Volume 5/2005

• CA-Plus wins Consumers Choice Award
• CA-Plus has 6 offices across Canada
• What's happening with Sage & Accpac?

It is relatively simple to decide on upper and lower price limits for your products. At some point prices will be lower than costs, so that the venture is not worth your while. At the other extreme, beyond a certain point no one will be willing to buy a product or service you have to offer. Just where prices settle between these two extremes will depend on the relative strength of these three key factors-cost, demand and competition.

Costs are important. Once costs are are known they provide a reference point for assessing profitability and enable you to see whether or not the expected return is satisfactory. In addition, apart from loss leaders and short term promotions, they show the minimum level below which prices will not normally be set. Whatever pricing strategy you decide to adopt, there must be a price below which it is simply not worth your effort. However, this is the only point at which costs should affect pricing decisions.

Using a simple "cost-plus" formula for determining prices, although convenient, takes no account of either what the market will bear or how your products or services compare with the competition.

There must be a demand for your product, otherwise it will not sell - at any price. However once it has been established that a demand exists, all too often prices are set in relation to costs and competition, without taking demand properly into account.

We must remember that customers do not simply buy products - they buy benefits, i.e. the benefits that acquiring the product or service will bring. Ask yourself the following questions:

• What benefits do customers get by buying my/our product?
• What special benefits do they get by buying from me/us?
• What are these benefits likely to be worth to them?
• What might they be prepared to pay for these benefits?

Only by considering the possible prices for your product or service can you take into account the effect that competition might have in keeping the price down.

Some markets - especially where barriers to entry are low and products are more or less the same - can be extremely competitive. However, not all competition takes the form of price cutting - often it leads instead to an emphasis  on brand advertising to improve the image and price position of the product. In markets like these, although advertising clearly has an impact, it is by no means easy to decide just how much advertising is required to achieve a given price premium.

The main point to remember is that you don't have to undercut everybody to break into a particular market. If the lower price sector is crowded already, it may well be better to aim for another part of the market altogether - provided, of course, that you adapt your marketing plans and budgets accordingly.

Since costs, demand and competition can all change fairly frequently, it is important to keep your prices under review, to be sure that they are in line with what you are trying to achieve.

Getting one's prices right is vital to the success of any business. It has a direct effect both on levels of output and on profitability. In contrast, the significance of price to the customer can vary widely from one market to another. Many factors affect the customers decision to buy - quality, reliability, after-sales service and price can all play a part.

In consumer markets where products are fairly similar and heavily branded, price is often paramount. For lower-priced goods on the other hand, where the effort of "shopping around" is less worthwhile, other factors such as convenience can be much more important.

For industrial markets, where purchasing decisions are often made by professional buyers, the choice between suppliers can be quite complex. Price is usually of some importance - but so too are other factors such as reliability of supply. After all, there is little point in negotiating the best possible discount if this means that you are last in the queue for deliveries.

Efforts by firms to improve their profitability often concentrate on reducing costs and increasing sales to spread overheads. Companies frequently spend considerable amounts of time and effort trying to increase efficiency and reduce costs, whereas making higher prices stick in the market place can often have a more dramatic effect on profitability. Indeed it is frequently easier to increase profitability by improving profit margins than by chasing extra sales, especially if your market share is substantial already.

Of all the factors affecting profitability, the profit margin is most directly significant. This is not surprising when we consider the following relationship:

From this simple arithmetic it is clear that increasing the profit margin, for example by four percentage points, has the effect of increasing overall return on assets by almost half!

The only time when price setting is not a problem is when you are a "price-taker" and have to set prices at the going rate, or else sell nothing at all. This normally only occurs under near-perfect market conditions, where products are almost identical. More usually, pricing decisions are among the most difficult that a business has to make. In considering these decisions it is important to distinguish between pricing strategy and tactics. Strategy is concerned with setting prices for the first time, either for a new product or for an existing product in a new market; tactics are about changing prices. Changes can be either self-initiated (to improve profitability or as a means of promotion) or in response to outside change (i.e. in costs or the prices of a competitor).

This section deals with pricing strategy - pricing tactics are discussed later.

Pricing strategy should be an integral part of the market- positioning decision, which in turn depends, to a great extent, on your overall business development strategy and marketing plans.

Setting prices at different levels has important implications for sales output, market share and profitability. When introducing new products, some key decisions about market-positioning must therefore be made at the outset. The answers to the following questions can be all important:

• What benefits does the new product offer compared with the products of competitors' ?
• What are these benefits likely to be worth and to whom ?
• How long will this competitive advantage last ?  What is the products expected life cycle ?
• What is the total potential market at different prices ?
• How large a market share is being sought ?
• Is a quick return required, or are you prepared to exploit the potential more gradually ?
• Are resources available for spending on advertising to support a brand image and justify a premium price ?
• How will the product fit in with others in the range - will it create new sales or shorten the lives of other products ?

