Pricing - University of Massachusetts Boston



Pricing

Key to profits: The price obtained for what is sold affects each factor in the profit equation.

Every sales dollar received over break-even costs goes directly into profits. The difference between the product’s marginal revenue (the actual money for which the product is sold) and its marginal costs (the producer’s out-of-pocket costs) goes into profit once the break-even point is reached.

The formula has great implications, for it means, that if a firm sells something with a relatively low marginal cost, profits come quickly after it reaches the break-even point. If marginal costs are relatively high, profits come much more slowly.

1 Break-even analysis

Helps not only in making pricing judgments but it also helps the entrepreneur decide whether or not to undertake a venture.

Definition: Break-even analysis is a mathematical formula that discloses how much output must be sold for the firm to break even: that is, the cash coming in equals the cash coming out

Break even charts enable an entrepreneur to glance over potential profits.

Fixed Cost

Break-even point (in units) = -----------------------------------------------------

Sales price per unit – Variable cost per unit

Break-even point: When total revenues are equal to total cost. The break-even point in units is the number of units that need to be sold to cover all costs, both fixed and variable.

Fixed costs: Costs that remain constant over the entire range of output. These costs typically include rent, insurance, interest charges, executive salaries, and the like.

Variable costs: Costs that vary directly with the sales level, manufacturing labor, materials used in production, sales costs, and the like.

For example, if the company’s fixed costs are estimated at $50,000 and variable costs of $.20 per unit with a $1 retail price per unit, the break even point would be 62,500 units.

Now the entrepreneur starts thinking: “Can I sell that many?” What would happen if the price were increased to $2 retail with the same variable cost per unit of $.20? So recalculate, the break even point would now be 27,778 units.

Sometimes is extremely helpful to chart the break-even relationships. It can be seen at a glance what happens to profits as prices and volumes are changed.

Entrepreneurs should not assume a sales volume and then determine the profits. The should do it in reverse: first determine the sales volume necessary for the business to break even.

2 Evaluating pricing constraints

1) In many industries there is a market price for a company’s products. Much entrepreneurial effort is devoted to avoiding markets in which one has little control over price. They are called commodity markets.

2) The government sometimes regulates prices

3) Low prices leave little room for error. High prices cover up many miscalculations.

4) The prices of other products limit pricing freedom. Both directly competitive and substitute products affect what a business can get for its product. In most markets the buyer confronts an array of products that vary from expensive, top-of-the-line products down to cheap junk that may be barely acceptable. All of these items affect price. An entrepreneur will have to fit a product’s qualities and features into this spectrum of prices.

3 Pricing procedure

1 Determine the relevant price range

• Price floor: the bottom of the range, the floor, it is usually set by costs.

• Market price: the price is what a seller is willing to sell the product for and what a buyer is willing to pay. There is no need to sell bellow market. By definition, it can sell its entire output at market price. That’s what a market price means.

• Ceiling price: how much can a product sell for. Six factors:

1- Savings: Saves the buyer money. The business can confiscate a good portion of proven savings.

2- Competitors prices. Pricing should be done on “relation to” competitors: either charging a premium or discounting.

3- Substitutes: Their price can limit how much a venture can get for its goods.

4- Complementary products: Often an item is not really bought separately but is purchased as part of a package of products and services … If an item is but a minor part of a larger package, then its price may not be too important to the buyer.

5- Market perceived values: It is elusive but keep in mind that at the end what matters is not what the product costs or what other products sell for, but rather what the buyer will pay for an offering. Also note that people rely on price to help form their value judgments. They will often assume that the highest-priced article is the best.

6- Distributive-network pressures. Often price will have to conform to the attitudes of product distributors.

2 Evaluate price sensitivities

Investigate the price at which the middleman wants to have some product to offer the trade. For example, a menswear merchant might have three price points for his suit department. … When a dealer looks at an item and tells the manufacturer that it will sell for $20, the manufacturer should consider their opinions carefully.

3 Select a strategy

There are two basic pricing strategies: price skimming and penetration pricing.

Price skimming. There are several and persuasive arguments suggesting that new ventures should being by trying to price skim:

• Prevention for errors. It is easier to lower the price than to raise it.

• Limit sales: a low price may attract more activity than the organization can handle, leading to an unfortunate reputation for poor service just at the time the company is trying to impress the market otherwise.

• Increases gross profit.

• By starting high and progressively lowering price, each segment of the market busy in on the proposition when the price hits its value scale.

• It is called for when there are hints of a an inverse-demand situation (people order more the more expensive the item is).

• Disadvantage: It attracts competition

Penetration pricing. It is adequate for entrepreneurs who think an item will have a good long-run market and he or she really doesn’t have any way of restricting competition, then a low price may do several things.

• It will discourage competition

• Will facilitate distribution and market penetration

• Disadvantage: Financial requirements for a penetration-pricing strategy are often higher than the new venture can afford.

Pricing in general is less of an individual decision. Most frequently the market will quickly indicate what the price has to be. With the help of the distribution networks, entrepreneurs will be able to set reasonable prices with which to begin operations.

4 Some policies to consider (check in the reading only consider if relevant to your project)

5 Pricing for service businesses

The first step is to determine what price the potential customers would be willing to pay versus what the entrepreneur wants to charge. Strategies to obtain price information:

• Call on clients and ask them what they would be willing to pay for different services.

• Talk to other entrepreneurs offering similar services outside the immediate geographic area.

• Find out what competitors are charging.

Services can be priced at the high end, the normal market rate or at lower prices to create more demand.

Do note that customers equate lower price with lower quality. Experts report that professionals who charge fees in the upper range are usually the most successful. When an entrepreneur is starting a new venture, communicating credibility is the biggest challenge.

1 Other pricing factors

Pay attention to your fixed cost as a service provider. Most owners of service businesses plan on working 15 days per month, with the remaining five workdays dedicated to managing the business in those nonbillable activities.

After estimating the nonbillable time needed to operate the business, the next step is to calculate daily and hourly rates for pricing.

The entrepreneur must decide whether to hourly rate, a daily rate, or standard fees for specific services, or a pricing structure that includes more than one of these rates.

6 Markup

Markup is the percentage amount of the retail price on an item over and above the cost, this figure is always related to the retail price (not the price that was originally paid). Then, the markup is the difference between retail and cost.

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