Cost-plus pricing (or mark-up pricing) adds a profit margin to the costs of production in order to determine the selling price of a good or service. This ensures that each unit sold adds contribution (see Unit 5.5) by ensuring the selling price is higher than the production costs. The difference between the price and the cost is called the mark-up (or the profit margin), which is usually expressed as a percentage figure, such as 50% above the cost per unit.

For example, if a toy costs $10 per unit to make and the firm wanted to earn a 80% profit margin, then the selling price would be: $10 × 1.8 = $18.

The mark-up can also be expressed in absolute terms, such as $7.50 contribution per unit above the average cost of output. This would mean the toy would be priced at: $10 + $7.50 = $17.50.

 Advantages of cost-plus pricing

• It is simple to understand and calculate.

• It makes sure the selling price is above the average total cost of production, thus ensuring each sale earns a positive contribution.

• It is suitable for almost all goods and services.

• It is particularly important and relevant in markets when raw material costs are rising.

• It is also a valid pricing strategy if customers are prepared to pay a high price for specialist/unique products, in order to maximize profit.

 Disadvantages of cost-plus pricing

• It ignores prices being charged by competitors, including those that charge a much lower price.

• It can give firms very few incentives to reduce costs.

• It does not directly consider the needs of customers when the price is set.

• Rather than focusing on the possible level of demand for a firm’s products, it concentrates on calculating the price instead.

Penetration pricing is setting a low price in order to enter an industry. It allows the firm to compete against existing firms and to gain market share. Quite often, penetration pricing takes the form of a heavily advertised discounted price offer in order to attract a large number of customers in a short space of time. The low price can also allow the firm create brand awareness and brand recognition. As the firm establishes itself and gains brand recognition, the price can be raised.

 Advantages of penetration pricing

• Allows a business to enter a market and/or to launch a new product into an existing market, acquiring brand recognition rapidly.

• It can discourage other firms from entering the industry due to the low prices and low profit margins.

• Lower prices can give the business a price advantage over its competitors, thus leading to high sales and gaining market share.

• Lower prices can also encourage word of mouth promotion, thus leading to even higher sales volume.

• Low prices (and hence lower profit margins) can force businesses to concentrate on improved cost control and higher levels of productivity.

 Disadvantages of penetration pricing

• Penetration pricing is not a sustainable (long-term) pricing strategy as low prices can lead to losses or very low profit margins.

• If costs rise suddenly due to external factors, the business could find the low prices are no longer a profitable option.

• Low prices can backfire as customers associate the organization and its products as being of ‘cheap’ or low quality (inferior). This will make it difficult for the business to raise prices at a later date.

Loss leader pricing consist of pricing a product below its cost of production so as to attract customers to also purchase other items (with their higher profit margins) at the same time. For example, a grocery store might reduce the price of a particular product from $2.99 to just $0.99 in order to attract customers to buy other products too.

Of course, some customers might go into the store to only buy multiple quantities of the loss leader product. So, in order to preserve its finances, the business usually imposes a maximum limit on how many units of the loss leader per visit. Loss leaders are not sustainable in the long run so are often offered for a limited time period only.

Loss leader pricing is often used to encourage customers to purchase the target product (the loss leader product) along with complementary products sold at higher, more profitable prices. An example is hand-held shavers being sold relatively cheaply, but selling the razor blades at a price with signficantly higher profit margins.

Supermarket operators are experts at using loss leader pricing

Another industry that uses loss leader pricing is the games console market. Producers such as Sony, Microsoft, and Nintendo fo not earn profit from the actual games consoles. These are often sold at a large loss, but the intention is to earn profit from the subsequent sales of games,  game pass subscriptions, in-app purchases, and accessories (such as hardware products, pro controllers, and collectables). The loss leader (the physical games console) is used by the games console makers to get customers onto their platform and services. This pricing method has been used by games console manufacturers for decades. For example, back in 2006, at the time of launch of the Sony PS3 , each device was sold at a loss of around $240 per console.

Perhaps the best real-world example of a loss leader is Costco’s hotdog meal, which has been used as a loss leader by the American multinational corporation since the 1980s. Costco's pizzas are an another example, outselling most pizza chains throughout the USA.

Costco has used loss-leader pricing since the 1980s

 Advantages of loss leader pricing

• Loss leaders can help a business to attract customers as most people tend to like getting a bargain.

• The business can benefit from higher sales revenue from customers who buy other products in addition to the loss leader.

• Loss leader pricing can be used by businesses as a quick and effective way to clear out older stock or merchandise.

• Loss leading is a common method used by businesses to enter or penetrate a market.

