Full Cost Plus Pricing
Definition of Full Cost Plus Pricing
Full cost plus pricing is a price-setting method under which you add together the direct material cost, direct labor cost, selling and administrative costs, and overhead costs for a product, and add to it a markup percentage (to create a profit margin) in order to derive the price of the product. The pricing formula is:
Total production costs + Selling and administration costs + Markup
Number of units expected to sell
This method is most commonly used in situations where products and services are provided based on the specific requirements of the customer; thus, there is reduced competitive pressure and no standardized product being provided.
The Full Cost Plus Calculation
ABC International expects to incur the following costs in its business in the upcoming year:
§ Total production costs = $2,500,000
§ Total sales and administration costs = $1,000,000
The company wants to earn a profit of $100,000 during that time. Also, ABC expects to sell 200,000 units of its product. Based on this information and using the full cost plus pricing method, ABC calculates the following price for its product:
$2,500,000 Production costs + $1,000,000 Sales/admin costs + $100,000 markup
200,000 units
= $18 Price per unit
Advantages of Full Cost Plus Pricing
The following are advantages to using the full cost plus pricing method:
§ Simple. It is quite easy to derive a product price using this method, since it is based on a simple formula. Given the use of a standard formula, it can be derived at almost any level of an organization.
§ Likely profit. As long as the budget assumptions used to derive the price turn out to be correct, a company is very likely going to earn a profit on sales if it uses this method to calculate prices.
§ Justifiable. In cases where the supplier must persuade its customers of the need for a price increase, the supplier can show that its prices are based on costs, and that those costs have increased.
Disadvantages of Full Cost Plus Pricing
The following are disadvantages of using the full cost plus pricing method:
§ Ignores competition. A company may set a product price based on the full cost plus formula and then be surprised when it finds that competitors are charging substantially different prices.
§ Ignores price elasticity. The company may be pricing too high or too low in comparison to what buyers are willing to pay. Thus, it either ends up pricing too low and giving away potential profits, or pricing too high and achieving minor revenues.
§ Product cost overruns. Under this method, the engineering department has no incentive to prudently design a product that has the appropriate feature set and design characteristics for its target market (see the target costing method). Instead, the department simply designs what it wants and launches the product.
§ Budgeting basis. The pricing formula is based on budget estimates of costs and sales volume, both of which may be incorrect.
§ Too simplistic. The formula is designed to calculate the price of only a single product. If there are multiple products, then you need to adopt a cost allocation methodology to decide on which costs are to be assigned to which product.
Evaluation of Full Cost Plus Pricing
This method is not acceptable for deriving the price of a product that is to be sold in a competitive market, for several reasons:
§ It does not factor in the prices charged by competitors
§ It does not factor in the value of the product to the customer
§ It does not give management an option to reduce prices if it wants to gain market share
§ It is more difficult to derive if there are multiple products, since the costs in the pricing formula must now be allocated among multiple products
Penetration Pricing
Definition of Penetration Pricing
Penetration pricing is the practice of initially setting a low price for one's goods or services, with the intent of increasing market share. The price may be set so low that the seller cannot earn a profit. However, the seller is not irrational. The intent of penetration pricing can follow any of these paths:
§ Drive competitors out of the marketplace, so the company can eventually increase prices with little fear of price competition from the few remaining competitors; or
§ Obtain so much market share that the seller can drive down its manufacturing costs due to very large production and/or purchasing volumes; or
§ Uses excess production capacity that the seller has available; its marginal cost to produce using this excess capacity is so low that it can afford to sustain the penetration pricing for quite some time.
It is relatively common for a new entrant into a market to engage in penetration pricing, in order to grab an initial block of market share. It is particularly likely when the new entrant has a product that it cannot differentiate from those of competitors in a meaningful way, and so chooses to differentiate on price.
A business intent on following the penetration pricing strategy should have substantial financial resources, since it may incur significant losses during the early stages of this strategy.
This approach can work well in a mass market environment where large numbers of very similar products are sold, since it creates the opportunity for someone to drive down prices over very large production volumes.
If a company obtains sufficient sales volume through this pricing strategy, it can become the de facto industry standard, which makes it easier to defend its position in the market.
The Penetration Pricing Calculation
ABC International wants to enter the market for blue one-armed widgets. The current market price for a blue one-armed widget is $10.00. ABC has a large amount of excess production capacity, and so has an incremental cost of only $6.00 for the product. Accordingly, it elects to enter the market at a $6.25 penetration price, which it feels comfortable maintaining for the foreseeable future. Competitors rapidly evacuate the market, and ABC becomes the dominant seller of blue one-armed widgets.