Once these questions have been answered the market strategy, and the broad price level implied should start to emerge.

A business introducing a new product may decide to adopt an "up-market" strategy and charge a higher price at first, only introducing lower-price models or reducing the price of the existing model as the competition starts to catch up. Alternatively, it may follow a market share or market penetration pricing strategy. In this case it aims for market domination by setting a low price from the start, calculating that this will discourage competitors and enable it to capture a larger market share and achieve greater volume production at lower unit cost. In this way profits may still be higher despite lower prices. Such a pricing strategy can pay off handsomely, especially where demand is price sensitive and costs fall significantly with higher production.

There is no "right" pricing strategy for all situations. The one to choose will depend on the prevailing market conditions and what your company is trying to achieve.

Price positioning must take account of a product's position in it's life cycle as well as the life cycle of replacement products. As a product gets towards the end of its effective life its price position is likely to become weaker. If its price is changed this may affect other products in the range. A lower price, for example, may extend the product's own life but curtail the life of other, more profitable, new products.

The response from competitors is likely to be greater the larger the market share you hold. The bigger your market share the more impact you will have on your competitors and therefore the more careful you need to be before making a price change. After all, if you are going to start a price war you should try to make sure beforehand that you are going to win it.

Prices will depend on the size of the planned marketing budget, since this will affect your ability to convince buyers to pay higher prices. Although advertising can help sustain higher prices by creating a brand awareness and greater customer loyalty, don't forget that it can be very expensive.

If you have invested time and money building up a brand image emphasizing the various non-price benefits of your product, it may do more harm than good to introduce low-price products into your range. Consider carefully what low-priced items may do to the brand/business image that you are trying to develop.

Tactical pricing is concerned with making changes in your own prices and responding to price moves by others. Of course, pricing should not be seen in isolation but as a part of the overall marketing mix. Offering larger discounts- equivalent to cutting prices- might for example be a legitimate response to the start of a competitor's advertising campaign.

• If you have excess capability and need a short-term increase in business, and if you have failed to achieve this by more or better non-price marketing.
• If you are seeking to expand market share in the face of intense competition.
• If you are aiming at market domination in the hope of higher-volume production and lower unit costs.

On the other hand, price increases often result from over-demand for your product. If you cannot supply all customers, a price increase can be used effectively to ration supplies.

Whatever form they take, price changes will almost always have an impact of some kind. Although suppliers, distributors and government may all be interested in your price changes for different reasons, the two key reactions are likely to be those of customers and competitors.

If general conditions are good, you can usually increase your prices without too loud a howl from your customers; but in times of recession, your greatest concern is to maintain your market share. Then you will price not for profit, but to retain your customers.

A company thinking of changing it's prices must also consider how it's competitors are likely to react. Such reactions are especially important where:

• there are few firms in the market and your own share is relatively large;
• the product/services are relatively homogenous;
• customers are both discriminating and well-informed

Complex strategy models can be developed to try to estimate how competitors are likely to react to price changes under different circumstances. Broadly speaking, the approaches are either statistical or conjectural. The statistical approach analyses how competitors have responded in the past on the assumption that they have a consistent price reaction policy. Unfortunately the problem with this is that firms do not always react logically.

The conjectural approach , on the other hand, amounts to putting yourself in your competitor's shoes and estimating how you would react in the circumstances. To do this you need to find out as much about each of your competitors as possible. Are they pursuing a market share objective? If so they may well decide to match your price change. On the other hand, if they are trying to maximize profits, they may well respond to a price reduction by taking action on another front such as spending more on advertising or improving product quality.

How much profit are your competitors making? If you don't know then you should try to find out. You will then be in a much better position to judge how any price change will affect their profitability and how much freedom of action they actually have. Knowing whether or not your competitors can afford to enter a price war is something you should try to find out before you start one- not afterwards.

We have looked at the possible effects of initiating price changes - let us now consider the opposite question. How should we react to price changes made by competitors?

In some situations - in markets with near perfect competition and homogenous products - you may have little choice but to match a competitors price cut. Not to do so would probably mean losing most if not all of your sales. If on the other hand the competitor increases his price you must choose between fully or partly matching the rise or making no change at all. In doing this you must judge how the market as a whole is likely to react, as well as estimating the subsequent response of your competitors to your own actions. A refusal to increase your price may make the competitors reverse the original increase, so that an opportunity to raise overall profit margins may be lost.

