Dr. Prerna Jain

COST PLUS PRICINGIt is also known as “Mark –up pricing” “Average

cost Pricing “ or “Full cost pricing.” The general practice under this method is to add up a fair percentage of profit margin to AVC. The formula is:

P= AC + mHence a firm will consider total cost per unit or

average cost and determine a mark up, depending upon various considerations such as target rate of return, degree of competition, price elasticity and availability of substitutes.

Example: Technologies Pvt. Has invested Rs. 10 crore in plant and machinery, with a capacity to produce 10,000 units of television per month. TVC is estimated at Rs. 5 crore and the firm expects a return of 20% on total investment. What should be the price of TV if we suppose that the firm can sell its entire output?

Solution:Base Price = TC = 10+5 = Rs. 15 crore

Margin = 20% of 15 = 3 croreTotal Revenue = 15+3 = 18 crorePrice = 18,00,00,000/10,000 = Rs. 18,000 per TV

The method of mark up pricing is very simple and convenient.

But there is one major limitation of this method, it is not suitable when competition is tough or when a new or existing firm is trying to enter a new market.

MARGINAL COST PRICINGWhen demand is slack and market is highly

competitive, full cost pricing may not be the right choice; an alternative in such a situation is to fix the price on the basis of variable cost, instead of full cost. The method remains same except that only variable cost is considered instead of total cost for the purpose of price determination. Marginal cost pricing is also known as incremental cost pricing.

Determine the price of television on the basis of marginal pricing:

Solution:Base price = VC = Rs. 5 crore.i) Margin = 20% (of TC) 15 = 3 crore; Total Revenue = 5 + 3 = Rs. 8 crore Price = 8,00,00,000/10,000 = Rs. 8,000 per TVii) Margin = 20% of VC = 1 crore; Total Revenue = 5+1 = Rs. 6 crore Price = 6,00,00,000/10,000 = Rs. 6,000 per TV

Thus we can see that the highest price by using marginal cost pricing method would be Rs. 8ooo when margin is calculated on total investment, this is less than half of the price charged under full costing. If the company charges a margin on variable cost, the price would be further lower, namely Rs. 6000.

This method is very useful to beat competitors, it is also used by firms to enter a new market. It is very useful in case of goods of public utility where profitability is not the objective.

Penetration PricingWhen a firm plans to enter a new market which is

dominated by existing players, its only option is to charge a low price, even lower than the ongoing price. This price is called penetration price.

Reliance brought a kind of revolution in Indian mobile phone industry by using this strategy in a market which was dominated by BSNL.

Air Deccan, Nirma.The principle of marginal costing may be used for

this purpose. However this method is also short term in perspective and its success largely depends upon the price elasticity of demand of the product.

ENTRY DETERRING PRICINGCreation of monopoly depends upon entry

barriers. One such barrier may be created by a large player to eliminate or reduce competition, by keeping the price low, thus making the market unattractive for other players. If the prevailing price is already very low, new entrants with high fixed cost will not be able to enter the market at a price lower than the prevailing price.

On the other hand, existing small players may not be able to survive at this price due to higher average cost. Thus this practice is also known as Limit pricing.

Preventing entry of new players is just opposite to penetrating a new market, though quite interestingly, pricing strategy is the same in both, that is charging a low price.

Success of entry deterring pricing strategy depends on the fact that the firm earns economies of scale and hence can afford to charge low price.

GOING RATE PRICINGHave you wondered why all the brands of packaged

drinking water are priced the same? Or packs of fruit juice? Or soft drinks or milk packets? The answer is simple, all the players are using going rate pricing strategy. This strategy is adopted when most of the players do not indulge in separate pricing but prefer to follow the prevailing market price. Normally the price is fixed by the dominant firm and other firms accept its leadership and follow that price. The success of this strategy is dependent on the fact that most of the firms do not want to enter into a price war kind of situation. Secondly small or new firms may not be sure of shift in demand by charging a price different from the prevailing market price. Thirdly the products sold by the players are very close substitutes, hence their cross elasticity is very high

Product life cycle based pricingEvery product passes through many stages

starting from introduction, going through growth and maturity and leading to saturation and ultimately reaches decline. Each phase is unique in itself, with varied features. Moreover a product faces different demand patterns and consumption levels under different stages; hence there is a need for revising its price as it passes through different stages. Charging a uniform price for a product across all theses stages would amount to less than optimum revenue for the firm.

Instead an intelligent firm would devise different pricing for a product at different stages of its lifecycle.

Ex: First cellular phone with camera and radio, or the first TV with flat screen.

The most popular strategies under this category are price skimming, product bundling and perceived value pricing.

A) Price Skimming: Producers know that there is a segment of consumers who have deep pockets and who would like to be among the first few proud possessors of the latest product. These consumers are mostly governed by the status symbol factor and not by the intrinsic value of the product. Hence producers charge a very high price in the beginning to skim the market and earn super margins on sales. In the introduction stage the mark up on cost is normally very high.

Once the product is established and approaches maturity, sellers reduce their profit margin and charge lower price for the same product to attract large number of consumers who have lower paying capacity or in other words who have high price elasticity for the product.

Price skimming strategy deals with a complete pricing package suitable for different life cycle stages of a product, i.e., high price at the time of introduction and lower price during maturity. Nokia has been successfully using this strategy for its products.

