Topic 2: Setting prices for service organizations

For organizations that provide services rather than tangible goods or products, setting
selling prices can be very difficult. This is because a high proportion of the costs of such
organizations are usually indirect. This makes it difficult to determine reliably the cost of service
provision and apply pricing related models such as cost-plus pricing and target costing.

The core reason behind establishing the organization with the aim of selling services to
customers is to earn profit, except non-profit organizations. Apart from all factors including
competition, target market, target location, etc. pricing decision is the most essential part to
evaluate whether the organization is profitable or not.
It has been highlighted in the study of McKinsey as well that pricing has a greater impact
on profitability than sales volume increases, cost reductions or other improved efficiencies while
considering that service level to be delivered must meet the needs of the customer.
Price is the essential element in the enhanced marketing mix of 7Ps & it was as well in
the traditional marketing mix of 4Ps. Pricing is the factor which is considered as the major cause
behind the success or failure of the service organization.
Setting the price for the services to be delivered to the customer is hugely challenging
task. Services are any activity of benefit that one party can offer to another that is essentially
intangible & does not result in the ownership of anything. Its production may or may not be tied
to a physical product.
The characteristics of the services are absolutely different than the manufactured products
& it makes the task complicated. It includes intangibility (refers to the lack of substance which is

involved with service delivery, unlike goods there is no substantial material or physical aspects
to a service: no taste, feel, visible presence & so on), inseparability (many services are created at
the same time as they are consumed. No service exists until it is actually being
experienced/consumed by the person who has bought it), variability (many services face the
problem of maintaining consistency in the standard of output. It may be hard to attain precise
standardization of the service offered), perishability (services are innately perishable) & lack of
ownership (services do not result in the transfer of property. The purchase of a service only
confers on the customer access to or a right to use a facility).
Pricing for goods is easy & straight forward, while for services it is complicated, may be
controlled by several authorities, varies with time, place, people, etc.
Features that make pricing of services different than pricing of manufactured products
include:

No ownership of services (Its usually harder for managers to calculate the

financial costs involved in creating an intangible performance for a customer than it is to

identify the labor, materials, machine time, storage, & shipping costs associated with
producing a physical good).

Higher ratio of fixed costs to variable costs (It is because of the labor &
infrastructure needed to create performances, many service organizations have a much
higher ratio of fixed costs to variable costs than is found in manufacturing firms. Service
businesses with high fixed costs include those with an expensive physical facility (e.g. a
hotel, a hospital, a university, or a theatre), or a fleet of vehicles (e.g. an airline, a bus
company, or a trucking company), or a network dependent on company-owned

infrastructure (e.g. a telecommunications company, an internet provider, a railroad, or a

gas pipeline)).

Variability of both inputs & outputs (Its not always easy to define a unit
of service, raising questions as to what should be the basis for service pricing &
seemingly similar units of service may not cost the same to produce, nor may they be of
equal value to all customers).

Many services are hard to evaluate (The intangibility of service

performances & the invisibility of the backstage facilities & labor make it harder for
customers to know what they are getting for their money than when they purchase any
physical goods).

Importance of time factor (Same service may have more value to

customers when delivered faster. Customers are highly aware of importance of time and
when a service delivery takes much time; customers get bored of waiting).

Delivery through physical or electronic channels (May create differences

in perceived value, as services are delivered mostly through these channels customer may
expect something different than what they actually acquired).
Customers own different perceptions in their mind about the price of the proposed
services to be delivered to them, including:
1.

Price as an indicator of service quality: a) the price has a direct

relationship with the quality. b) Customers prefer cues like company reputation, level of
advertising to access the quality. c) In other situations when quality is hard to detect or
price varies a great deal within a class of services, consumers may believe that price is
the best indicator of quality. d) It is the most prominent where the levels of the same
types of service are differentiated by price like; air tickets, rail tickets, etc. e) In case of

