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Sunday, August 30, 2009

Pricing Methods

To achieve certain pricing objectives we can make use of certain pricing methods that would depend upon the goal of the organisation. These methods include:

1. Cost-plus pricing - In this option we would need to just set the price at the production cost plus a certain profit margin that the company is expecting.

One equation I have used a lot is for calculating cost-plus prices is: P = (AVC +FC%) X (1+ MK%), where P = price, AVC = average variable cost, FC = percentage apportionment of fixed costs, and MK% = percentage markup. Variable costs are those that vary as the output level varies, and fixed costs are costs that do not vary with the level of output. Fixed costs include costs such as property, equipment and labor. AVC or average variable cost is variable cost divided by level of output.

Now Cost-plus pricing has several benefits, but drawbacks include times when target-return/ Value based pricing methods would be more successful. Cost-plus pricing systems are easy to administer and calculate, and require only minimal information while preventing runaway or unexpected costs. Problems include a lack of incentive for efficiency in resource consumption, and a lack of consideration for both consumers and competition. Further, sunk costs (expenditure that has been made and cannot be recovered) and opportunity costs (costs associated with opportunities that are forgone when a firm's resources are put to their best alternative use) are not differentiated in cost-based pricing from other forms of cost, probably leading to inefficient outcomes. 

2. Value -based pricing - We would base the price on the effective value to the customer relative to alternative products.

This is the most complex pricing methodology that I have encountered, & is considered to be the most accurate & profitable. For this methodology we would need to consider through careful evaluation of customer operations & proper survey's which are sometimes used to determine the value, and therefore the willingness to pay, as a customer attributes to a product or a service. Frameworks for value-based pricing include Economic Value Estimation are Relative Attribute Positioning, Van Westendorp Price Sensitively Meter, Conjoint Analysis.

Reference : www.cval.com/pdfs/VBMarketingAndPricing.pdf

3. Target return pricing - This method allows you to set the price to achieve a target return-on-investment.

It is what I call a reverse engineering pricing model where the marketing team plays the king. The methodology involves (1) identifying the price at which a product will be competitive in the marketplace, (2) defining the desired profit to be made on the product, and (3) computing the target cost for the product by subtracting the desired profit from the competitive market price. The formula

Target Price - Desired Profit = Target Cost

Target cost is then given to the engineers and product designers, who use it as the maximum cost to be incurred for the materials and other resources needed to design and manufacture the product. It is their responsibility to create the product at or below its target cost.

4. Psychological pricing - Price on factors such as signals of product quality, popular price points, and what the consumer perceives to be fair.

Apart from these basic approaches vendors have another innovative pricing models like introducing a  subscription model in which the customer subscribes for a set period of time, such as one year, this subscription must be renewed for the product/service to work. This model offers stability to both the supplier and the customer since it reduces the large swings in investment cycles.

If you want some perspective on how you or  your company needs to enhance their Sales/Client Management Capabilities, please email me at shubhanjan.saha@gmail.com
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