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Price is the selling price per unit customers pay for your product or service. Pricing your
product or service is one of the most important business decisions that firms will make.
Firms should offer a price leading to profitability that target market is willing to pay.
There are many approaches to pricing. The price which is set is the cost to the customer.
Ideally, it should be higher than the costs incurred in producing the product. However,
there will be times to set prices at or below cost for a temporary, specific purpose, such as
gaining market entrance or clearing inventory. How the customer perceives the value of
the product determines the maximum price customers will pay. This is sometimes
described as "the price the market will bear." Somewhere between the cost and "the price
the market will bear" is the right price for product or service. Consequently, once you
understand your costs and your maximum price, you can make an informed decision
The pricing strategy is another marketing technique you can use to improve your overall
policies and to constantly monitor prices and operating costs to ensure profits.
If a company raises the price of a product, unit sales ordinarily fall. Because of this,
pricing is a delicate balancing act in which the benefits of higher revenues per unit are
traded-off against the lower volume that results from charging higher prices. The
sensitivity of unit sales to changes in prices is called the price elasticity of demand.
A product's price elasticity should be a key element in setting its price. The price
elasticity of demand measures the degree to which the unit sales of a product or service
are affected by a change in price. Demand for a product is said to be inelastic if a change
in price has little effect on the number of units sold. The demand for designer perfumes
Lowering prices on these luxury goods has little effect on sales volume; factors other than
price are more important in generating sales. On the other hand, demand for a product is
said to be elastic if a change in price has a substantial effect on the volume of units sold.
An example of a product whose demand is elastic is gasoline. If a gas station raises its
prices for gasoline, there will usually be a substantial drop in volume as customers seek
Price elasticity is very important in determining prices. Managers should set higher
markups over cost where customers are relatively insensitive to price (i.e., demand is
inelastic) and lower markups where customers are relatively sensitive to price (i.e.,
the bargain basement has a much lower markup than merchandise sold elsewhere in the
store because customers who shop in the bargain basement are much more sensitive to
• The price of the product has no effect on the sales or costs of any other product.
The formula can be derived using calculus.
Using the above markup is equivalent to setting the selling price using this formula:
The formula for the profit maximizing price also conveys a very important lesson. The
optimal selling price should depend on two factors--the variable cost per unit and how
sensitive unit sales are to changes in price. In particular, fixed costs play no role in setting
the optimal price. Fixed costs are relevant when deciding whether to offer a product but
are not relevant when deciding how much to charge for the period.
Despite the apparent optimality of prices based on marking up variable costs according to
the price elasticity of demand, surveys consistently reveal that most managers approach
the pricing problem from a completely different perspective. They prefer to mark up
some version of full, not variable, costs, and the markup is based on desired profits rather
approach (price elasticity of demand) both in what costs are marked up and in how
markup is determined. Under the absorption costing approach to cost plus pricing, the
cost base is the absorption costing unit product cost rather than variable costing.
For example, let us assume that the management of Ritter Company wants to set the
selling price of a product that has just undergone some design modification. The
accounting department has provided cost estimates for the redesigned product as shown
below:
The first step in the absorption costing approach to cost plus pricing is to compute the
unit product cost. For Ritter Company, this amounts to $20 per unit at a volume of 10,000
Direct materials $6
Direct labor 4
Variable manufacturing overhead 3
Fixed manufacturing overhead ($70,000 / 10,00 units) 7
-------
Unit product cost $20
====
Ritter Company has a general policy of marking up unit product costs by 50%. A price
quotation sheet for the company prepared using the absorption costing approach is
presented below:
Direct materials $6
Direct labor 4
Variable manufacturing overhead 3
Fixed manufacturing overhead (based on 10,000 units) 7
--------
Unit product cost 20
Markup to cover selling, general, and administrative expenses and desired
10
profit--50% of unit manufacturing cost
--------
Target selling price $30
Note that selling, general and administrative (SG&A) costs are not included in the cost
base. Instead, the markup is supposed to cover these expenses. Let us see how some
Using the absorption costing approach, the pricing problem looks deceptively simple.
