The marketing mix consists of the four Ps (product, place, promotion and price). The marketing manager has to decide what type of pricing strategy to use for the overall marketing plan. The options depend on how cost is determined.
Marketing Mix 4Ps: Pricing
How does a company decide on the price of a product or service? It might seem to be an easy task, but developing a pricing strategy can be very complicated. The marketing mix contains the four Ps (product, place, promotion and price). Price is the most flexible P in that it can be altered the quickest according to business needs. Some companies make the mistake of ignoring the demand for a product and just setting a price based on costs.
Whack-a-Wing is a fast food restaurant that’s launching a new soup. The company must determine a price that the target market will feel is appropriate and fair and encourage a purchase. Let’s look at some basic pricing terminology before we tackle Whack-a-Wing’s dilemma.
Cost has five terms that marketing managers must understand to develop an appropriate price for products and services. The first term is called variable cost, and it is a cost that varies with changes in the level of output. An example would be material, such as chicken for Whack-a-Wing’s soup product. In contrast, fixed costs are costs that do not change with the level of output.
An example of fixed costs would be Whack-a-Wing’s office rent or executive salaries.
Costs Per Unit
In order to figure out the appropriate price, a starting point is to determine the cost per unit of product. This can be accomplished by finding the average variable cost (AVC), average total cost (ATC) and marginal cost (MC). Average variable cost (AVC) is the total variable cost divided by the quantity of output. Average total cost (ATC) is the total cost divided by the quantity of output.
AFC (average fixed costs) is the fixed costs of production (FC) divided by the quantity (Q) of output produced (AFC = FC / Q). As the total number of goods produced increases, the average fixed cost decreases because the same amount of fixed costs is being spread over a larger number of units of output. AVC + AFC = ATC. This gives the company an idea of what costs are associated by producing one unit of product (one can of Whack-a-Wing soup).
Marginal cost (MC) is the change in total costs associated with a one-unit change in output. Marginal cost decreases initially and it is usually cheaper to produce products when quantity is increased. At some point, though, marginal cost will increase as diminishing returns will occur. This means that less output is produced for every additional dollar spent on variable output.
Here is a very easy example of marginal cost and benefit. Let us say that you are given a plate of freshly baked chocolate chip cookies.
Your cookie satisfaction level begins at zero. For every cookie you eat, you increase your marginal benefit score by +5. For a while, you are going to keep increasing by +5. At some point, you will grow tired of eating the cookies and reach a plateau. This is where marginal cost equals marginal benefit, so less output is reached (or a diminished return) or you’re less happy with your cookies. When MC is less than AVC or AC, the incremental cost will cause a decrease in average costs. When MC is greater than AVC or ATC, then the average costs increase.
When marginal cost equals marginal revenue, then profit maximization occurs, which means that any additional production of product will produce more profit. Costs are the basis for determining pricing, along with demand.
Whack-a-Wing has used markup pricing in the past to determine the retail cost of their menu items. It is determined by adding the cost from the producer with the amounts for profit and expenses.
A bowl of chicken soup costs Whack-a-Wing about $0.75 and is going to be sold for $3.00 in their stores.
This would mean that Whack-a-Wing is marking up their soup $2.25. The markup percentage would be $2.25 / $0.
75 = 300%! This gives the fast food retailer room to discount the soup with sandwich purchases and even run specials.
Profit Maximization Pricing
Another type of pricing Whack-a-Wing could consider is called profit maximization. This type of pricing is when marginal revenue equals marginal costs. Marginal revenue is the extra revenue associated with selling an extra unit of output. The rule that is followed is that a company will continue to make and sell the product as long as the revenue of the last unit produced and sold is greater than its cost.
The last type of pricing methodology that Whack-a-Wing could use would be break-even pricing.
This is a method of determining what sales volume must be reached before total revenue equals total costs. Let’s use Whack-a-Wing as an example again. Whack-a-Wing has to find where total costs equal total revenue to determine the break-even point where profits can be earned by the firm.
Pricing scenario models are not perfect, but they give companies a place to start. There can be issues with using break-even analysis for pricing, and the issue of demand for the product is ignored.
Other Forms of Pricing
Companies can also decide on a pricing strategy based on the stage of the product life cycle. For example, a company that has developed a new technology product could set the price high because demand will be high.
Another product life stage example would be Whack-a-Wing’s new soup product. The company might offer an introductory low price of $1.00 to get a customer to try the soup. After accumulating a large amount of business, Whack-a-Wing could then increase the soup to the $3.00 price.
Some companies rely on setting their price based on the competition. Airline companies follow this type of pricing and react to any changes in the market with a pricing war.Lastly, the Internet plays a huge role in price determination. It’s very easy to price shop, and companies need to be aware of competitor’s prices in order to not lose customers with a click of the mouse.
Marketing managers have a few pricing options when developing the marketing mix. First, they must have an understanding of the cost components and then decide on what type of pricing strategy they will use for the product. Break-even, markup, competitive matching or profit maximization are the most popular ways to determine the best price based on cost and demand.
You will be able to explain the purpose, advantages and disadvantages of the pricing options of break-even, markup and competitive matching after watching this video.