UNDERSTANDING COSTS AND DEVELOPING PRICING STRATEGIES
Universities – tuition, professional firms – fee, banks – a service charge, turnpikes – a toll,
transportation – fare, brokers – commissions, housing – rent, museums – admission charge, local
utilities and hotels – rate.
Additional key costs that customers may incur using a service:
- Time. For customers, there is an opportunity cost to the time spent in pursuit of service (that
time could be spent in other ways).
- Physical efforts (required to obtain a service).
- Psychic costs – mental effort, feelings of inadequacy, or even fear.
- Sensory costs – dealing with noise, smells, drafts, excessive heat/cold, uncomfortable seating,
visually unappealing environments, even unpleasant tastes (one of the reasons children dislike
health care).
Customers weights the benefits vs. all costs (price + additional costs above) when making buying
decisions.
Foundations of pricing strategy.
Costs, competition, value.
Costs = floor, value = ceiling, competition = conditioned level at which the price is set.
(There are many exceptions, like loss-leader, or price being the only attribute that is associated with
quality in case of absence of tangible clues, but the general idea is above).
Understanding value.
Research by Zeithaml: “What constitutes value – even in a single product category – appears to be
highly personal and idiosyncratic”.
E.g., for beverages, she found 4 broad expressions of value:
- value is low price;
- value is whatever I want in a product;
- value is the quality I get for the price I pay;
- value is what I get for what I give.
The fourth is the most applicable for services; to paraphrase:
“Net value is the sum of all perceived benefits (gross value) minus the sum of all perceived costs”.
(The greater the positive difference between perceived benefits and perceived costs, the greater the
net value).
(Economists use the term “consumer surplus” to define the difference between the price a consumer
actually pays and the greater amount he or she would have been willing to pay to obtain the desired
benefits (or “utility”) offered by the product in question.
A service with negative value is likely to be characterized as “poor value”, being declined for
purchase.
A marketer can increase net value by such means as:
- Reducing the amount of time involved in service purchase, delivery and consumption;
- Minimizing unwanted mental effort or psychological stress involved in obtaining a service;
- Pruning out any unwanted physical effort that customers are required to undertake in order to
obtain service;
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Understanding costs and developing
pricing strategies
- Minimizing unpleasant sensory experience.
(Related to the key costs consumers incur).
When customers evaluate competing services, they are basically comparing net values. However,
perceptions are often highly inaccurate due to imperfect information. Further, perceptions of
benefits and cost may vary widely from one customer to another, or even from one situation to
another.
Also, evaluations may sharply differ between pre-use and post-use. (Careful managers prefer to
disclose all associated costs prior to consumption).
Establishing monetary pricing objectives.
Underlying any decision on pricing strategy must be a clear understanding of the organization’s
objectives.
Three basic categories of pricing objectives open to a service organization:
1. Revenue oriented.
- Profit seeking:
- Make the largest possible surplus;
- Achieve a specific target level, but do not seek to maximize profits.
- Cover costs:
- Cover fully allocated costs (including institutional overhead);
- Cover costs of providing one particular service or manufacturing one particular product
category (after deducting any specific grants and excluding institutional overhead);
- Cover incremental costs of selling to one extra consumer.
2. Operations oriented.
- Vary prices over time so as to ensure that demand matches available supply at any specific point
in time (thus making the best use of productive capacity).
3. Patronage oriented.
- Maximize patronage (where capacity is not a constraint), subject to achieving a certain
minimum level of revenues.
- Recognize differing ability to pay among the various market segments of interest to the
organization and price accordingly.
- Offer methods of payment (including credit) that will enhance the likelihood of purchase.
Revenue-oriented objectives.
Within certain limit business organizations attempt to maximize the surplus of income over
expenditures. Public and non-profit organizations are more concerned about breaking even or
keeping the operating deficit within acceptable bounds.
Costs: fixed, semi-variable, variable.
Fixed: are incurred (at least in short run) even if no services are provided.