All you have to do is calculate cost, decide how much profit you want, and then set your
price. It appears that you can ignore demand and arrive at a price that will safely yield
profit whatever profit you want. However, as noted above, the absorption costing
approach relies on a forecast of unit sales. Neither the markup nor the unit product cost
can be computed without such a forecast. The absorption costing approach essentially
assumes that the consumers need the forecasted sales and will pay whatever price the
company decides to charge. However, customers have a choice. If the price is too high,
they can buy from a competitor or they may choose not to buy at all. Suppose, for
example, that when Ritter Company sets its price at $30, it sells only 7,000 units rather
than the 10,000 units forecasted. As shown in above calculations, the company would
then have a loss of $25,000 on the product instead of a profit of $20,000. Some managers
believe that the absorption costing approach to pricing is safe. This is an illusion. This
approach is safe only as long as customers choose to buy at least as many units as
Rather than focusing on costs--which can be dangerous if forecasted unit volume does
not materialize--many managers focus on customer value when making pricing decisions.
In traditional costing system it is presumed that a product has already been developed,
has been costed, and is ready to be marketed as soon as a price is set. In many cases, the
sequence of events is just the reverse. That is, the company already knows what price
should be charged, and the problem is to develop a product that can be marketed
profitably at the desired price. Even in this situation, where the normal sequence of
events is reversed, cost is still a crucial factor. The company can use an approach called
target costing.
Target costing is the process of determining the maximum allowable cost for a new
product and then developing a prototype that can be profitably made for that maximum
The target costing for a product is calculated by starting with the product's anticipated
selling price and then deducting the desired profit. Following formula or equation
The product development team is then given the responsibility of designing the product
Following set of activities further explains the concept of target costing technique:
characteristics of markets and costs. The first is that many companies have less control
over price than they would like to think. The market (i.e., supply and demand) really
determines prices and a company that attempts to ignore this does so at its peril.
Therefore, the anticipated market price is taken as a given in target costing. The second
observation is that most of the cost of a product is determined in the design stage. Once a
product has been designed and has gone into production, not much can be done to
significantly reduce its cost. Most of the opportunities to reduce cost come from
designing the product so that it is simple to make, uses inexpensive parts, and is robust
and reliable. If the company has little control over market price and little control over
cost once the product has gone into production, then it follows that the major
opportunities for affecting profit come in the design stage where valuable features that
customers are willing to pay for can be added and where most of the costs are really
determined. So that it is where the effort is concentrated--in designing and developing the
product. The difference between target costing and other approaches to product
development is profound. Instead of designing the product and then finding out how
much it costs, the target cost is set first and then the product is designed so that the target
cost is attained.
1. Effective implementation and use requires the development of detailed cost data.
4. May reduce the quality of products due to the use of cheep components which
called time and material pricing. Under this method, two pricing rates are established--
one based on direct labor time and other based on the cost of direct materials used. This
pricing method is used in repair shops, in printing shops, and by many professionals such
as physicians and dentists. The time and material rates are usually market determined. In
other words, the rates are determined by the interplay of supply and demand and by
competitive conditions in the industry. However, some companies set the rates using a
process similar to the process followed in the absorption costing approach to cost plus
pricing. In this case, the rates include allowances for selling, general and administrative
expenses; other direct and indirect costs; and a desired profit. This page will show how
Time Component:
The time component is typically expressed as a rate per hour of labor. The rate is
1. The direct costs of the employee, including salary and fringe benefits.
2. A pro rata allowance for selling, general, and administrative expenses of the
organization.
In some organizations (such as a repair shop), the same hourly rate will be charged
regardless of which employee actually works on the job; in other organizations, the rate
may vary by employee. For example, in a public accounting firm, the rate charged for a
new assistant accountant's time will generally be less than the rate charged for an
Material Component:
invoice price of any materials used on the job. The material loading charge is designed to
cover the costs of ordering, handling, and carrying materials in stock, plus a profit margin
To provide a numerical example of time and material pricing, consider the following:
Quality Auto Shop uses time and material pricing for all of its repair work. The following
Repairs Parts
Mechanics' wages $300,000
Service manager--salary 40,000
Parts manager--salary $36,000
Clerical assistant--salary 18,000 15,000
Retirement and insurance--16% of salary and wages 57,280 8,160
Supplies 720 540
Utilities 36,000 20,800
Property taxes 8,400 1,900
Depreciation 91,600 37,600
Invoice cost of parts used 400,000
hour of repair time is considered to be feasible, given the competitive conditions in the
market. For parts, the competitive markup on the invoice cost of parts used is 15%.
