Reading: Lesson 5 - Pricing and Costs

11.5.A - Pricing and Costs

1. PAYMENT TERMS AND DISCOUNTS

1. Marketing managers help a business maximize profits by developing pricing strategies. This requires that a marketing manager understands pricing principles and the mathematical relationships between a product’s price and business expenses. Marketing managers establish a price at which they would like to sell a product. The initial price that the seller posts on a product is its list price. Often, however, customers do not pay the list price. The terms of sale offered by the seller or requested by the buyer affect the actual price paid. The terms of sale identify delivery conditions, the invoice due date, and credits or discounts for which the buyer qualifies. The buyer may specify requirements the seller must meet. The buyer and seller discuss those requirements and then negotiate any changes before a final decision is made. The buyer and seller also discuss price, quantity, and delivery time and location and agree on the terms of the sale. The supplier then receives the buyer’s purchase order or contract, which details the form, quantity, and price of the products to be supplied.
   
2. Companies that sell to other businesses often extend credit to their customers. They list their credit terms on the invoice. Invoices often state credit terms in a form such as net 30 days, which means that the buyer must pay in full within 30 days from the date on the invoice. Some businesses offer longer payment terms, such as net 60 days. The longer the term, the better for the buyer, who then has a chance to sell products by the time payment is due and earn interest on the money that will be paid to the supplier. Suppliers may offer discounts on products that their business customers purchase. Discounts are reductions from a product’s list price designed to encourage customers to buy. Common types of discounts are trade, quantity, seasonal, and cash discounts.
3. A trade discount is a price reduction that manufacturers give to their channel partners, such as wholesalers or retailers, in exchange for additional services. For example, a manufacturer may give retailers a 30 percent discount but may give wholesalers a 45 percent discount from the list price (or 15 percent more than retailers). In this case, the manufacturer expects the wholesalers to perform marketing activities beyond those expected from retailers.
   
4. A quantity discount is a price reduction offered to customers that buy in quantities larger than a specified minimum. For example, a paint store that orders 200 gallons of paint from a wholesaler pays a certain price per gallon. However, the wholesaler may lower the price per gallon if the store orders at least 1,000 gallons at one time. The purpose of the discount is to encourage customers to buy in greater quantities. The manufacturer can afford to sell the larger quantity for a lower price because that sale reduces the cost of inventory, the amount of storage space needed, the insurance costs, and the administrative costs of product handling. Quantity discounts may be based on the number of units purchased or the dollar value of the order.
   
5. A seasonal discount is a price reduction offered for ordering or taking delivery of products before or after the normal buying period. It encourages the buyer to purchase earlier than necessary or at a time when orders are normally low. An example is a discount on snowmobiles purchased in the summer. The seasonal discount is a way the manufacturer attempts to balance production and inventory levels throughout the year for products that are normally purchased at a few specific times during the year.
   
6. To encourage early payment, many businesses offer a cash discount. A cash discount is a price reduction given for paying by a certain date. A cash discount is usually stated as a percentage of the total purchase price (for example, 2 percent). Businesses offer cash discounts with various dating and credit terms. For example, the terms of a purchase may be net 30 days with a 2 percent discount for payment within 10 days. If the invoice is dated May 1, the buyer can deduct 2 percent from the total price when paying on or before May 11. Otherwise, the buyer must pay the full amount by May 31. Businesses write terms like these in the format 2/10, n/30.
   
7. The prices businesses charge can make the difference between the success and failure of their products. Customers must view the product as a good value for the price. The price must be competitive with prices of competitors’ products, yet high enough for the business to make a profit on the sale. The selling price is the actual price customers pay for the product. The selling price is determined by subtracting any discounts from the list price. Businesses often set list prices higher than the price at which they end up selling the products to customers. The selling price is the expected revenue for the business for each product sold. To make a profit, businesses must plan for discounts when setting their list prices. The Figure below illustrates the components that marketing managers consider when setting prices. To make a profit, marketers must set prices high enough to more than cover all costs. The income remaining after deducting costs from the selling price is the net profit for the sale. 
   

   
   

8. The largest cost that the price must cover is the cost of goods sold. The cost of goods sold is the cost to produce the product or buy it for resale. For manufacturers, the cost of goods sold is the total cost of the materials, operations, and personnel used to make the product. For wholesalers and retailers, it is the price they pay their supplier to buy the product plus the cost of transporting it to their location for resale to their customers. For example, if the invoice price of an item is $55 and the transportation charge is $5, the cost of goods sold is $60. Operating expenses are the costs of operating the business. These expenses do not include costs involved in the actual production or purchase of merchandise, which would be part of the cost of goods sold. Most costs involved in the day-to-day running of a business are operating expenses. The Figure below lists some common operating expenses. The margin or gross profit is the difference between the selling price and the cost of goods sold. In the Figure above, the margin is 40 cents. Marketers think of the margin as the percentage of sales available to cover operating expenses and provide a profit. For example, a business may operate on a 25 percent margin. If operating expenses are more than 25 percent of sales, the company will have a loss rather than a profit. 
   