• Some firms use loss leaders as a brand switching strategy, i.e. the low price attracts customers away from rival brands.

 Disadvantages of loss leader pricing

• Customers may get used to and expect the business to continue offering loss leader products. This can be expensive for the business to sustain.

• The business makes a loss on using this pricing method (hence its name), yet there is no guarantee that customers will buy other products with positive profit margins.

• The business must have enough inventory of the loss leader product otherwise it will cause customer dissatisfaction. However, stockpiling can be expensive and harm the organization’s liquidity position.

• Loss leader pricing can be anti-competitive and deemed to be unethical. It is often regarded as a controversial pricing method in the same way as predatory pricing.

Predatory pricing is a pricing method that involves charging a low price, sometimes even below the cost, so as to damage the sales of rivals. It is also used by established market leaders to restrict new entrants, thereby limiting competition.

It can be a risky strategy to use as many governments impose anti-competitive laws, so firms can be fined for using predatory pricing with the intent to restrict competition. In some cases, predatory pricing can lead to a price war, whereby existing firms repeatedly cut prices in an attempt to destroy the sales of their rivals. This can be good for consumers, at least in the short term, as they benefit from lower prices. However, price wars are unsustainable in the long term. Quite often, price wars will result in some (smaller) firms leaving the industry as there is mounting pressure to reduce costs.

Supermarkets often using predatory pricing strategies

 Advantages of predatory pricing

• Low prices tempt customers to buy more of the product and for non-customers to switch to buying the product (ditching the rival product in the process).

• Low prices can be a barrier to entry, preventing potential rivals from competing in the industry.

• A dominant firm that uses predatory pricing can inflict losses on its rivals that cannot compete by continually reducing prices.

 Disadvantages of predatory pricing

• Predatory pricing is anti-competitive, so is illegal in many countries and violates competition laws. For example, in the European Union (EU), it is illegal for a business to sell its products at a loss in order to eliminate competition.

• Lower prices can cause some customers to question or doubt the quality of the product.

• Predatory pricing is likely to cause rival firms to retaliate by reducing their own prices. This can therefore lead to a price war, with no obvious winner in the long term.

• It is not a sustainable pricing strategy as firms cannot afford to keep reducing prices.

Premium pricing involves a business permanently setting a high price for its products because of the associated image, reputation, or status associated with its high-quality products. For example, Apple and Ferrari use premium pricing (their products are generally more expensive than those from similar competitors). Example include:

• Premium economy air travel (more expensive than an economy class ticket but with premium add-ons such as extra leg room and baggage allowance).

• Tailor-made clothing - Tailors will charge premium prices for bespoke products, such as shirts, suits, wedding dresses, and shoes, due to the uniqueness of the items and to create an impression of luxury and better quality.

• Organic produce and drinks - An organic version of a fruit, vegetable, or coffee will have a premium price than regular versions of these products as consumer may feel that the higher price means they are getting a better product.

Premium pricing is also used in the case of ostentatious consumption and conspicuous consumption.

1. Ostentatious consumption is the purchase of expensive products which impress and make customers feel good about themselves. A large part of the satisfaction comes from knowing the premium price paid for the product. Examples include Christian Dior perfumes, Rolex watches, Chanel handbags, Armani suits, and Vera Wang wedding dresses. Demand would fall if the price falls since the prestige and exclusivity associated with such premium products are reduced.

2. Conspicuous consumption is the lavish spending of some (very rich) customers for the purpose of upholding their social status, rather than to serve their real needs. The term was coined by 19th Century American economist Thorstein Veblen. Examples include highly expensive luxury cars (such as Rolls Royce, Bentley, and Maybach) and collector items (such as original paintings from Picasso and Van Gogh). For example, Paul Newman’s Rolex Daytona was sold for a record $17.8 million (October 2017). There is often a grey area between conspicuous consumption and ostentatious consumption, but the latter includes customers who are not necessarily on very high income levels.

Dynamic pricing is a pricing method that strives to determine the optimum price at different periods of time. Prices are based on the ability and willingness of customers to pay at a specific time for a good or service. Dynamic pricing (often referred to as surge pricing or time-based pricing) is flexible and based on real-time data. Hence, this pricing method involves the use of flexible prices to reflect changing market conditions.

For example, all major airlines use dynamic pricing to set ticket prices. When customers try to book a seat on a flight, the price might depend on numerous factors, such as:

• how many seats are left on that particular flight (the price tends to increase with fewer available seats)

• whether customers want extra leg room or an exit seat

• how far in advance customers book their flight (the earlier customers book, the cheaper the price tends to be).