The following schedule shows the calculation of the billing rate and the material loading
Note that the billing rate, or time component, is $30 per hour of repair time and the
material loading charge is 45% of the invoice cost of parts used. Using these rates, a
repair job that requires 4.5 hours of mechanics time and $200 in parts would be billed as
follows:
Rather than using labor hours as the basis for calculating the time rate, a machine shop, a
This method of setting prices is a variation of the absorption costing approach. As such, it
is not surprising that is suffers from the same problem. Customers may not be willing to
pay the rates that have been computed. If actual business is less that the forecasted 24,000
hours and $400,000 worth of parts, the profit objectives will not be met and the company
According to Mckinsey Company’s consultants, the fastest and most effective way for a firm to
achieve maximum profit is to get its price right (Marn and Rosiello, 1992). These consultants
reported that a 1 percent price improvement generates an average of 11.1 percent increase in
profits among the 2,462 companies they studied. Given the importance of price in generating
revenues and profits for a company, the approach used by service firms in price setting has
marketing, Zeithaml et al. (1985) found that cost-oriented pricing was the most popular
approach used by service firms. Although this method offers some advantages, the simplistic
nature of cost-oriented pricing is not effective in a complex and competitive business world. As
consumers have become more sophisticated and demanding, it is imperative that service firms
be adapted to this changing environment when setting prices. The objective of this paper is to
develop a service pricing approach by which price setting can be related more closely to the
sensitivity and unique service characteristics. First, we will review the advantages and
disadvantages of six service pricing approaches, which have been presented and discussed in
Then, based on the review, a multi-step synthetic pricing approach for service marketing
will be developed.
There are more than the above six pricing approaches in service marketing literature. For example,
skimming pricing strategy and penetration pricing strategy are suggested for new services (Dean,
1970). This paper only covers these six pricing approaches because of their managerial implications
for price setting in service firms. We will first describe briefly each pricing approach and then
approach
cost-oriented approach and competitive-oriented approach are the two traditionally dominant pricing
approaches in the service industry. A cost-oriented pricing approach sets a service price based on
all the costs plus a desirable profit margin (Beard and Hoyle, 1976; Dearden,1978). It is usually based
on full cost, but it can also be a contribution and incremental basis. For competitive-oriented pricing
approach, the price is set to meet the market competitive situation (Kotler and Bloom, 1984). The
simplistic nature of these two pricing approaches provides the advantage of a useful and quick pricing
method. On the other hand, the simplicity of these two pricing approaches also causes them to lose
their effectiveness as the business world becomes more dynamic and complex (Guiltinan, 1987). In
general, a competitive-oriented service pricing approach provides no guidance on how much higher or
lower than a competitor’s price a service provider should set its price (Arnold et al., 1989). Also most
• not incorporating unique service characteristics and selling conditions into the decisions (Hoffman
Hoffman and Arnold (1989) proposed an extended cost-oriented pricing approach for professional
service providers. The model included the traditional cost-oriented pricing factors of fixed costs,
variable costs and the firm’s profit goals, along with the factors that make up the extended model:
essentiality – the extent to which the purchase of the service is postponable, durability, value added,
and the percentage of performance capacity. The factors influencing service pricing can be partitioned
(1) Traditional factors: variable cost (VC), fixed cost (FC) and profit goal (PG);
(2) Unique premium characteristics: essentiality (Ep), durability (DURp) and tangibility (value
added,V*);
To formulate a service price, first, a service manager needs to determine a proper cost basis (FC +
VC) for a particular service. Second, the cost used in the pricing basis should be adjusted by the
percentage capacity of fixed cost actually consumed for delivering a service. For example, if a service