Advantages of Penetration Pricing
The following are advantages of using the penetration pricing method:
§ Entry barrier. If a company continues with its penetration pricing strategy for some time, possible new entrants to the market will be deterred by the low prices.
§ Reduces competition. Financially weaker competitors will be driven from the market, or into smaller niches within the market.
§ Market dominance. It is possible to achieve a dominant market position with this strategy, though the penetration pricing may have to continue for a long time in order to drive away a sufficient number of competitors to do so.
Disadvantages of Penetration Pricing
The following are disadvantages of using the penetration pricing method:
§ Branding defense. Competitors may have such strong product or service branding that customers are not willing to switch to a low-price alternative.
§ Customer loss. If a company only engages in penetration pricing without also improving its product quality or customer service, it may find that customers leave as soon as it raises its prices.
§ Perceived value. If a company reduces prices substantially, it creates a perception among customers that the product or service is no longer as valuable, which may interfere with any later actions to increase prices.
§ Price war. Competitors may respond with even lower prices, so that the company does not gain any market share.
Evaluation of Penetration Pricing
This method is most useful for large companies that have sufficient resources to lower prices substantially and fight off attempts by competitors to undercut them. It is a difficult approach for a smaller, resource-poor company that cannot survive long at the paltry margins provided by penetration pricing.
Loss Leader Pricing
Definition of Loss Leader Pricing
Loss leader pricing is the practice of selling a small number of products either at or below cost, on the assumption that buyers will purchase other products at the same time that are considerably more profitable; the resulting combined sale transaction is assumed (or hoped) to be profitable. The loss leader concept can be used to bring customers into a physical store location or to access a website - in either case, selected merchandise that is much more profitable will be positioned near the loss leader product, so that buyers have every opportunity to make additional purchases
Correct merchandising is a key part of the use of loss leaders, so that buyers must walk past many other items in a store before finding the loss leader item. Conversely, inadequate merchandising would place these items near the front of the store, where someone could buy them and proceed directly to the cash register without buying anything else.
Example of Loss Leader Pricing
One of the heaviest users of loss leader pricing is grocery stores, which routinely advertise low prices on selected items. This practice is also used by the manufacturers of ink jet printers, as well as a variety of stores just before Christmas, when they advertise deep discounts for early-morning shoppers.
Advantages of Loss Leader Pricing
The following are advantages to using the loss leader pricing method:
§ Sales increase. When buyers purchase other items in addition to the loss leader, the seller can make a larger profit than would have been the case if it had not offered the loss leader.
§ New stores. Loss leader pricing is an excellent way to attract shoppers to a new location, since they might otherwise never enter the store, but will do so to take advantage of a particular pricing deal. Thus, it can be used to build a customer base.
§ Merchandise elimination. The strategy can be used to clear out older merchandise, so the seller can restock its warehouse with newer products.
Disadvantages of Loss Leader Pricing
The following are disadvantages of using the loss leader pricing method:
§ Risk of loss. A company may incur a substantial loss from this pricing strategy if it does not closely monitor sales of other items positioned alongside the loss leader; the risk is that customers may buy only the loss leader, and in large quantities.
§ Stockpiling. If the loss leader price is unusually good, and it is for a necessary item that a consumer may use in bulk, it is possible that each buyer will purchase the largest possible quantity of the item, and then stockpile it for later use. A seller can avoid this issue by limiting purchase quantities or only offering products that have a limited shelf life and which therefore cannot be stockpiled.
§ Pricing perception. Retaining a deep discount for too long can give buyers the impression that a product should have a lower price at all times, which can reduce its unit sales once management stops the loss leader promotion and returns the product to its normal price.
Evaluation of Loss Leader Pricing
This is a reasonable and well-tested approach for building traffic to a store or website, but you must monitor it carefully to ensure that it is actually generating an incremental profit, rather than a substantial loss.
Price Skimming
Definition of Price Skimming
Price skimming is the practice of selling a product at a high price, usually during the introduction of a new product when the demand for it is relatively inelastic. This approach is used to generate substantial profits during the first months of the release of a product, usually so that a company can recoup its investment in the product. However, by engaging in price skimming, a company is potentially sacrificing much higher sales that it could garner at a lower price point.
