Many companies decide on a selling price for their products by adding a

percentage to their cost. Comment on this approach to pricing, indicating the

other factors that should be taken into account when deciding on a price of a new
product.

According to Kolter (2005), price is the amount of money charged for a product or
service, or the sum of the values that consumers exchange for the benefits of
having or using the product or service. Pricing is the process of determining what a
company will receive in exchange for its products or services. A company’s survival
depends highly on its pricing decisions. Companies generally, would choose a price
that would cover all costs (cost of producing, distributing, selling, etc.) and leave a
profit margin large enough to award their investors. This is why many companies
decide on a selling price for their products by adding a percentage to their cost. This
pricing approach is a cost-plus pricing approach.

There are different cost-plus pricing methods:

♣ Total Cost-plus Profit Percentage

The profit is added to the total absorption cost (sum of variable and fixed
costs) as a predetermined percentage of that cost. For example, if a
company anticipates a total cost of sales $500000 and wants a profit of
$75000, a profit margin of 15% on cost would be added to the work to be
carried out.

This is useful when the pricing objective is to set a fair price as against
profit maximisation.

♣ Marginal Cost-plus Contribution Percentage

A percentage is added to marginal cost of work. Marginal cost is the

additional cost of producing one more item for sale; it is the same as the
variable cost. The amount by which price exceeds production cost
represents the contribution made to the business. Example, if a company
anticipates marginal costs of $500000 and fixed costs to be $200000, and
wants a profit of $75000, the contribution percentage is:

 200000 + 75000 
 500000  × 100 = 55%
 This method allows the possibility of pricing below total costs during
recession times, in order to attain higher utilisation capacity. The method
can recognise relevant cost, opportunity costs and incremental cost.

♣ Marginal Cost-plus Key-factor Margin

Marginal cost of work can be difficult to estimate. Therefore, by basing the

margin on a key factor which can be used to estimate available capacity
(such as labour), to ensure profit target is reached regardless of the mix of
work. This method is useful when demand is low.

♣ Standard Cost-plus Pricing

Is similar to total cost-plus profit percentage, except that the standard cost
is used instead. Standard cost is a predetermined cost that should be
attained under a given set of operating conditions.

♣ Break-even Pricing or Target-Profit Pricing

The company determines the price at which the target profit is made for a
given sales volume. A break-even chart, which shows the total cost and
total revenue expected at different sales volume, is used.

FixedCost
Pr ice = + VariableCost
BreakEvenVolume

Example, for a company with a fixed cost of $30000, a variable cost of $20
and the wanted break-even volume of 6000 units.

The price per unit = (30000/6000) + 20 = $25

 Therefore, the company has to sell more than 6000 units at $25 to make a
profit.

Break-Even chart for the break-even pricing example stated above.

Cost-plus pricing has its advantages and disadvantages.

The advantages of cost-plus pricing:

1. It is simple, easy to calculate and administer.

2. Minimal information required – only cost information.

3. Price increases can be justified in terms of cost increases.

4. It insures seller against unpredictable costs.

5. Profit is made as long as the budgeted sales volumes are achieved.

The disadvantages of cost-plus pricing:

1. It provides no incentive for efficiency.

2. It ignores the role of consumers and does not take into consideration what
they can afford, or what they are willing to pay, or their demand for the
product/service.

3. It ignores the role of competitors. Cost-plus pricing can lead to over-pricing or

under-pricing relative to competitors, which can lead to decreasing profits.

From the list of disadvantages of cost-plus pricing, it should be apparent that other
factors, other than cost, affect pricing decisions. There are internal factors and
external factors that affect pricing decisions. Internal factors include: a company’s
marketing objectives, marketing-mix strategies, organisation and finally costs.
External factors include competition; the nature of the market and demand; and
factors such as the economy, reseller needs and government actions. The seller’s
pricing freedom varies with different types of market.

Common pricing objectives include survival, current profit maximisation, market-

share leadership, and product-quality leadership. Pricing decisions affect and are
affected by product design, distribution, and promotion decisions – that is, the
marketing mix strategies. In terms of organisation, top management usually sets
pricing policies, but some pricing authority may be delegated to lower-level
managers, including salespeople, production, finance and accounting managers. Of
course, costs determine the minimum price that can be set without a loss.

The types of markets are (Kolter, 2005):

♣ Pure competition - a market in which many buyers and sellers trade in a

uniform commodity – no single buyer or seller has much effect on the
going market price.

♣ Monopolistic competition - a market in which many buyers and sellers

trade over a range of prices rather than a single market price.

♣ Oligopolistic competition - a market in which there are a few sellers that

are highly sensitive to each other’s pricing and marketing strategies.

