Pricing

Related Terms: Loss Leader Pricing; Penetration Pricing

The pricing of goods and services is almost always determined by demand, which creates the market or confirms an offering as legitimate, by competition, which lowers prices when present and increases them by its absence, and, finally, by the cost of producing the item or providing the service. A good deal of mythology and mystification surrounds the subject of pricing, but these fundamental relationships enable the business owner to price his or her goods correctly without either gouging or leaving too much on the table.

At the most fundamental level a sale is the consequence of an auction in which the price is set by bidding. If the highest bid is not high enough, the seller will not sell. If no one bids, there is no price. The rarer and the more valuable an object is (i.e., the higher the demand relative to supply) the higher the price. The more common the good and the more sluggish the demand for it, the lower the price—but objects will not be sold below the seller's cost except under unusual circumstances.

Bidding for every little thing in an open auction is, of course, very inefficient. For this reason pricing methods have evolved but still represent, as it were, a kind of ritualized and very slow-motion auction. Prices will rise or drop depending on demand. Demand will rise and fall depending on supply. But while this happens instantly in live-auctions, it takes place almost imperceptively in normal commerce.

PRICING A GOOD

The price of a good or of a service (hereafter we'll mean both by simply saying "product") is its total cost for the seller plus a profit margin over and above this cost the purpose of which is to keep the business in business. The cost will be the cost, of course. The profit margin will depend on the strength of the demand and the intensity of the competition. To be sure, pricing is dynamic. If a seller discovers that consumers like a product but will not pay the price, this often acts as feedback. The seller will attempt to reduce the cost as much as possible while attempting to maintain quality high enough still to command consumer interest. One modern technique of cost-reduction is to buy goods from regions where labor costs are low—and this strategy has created the discounting and outsourcing phenomena so prevalent in the mid-2000s.

Ideally the seller will select a location and an "ambiance" appropriate to the products sold. Ideally the seller will understand his or her turnover of goods well enough to know which lines sell sufficient quantities to maintain the store in business and which products, even if slower-moving, provide the extra margin of profitability. Ideally the seller will be sufficiently aware of the effective competition, namely that likely directly to compete with him or her, and the prices charged by that competition.

Common mistakes in pricing arise from careless tracking of overhead costs, product mix, changing consumer preference, and competitors' behavior. If the out-of-pocket costs of products sold have been declining and the merchant is in the habit of marking things up by a standard percentage, the new pricing may not absorb the total overhead, especially if overhead has been growing. The merchant may also overprice if costs have been rising; a standard mark-up will now produce more than overhead costs and the usual profit—but customers may no longer buy as readily. In service operations where bidding on jobs is common, careless and mechanical methods of estimation may sometimes result in seriously underbidding difficult jobs because the owner or salesperson didn't want to bother getting the ladder out and climbing a roof—or an analyst has failed to make five preliminary phone calls to really understand how easy or difficult it will be to get the information a customer wishes to have collected.

Good pricing behavior is therefore dependent on—

• Detailed and up-to-date knowledge of costs beyond the cost of the actual item, i.e., overhead cost and how it is changing. Increases in rent, salaries, benefits, utilities, and services must be noted immediately and a running overhead rate must be available monthly in updated format.
• Product knowledge including, in some categories, the "service" costs a product is likely to demand after its sale. Selling a computer installation may require a certain number of hours spent on the telephone after installation just in holding customers' hands. This cost must be known in advance.
• Careful and detailed estimating of technical and services sales, sometimes including quick studies and tests and/or visits and close inspections in order to understand jobs fully.
• Current knowledge of competitor pricing.
• A deep understanding of the product mix sold with special attention to that mix of products which carries the business. A specialty grocer may "carry" the store by selling dairy products, bread, cereals, soups, and fresh produce. The expensive meat counter with expert butchers may simply be paying for itself but may be the very reason why customers put up with the limited parking. The real profit may come from the company's extensive line of wines for which its customers are willing to pay a premium. For good pricing strategy, all this must be known.
• Close and detailed knowledge of vendors' offerings to identify unusual opportunities.

PRICING STRATEIES

Pricing itself is a form of communication. Not surprisingly, many different kinds and flavors of pricing strategy exist. Major categories include the following.

Manufacturer's Suggested Retail Price

Many small businesses prefer to price their goods in accordance with the manufacturer's suggested retail price. In some cases this is forced on the business because the price is prominently printed on the packaging. Going below it is possible, but going above it is almost impossible. Where such pricing is literally suggested, not printed, the business adopting this approach without analysis can make mistakes.