Airline companies are experts at dynamic pricing

Other examples of businesses or markets that use dynamic pricing include:

• Car park operators - In some car parks, such as those at international airports, drivers who arrive during off-peak periods are charged a lower price per hour, whereas those who park their vehicles during peak times (when demand is less price sensitive) and the car park is full, the price per hour rises.

• Delivery (courier) companies, such as DHL, FedEx or TNT, will charge extra for same-day delivery.

• Airbnb uses dynamic pricing to fill vacant rooms and accommodation with prices based on demand at the time.

• Hotels charges higher prices during weekends and peak seasons, such as during school holidays in the summer. By contrast, they offer discounts to guests during off-peak periods.

• Spectator sorting events, such as football (soccer), baseball, basketball, and tennis - The price of tickets to these events/competitions will depend of several factors, including who the opponents are, the aay of the week, recent team or individual performance, and even the weather.

• Utilities suppliers (providers of gas, water, and electricity) charge customers more per unit of consumption during peak hours of the day.

In reality, the dynamic price changes are automated (based on computer software, data, and the use of mathematical formulae or algorithms) in order to adjust pricing accordingly. For example, some businesses will offer "early bird" discounts for customers who confirm train, movie, airline, or restaurant bookings in advance.

 Advantages of dynamic pricing

• Businesses that use dynamic (surge) pricing can increase sales revenue by capturing the willingness of customers to pay more during peak periods.

• Without dynamic pricing, it may be harder to incentivize business to supply their services, such as trying to catch a taxi during off-peak times when taxi drivers are less willing to work.

• Dynamic pricing enables customers to avoid queues (caused by excess demand) and surpluses (caused by excess supply).

• Consumers who are charged higher prices may feel disgruntled (ripped off or cheated).

• Surge pricing is often associated with being unethical as it is perceived to exploit customers, such as pharmaceutical companies charging higher prices during a major pandemic.

• It can be time consuming for customers to have to spend time finding the best deals/prices.

• There is also the potentially high cost to the business of monitoring and evaluating the data needed for dynamic pricing.

 Watch this short video which explains how Uber uses dynamic (surge) pricing:

Competitive pricing (often called competition-based pricing) is a pricing method where businesses set their prices based on what rivals are charging. Hence, competitive pricing is one of the simplest pricing methods available to businesses. It is suitable in highly competitive markets where products are homogeneous or have very similar attributes and functions.

Mobile phones are often competitively priced

 Advantages of competitive pricing

• It is a low risk pricing strategy as the possibility of making a mistake with pricing is minimised. This is because competitive pricing helps to ensure a firm's prices are not too high or too low from the average price being charged in the market.

• It is one of the simplest pricing methods, especially for new and small businesses. This methods simply requires the business to determine who their main competitors are and collect the prices charged by these firms before making a final pricing decision.

• There is flexibility as the business can make changes to prices to accommodate changes in the industry.

 Disadvantages of competitive pricing

• It is difficult to stand out in a highly competitive market if prices are similar to those of rivals. The business will therefore have to compete on non-price factors, such as improved advertising, branding, packaging, and improved customer loyalty schemes - all of which can be rather expensive.

• The task of collecting and comparing price data from competitors can be time consuming and expensive, especially for smaller businesses. This could include the cost of purchasing price monitoring software.

Contribution pricing is a pricing method that involves setting the price greater than the per unit variable costs of production to ensure that a positive contribution is made towards the firm's fixed costs. For example, if a firm has variable costs per unit of $5 and a selling price of $9, then each unit sold earns a contribution of $4 towards the payment of fixed costs.

Knowledge of contribution can enable businesses to make more informed decisions about prices. For example, suppose a hot dog retailer has unit variable costs of $4 and fixed costs of $600 per week. This means that if the selling price is $10 per hotdog:

• Unit contribution = $10 – $4 = $6

• Break-even = Fixed costs / Unit contribution = $600 / $6 = 100 units (hotdogs).

If the selling price is $12, then the following applies:

• Unit contribution = $12 – $4 = $8

• Break-even = Fixed costs / Unit contribution = $600 / $8 = 75 units (hotdogs).

It can be seen that a higher contribution per unit leads to a quicker break-even. In the above case, by raising the price by 20%, the firm can break even at a much lower number of hotdogs. However, a higher price could mean fewer customers, so knowledge of price elasticity of demand (see section below) can be beneficial prior to determining which price to set.

In any case, a firm must have a positive contribution to have any chance of earning a profit, i.e., the selling price must exceed the variable cost per unit. Only once sufficient units of the product are sold can the total contribution cover the fixed costs. Thereafter, further sales will generate a profit for the business.

