What Is Pricing and What Are Some Common Pricing Strategies?
Three Different Pricing Strategies
Pricing, as the term is used in economics and finance, is the act of setting a value on a product. While the basic concept is extraordinarily simple, many wonder about two things: price vs. cost and how to set price.
Are Price and Cost the Same Thing?
Although the two are used almost interchangeably in informal speech, in more formal business discussions price and cost are not at all the same. Price is what the buyer pays for the product or service. Cost is the seller's investment in the product subsequently sold.
Note that this difference between the price the buyer pays for the product and the cost to the seller to acquire or make the product is contextual. For a wheat farmer, the food wholesaler is a buyer and the price set by the farmer is what the wholesaler pays to acquire the wheat. For the food wholesaler, however, what she pays for the wheat is her cost; subsequently, she will set a price above that cost, which the bakery may then pay to acquire the wheat.
The difference is clearer on a company's income statement where the price variable is associated with sales and appears as a revenue item on the income statement. The cost of manufacturing the product, on the other hand, is shown on the income statement as cost of goods sold.
How Does the Seller Set the Price?
There are many specific cost-setting methods, but nearly all come down to some variant of three general approaches:
- Cost-based pricing. This approach ignores (in theory but not always in practice) what any other seller sets as the price for the same or a similar product, and bases the selling price on its relation to cost. Mark-up pricing is a particular instance of this general approach. In musical instrument sales, for instance, most instruments have one of two markups, an A markup, where the cost of drums and guitars is 50 percent of the retail price, and a B markup, where the cost of keyboard instruments is 60 percent of the retail price. These are merely conventions; retailers of different goods may have markups with different percentages. One interesting consequence of markup pricing is that within an industry it can establish a norm, thereby effectively reducing the impact of competition.
- Competitive pricing. Competitive price, as the name suggests, looks to the seller's competition before setting a price. What are they selling the product for? The seller may then set the same price, knowing this deprives the other seller of the price advantage or, more competitively, may offer to undercut any bona fide offer by a small percentage.
- Demand-based pricing. This approach may be the consequence of either growing demand or diminishing demand. In the first instance, a seller may increase the selling price of something in limited supply. Residential house sales are one such instance. Since every residence represents a unique product – no other house in the world (housing developments excepted) is exactly like the one for sale. If the realtor sees that the demand justifies it, she will advise the owner to accept "competitive bids." If the house is in sufficient demand, the eventual selling price may be several thousand dollars higher than the original asking price. In other instances, a product in high demand may be no longer manufactured; in response to the increasing scarcity of the product, the seller may raise the selling price. Discount sales, on the other hand, often represent a form of demand-based pricing, where decreasing demand necessitates moving the seller price lower, perhaps several times, in order to clear inventory.
Each of these three approaches has many variants, one of which is penetration pricing. Some markets offer an interesting mix of all three. eBay, for instance, offers wholesalers a market where they set the price, often on the basis of the product's cost. At the same time, because the market is open, with many buyers and sellers, most successful sellers set prices competitively. At other times, eBay sellers may ask far more for a used product than the original retail price, simply because the demand justifies it. Plus, eBay also sponsors auctions, another form of variable pricing based on demand.