7 types and how they work.
by august j. aquila
price it right
pricing in the real world is much different than in the accounting profession.
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usually, wholesalers and retailers set their prices by using markups as the product moves through a distribution channel. producers or manufacturers usually set a list price. think of the manufacturer’s suggested list price on the window of a new car. car dealers will use various methods to price the new vehicle.
let’s look at the most common pricing strategies that you may consider.
pricing on cost
cost-based pricing is a fairly straightforward concept, in which the organization understands the operation costs of producing a given good and prices that good as close to this cost level as possible. it is often referred to as cost-plus pricing, as the firm must retain some value or profit from the sale. this markup can be set at a fixed percentage, such as 5 percent. if a given good will cost $10 to develop, a perfect cost-based pricing would be to sell it at $10. a cost-plus pricing model at 5 percent would be to sell the product at $10.50.
while the concept of cost-based pricing is quite simple, the accurate measurement of cost can sometimes be a bit complex. there are fixed costs, variable costs and indirect costs, which all must be factored into the overall calculation. each of these costs is impacted differently by volume, and as a result cost-based pricing may fluctuate over time. this creates some requirements for
- projecting volume,
- basing cost off of a certain volume and
- understanding the potential in variance.
fixed cost changes over time, for the simple reason that each additional unit produced will lower the average cost per unit relative to fixed investments. take, for example, an investment in a machine for $10,000. the machine can produce 10,000 units in a year. at maximum capacity, this machine will cost $1 per unit. however, the demand is not high enough to produce at this capacity. instead, it is only producing 5,000 units a year. now the cost per unit is $2.
the variable cost is consistent for each new unit, and as a result is not sensitive to overall volume. what this means is that producing 1 unit will cost $5, and producing 10 units will cost $50, 100 units $500. indeed, sensitivity to volume is often one of economy of scale, which is to say that purchasing inputs for production may even become cheaper the higher the quantity that is produced. as a result, variable costs and quantity have a very different relationship than fixed costs and quantity.
impact of quantity on cost types
this simple chart underlines the relationship between fixed, variable and total cost compared to quantity produced and/or sold.
indirect cost
complicating the concept of cost-based pricing is the indirect cost of doing business. many aspects of an organization are not directly related to production, and are therefore somewhat difficult to factor into the overall equation. salaries of corporate staff, administration costs, legal costs, office costs, utilities, electricity and other supports must be accurately projected and built into the cost-based pricing model in order to ensure that the organization is properly pricing the product for profitability.
overall, when a company decides to price goods based on cost, it is important that the internal mechanisms of measurement for fixed, variable and indirect inputs are highly accurate and developed. this cost method is often considered a low-cost method, as the firm is attempting to forward as much value as possible to the consumer. this model is best for organizations working to compete on price, and striving for optimal efficiency in the production process.
price leaders
there are price leaders in every market. they determine the going price for the product or service and all other competitors follow suit. the firms that are price leaders normally have an excellent understanding of their clients’ wants and needs and are effective in providing high value.
usually this strategy is successful when there are a small number of organizations and there are significant barriers to entry. unfortunately, this is not the typical accounting firm market, and hence, we don’t see this type of pricing strategy in the accounting profession. rather, accounting firms continue to underprice each other.
prestige pricing
some companies are able to develop a prestige pricing strategy. nike is a great example. the prices for its shoes are set higher than normal because its customers value the image of the brand and the features over those of its competitors. several years ago, volkswagen came out with a high-end vehicle that did not sell. the market considered volkswagen a manufacturer of low-end rather than high-end automobiles. the company had an image problem.
blue-chip consulting firms, such as mckinsey & company, accenture, etc., often follow a prestige pricing strategy by setting their prices high to suggest a high quality or high status of their products. mercedes-benz and other luxury car manufacturers also use this strategy.
watches can cost you as little as $40 or less or they can cost thousands of dollars. they all tell time, but the higher-cost watch is a status symbol. it shows that the individual wearing it has been financially successful. it’s not the functionality of the watch, but what the brand stands for. the question here is “what does your brand stand for?” in any market there are go-to service firms that employ this strategy. do you know the ones in your market?
bait and switch
this strategy is definitely not recommended for any firm. it is included because it is commonly used by retailers in developing their pricing strategies. this pricing strategy falls at the other end of the spectrum from prestige pricing.
firms that employ this type of pricing strategy announce a very low price with the purpose of attracting customers. as the name implies, the firm does not intend to sell the product/services at these artificially low prices, but rather to get the customer to purchase a higher-priced item or service. all you need to do is to check the local paper for audio and stereo equipment, tvs, automobiles, etc., for the “special priced,” limited availability items to get an idea of this type of pricing strategy. other examples include resorts that promote a low nightly fee and then charge a very high daily resort fee to the vacationer’s bill.
market penetration
this pricing strategy is normally used when a service provider or manufacturer wants to buy market share. to achieve a significant share of the market, the firm would price its services or goods at a very attractive price. some firms set their fees based on their marketing strategies. if, for example, a firm is trying to penetrate a market, it will be inclined to determine its fees based on the competitors in that particular market. for the most part, those firms that follow a penetration pricing strategy will tend to charge lower fees than their competition.
during the last few years we have seen more of market penetration pricing in the accounting profession. firms that want to get into a new market will often significantly underprice their accounting and assurance services.
there are times when low fees may be advisable, but they are based on a strategy and not just pricing. for example:
- the market appears to be highly sensitive to fee levels and therefore a low fee will stimulate more rapid market growth.
- a low fee would discourage actual and potential competition.
- a low fee would not be viewed by clients as an indicator of poor-quality work.
- the more experience the firm obtains, the lower its costs of attracting and servicing clients.
there are other ways to increase market penetration rather than just cutting prices. for example, you can increase the promotions for the service and thus increase the pull strategy for the service, or you can directly market to your competitors’ clients.
market skimming
this strategy is normally used when a new or improved product comes out and the producers know that there will be a small section of the market that is willing to pay a premium price to be one of the first in the market to have the product. think of the original iphone by apple.
the pricing works well when the demand for the product or service is high and the relative supply is low. when a new drug becomes available, it will be priced using this strategy. if a new medical technique becomes available, it could be priced using this strategy. firms will try to make a large profit from a small number of clients.
as more and more providers of the service or product enter the marketplace, this strategy becomes less attractive. firms recognize that they can make high short-term profits. unless your firm offers a unique or specialized service, or unless you have developed an extraordinary perception in the marketplace as an expert in a certain unique area, you probably won’t be able to use this strategy.
for example, there are some firms that have created specialized services, such as process improvement or profit enhancement tools for certain industries. since no one else in the marketplace currently has such a service, these firms are able to charge a premium price.
what the market will bear
many professionals today price their services based on what the market will bear. think for a minute about the following professionals: real estate broker, life insurance broker, financial advisor, business broker. what do they all have in common? their fees are not based on hourly rates – rather they are based on the relative value or complexity of the medical procedure, the amount of the real estate transaction, the premium of the life insurance policy, the number and value of the stocks bought or sold, and the value of the business bought or sold.
pricing is a sophisticated technique that is given a lot of thought and attention by most businesses. in a buyer’s market, pricing is dictated more by the buyer than by the seller. conversely, in a seller’s market, the providers of the services and products can set their prices higher.
at different times, non-price factors become more important than the straight price. these non-price factors over the years have ranged from advertising, customer service, word of mouth, quality, service, social media, service guarantees, service providers and so forth. in the accounting profession, the accountant-client relationship is often a key factor in obtaining a premium fee.