performance consumes less than 100 percent capacity, then a marginal or contribution cost basis
should be used rather than a full cost basis. Third, add a differentiated service characteristics premium
(SCP), which is derived by comparing service characteristics with average market competitors or a
target competitor, into the adjusted pricing basis. The term “premium” is used to indicate pricing
above the market. Hoffman and Arnold (1989) summarized their model as follows:
(Ep) + (DURp) + V*
where:
VC = variable costs;
FC = fixed cost;
PG = profit goal;
SCP = service characteristics premium;
Ep = essentiality premium;
In contrast to traditional cost-oriented approaches, the major advantage of the extended cost-oriented
approach is that it incorporates premium factors into managerial profit-pricing consideration. Also, the
extended approach, to a certain extent, considers the competitive advantages of product differentiation
in service pricing. The major disadvantage is that the service characteristic premium increases the
complexity of the pricing task. Premium factors are very difficult to evaluate objectively with a
monetary term. Also, it is reasonable to believe that there should be more than the three premium
Arnold et al. (1989) also proposed a premium service pricing approach which incorporates into the
firm’s pricing strategy recognition of the ability to differentiate the firm’s competitive advantages
from those of competitors. The differentiation premium (DP) comes from four factors:
Each of these factors ranges from +1 to –1. The service differentiation premium price (Pdp) is equal to
this differentiation premium plus an average competitors’ price (ACP). The relationships can be
shown as follows:
DP = f (Ap, Rtp, CIp, Psp)
Pdp(SL) = ( 1 + DP ) * (ACP)
where:
DP = differentiation premium;
Ap = availability premium;
According to Arnold et al. (1989) availability refers to the number of services as well as the types of
services available to the consumers. Reputation testability refers to the degree to which the service
performance can be evaluated objectively prior to consummation. Arnold et al. (1989) used the term
reputation testability, therefore, we used the same term. Reputation testability would be related to
search, experience and credence qualities (Darby and Karni 1973; Nelson, 1974) with reputation being
of greater importance for credence quality services. Commitment incentive refers to the relationship
between profitability and the duration of the commitment between the service provider and its
customer(s). This relationship can have a major influence on a pricing strategy. Price sensitivity
depends on the number of service alternatives of which consumers are aware. In general, the positive
• Less price sensitivity resulting from service customerization and product differentiation
Client-driven pricing approach
Ratza (1993) developed a client driven model for service pricing. The model is based entirely on
clients’ response to price, namely the quantity of service used and the number of clients gained or lost.
The major advantages of this model are: consideration of the relationship between market share
(demand) and price; and maximizing short-term and long-term profit. The major disadvantage of his
model is that it is built on the economic assumption of static equilibrium along with zero marginal cost
and constant/or linear consumption. Because service firms compete in dynamic and changing
environments, this approach has the problem of being too simplistic. In addition, it is not easy for a
firm to acquire complete chronological firm based sales (demand) and price data for simulation
purposes, especially for a service innovation or a newly offered service. Besides, stabilizing market
price is one of the major tasks of marketing managers. A frequently fluctuating pricing strategy may
damage the company’s image. For future model modification, instead of depicting the relationship
between price and the entire firm’s demand, it is more practical to focus on individual client’s
According to Guiltinan (1987), “Broadly defined, bundling is the practice of marketing two or more
products or services in a single package for a special price”. The rationales for service bundling are:
the cost structure consists of a high degree of cost sharing and a high ratio of fixed cost to variable
cost (Dearden, 1978); and the demand for a firm’s services is generally interdependent. From an
High price for each good from some buyers who care very little for the other.
