Why Pricing Decision Is Important - Case Study Example

The pricing decision Introduction The pricing decisions in an organization are based on several factors Obigbemi p. 230) “Some of the factors that influence pricing decision are demand, competitors, cost, political, environmental, legal and image-related issues. Horngren, et al (1996:428), buttresses this point by stating that managers are frequently faced with decisions on pricing and profitability of their products”. The strategy of the management with reference to particular situation plays an important role though cost considerations are fundamental to the decision making. These situations include new product promotion, test marketing, countering competition or predatory pricing, promotion of associated products and cost plus contracts. Fazlzadeh, Mohammadi & Sepehrfar (2011, p. 66) state “Setting optimal prices, however, is a complex problem in general and is particularly challenging in industrial or B2B market settings, where purchase prices of products and services typically vary from one customer account to another as prices are negotiated and modified from list prices in the course of the purchase process”. Based on the purpose, marginal, differential or total costing method would be adopted in pricing. The pricing strategies also vary according to the type of market such as monopoly, monopolistic or oligopoly. The strategy of skimming the market or the policy of ‘what the traffic will bear’ in the case of products backed up with IPRs are not uncommon in the market place. Also, pricing strategy for the same product by the same company varies based on the usage or purpose. For instance LPG cylinder used for commercial purposes could be costlier than the LPG used for domestic purposes. This paper seeks to discuss about various strategies adopted by businesses in pricing decisions. Why pricing decision is important? The strategic importance of pricing is many fold. Promotion Strategies (2010) states, “The marketing promotion mix is the use of the 4 Ps. These are Product, Price, Place, and Promotion. This system first appeared in 1949 and was developed by Philip Kotler”. The pricing is an important area in the management decision making, because profitability of any business hinges on right price for the product for making the most out of the prevailing economic situation and developments in technology, internet and telecommunications in the context of the business. Bayati & Makui (2011, p. 371) observe “Making an appropriate pricing and marketing strategy is a crucial management issue in E-commerce”. The appropriate pricing strategy is adopted after analyzing the factors related to various pricing situations. Evidence – Chevrolet’s Spark Chevrolet has introduced the model ‘Spark’ for marketing in the developing countries, in the small car segment, which is not very popular in US or other developed countries. The price of the car is fixed at INR. 279,000 in India which works out to just US$ 6200 approximately. In the case of new products, in spite of the extensive market research on potential demand for the product, adopting a right pricing strategy is important to be competitive in the market. As it is a question of creating demand for the new product, pricing is the key to success in influencing the consumers’ decisions. Price sensitivity of the consumers is an important variable in the decision making process, and the proper positioning of the product in the market place and its rational pricing would stimulate demand for the product from the target consumers. The strategy should also ensure that the competitors are not tempted to introduce similar products in view of the attractive margin. This philosophy aims at sustainable growth in the long run. Therefore, the prices are fixed with a reasonable margin and at the same time not tempting the competitors to rush into this segment to spoil the first mover advantage. Argument for fixing prices at a lower level The pricing decision in this case is taken in the backdrop of uncertainties about the success of a product after taking into account the factors such as utility, technology, convenience and acceptability on various grounds as discussed by Alvin Toffler in his famous book ‘Future Shock’ in respect of new technologies like telephone and television in the history of mankind. Eskin & Baron (1977, p. 499) state “Two of the most important components of a marketing plan are pricing and the level of expenditure on advertising”. The prices for test marketing need to be fixed up after taking into account the notional cost at a level based on the critical mass to make the product line self-sustained. Therefore, forecasting into the future and intuition on the part of the management about the acceptability of the product are prerequisites for a successful pricing policy, because test marketing is undertaken to gauge the perceptions and the price sensitivity of the buyer. Subsequently General Motors India increased the Spark’s price by reducing the discount by INR 20,000. Indian Cars Bikes (2010) observed “While this price hike is