What to Consider When Setting Prices

Every first year undergraduate student of business is taught the standard model of supply and demand.  This theory has three main elements;

  • Demand – the quantity of goods consumers will want to buy at a given price;
  • Supply – the quantity of goods a business wants to sell at a given price; and,
  • Price – the cost of the product demanded from consumers.

The theory states that there will be an equilibrium price of goods in a particular market.  If supply exceeds demand, consumers will expect to pay a comparatively lower price for goods.  If demand exceeds supply, consumers will be willing to pay a higher price.  The equilibrium price is found at the point where supply matches the level of market demand.

Many companies will price the goods they produce at a point which is above the cost of production but which is not too high so as to restrict demand.

So, it appears that setting prices for goods is a relatively simple process, you add a profit margin to your costs but not one so large as to restrict demand.  Things are not quite that simple; other aspects of the business environment; such as competitor’s strategies, your marketing strategy and the position of your product within a product mix; need to be taken into account.

Philip Kotler, the distinguished American marketing academic describes three major pricing strategies:

  • Customer Value-Based Pricing;
  • Cost-Based Pricing; and,
  • Competition-Based Pricing.

Cost-based pricing is the simplest of these models.  You set your price based on the cost of producing the goods and then you try to convince customers that the price represents genuine buyer value.  This is the model used by Aldi and Lidl where they compare their own label products with big name brands and claim that there is little or any difference between the two.  The likes of Aldi aim to be low cost suppliers.  They look to sell goods at low prices but lower costs maintain profit margins.

Cost-based pricing also operates in the luxury goods market.  Steinway Pianos cost tens of thousands of pounds but the company justifies the price of their instruments over mass produced alternatives stating the quality of the components and the craftsmanship in a Steinway piano justifies the cost.

Consumer value-based pricing uses buyer’s perceptions of a goods value to set its price.  Cost of production retains an important role in the development of a pricing strategy but setting final prices begins with the customer.  In value-based pricing, a business will assess the needs and values of target customers, set the price to match that perceived value, then determine costs and then design a product to deliver the desired value at that target price.

Applying this model to musical instruments, a top of the range Gibson Les Paul guitar costs thousands but to those who own one, price is nothing; the experience of ownership is everything.

There are two commonly used value-based pricing models, Good-value pricing and Value-added pricing.

Good-value pricing is delivering a certain quality of product at a reasonable price.  Ryanair and EasyJet are examples of good-value pricing, they may not offer the same level of service as a national flag airline but the price charged for their service is matched by consumers quality expectations.  For example, people are willing to put up with limited luggage capacity and having to buy food on the flight when they are travelling short-haul.  Ryanair has announced its intention to fly across the Atlantic.  Whether customers will be willing to put up with their levels of service on a long-haul flight remains to be answered.

Another example of value-based pricing is the McDonald’s Saver menu, where you can buy a basic burger for a pound.  It isn’t a big mac, but it offers to remove your fast food craving at a reasonable price.  Poundland sell everything at a low price but customers quality expectations are also lower.

Value-added pricing is used where a company wants to avoid a price war with a competitor.  If a competitor lowers their prices, rather than following suit, a business will retain its price level but add features to the product which are of value to customers.

A good example of value-added pricing is the Dominion cinema in Edinburgh.  This is an independently owned cinema in Edinburgh’s middle class Morningside area.  It’s major competitors are large cinema chains with out of town multiplexes.  The cinema chains offer large numbers of seats at a relatively low cost.  they offer a standard service with high cost fast food and confectionery.

The Dominion charges slightly more than the large chains but offers better seating, a bar service (the cinema still has intermissions) and a friendly family orientated atmosphere.  The feeling at the Dominion is that you are part of a club and you are a guest as much as a customer.  These value added features means that the independently owned Dominion is extremely highly rated and thrives despite the big brand competition.

Prices should not be set in isolation.  Price is an important element of the marketing mix and it needs to be considered as part of the wider product marketing mix.

Philmus Consulting can assist your business in determining pricing strategies as part of a wider marketing mix.