Contribution pricing can be used by businesses to decide whether to accept special or additional orders. For example, a hotel with vacancies (empty rooms) or a flight with spare capacity (empty seats) can be sold at a discounted price, so long as there is a positive contribution (price exceeds variable unit cost). This is because the additional order contributes to the firm's fixed costs.

 Advantages of contribution pricing

• Contribution pricing and contribution analysis enables managers to determine which products from the firm’s product portfolio generates the highest (and the least) amount of total contribution. In general, products with the highest total contribution are prioritised as these contribute the most towards paying the firm's fixed costs. Products that contribute the least amount or have a negative total contribution may need to be discontinued.

• It is straightforward to calculate, so long as managers can establish the variable cost per unit, fixed costs, and a selling price.

• Contribution pricing enables managers to know how much profit the business will earn on each unit sold after the firm has reached its break-even level of sales.

• It is a useful pricing method for when deciding on the price to charge customers for a special or additional order.

 Disadvantages of contribution pricing

• Contribution pricing and contribution analysis assume that the selling price of a product is constant, but in reality customers are often given a price discount for larger orders (purchasing economies of scale).

• Despite what might appear to be an ideal price based on contribution analysis, it is still important for a buisness to check the prices being charged by its closets competitors in the market. Not doing so could simply reduce the firm's competitiveness in the market.

• Allocating fixed costs appropriately between the many products sold by a large business can prove to be extremely difficult, so this would lead to inaccurate prices being set.

• Contribution pricing and contribution analysis assume that manufacturers produce and sell exactly the same number of units. However, in reality, producers often make more than they can sell, and there are often spoilages (damage) to stocks (inventories) which can therefore not be sold to customers.

 Exam Practice Question 4

Distinguish between cost-plus pricing and contribution pricing.  [4 marks]

 Teacher only box

Answer

Contribution pricing focuses on the contribution margin, i.e., the difference between the selling price and variable costs per unit or P – AVC. It emphasizes on maximizing the contribution per unit in order to cover fixed costs and generate profits.

In contrast, cost-plus pricing considers both variable and fixed costs, adding a percentage mark-up to determine the selling price, i.e. cost-plus pricing = average total cost + desired profit per unit. It ensures all costs are covered and includes a pre-determined profit margin.

Essentially, cost-plus pricing is set according to the total cost of production of a good or service whereas contribution pricing is set according only to the variable cost per unit.

Award [1 - 2 marks] for an answer that shows limited understanding of the demands of the question.

Award [3 - 4 marks] for an answer that shows good understanding of the demands of the question, with a clear distinction made between contribution pricing and cost-plus pricing.

Price elasticity of demand (PED) measures the extent to which the demand for a product changes due to a change in its price. For example, the demand for fresh flowers during Valentine’s Day and Mothers’ Day is less price-sensitive than during off-peak periods. Hence, florists know they are able to charge higher prices during these times of the year.

Create a table of with three column headings:

1. Example of a good or service
2. A suitable pricing method
3. An unsuitable pricing method

Outline the reasons for the suitable and unsuitable of the pricing methods referred to. Also, ensure that all the various pricing methods in the syllabus are covered (5 for SL and 9 for HL).

An example is provided below as a starting point.

Key terms for HL only students are shown in red text.

• Competitive pricing is a pricing method where businesses take account of the prices charged by competitors when setting their own prices.

• Contribution pricing is a pricing method that involves setting the price greater than the variable costs per unit of production to ensure that a positive contribution is made towards the firm's fixed costs.

• A cost-plus (or mark-up) is a pricing strategy that adds a certain percentage to the cost of production in order to determine the selling price of a good or service.

• Dynamic pricing is a pricing method that strives to determine the optimum price at different periods of time. Prices are based on the ability and willingness of customers to pay at a specific time for a good or service.

• Loss leader pricing refers a product that is sold at a price below the cost of production so that customers may buy other regular and/or higher priced items along with it.

• Penetration pricing is a pricing method that involves setting a low price in order to enter an industry. It allows the business to compete against existing firms in the industry and to gain market share.

• Predatory pricing is a pricing method that involves charging a low price, sometimes even below the cost, so as to damage the sales of rivals. It is often used by established market leaders to restrict new entrants, thereby limiting competition.

• Premium pricing involves a business setting a high price for its goods or services because of the associated image, reputation, or status associated with its high-quality products.

• Price refers to the value of a good or service that is paid by the customer. Price will usually cover the costs of production, allowing the business to earn profit.

• Price elasticity of demand (PED) measures the extent to which the demand for a product changes due to a change in its price.