♣ A pure monopoly - a market consisting of one seller. The seller may be a

government monopoly (a postal service), a private regulated monopoly
(a power company), or a private non-regulated monopoly (Microsoft
Windows).
 The internal factors such as the marketing objectives and strategy are heavily
influenced by the external factors – competition, market, and demand. For instance,
a common marketing objective is current profit maximisation, which depends on the
demand and competitors’ prices. If demand is low or competitors’ prices cheap,
then the company must set their prices low to achieve their objective. Therefore,
the primary considerations in price setting are as illustrated in the figure below.

The price that a company charges will be somewhere between one that is too low
to produce a profit and one that is too high to produce any demand. The cost of
production is the lowest possible price to set and the consumers’ perceived-
value/demand of a product is the highest price. Companies must consider
competitors’ prices and other external and internal factors to determine a suitable
price between the lowest and highest price bounds.

A company needs to be aware of its competitors’ costs and prices, as well as how
its competitors would respond to its own pricing decisions, to help determine a price
to set for its own products. The weight of competitors’ prices on pricing depends on
the competitive nature of the market. Market leaders with products that dominate
the market are not heavily influenced by competitors’ prices. For markets without a
dominant leader, in which its sellers are highly sensitive to competitors’ prices, the
pricing of competitive products must be done carefully.

Pricing is highly influenced by consumers’ perceived value of a product/service.

Marketers must determine consumers’ reasons for buying a product and set their
prices according to the consumers’ perceived value of the product. Marketers can
set high prices on products or services that are perceived as prestigious or unique.
However, too high a price can cause a reduction in demand. Of course, low prices
generally result in high demand.

In pricing a new product, the strategy used depends on whether the product
imitates already existing products or if the product is an innovative one. A new
product has to be positioned against competitors’ products in terms of value and
price. There are four price-positioning strategies as illustrated below:
 For a product that imitates existing products, premium pricing and economy pricing
are generally used. Premium pricing is charging a high price for a high quality
product/service. This is used when a company has a great competitive advantage.
Economy pricing is charging a low price for a low quality product. This is used when
the cost of production is small, and little capital is spent on advertising.

For new innovative product or service, penetration pricing and skimming pricing
are used. Penetration pricing is charging a low price for a high quality product. This
is used to introduce a new product into the market. Once consumers become
familiar with the product, the price is then raised to obtain maximum profit.
Penetration pricing can also be used an imitative product on the expectation that
consumers would switch brands based on the lower prices. This strategy is used to
increase market share and/or sales volume. Supermarkets commonly use this
strategy.

Advantages of Penetrating Pricing:

1. Can result in fast diffusion and adoption; taking competitors by surprise.

2. It creates cost control and cost reduction from early start of the business.

3. Discourages competitors entry onto the market with the company’s low
prices.

4. It can be based on marginal cost pricing.

Disadvantages of Penetrating Pricing:

 1. It establishes long-term price expectations for the product/service.

2. Low profit margins may not be sustainable long enough for the strategy to be
effective.

Skimming pricing is charging a high price for a low quality product/service. The
high prices attract customers initially and prices are lowered with time as other
companies begin to put out a similar product at lower prices onto the market. The
increase in supply with time also causes prices to decrease. This strategy allows the
sunk costs to be regained before the market becomes competitive. Price skimming
has been used for high-end electronics such as play-stations. The disadvantages of
this strategy includes: it encourages entry of competition onto the market, slow rate
diffusion and adaptation of product, the inventory turn rate can be slow, and
negative publicity can result if prices are lowered too quickly.

In the end, the consumers determine if the price is right. They compare value with
price of each competitor’s products/services. Although a cost-plus pricing method
ensures profits once projected sales are achieved it may not produce the right
price. Companies must consider the perceived value of a product, competitor’s
prices and the costs of production, distribution and selling, along with other internal
and external factors, to determine the right price. For innovative products,
penetrative pricing and price skimming strategies are used to eventually set a right
price.

References

1. Kolter, P. et al., Principles of Marketing (4th ed.), Pearson Education Ltd. ,

England, 2005, pages 664 – 706

2. Shah, P., Management Accounting, Oxford University Press, New Dehli,

2009, pages 667 – 684

3. “Pricing Strategies”, available at:

http://marketingteacher.com/lesson-store/lesson-pricing.html, (07.11.10)

4. Wikipedia, available at: http://en.wikipedia.org/wiki/Main_Page

The following links were used from Wikipedia website:

http://en.wikipedia.org/wiki/Pricing, (7.11.10)
 http://en.wikipedia.org/wiki/Price_skimming, (07.11.10)

http://en.wikipedia.org/wiki/Penetration_pricing, (07.11.10)

5. “Marketing”, available at: http://www.netmba.com/marketing/pricing/,

(07.11.10)