Pricing: Are you fixated with Cost-Plus?

Most ‘O’ level economics students are familiar with the standard model demand curve.  This is a graphical representation of the effect on demand as price changes.  The standard model states that as the price of goods rises, demand for that good falls.  However, as everyone in business knows, the standard model often does not reflect the complex relationship between price and demand in the marketplace.

Despite the standard model not accurately representing the actual effect of price in many markets, it seems that many small businesses look to minimise their price as primary driver of demand.  This has led to an over reliance on cost-plus pricing strategies amongst SME’s.

Cost-plus pricing is a strategy driven by an accountancy-based view of price.  Many businesses simply calculate the fixed and variable costs of producing a product or service; total them; and add a fixed profit margin.

It may be that in some sectors, such as construction, a competition element is added to the cost-plus calculation.  Often the profit margin applied is calculated by assessing the probability of success in gaining a contract.  For example:

  • A profit margin of £100 gives a 90% probability of obtaining the contract
  • A profit margin of £200 gives an 80% probability of obtaining the contract
  • A profit margin of £300 gives a 40% probability of obtaining the contract
  • The profit margin applied will be £200 as this gives the best combination of margin compared with probability of success.  Multiplying £200 by 80% gives a notional level of profit of £160 compared to £90 in relation to a £100 margin and £120 in relation to a margin of £300.

Marketers take a much wider view of pricing strategy.  Of course costs and levels of competition in a market are important when setting a products price but so are a whole range of other factors:

  • What is the value of the product or service to the customer: In their book, Principles of Marketing, Philip Kotler and Gary Armstrong cite the example of the Panera Bread Company, a US bakery chain.  The company’s CEO, Ronald Shaich states, “give customers something of value and they will be happy to pay for it.
  • Psychological aspects of pricing:  This is where the price of goods plays a part in their attractiveness to customers.  This is often used in relation to luxury goods, many of which cost a similar amount to produce than cheaper alternatives but a high price is seen as part of the brand.  There may be price inelasticity in the market where there is a disconnect between the price charged and the level of demand.  In short, no matter the price charged, demand will remain.
  • The level of competitiveness in the market:  In highly competitive markets high prices may have a dramatic effect on a firm’s market share whereas in less competitive markets the ability to charge a price premium may be available.  For example, in the early days of cinema, Thomas Edison held the patent for film cameras.  That patent, which was strongly enforced, often by illegal means, meant that Edison could enforce the market price.  Hollywood developed as the centre of US film production largely because film-makers wanted away from Edison’s bully tactics on the American east coast. That and complaints about Edison’s enforcers ended his ability to control price.
  • Explanability:  How easy is it for your sales force to justify a particular price with your customer base?
  • Effect of price on retailers and distributors: When you sell to distributors and retailers, they want a profit margin for themselves.  If your wholesale price is too high, limiting an intermediaries margin, they may choose to buy an alternative product from a competitor.
  • Ability to negotiate margins:  Much has been made in the news about the price of milk and protests by dairy farmers outside processing plants.  It is clear that farmers do not have a strong position with which to negotiate profit margins or prices with those they supply.  There is a glut of raw milk on the market, supply outweighs demand.  There has been a contraction in the number of dairy processors and the processing of milk into dairy products is in the hands of a handful of multi-national companies.  Supermarkets have pushed prices down as they use milk as a loss leader. The power in the market is with the milk processors and supermarkets and they can impose a price per litre on farmers.
  • Political Factors: For example, the UK government has placed pressure on drug companies to reduce their prices when supplying the NHS.  There have been several newspaper articles implying that drug companies are profiteering with public money.  Applying a high price to certain drugs, and this being publicised, may have significant political impact on a company, its market position and in the long run, its profitability.
  • The product’s price and its position in the product line:  I remember Top Gear reviewing a mid-range Porsche.  The car was between the two other models the company produced.  It’s power and level of equipment was the median between the cheaper Boxster and the more expensive 911.  It’s price was exactly in the mid-point between the cost of the Boxster and the 911.
  • Is there a correlation between price and quality: Again psychological pricing.  A pair of designer jeans at £300 are often seen by the buying public to be of higher quality that a £30 pair from a supermarket.
  • The position of the product in its lifecycle:  Often affects the price charged.  A new model of computer tends to start at a high price, to recoup development fees.  As the technology becomes more widely available, the price charged falls.  For example, when pocket calculators first appeared in the early 1970’s, they were for engineers, scientists and executives; and as a result cost several hundred pounds.  Today, you can buy a pocket calculator in a supermarket for a pound.

When a company places a new product on the market, they can use a variety of pricing strategies to position the product:

  • Rapid Skimming (High Price/High level of Promotion) – Apple used this strategy for the iPhone.  The phone was expensive when compared to those of competitors and there was a significant level of promotional expenditure.
  • Slow Skimming (High Price/Restrained Promotion) – As used by Rolls Royce Cars.  The cars are expensive but there is no widespread advertising or promotional activity.  Instead, promotional activity is targeted via personal selling and the dealer network to individual customers of high net worth.
  • Rapid Penetration (Low Price/High level of Promotion) – As used by most branded consumer goods. The aim is to sell high volumes quickly so there is widespread advertising and other promotional activity to drive sales.
  • Slow Penetration (Low Price/Restrained Promotion) – As used by most generic and own brand products.  The level of promotion may be little more than obtaining prominent shelf position in a supermarket.

For existing products, different pricing strategies also exist:

  • Build Objective – In price sensitive markets, when a competitor raises their price, you do not follow immediately and keep your lower price.  This hopefully draws customers to your product building market share
  • Hold Objective – This is a defensive pricing strategy where you maintain your price, often by cutting costs, to retain your market share
  • Harvest Objective – This is when prices are raised in a market where sales/market share are falling.  This is one strategy used for products in the dog quadrant of the Boston Consulting Group matrix and instead of disposing of the product you harvest it for cash (often referred to as a Cash Dog)
  • Reposition Objective – This is where you use a change in price to reflect your new market position.  For example, Skoda raised the price of their cars following the company being purchased by Volkswagon.  This increase in price reflected the higher quality of Skoda vehicles following significant retooling of their factories by the parent company.

Setting the price of your goods is a far more complex strategy than the simple application of cost-plus accountancy.  Philmus Consulting Ltd can help you to assess the appropriate price for your products and services as part of a consistent marketing mix.