B) Price Bundling (or Packaging): In this method two or more products are bundled together for a single price. This strategy is often used as a double edged weapon, for propagating a new product, as well as for selling a product in its stage of decline.

When a product is new and needs to be popularised, sellers adopt packaging of various products together and charge one price for the same.

Ex: Hotels provide free breakfast or drinks as part of room tariff.

C) Perceived value pricing: The underlying philosophy of this pricing is that a product is as good as a consumer finds it. Value of goods for different consumers depends upon their perception of utility of the good. Therefore the price a consumer is willing to pay would reflect the value of that product to him. A segment of buyers believe that higher the price, better the quality; hence they would be willing to buy anything that is tagged at high price. It is also termed as Psychological Pricing.

Perceived value pricing is normally adopted during the growth and maturity stage so as to differentiate the product from that of competitors’ and retain the quality conscious customers. Titan watches, Philips products, Tanishq jewellery and Parker pens are some of the brands which have consistently resorted to perceived value pricing by creating hype about high quality. Here the price of the product is not at all governed by the cost of production.

Value PricingValue Pricing: A variant of perceived value pricing

is value pricing, in which sellers try to create a high value of the product to keep the price low. The assumption is that price should represent value for money to consumers, in other words price charged should be lower than perceived value of product for the consumers. Thus in this method of pricing the seller allows some consumer surplus to the buyer.

This is a strategy suitable for the maturity and saturation stage when demand can be maintained by keeping focus on higher quality and lower cost. Ex: Koutons

Loss Leader PricingAn interesting strategy adopted by companies which produce or sell multiple products is to sell one product at a low price and compensate the loss by other products of the same firm. However the success of this strategy largely depends upon a combination of goods which are complementary in nature and one product cannot be utilised without the other product.Ex: printer and cartridgeIn this case the firms charge low price for the good which is durable and has high value and high price for the product which is consumable and has low value and hence has recurring demand.

Multi Product PricingIn order to understand the complexity of pricing of

multi product company it is desirable that you understand the possible relationships among the products of the same company. The interdependence between the products can be of three types viz. demand interdependence; supply interdependence; and input output relationship.

In case of substitutes: The seller has to options-i) charge the same price for the two goods, as Coca Cola has adopted for Coke and Thums Up brands, or ii) differentiate the products from each other and take advantage of perceived value pricing as in case of Surf Excel (premium segment) and Surf (economy segment) by HLL.

In case of complements an increase in demand for one product increases demand for the other as well; therefore optimal output is greater than when there was no demand interdependence. Here an increase in price of one good would result in fall in demand of both the goods. Therefore a suitable strategy would be either product bundling or loss leader.

Supply Interdependence: The case of production interdependence is when the same equipments and technology are used to produce multiple products, there is no increase in fixed cost and the firm makes use of economies of scope. Ex: cars like Maruti 800, Alto, Zen, WagonR etc. from Maruti are produced with the same plant and machinery; overheads are distributed and the same distribution network is utilised. In such a case the company adopts a combination of various pricing strategies by categorising its own products under different segments on the basis of the stage of product life cycle, consumers’ perceived value, distribution of costs and so on.

One of the strategies for such companies is RAMSAY PRICING

Input-output Relationship: There may be the case when a company undertakes all the stages of production involved in bringing out the final product. For example, Tata Sons produce iron and steel; it also manufactures cars, trucks and other vehicles. Steel is produced in a separate plant managed as an autonomous division (TISCO) and vehicles are manufactured in another similar autonomous division (Tata Motors). The product of TISCO is used as an intermediary product in TELCO (and is sold to other users as well). Thus products(steel and automobiles) of these units bear input output relationship; pricing in this case is called TRANSFER PRICING

RAMSAY PRICING: Economist Frank Ramsay gave a model for taxation which became very useful for pricing decisions of a multi product firm. He suggested that the govt. should levy high tax on the goods which had low price elasticity and low tax on goods which had high price elasticity.

TRANSFER PRICING: Transfer prices are the charges made when a company supplies goods, services or financials to another company to which it is related as its subsidiary or sister concern. When a multi product firm is engaged in production of such goods where one product is an intermediary for the other, i.e., it is vertically integrated. The firm now encounters the problem of fixing the price of a product demanded for internal use. Since use of these goods is part of total cost of final product but involves no cash outflow rather is only a transfer of accounts from one subsidiary to another, this is called transfer pricing.

Peak Load Pricing: This is a kind of price discrimination in which consumers are segregated on the basis of time segments; different prices are charged for the same facility used at different points of time by the same consumers. The time zone is divided into peak load and off peak load, consumers using the product at peak load time pay a higher price and users at off peak period pay a lower price. Ex: BSNL, Airlines provide various discounts on tickets purchased at different points of time.

RETAIL PRICING: Some of the popular techniques followed are discussed here:

Every Day Low Pricing (EDLP) Strategy: As per EDLP, a low price is charged throughout the year and none or very few special discounts are given on special occasions. This method can be successful only when retailer is very large in size to avail economies of scale and has very low overhead expenses. In India, Big Bazaar has tried the same strategy.

High-low Pricing – This method involves high prices on regular basis, coupled with temporary discounts on promotional activity. How is this different from EDLP? On all days the price is higher than EDLP, but on discount days it is lower than