   
   

9. Net profit is the difference between the selling price and all costs and expenses of the business. Net profit can be calculated using the following formula: 
   

   
   

10. Markup is the amount added to the cost of goods sold to determine the selling price. It is similar to margin. When stated in dollars and cents, markup and margin are identical. For example, in the Figure above, the markup is also 40 cents. Often businesses express the markup as a percentage of the cost of goods sold or as a percentage of the selling price. Thus, the markup in the Figure above is 66 2/3 percent of cost (40 cents/60 cents). Expressed as a percentage of the selling price, it is 40 percent (40 cents/100 cents). Some consumers confuse the markup percentage with profit. They believe that if a business has a 50 percent markup, it is making a profit of 50 percent of the selling price. However, markup must cover operating expenses. If the business with a 50 percent average markup on its products has operating expenses of 45 percent of sales, it will have a profit of 5 percent of total sales. Markdown is any amount by which the original selling price is reduced before the item is sold. Companies use markdowns when their inventory is not selling at a satisfactory rate. Because the costs associated with the products remain the same, markdowns reduce profits, so companies want to avoid them. 
    

2. PRICING STRATEGIES

1. Because businesses operate for profit, they must set prices that will entice customers to buy the products yet will make a profit after costs are deducted. Businesses can use different strategies to achieve this goal. For example, a business can establish a high price. Fewer customers will buy at a high price than a low price, but the company will make a greater gross profit per item sold. On the other hand, a business can choose to set a low price. More customers will buy at a low price than a high price, but the company will make less gross profit per item sold. In this case, the company hopes to make a satisfactory profit by selling a large number of items.
   
2. No one strategy is best in all cases. Either of these strategies can result in a satisfactory profit for the company. Consider the following example: Business A buys a product for $500 and offers it for sale at $1,000. It sells four of these in a month, making a gross profit of $2,000: 
   

   
   

3. Business B, selling the same product, thinks it can make a better profit by setting a lower price and selling a greater quantity. It offers the item for $800. In one month it sells six items, for a gross profit of $1,800: 
   

   
   

4. In this case, Business A’s strategy made the higher profit. However, there are many settings in which the lower cost strategy could result in the higher profit. Both of these companies made a gross profit, but they must deduct operating expenses to arrive at their net profit. If Business A’s operating expenses are much greater than Business B’s, then Business B might make the greater net profit, even though its gross profit was lower. The challenge is to choose the strategy that works best for the situation. Businesses must be careful about setting extremely high or extremely low prices. With extremely high prices, the business may not sell a sufficient quantity to yield a net profit. With extremely low prices, the business may not be able to cover its costs no matter the quantity sold. Between these two extremes is a reasonable price that satisfies customers and allows a reasonable profit. Next you will learn about some of the strategies marketing managers use to set a reasonable price.
   

5. The amount of competition among companies handling similar products or services is an important factor in establishing prices. If one company has much higher prices than its competitors for the same products, some of the company’s customers are likely to buy from the competitors. Even similar businesses in separate locations may compete for the same customers. If prices are too high in one area, many people will travel elsewhere to purchase goods or services. For example, if a gas station in one neighborhood is selling fuel for $2.399 a gallon and a station two miles away is selling the same brand for $1.949, customers may be willing to travel to buy where the price is lower. The Internet has had a major impact on pricing, because it makes price comparison easy for customers. Some websites can be used to search for the lowest prices for specific products. Customers who value low prices are likely to buy from the lowest-priced competitor that can meet service and delivery requirements.
   

6. A business may need to offer some of its merchandise at a price that does not allow a profit because a competitor has established an even lower price. However, it is not always necessary to have a lower selling price than competitors. If a company has a loyal group of customers and offers a product with some distinct advantages, or provides services that customers want and other companies do not offer, the company may be able to charge a higher price without losing customers. Remember that providing higher-quality products or more services may be expensive, so profits may not be higher just because prices are higher. When competition is intense, some companies may have to set some of their prices at or below the actual costs of doing business. In such a competitive situation, only the most efficient businesses make a net profit. Even when competition is not strong, if a company sets its prices too high, people will try to delay purchasing or find substitutes rather than pay prices that seem to give that company an unduly large profit.
   

7. When introducing a new product, many businesses set their selling price based on a specific profit they want to make. The business first determines the costs of producing and marketing the product, as well as all related operating expenses. It then sets the price by adding the amount necessary to make the target profit. But even setting prices based on a target profit won’t guarantee that the company will make that profit. Customers must like the product well enough to buy it at that price. Also, competitors selling the same product might sell for less, luring away customers. In either case, the company may have markdowns to attract more buyers, reducing profit below its target.
   