Eventually, a company that engages in price skimming must drop its prices, as competitors enter the market and undercut its prices. Thus, price skimming tends to be a short-term strategy.
When you engage in price skimming, the market size is small, since only early adopters are willing to pay the high price. Once early adopters have bought the product, sales volume usually declines, since the remaining potential customers are not willing to purchase at the price set by the seller.
Example of Price Skimming
ABC International has developed a global positioning system that can lock onto GPS satellite signals even from several feet underwater. This is a substantial improvement over existing technology, so ABC feels justified in pricing the product at $1,000, even though it only costs $150 to construct. ABC holds this price point for the first six months, while it earns back the $1 million development cost of the product, and then drops the price to $300 to deter competitors from entering the market.
Advantages of Price Skimming
The following are advantages of using the price skimming method:
§ High profit margin. The entire point of price skimming is to generate an outsized profit margin.
§ Cost recovery. If a company competes in a market where the product life span is short, price skimming may be the only viable method available for ensuring that it recovers the cost of developing products.
§ Dealer profits. If the price of a product is high, then the percentage earned by distributors will also be high, which makes them happy to carry the product.
§ Quality image. A company can use this strategy to build a high-quality image for its products, but it must deliver a high-quality product to support the image created by the price.
Disadvantages of Price Skimming
The following are disadvantages of using the price skimming method:
§ Competition. There will be a continual stream of competitors challenging the seller's extreme price point with lower-priced offerings.
§ Sales volume. A company that uses price skimming is limiting its sales, which means that it cannot lower costs by building sales volume.
§ Consumer acceptance. If the price point remains very high for too long, it may defer or entirely prevent acceptance of the product by the general market.
§ Annoyed customers. Early adopters of the product may be highly annoyed when the company later drops its price for the product, thereby generating bad publicity and a very low level of customer loyalty.
§ Cost inefficiency. The very high profit margins engendered by this strategy may cause a company to avoid making the cost cuts required to keep it competitive when it eventually lowers its prices.
Evaluation of Price Skimming
This approach is useful for earning back an investment in short order, but does not position a company to compete in the industry over the long term, since it never lowers costs by building unit volume. Thus, this approach may work best for companies that focus on research and development, and produce a constant stream of new products without any intention of becoming the low-cost provider.
Definition of Full Cost Plus Pricing
Full cost plus pricing is a price-setting method under which you add together the direct material cost, direct labor cost, selling and administrative costs, and overhead costs for a product, and add to it a markup percentage (to create a profit margin) in order to derive the price of the product. The pricing formula is:
Total production costs + Selling and administration costs + Markup
Number of units expected to sell
This method is most commonly used in situations where products and services are provided based on the specific requirements of the customer; thus, there is reduced competitive pressure and no standardized product being provided.
The Full Cost Plus Calculation
ABC International expects to incur the following costs in its business in the upcoming year:
§ Total production costs = $2,500,000
§ Total sales and administration costs = $1,000,000
The company wants to earn a profit of $100,000 during that time. Also, ABC expects to sell 200,000 units of its product. Based on this information and using the full cost plus pricing method, ABC calculates the following price for its product:
$2,500,000 Production costs + $1,000,000 Sales/admin costs + $100,000 markup
200,000 units
= $18 Price per unit
Advantages of Full Cost Plus Pricing
The following are advantages to using the full cost plus pricing method:
§ Simple. It is quite easy to derive a product price using this method, since it is based on a simple formula. Given the use of a standard formula, it can be derived at almost any level of an organization.
§ Likely profit. As long as the budget assumptions used to derive the price turn out to be correct, a company is very likely going to earn a profit on sales if it uses this method to calculate prices.
§ Justifiable. In cases where the supplier must persuade its customers of the need for a price increase, the supplier can show that its prices are based on costs, and that those costs have increased.
Disadvantages of Full Cost Plus Pricing
The following are disadvantages of using the full cost plus pricing method:
§ Ignores competition. A company may set a product price based on the full cost plus formula and then be surprised when it finds that competitors are charging substantially different prices.
§ Ignores price elasticity. The company may be pricing too high or too low in comparison to what buyers are willing to pay. Thus, it either ends up pricing too low and giving away potential profits, or pricing too high and achieving minor revenues.
§ Product cost overruns. Under this method, the engineering department has no incentive to prudently design a product that has the appropriate feature set and design characteristics for its target market (see the target costing method). Instead, the department simply designs what it wants and launches the product.
