low-income groups who perceive it to be a cheap relish to flavour their staple
food of maize porridge (or sadza). The product is also purchased by consumers in the higher income groups, among whom
it is used as a substitute for soured cream in baking. These varying perceptions of the product can allow differential pricing
according to the position in the market. Hodzeko's price as a relish for the staple food has to be held at fairly low levels, but
with some repackaging, and a different brand identity, the more affluent consumers can be persuaded to pay a higher price
for a product which still undercuts the price of soured cream.

Price setters have also to take account of perceived price-quality relationships. The product has to be priced at a level
commensurate with the target quality image and market positioning.

Relationship marketing

Commercial organisations have several important publics with which they must establish and maintain relations conductive
to a positive operating environment. These publics are sometimes termed stakeholders and include such diverse groups as
consumers, members of the channel of distribution, suppliers, the general public, shareholders and government. In short,
stakeholders are those individuals or groups who affect and/or are affected by, the operations of the organisation. Thus,
organisations have relationships with entities other than those with which they trade and those relationships have to be
carefully managed. Indeed, it can be argued that the management of those relationships is part of an organisation's overall
marketing effort.

Channel of distribution members: The interests of all participants in the channel of distribution for the organisation's
products have to be taken into consideration when making pricing decisions. By developing pricing policies and structures
which assist intermediaries to achieve their own profit objectives, an organisation is better able to retain the loyalty of
channel members. Where there is intense competition for distributive outlets it is the organisation which proves most
knowledgeable and sensitive about the needs of intermediaries that will fare best.

Suppliers: Just as the organisation must take account of the interests of its distributors, so it must be concerned about the
welfare of suppliers. Japanese automobile manufacturers have revolutionised supplier-manufacturer relations around the
world. North American and European car manufacturers traditionally operated a system of having would-be component
suppliers tender each time a new model was ready for mass manufacture. The fact that a particular supplier was already
satisfactorily producing and supplying components for other models was no guarantee of involvement in the supply of
components for the new car model. In contrast, Japanese manufacturers tend to develop long-term relationships with
component suppliers who have provided a satisfactory service in the past. Work is rarely put out to open tender. The
Japanese philosophy sees the component supplier as an extension of its own business. Whereas a component supplier, to
a North American or European automobile manufacturer, could expect to be brought in once the engineering design on the
car had been completed. The Japanese manufacturer does not provide the supplier with a set of specifications for the
component. Instead, the component supplier is briefed on the concept of the proposed new car and asked to develop a
design for the component which will assist in translating the concept into a tangible product. Suppliers to Japanese
automobile manufacturers enjoy a measure of security which enables them to plan for a longer period ahead and
encourages them to invest in new technology. Car manufacturers from other parts of the world have begun to appreciate the
need to develop closer relationships with their suppliers. General Motors, for example, has now adopted the Japanese
approach to supplier relations.

The general public: The general public has an interest in the activities of commercial organisations even if they do not buy
or use the organisations' products or services. The public will, for instance, be concerned about the state of business ethics
within an organisation and with issues such as the impact that an organisation's activities have on the environment, the
extent to which the organisation contributes to the local community (e.g. charitable works and contributions), the manner in
which it deals with the complaints and concerns of the community and the extent of its profits. Companies have to be careful
in the way they report prices and profits since these can easily be perceived as being excessive.

Government: Governments often take a keen interest in the prices charged, particularly if the product is a staple food. This
is true even where organisations have been freed from government control over prices because the price of basic foods is a
politically sensitive issue in most countries. The government will wish to be seen to be vigilant in preventing profiteering at
the expense of the common people. The situation can be particularly difficult for organisations such as agricultural marketing
parastatals who after years of suppressed prices find it necessary to raise prices substantially to become commercially
viable. Market liberalisation may give them greater freedom in price setting, but substantial price increases have to be
‘marketed’ to both government and the wider public.