pretty marginal, it could still swing buying decisions in the extremely price conscious Indian small car market”. Competitive pricing This is probably the area which involves the use of various pricing techniques in relation to a product. Costing is the cornerstone in the pricing process and therefore analysis and accumulation of cost against the processes and products in terms of material, labor and overhead further classified into fixed and variable with regard to its behavior and tax components such as excise duty and vat are involved in this process. Competitiveness depends upon technology, quality, customer relationship, and after sales service. For instance Indian Cars Bikes (2010) states “General Motors India have retained the 3 years, zero maintenance charge guarantee on the Chevrolet Spark, thus making the Spark a great value buy even after the price hike” . The decision making is guided by various factors such as economic situation, forecast of the demand, elasticity of the demand, orders in the pipeline, discount structure, terms of payment in the industry, rate of interest and availability of finance, labor and raw materials. Indian car market is dominated by local as well as international players in all the segments. The economic growth during the recent years is phenomenal and the car manufacturers are flocking the country for a share in the market. Predatory pricing In the small car segment of India, the Indian Company, Tata Motor’s ‘Nano’ has been priced very aggressively. According to the Competition Commission, a dominant player can be accused of predatory pricing if it sells its products below average variable cost with the intention of eliminating competition, but in Nano’s case, it was not treated as predatory pricing on the grounds that fixed cost would not be considered while charging a company for under- pricing a product. (The Economic Times, 2008) Generally, the intention of the predator is to annihilate competition to establish monopoly in the long run. When the price is ridiculously low competition withers out over a period of time as the financially weaker competitors can’t withstand the price cuts. In spite of the antitrust and other laws to curtail monopoly and other restrictive trade practices, predatory pricing is not ruled out in real life situations. Crane (2006, p. p. 26) observes “As more and more cases of alleged predatory pricing are filed and new theories of liability based on price discounting gain popularity, the risk grows that predatory pricing law will result in higher prices to consumers—the very antithesis of what antitrust law is supposed to achieve”. Critical analysis of pricing objectives and decisions In the evaluation of the pricing objectives, the method of costing adopted in pricing is very important which varies with the strategic importance and the objectives of pricing. Secondly, the market type influences the pricing decisions. Total costing Total costing method is generally used for pricing purposes. In this type of costing, materials, labor and overhead costs whether variable or fixed are all taken into account. The indirect or common costs such as administrative overheads, rent and interest are apportioned to the products and processes on suitable basis for the ascertainment of cost. Standard costs are used for working out the prices based on the actual historical cost with suitable adjustment for inflation, interest rates, exchange rates and other uncertain elements of cost. Apportionment of cost is a contentious issue in pricing based on total costing. The basis adopted for apportionment of fixed cost to the products and the Capacity considerations could vitiate the pricing decisions. Many a times apportionment of fixed costs such as management expenses, Research and Development expenses and selling and distribution costs is based on the policy decisions and the products could be charged with unreasonably low or high fixed costs. The policy decision could also be influenced by the divisional heads. The analysis of capacity considerations with reference to pricing is very crucial. If the production is below the break-even level, the fixed costs are charged based on break-even level of production or sales. However, when the break-even level is exceeded it is charged based on the actual production or sales generally. There seems to be an anomaly in this practice. For instance, there is difficulty in working out break-even level in a multi-product manufacturing company for the different products. Also, the problems are compounded if we consider that the break-even level for the same product will vary from company to company, whereas the pricing should be in line with the competition in the market. Pricing based on marginal costing “According to the Commission, a dominant player can be accused of predatory pricing if it sells its products below average variable cost with the intention of eliminating competition”. (The Economic Times, 2008) Therefore, it could be understood that costing plays a major role in pricing decisions. Marginal costing is used for special pricing purposes like