§ Budgeting basis. The pricing formula is based on budget estimates of costs and sales volume, both of which may be incorrect.
§ Too simplistic. The formula is designed to calculate the price of only a single product. If there are multiple products, then you need to adopt a cost allocation methodology to decide on which costs are to be assigned to which product.
Evaluation of Full Cost Plus Pricing
This method is not acceptable for deriving the price of a product that is to be sold in a competitive market, for several reasons:
§ It does not factor in the prices charged by competitors
§ It does not factor in the value of the product to the customer
§ It does not give management an option to reduce prices if it wants to gain market share
§ It is more difficult to derive if there are multiple products, since the costs in the pricing formula must now be allocated among multiple products
Penetration Pricing
Definition of Penetration Pricing
Penetration pricing is the practice of initially setting a low price for one's goods or services, with the intent of increasing market share. The price may be set so low that the seller cannot earn a profit. However, the seller is not irrational. The intent of penetration pricing can follow any of these paths:
§ Drive competitors out of the marketplace, so the company can eventually increase prices with little fear of price competition from the few remaining competitors; or
§ Obtain so much market share that the seller can drive down its manufacturing costs due to very large production and/or purchasing volumes; or
§ Uses excess production capacity that the seller has available; its marginal cost to produce using this excess capacity is so low that it can afford to sustain the penetration pricing for quite some time.
It is relatively common for a new entrant into a market to engage in penetration pricing, in order to grab an initial block of market share. It is particularly likely when the new entrant has a product that it cannot differentiate from those of competitors in a meaningful way, and so chooses to differentiate on price.
A business intent on following the penetration pricing strategy should have substantial financial resources, since it may incur significant losses during the early stages of this strategy.
This approach can work well in a mass market environment where large numbers of very similar products are sold, since it creates the opportunity for someone to drive down prices over very large production volumes.
If a company obtains sufficient sales volume through this pricing strategy, it can become the de facto industry standard, which makes it easier to defend its position in the market.
The Penetration Pricing Calculation
ABC International wants to enter the market for blue one-armed widgets. The current market price for a blue one-armed widget is $10.00. ABC has a large amount of excess production capacity, and so has an incremental cost of only $6.00 for the product. Accordingly, it elects to enter the market at a $6.25 penetration price, which it feels comfortable maintaining for the foreseeable future. Competitors rapidly evacuate the market, and ABC becomes the dominant seller of blue one-armed widgets.
Advantages of Penetration Pricing
The following are advantages of using the penetration pricing method:
§ Entry barrier. If a company continues with its penetration pricing strategy for some time, possible new entrants to the market will be deterred by the low prices.
§ Reduces competition. Financially weaker competitors will be driven from the market, or into smaller niches within the market.
§ Market dominance. It is possible to achieve a dominant market position with this strategy, though the penetration pricing may have to continue for a long time in order to drive away a sufficient number of competitors to do so.
Disadvantages of Penetration Pricing
The following are disadvantages of using the penetration pricing method:
§ Branding defense. Competitors may have such strong product or service branding that customers are not willing to switch to a low-price alternative.
§ Customer loss. If a company only engages in penetration pricing without also improving its product quality or customer service, it may find that customers leave as soon as it raises its prices.
§ Perceived value. If a company reduces prices substantially, it creates a perception among customers that the product or service is no longer as valuable, which may interfere with any later actions to increase prices.
§ Price war. Competitors may respond with even lower prices, so that the company does not gain any market share.
Evaluation of Penetration Pricing
This method is most useful for large companies that have sufficient resources to lower prices substantially and fight off attempts by competitors to undercut them. It is a difficult approach for a smaller, resource-poor company that cannot survive long at the paltry margins provided by penetration pricing.
Loss Leader Pricing
Definition of Loss Leader Pricing
Loss leader pricing is the practice of selling a small number of products either at or below cost, on the assumption that buyers will purchase other products at the same time that are considerably more profitable; the resulting combined sale transaction is assumed (or hoped) to be profitable. The loss leader concept can be used to bring customers into a physical store location or to access a website - in either case, selected merchandise that is much more profitable will be positioned near the loss leader product, so that buyers have every opportunity to make additional purchases
Correct merchandising is a key part of the use of loss leaders, so that buyers must walk past many other items in a store before finding the loss leader item. Conversely, inadequate merchandising would place these items near the front of the store, where someone could buy them and proceed directly to the cash register without buying anything else.
