Pricing, as the term is used in economics and finance, is the act of establishing a value for a product or service. In other words, pricing occurs when a business decides how much a customer must pay for a product or service.
Learn a full definition of pricing, how it compares to cost, and some common pricing strategies.
What Is Pricing?
Pricing refers to the decision-making process that goes into establishing a value for a product or service. There are many different strategies that a business can use when setting prices, but they are all a form of pricing. The price that's set during the pricing process is what the customer will pay for that product or service.
Though the terms are sometimes used interchangeably, pricing is not the same as cost.
How Does Pricing Work?
There are many pricing methods, but for the most part, they all boil down to some variant of three general approaches.
Some markets offer a mix of pricing strategies. For example, eBay offers wholesalers a market where they set the price, often based on the product's cost. At the same time, because many buyers and sellers are active on eBay, many successful sellers set prices competitively. Elsewhere on eBay, sellers may ask far more for a used product than the original retail price—such as old, out-of-print video games—simply because the demand justifies it. eBay also allows for auctions, which is another form of variable pricing based on demand.
This approach ignores (in theory, but not always in practice) what other sellers are setting their prices for the same product or a similar one. Instead, this pricing strategy bases the selling price on its relation to cost. Mark-up pricing, otherwise known as cost-plus pricing, is an example of this approach.
There may be common mark-up rates among industries, but ultimately, the decision comes down to individual retailers. A music shop, for example, may decide to mark-up guitars by 50% and keyboards by 60%. That means the price a customer pays for a guitar would be the cost the music shop paid plus 50% of that cost. A competing music shop on the other side of town may or may not use similar mark-up figures.
Competitive pricing, as the name suggests, looks to the seller's competition before setting a price. Knowing the competition's prices can give you a framework for your pricing. You may decide to match the competition, undercut them, or, if you feel you offer a better product or service, charge more than them.
One example of competitive pricing is penetration pricing, wherein a business purposefully sets an extremely low price to allow it to compete and gain a foothold in the industry. Once the business is more established, it will raise its price to be more in line with the competition.
This approach responds primarily to movement in demand—whether it's waning or growing. If demand is growing, a seller may increase the selling price, especially as supply becomes more limited. The housing market exemplifies this. Home prices are primarily based upon the number of buyers in the market and the number of homes available for sale.
Discount sales show how demand-based pricing works when demand is waning. Decreasing demand leaves a lingering supply, and the business may decide to lower prices to clear out the remaining inventory.
Pricing vs. Cost
|Pricing vs. Cost|
|What the customer pays for a product or service||The investment a business makes in hopes of making a sale|
|May or may not be tied to the cost of a product or service||Tied directly to the cost of investment|
|Factors into a business's revenue||Factors into a business's cost of goods sold|
Although the two are often used interchangeably in informal conversations, formal business discussions should never confuse price with cost. Price is what the customer pays for the product or service. Cost is the seller's investment in the product or service that's subsequently sold.
The difference between price and cost always depends on the context of the transaction, and where it occurs within the supply chain. For example, a wheat farmer sets a price that's paid by a food wholesaler. The wheat farmer's price is the food wholesaler's cost. After buying wheat, the food wholesaler will set a price to sell to a bakery. The food wholesaler's price is the bakery's cost.
The difference between these terms is clear on a company's income statement. The price variable is associated with sales, and it appears as a revenue item on the income statement. The cost of manufacturing the product is shown on the income statement as cost of goods sold.
- Pricing is the act of determining the value of a product or service.
- Pricing determines the cost paid by a customer, but it may or may not be tied to the cost paid by the business to produce the product or service.
- Price and cost are relative—one entity's price may be another's cost.