exports, deemed exports, use of idle capacity and promotion of the associated products. In the case of exports, the products are sold in different market and are not in direct competition of its products sold within the country. In the case of deemed exports, the company has to compete with the international suppliers in the tendering process, and these products are given export status for the purpose of concessions in taxation and subsidies. The price difference in both these cases does not affect the sale of the products in the domestic market. In the marginal costing principle, all direct or variable cost is taken into account for the purpose of pricing. The difference between the price and the total variable cost represents contribution towards fixed or indirect costs, which are to be incurred anyway whether the export order is undertaken or not. Therefore, this strategy improves profitability of a concern without affecting the current pricing strategies. Moreover, due to capacity considerations, the total fixed costs can’t be loaded on whatever quantity produced or sold during the period. In order to arrive at a realistic price, the fixed cost should be distributed over production at normal level or breakeven level. The following example illustrates the point. Pricing and Market type The small car segment in the developing countries is crowded with several international players with lot of models to offer. In a perfect market condition, the competition is expected to be fair and the price tends to be around the cost. The pricing in such a case could be determined by cost and demand and supply conditions, where cost is internal but demand and supply conditions are external factors common to the company and its competitors. In the modern times, the market consists of many buyers and sellers with ranges of prices rather than a single market price and variation in products or product differentiation, and this type of market is called as monopolistic. In oligopoly, there are few sellers in the market who are sensitive to competitor’s pricing and marketing strategies. The prices in the oligopoly and monopolistic situations need to be continuously reviewed based on the external factors, and strategies firmed up internally to meet the challenges through innovations, efficiencies and cost cutting exercises. There are also price controls in vogue in many countries which influence the pricing decisions. Senarathna, Mannapperuma & Fernandopulle (2011) state “Most developed countries other than the USA practice direct and indirect pricing policies with the common objective of achieving affordability of medicines”. Conclusion In the backdrop of globalization, the pricing decisions involve analysis of factors relating to cost, demand and supply and several other factors related to internal and external environment. The pricing decisions hinges on the strategic importance of pricing, the objectives of pricing and the types of markets. Costing of the products forms the basis of pricing in most of the pricing decisions. The strategies adopted in pricing decision also vary with the economic situation, internal strengths and weaknesses and the intensity of competition in the market. References Azar, O. H., 2011, ‘Relative thinking in consumer choice between differentiated goods and services and its implications for business strategy’, Judgment and Decision Making, Volume6, Issue 2, 26 April 2011, Bayati, M. F. & Makui, A., 2011, ‘A multi objective geometric programming approach for electronic product pricing problem’, Management Science Letters, Volume1, Issue 3, viewed 26 April 2011, Chevrolet, 2010, Spark, viewed 5 May 2011, Crane, D. A., 2006, ‘The Perverse Effects of Predatory Pricing Law’, Regulation, Winter 2005-2006, viewed 26 April 2011, Eskin, G. J. & Baron, P. H., 1977, Effects of Price and Advertising in Test-Market Experiments, Journal of Marketing Research, American Marketing Association, Volume 14, Number 4. Fazlzadeh, A., Mohammadi, P. & Sepehrfar, A., 2011, ‘How Agency-Theoretic Factors Affect the Delegation of Pricing Authority to the Sales Force: An Empirical Study’, International Journal of Marketing Studies, Volume 3, Issue 1, 27 April 2011,   Indian Cars Bikes (2010), General Motors India ups the Chevrolet Spark 1.0’s price by cutting discount by INR 20,000, 6 May 2011, Obigbemi, I., 2010, ‘THE ROLE OF COMPETITION ON THE PRICING DECISION OF AN ORGANISATION AND THE ATTAINMENT OF THE ORGANISATIONAL OBJECTIVE’, Annals of the University of Petrosani, Volume X, Issue 1, 26 April 2011,   Promotion Strategies, 2010, The Marketing Mix - The 4 PS, viewed 25April 2011, Senarathna, SMDKG., Mannapperuma, U. & Fernandopulle, B. R., 2011, ‘Medicine prices, availability and affordability in Sri Lanka’, Indian Journal of Pharmacology, Volume 43, Issue 1, viewed 25April 2011, The Economic Times, 2008, Fixed cost not to be included in predatory pricing: CCI, 15 June 2008, viewed 5May 2011, Wolk, A. & Skiera, B., 2010, ‘Tariff-Specific Preferences and Their Influence on Price Sensitivity’, Business Research, Volume 3, Issue 1, 27April 2011,   Read More