Example of Loss Leader Pricing
One of the heaviest users of loss leader pricing is grocery stores, which routinely advertise low prices on selected items. This practice is also used by the manufacturers of ink jet printers, as well as a variety of stores just before Christmas, when they advertise deep discounts for early-morning shoppers.
Advantages of Loss Leader Pricing
The following are advantages to using the loss leader pricing method:
§ Sales increase. When buyers purchase other items in addition to the loss leader, the seller can make a larger profit than would have been the case if it had not offered the loss leader.
§ New stores. Loss leader pricing is an excellent way to attract shoppers to a new location, since they might otherwise never enter the store, but will do so to take advantage of a particular pricing deal. Thus, it can be used to build a customer base.
§ Merchandise elimination. The strategy can be used to clear out older merchandise, so the seller can restock its warehouse with newer products.
Disadvantages of Loss Leader Pricing
The following are disadvantages of using the loss leader pricing method:
§ Risk of loss. A company may incur a substantial loss from this pricing strategy if it does not closely monitor sales of other items positioned alongside the loss leader; the risk is that customers may buy only the loss leader, and in large quantities.
§ Stockpiling. If the loss leader price is unusually good, and it is for a necessary item that a consumer may use in bulk, it is possible that each buyer will purchase the largest possible quantity of the item, and then stockpile it for later use. A seller can avoid this issue by limiting purchase quantities or only offering products that have a limited shelf life and which therefore cannot be stockpiled.
§ Pricing perception. Retaining a deep discount for too long can give buyers the impression that a product should have a lower price at all times, which can reduce its unit sales once management stops the loss leader promotion and returns the product to its normal price.
Evaluation of Loss Leader Pricing
This is a reasonable and well-tested approach for building traffic to a store or website, but you must monitor it carefully to ensure that it is actually generating an incremental profit, rather than a substantial loss.
Price Skimming
Definition of Price Skimming
Price skimming is the practice of selling a product at a high price, usually during the introduction of a new product when the demand for it is relatively inelastic. This approach is used to generate substantial profits during the first months of the release of a product, usually so that a company can recoup its investment in the product. However, by engaging in price skimming, a company is potentially sacrificing much higher sales that it could garner at a lower price point.
Eventually, a company that engages in price skimming must drop its prices, as competitors enter the market and undercut its prices. Thus, price skimming tends to be a short-term strategy.
When you engage in price skimming, the market size is small, since only early adopters are willing to pay the high price. Once early adopters have bought the product, sales volume usually declines, since the remaining potential customers are not willing to purchase at the price set by the seller.
Example of Price Skimming
ABC International has developed a global positioning system that can lock onto GPS satellite signals even from several feet underwater. This is a substantial improvement over existing technology, so ABC feels justified in pricing the product at $1,000, even though it only costs $150 to construct. ABC holds this price point for the first six months, while it earns back the $1 million development cost of the product, and then drops the price to $300 to deter competitors from entering the market.
Advantages of Price Skimming
The following are advantages of using the price skimming method:
§ High profit margin. The entire point of price skimming is to generate an outsized profit margin.
§ Cost recovery. If a company competes in a market where the product life span is short, price skimming may be the only viable method available for ensuring that it recovers the cost of developing products.
§ Dealer profits. If the price of a product is high, then the percentage earned by distributors will also be high, which makes them happy to carry the product.
§ Quality image. A company can use this strategy to build a high-quality image for its products, but it must deliver a high-quality product to support the image created by the price.
Disadvantages of Price Skimming
The following are disadvantages of using the price skimming method:
§ Competition. There will be a continual stream of competitors challenging the seller's extreme price point with lower-priced offerings.
§ Sales volume. A company that uses price skimming is limiting its sales, which means that it cannot lower costs by building sales volume.
§ Consumer acceptance. If the price point remains very high for too long, it may defer or entirely prevent acceptance of the product by the general market.
§ Annoyed customers. Early adopters of the product may be highly annoyed when the company later drops its price for the product, thereby generating bad publicity and a very low level of customer loyalty.
§ Cost inefficiency. The very high profit margins engendered by this strategy may cause a company to avoid making the cost cuts required to keep it competitive when it eventually lowers its prices.
Evaluation of Price Skimming
This approach is useful for earning back an investment in short order, but does not position a company to compete in the industry over the long term, since it never lowers costs by building unit volume. Thus, this approach may work best for companies that focus on research and development, and produce a constant stream of new products without any intention of becoming the low-cost provider.