8. The marketing managers of a fashion retailer know that at certain times the products will be in great demand, and at other times the demand will be very low. Swimsuits sell quickly early in the season but slowly late in the season, unless the retailer greatly reduces the prices. Because a retailer cannot predict the exact number of suits it will sell, managers within the company will set a selling price at the beginning of the season that should ensure a net profit on the entire inventory of swimsuits, even though it may have to drastically reduce prices later in the season. A manufacturer of a product that suddenly becomes popular may want to sell at a high price while the demand is great. When new competitors enter the market or customers tire of the product and demand begins to decline, the manufacturer will need to sell the product at a much lower price. The introduction of new products in the market presents an interesting study in price decisions. When high-definition televisions (HDTVs) were introduced in the market, a few brands were priced extremely high—several thousand dollars—compared to older style televisions. As customer demand increased, many more competitors entered the market, and prices began to drop to between $300 and $1,000. From there, new technologies such as 4DTV were introduced to the market.
   

9. Products that are priced higher usually sell more slowly than those that cost the same but are priced lower. For example, a product with a cost of $40 may be priced at $60 but may not sell for two months. A similar product that also cost $40 may be priced at $48 and sell in two weeks. If the second product continues to sell at that pace, the business will sell more of it and achieve a larger net profit over the course of the year. A business must be careful that the lower price is high enough to cover operating costs and still contribute to profit. Otherwise, using the lower price is a poor decision. For example, if the product priced at $48 had a cost of goods sold of $40 and must cover $10 worth of operating expenses, then the business will never make a net profit on the product no matter how many it sells. If a business has a low rate of inventory turnover, it must charge higher prices to cover the cost of the inventory and the operating expenses of the business. For instance, many items in an exclusive jewelry store may be sold and replenished at the rate of once a year or less. The jeweler, therefore, must mark the retail price of the products very high in relation to their cost to make a reasonable profit.
   

10. A business that offers credit, free delivery, or 24-hour emergency service will have higher operating expenses than one that offers limited services. Higher operating expenses require a higher selling price to yield the same net profit as that earned by a business with lower expenses. If customers expect a high level of service, or if a business is using the extra service to appear different from competitors, the business will have to set prices higher to achieve a profit. 
    

3. CONTROLLING COSTS AND PROFITS

1. Marketing managers are not always able to increase prices just because the business is not making a profit. The costs of merchandise and operating expenses often increase, but prices charged to customers cannot be raised due to competition. Businesses have to make careful purchasing and operating decisions to avoid unnecessary expenses. Three important areas that can affect costs and profit are (1) markdowns, (2) damaged or stolen merchandise, and (3) merchandise returns. When managers pay close attention to the three problem areas of mark-downs, damaged or stolen merchandise, and returns, they can keep operating expenses to a minimum. As a result, they can maintain profits while lowering the markup percentage. In that way, both the businesses and their customers benefit.
   
2. In many cases, businesses are forced to sell some products at lower prices than they had planned. This can happen because they purchase products that customers do not want or that go out of style. Businesses must also sell products at lower prices when they overestimated demand and bought too many products, when competition increases, or when competitors lower prices. Businesses cannot always avoid markdowns, but they usually can control them. Careful purchasing can eliminate many markdowns. Proper product handling and marketing practices can also reduce the number of markdowns.
   
3. Some products may be damaged to the extent that they cannot be sold. Other products may be stolen by shoplifters or employees. These situations have a serious effect on profits. Assume that a product with a selling price of $5.00 is damaged or stolen. The product cost the business $4.00, and operating expenses amounted to $.75 for each product. Expected net profit was $.25. In order to recover the cost of that one damaged or stolen product, the business will have to sell 16 more products than originally planned (16 products 3 $.25 5 $4.00). It will have to sell another three products to cover operating expenses. The business will not earn any net profit on the sale of the 19 products if just one product out of 20 is damaged or stolen. To reduce the amount of damaged and stolen merchandise, companies may take actions such as employing security guards, installing surveillance cameras, and training employees to handle merchandise carefully.
   
4. If customers are not satisfied with their purchases, they may return the products for a refund. This adds to expenses in two ways. If the business can resell the merchandise, the resale will be at a reduced price. Also, many expenses are involved in handling and reselling the returned merchandise, which increases operating expenses. Further, some returned merchandise cannot be resold. To make a profit, businesses must consider their history of returned merchandise when buying and pricing merchandise. They must try to buy just the type and quality of merchandise that customers prefer in order to help reduce returns. Salespeople should be trained to sell products that customers need rather than attempting to convince customers to buy things they do not need. Offering customer service and support to help customers use the products properly and resolve problems also reduces the amount of merchandise returned.