Semi-variable costs: typically rise in a stepwise function. They are related to the number of
customers served or volume of services produced by an organization. Incurred are operating costs
such as incremental utilities, cleaning at service delivery sites, and wages and salaries incurred in
paying overtime or hiring additional personnel.
E.g., it is not feasible to add just one extra seat on a full flight; to accommodate an extra passenger
means putting on a bigger aircraft or adding a backup aircraft (as is guaranteed on certain shuttle
services). Adding more or larger equipment would involve extra labor costs, result in additional fuel
consumption, and probably lead to increased maintenance expenditure.
Variable costs are those associated with making an additional sale – such as a new loan at a bank, a
single seat in a train or theater, a room in a hotel, or one more repair job. Usually, these costs are
extremely low (a theater place or a passenger in a train; unless user are particularly prone to littering
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Understanding costs and developing
pricing strategies
and vandalism). However, when dealing with tangible assets (repairing a car), may involve use of
spare parts, oil, and electrical power that is costly.
Contribution margin = the difference between the variable cost to the seller and the price charged to
the purchaser. This contribution goes to defer semi-variable costs and overhead.
In general, determination and allocation of costs is a difficult task that falls under the province of
cost accounting (and may require the marketing manager to work closely with the firm’s controller).
It is particularly problematic in service operations because of the difficulties of deciding how to
assign overhead costs.
For instance, a hospital might assign overhead to its emergency unit on the basis of the percentage
of the total floor space it occupies, the percentage of employee hours or payroll it accounts for, or
the percentage of total patient contact hours involved. Each of these methods would probably yield
a totally different fixed-cost allocation; one might make the emergency room appear a financial
drain, another make it seem a break-even operation, and a third make it look highly profitable.
Break-even analysis.
Three critical issues:
- relation of sales volume to price sensitivity (will customers be willing to pay this much?);
- market size (is the market large enough to support this level of patronage?);
- extent of competition (how strong an appeal do our competitors offer to potential customers?).
The value of break-even analysis is that it relates the demand characteristics of the market to the
cost characteristics of the organization. It is particularly useful for deciding whether or not to make
an addition to the organization’s product line and, if so, what price to charge.
Low cost per unit of service can become a stimulus for reaching broader target market (e.g., lowcost Southwest Airlines targeted even people who traveled by road or did not travel at all).
Operations-oriented objectives.
Hotels seek to fill their rooms (since an empty room is an unproductive asset). Professional firms
want to keep their staff members occupied, airlines want to fill empty seats, repair shops try to keep
their facilities, machines, and workers busy.
Two critical issues arise:
- forecasting and
- managing demand.
Stimulating patronage.
Initial trouble is usually the attraction of customers.
Price reductions can stimulate trials.
Firms, wishing to maximize their appeal among specific types of customers need to adopt pricing
strategies that recognize a differential ability to pay among various market segments (as well as
variations in preferences among customers for alternative levels of service).
In practice, pricing strategies cannot be developed with the single-minded aim of satisfying just one
class of objectives. Realistically, each of the three perspectives noted earlier must be included,
although the comparative importance of profits, operations, and customer preferences may vary
from one situation to another.
Pricing relative to demand levels.
Service organizations may be eager to attract the largest possible number of customers or patrons,
since high patronage not only ensures that the organization’s resources are fully utilized but also
increases public visibility.
Customers, however, prefer non-overcrowded places.
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Understanding costs and developing
pricing strategies
Pricing to maximize use or attendance is not necessarily the same as pricing to maximize revenues.
Much depends on the extent to which a change in price affects people’s willingness to buy.
Price elasticity.
Customers are heterogeneous and express behaviors with different price elasticity.
A theater, for example, should do prior research to offer tickets at different prices (for different
locations), where sales occur proportionally.
(The goal in this case can be “maximizing revenues”, subject to a minimum attendance goal per
performance of 70% of all seats sold).