Mixed bundling can make use of both of these advantages by selling the bundle
Operationally, a firm ultimately must determine a specific price discount which is computed from the
combined prices of two or more individual service items. Thus, before a “package price” of bundled
services can be formed, the individual price of each service has to be formulated. This approach
requires more knowledge of specific costs, demand elasticity and cross-elasticity and reservation price
distributions. Although the bundle pricing approach is much more complicated than the previous five
pricing approaches, the use of bundle pricing appears to have been expanded significantly in recent
None of the above service pricing approaches fulfills simultaneously the considerations of
demand/supply, profit, unique service characteristics and cost structure. This does not mean the above
pricing approaches are not useful. Rather, it reflects the complexity and difficulty of pricing in the real
business world. In fact, pricing is one of the most critical pressures of top executives (Anonymous,
1987). Although it may be too much to expect a single pricing approach to include all the pricing
considerations, there exists a need for a better pricing approach. Two observations can be made from
the pricing approaches reviewed in previous sections. First, a complete pricing model is likely to be
complicated because more pricing variables have to be included. Second, instead of using one single
pricing approach, a better way may be the use a group of pricing approaches to set service prices. The
A multi-step synthetic service pricing approach is proposed to deal with the complexity of market
competitiveness, cost structure, profit goals, price/demand sensitivity and service unique
characteristics. To set a proper service price, the proposed pricing approach combines the pricing
decision process and the other pricing approaches rather than using a singular
Pricing scenario
The multi-step synthetic pricing approach contains six steps as shown in Figure 1. The first step is to
determine market positioning for the service and to identify competitors. As is well known, price
setting cannot be formulated solely without considering marketing objectives, market competitiveness
and other marketing variables. Market positioning and targeting competitors can clarify the directions
of price setting and verify the role of price in the marketing mix. The main objective of this step is to
decide a proper comparable pricing basis for further calculation of a differentiation premium price. In
their model, Arnold et al. (1989) suggested using the average competitors’ price as a pricing basis.
Certainly, many different pricing bases can be used as long as they are logical and reasonable.
However, for discussion purposes, the average competitors’ price is adopted. The pricing basis can be
either an unbundled price or a bundled-package price. The second step is to formulate a market
premium service price (MPC). Essentially, the same concept of differentiation premium approach
suggested by Arnold et al. (1989) is used. Based on some chosen criteria of service performance, a
service provider can examine the target competitors’ strategies to develop a unique service
where:
through market comparison. To form a differentiation premium, many unique service characteristics
can be used. For example, those unique service characteristics such as availability, reputation,
commitment incentive, price sensitivity (Arnold etal., 1989), essentiality, durability, tangible value
(Hoffman and Arnold, 1989), access, communication, courtesy, reliability, security, responsiveness
(Parasuraman et al., 1985), and industrial unique attributes (Bonnici, 1991;Parasuraman et al., 1985;
The third step is to formulate a cost-plus price (CPP). CPP is computed by the traditional cost-oriented
pricing approach along with the adjustment ofHoffman and Arnold’s (1989) percentage of production
capacity used in a particular service delivery. The formula can be written as:
CPP = { VC + ( PC * FC ) + PG }
where:
VC = variable cost;
FC = fixed cost;
PG = profit goal.
CPP serves the role of internal profit-cost control. Essentially, CPP is a managerial expected price
which contributes a desirable profit to a service firm. CPP is only an internal planning result and needs
to be balanced with external market feedback (price competition). The fourth step is to compare MPC
with CPP. If MPC is greater than or equal to CPP, then MPC is the chosen service price (SP) and then
moves to the adjustment of price standard limits (SL). Conversely, if MPC is smaller than CPP, a
service provider has two choices. One is to take MPC as a chosen service price. After all, CPP is only
an internal goal and a self guidance item for managerial purposes. MPC, rather than CPP, represents
the reality of market competition. The other option is to improve the service differentiation premium
(SDP) to achieve the desirable profit-pricing goal. The SDP premium can be increased through either
marketing efforts or service improvement. After a SP is chosen, it needs to be checked whether or not
the SP fits within the range of price standard limits (SL). If the chosen SP does not lie within standard
pricing limits, then the SP will be replaced by either a SL ceiling price (if the SP is higher than SL
ceiling price) or a SL floor price (if the SP is lower than SL floor price). Therefore, the SP after SL
where:
In the last step, SP(SL) is modified by a client–driven consideration derived from Ratza’s (1993) pricing
concept. The objective is to pursue maximum profit from individual clients or a homogeneous group
of clients. Instead of using the entire company’s demand, it is suggested that the clients be segmented
into at least two categories: institutional or large-volume clients; and general clients. It is logical to
believe that heterogeneous groups will have different price elasticities. The more homogeneous groups