high risk services like medical treatment, customer looks price as a surrogate for quality.
f) It is the least prominent between two service providers offering the same types of
services in different times, at different places, for different people, with different
contents. g) Thus in addition to cover the cost & match competitors price, prices must be
set with care to convey the appropriate service quality. h) Price is an attraction & a
repellent simultaneously. Because in the absence of anything visible or tangible, the price
is the only indicator, so pricing must be done.
2.
Non-monetary costs & prices: More often, the customers incur several
non-monetary costs while consuming a service. Thus demand is function of not only
monetary price but also non-monetary prices. These can be following; a) Time costs
(since most services require direct participation of the consumer & thus their real time),
b) Search costs (the effort invested to identify & select among services you desire since
prices for services are rarely displayed in shelves an each service establishment offers
only one brand of service except brokers & agents), c) Convenience costs ( like
customers have to travel to the service, if service hours do not coincide with customers
available time), d) Psychological costs (fear of not understanding; e.g. education, fear of
rejection; e.g. bank loan, fear of results; e.g. surgery).
Organizations that provide services rather than tangible goods or products, face numerous
issues while pricing of services to be delivered to the customer. Organizations dealing in service
providing business consider the pricing of their services critical as: customer knowledge of
service price a reference price is a price point in memory for a good or a service, high degree
of variability often exists across providers of services not every physician defines a checkup
the same way, providers are unwilling to estimate prices in advance legal service providers;
fundamental reason being they do not know themselves what the service will involve until the

process of service delivery unfolds, individual customer needs vary your haircut from the same
stylist may cost you differently, price invisibility particularly in financial services, most
customers know about only the rate of return & not the costs they pay in form of fund &
insurance fees, comparison of prices becomes difficult unlike goods where the product range is
displayed for comparison like to compare dry cleaning prices, customer must drive to or call
individual outlets.
When pricing services, there is a bit more margin than pricing products. Pricing is both an
art & a science. After determining the basic objectives of pricing, proper pricing must be done by
the organizations. Selection of pricing strategies involving pricing related models varies from
organization to organization. Characteristics of services & features that making the pricing of
services different & incurring of non-monetary costs results in creating difficulties for the
organizations to apply any of the available pricing models. Among all pricing models; cost-plus
pricing model is the most commonly used model & usually referred as a standard method of
pricing.
Cost-plus pricing model is the simplest method of pricing & in business seeks to
determine the cost of providing a service & then add an additional amount to represent the
desired profit or in other words; the total cost is ascertained or estimated & a mark-up is added in
it. This pricing strategy is adopted by most of the professionals.
Target costing is also well-known approach which usually works in the opposite way to
normal methods of pricing, by setting a selling price & then working backwards to find the target
cost. Target costing is a pro-active cost control system. The target cost is calculated by deducting
the target profit from a predetermined selling price based on customers views.

Cost-plus pricing model & target costing approach, both encountered with all or few of
the following problems:

The one special problem in cost-plus pricing & the target costing approach

is the unit in which a service is purchased, the unit price is a well-defined idea, but is a
vague concept in services. Hence most of the professional services are sold by not the
output unit but the input units, like consultancy services are priced by the no. of hours the
professional have put in.

Costs are difficult to trace: Costs are difficult to trace or calculate in

service business, particularly where multiple services are provided by the firm.

Labor is more difficult to price than materials: A major component of cost

is employee time rather than material cost, & value of peoples time particularly nonprofessional time, is not easy to calculate or estimate.

Costs may not equal value: Actual service costs may under-represent the
value of the service to the customer. The same service given against different
context/back drop has different value attached to it even though it needs same time &
effort.
In service businesses it is often difficult to establish, for cost purposes, what a unit of
service is, let alone to calculate its cost. Particular difficulties occur with highly intangible
services where people are the chief element of cost. For example it may be difficult to measure
the time spent in performing a service; also overhead allocation may be problematic. Yet it is
difficult to develop a pricing strategy for a service business without some clear idea of costs; if
only to establish how costs act as a constraint on the lower limit of price discretion available to
the price maker. People-intensive services like professional services have to develop more

accurate methods of identifying and allocating costs to overcome the problems of costing in such
service businesses.

References:

Arnold, D.R. and Hoffman, K.D. and McCormick, J. (1989), Service Pricing: A

Differentiation Premium Approach, the Journal of Services Marketing, 3(3), pp.25-33

Hoffman, K.D., Turley, L.W. and Kelley, S.W. (2002), Pricing Retail Services, Journal

of Business Research, 55, pp.1015-1023

Langeard, E. (2000), Specificity of the Pricing Policy in Service Activities, Innovations
and Perspectives, In: The International Research Seminar in Service Management, Le

Londe Les Maures, June, pp.243-256

McGraw-Hill, Pricing of Services. The McGraw Hill Companies.
Schlissel, M.R. (1977), Pricing in a Service Industry, MSU Business Topics, 25, pp.37-

48
Schlissel, M.R. and Chasin, J. (1991), Pricing of Services: An Interdisciplinary Review,
The Services Industries Journal, 11(3), pp.271-286