(Mostly, organizations are concerned about maximizing yield; by varying prices a company
estimates the load and payoffs).
Formulating pricing strategy.
Determining pricing strategies in a service organization requires making decisions on a range of
different issues. These, in turn, must be based on clear understanding of the organization’s
objectives and sound information on a range of relevant inputs.
Below go major issues related to monetary pricing decisions, each of which can be further
subdivided. (The table makes clear that although the first pricing decision is how much to charge,
the information needed for a complete pricing strategy extends much further).
1. How much should be charged for the service?
- What costs is the organization attempting to recover? Is the organization trying to achieve a
specific profit margin or return on investment by selling this service?
- How sensitive are customers to different prices?
- What prices are charged by competitors?
- What discounts should be offered from basic prices?
- Are psychological pricing points customarily used? (e.g., $4.95).
2.
-
What should be the basis for pricing?
Execution of a specific task.
Admission to a service facility.
Units of time (hour, week, month, year).
Percentage commission on the value of the transaction.
Physical resources consumed.
Geographical distance covered.
Weight or size of object serviced.
Should each service element be billed independently?
Should a single price be charged for a bundled “package”?
3.
-
Who should collect payment?
The organization that provides the service.
A specialist intermediary (travel or ticket agent, bank, retailer, etc.).
How should the intermediary be compensated for this work – flat fee or percentage
commission?
4.
-
Where should payment be made?
The location at which the service is delivered.
A convenient retail outlet or financial intermediary (e.g., bank).
The purchaser’s home (by mail or phone).
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Understanding costs and developing
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5.
-
When should payment be made?
Before or after delivery of the service?
At which times of day?
On which days of the week?
6.
-
How should payment be made?
Cash (exact change or not?)
Token (where can these be purchased?)
Stored value card.
Check (how to verify?)
Electronic funds transfer.
Charge card (credit or debit?)
Credit account with service provider.
Vouchers.
Third-party payment (e.g., insurance company, government agency?)
7. How should prices be communicated to the target market?
- Through what communication medium? (advertising, signage, electronic display, sales-people,
customer service personnel).
- What message content (how much emphasis should be placed on price?)
How much to charge?
Cost = floor.
Predicted sales volume = ceiling.
(The difficulty is an accurate forecast).
Competition conditions the gap.
If the price is “below the floor”, a company may seek to delegate certain parts of the service to third
parties, which are capable to lower the costs through economies of scales.
Discounting should be selective. (Discounting all services leads to diluting the average price
received and reducing the contribution from each sale). Selective discounting can rise opportunities
to tap new segments and fill capacity that would otherwise go unused.
The challenge is to understand the price elasticities of different segments and to discourage highpaying segments from taking advantage of discounts designed to lure more price-sensitive
consumers.
What should be the basis for pricing?
This requires defining the unit of service consumption (time, unit, size, value…).
For a fast-food there can be either mark-up on food (usually), or “rent-a-table” price (fixed entrance
price).
With continuous measures (e.g., distance), usually discreteness is introduced for simplicity
(zoning).
Itemization may be preferred (restaurant), but an airline (People Express), offering low ticket prices
but charging for all ancillary services (check-in, baggage registration, food) eventually failed,
because people do not like making a bunch of small payments.
Frequently, companies offer price packages (e.g., mobile or internet providers).
Bundling is another approach, which, although, is frequently subject to ethical conflicts.
(Companies set low service prices, but screw money for expensive extras).
Who should collect payment?
Intermediaries with developed networks can do this task better. (Examples?)
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Understanding costs and developing
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Where should payment be made?
See above, plus the use of electronic payment systems (through Internet).
When should payment be made?
Essentially – before or after the service?
How should payment be made?
E.g., fast-food hall with debit cards purchased at entrance and balanced at the exit.
(Examples of alternatives to cash?)
Communicating prices to target markets.
(Ethical issues and discussion of Ads by mobile operators in Ukraine).
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Understanding costs and developing
pricing strategies