In markets with on-homogenous products, you have more freedom in deciding how to respond to a price change. Since price may be only one factor - albeit an important one - in determining buyer behaviors, you may decide to change other elements of the marketing mix, for example, by concentrating more on advertising, improving product quality or deliveries.

The best approach is to consider the expected pay-off from adopting different responses. Start by trying to answer the following questions:

• Why did the competitor change his price in the first place? Was it to raise his own market share? To utilize spare capacity? To off-set increased costs ?
• Is the price change likely to be permanent or only temporary ?
• What will happen to your market share and profitability if you do not match the price change ?
• What are other competitors likely to do ?

We do not pretend that there is a simple solution to this problem. However, a logical approach should pay dividends. Always try to put yourself in your competitor's shoes and estimate how he will respond to your own actions. The less firms there are in the market the more complex things can become, since each companies' actions have a greater effect on the position of others. A further problem is that decisions about responding to price changes will often have to be made quickly whereas the competitor who initiated the change may well have spent considerable time making this decision.

Offering discounts can be a useful tactic in response to aggressive competition by a competitor. However, discounting can be dangerous unless carefully controlled and conceived as part of your overall marketing strategy.

Discounting is common in many industries - in some it is so endemic as to render normal price lists practically meaningless. This is not to say that there is anything particularly wrong with price discounting provided that you are getting something specific that you want in return. The trouble is that, all too often, companies get themselves embroiled in a complex structure of cash, quantity and other discounts, whilst getting absolutely nothing in return except a lower profit margin.

• Cash and settlement discounts - These are intended to bring payments in faster. However, since such discounts need to be at least 2,5% per month to have any real effect, this means paying your customer an annual rate of interest of 30% just to get in money which is due to you anyway. What is more, customers frequently take all the discounts on offer and still do not pay promptly, so that you lose both ways. Much better, we believe, is either to eliminate these discounts altogether and introduce an efficient credit control system, or change your terms of business so that you can impose a surcharge on overdue accounts instead. Whilst you may lose some business by doing this, these will probably be the worst payers anyway. If some customers will not pay you for months you are probably better off trying to win others who will.
• Quantity discounts - The trouble with these is that, when formalized on a published price list, they become an established part of your pricing structure and as a result their impact can be lost. If you are not very careful, although they may have helped you win the business to start with, in the long run the only effect they have is to spoil your profit margin. As a general rule, only publish the very minimum of quantity discounts - your very largest customers will probably try to negotiate something extra anyway. Also keep quantity discounts small, so that you hold something in reserve for when your customers do something extra for you, such as offering you sole supply, or as part of a special promotion.
• Promotional discounts -   These are the best kind of discounts because they enable you to retain the power to be flexible. There may be times when you want to give Ann extra boost to sales - to shift an old product before launching an updated one for example. At times like these special offers or promotional discounts can be useful. But try to think of unusual offers - a larger pack size for the same price or a " five for the p[rice of four " can often stimulate more interest than a straight percentage discount. They also make sure that the end user gets at least some of the benefit, which doesn't always happen with other types of discounts. Two other points to remember are:

• Make sure you retain control over your special promotions, with a specific objective, a beginning and an end point. Be sure to terminate them once they have outlived their usefulness.

• Ensure that your offers are linked to sales and not simply to orders. Otherwise you may find that orders to you are up for a while, only to be followed by a barren period whilst your customer supplies the end user from his accumulated stocks.

Clearly the role of discounts will vary from one type of business to another and not all of the comments above will apply to you. In part your ability to minimize discounts, or eliminate them altogether, will depend on the non-price benefits of your product. But, whatever business you are in, you should always ask yourself what your discounts are supposed to achieve, whether they are effective, and how long they are expected to last. In general, keep standard discounts low to retain maximum flexibility and ensure that they are consistent with your overall marketing and pricing strategy.

It may seem a little trite to say that unless one knows how much a product costs, there is every danger that one cannot set an appropriate selling price. Indeed in a manufacturing concern, an ill-judged price may not cover the cost of producing an item.

The term "cost" can itself be something of an anomaly. What is the cost of the pen with which you write? What elements were included in the cost of producing that pen? Should one take into account only the expenses that were incurred in producing the item or must one apportion other expenses without which the business as a whole could not run?

It should be obvious at this point that, whichever method one chooses, the "cost" of the item is likely to differ quite substantially.

The two main costing procedures are (a) Absorption costing and (b) Marginal costing.

• Absorption costing - In absorption costing, all costs of running the business are absorbed. Thus there is no distinction in the nature of the expenses. The owner simply has to consider the best method of apportionment, i.e. Fixed and Variable costs. Example:

Therefore, unit cost = R3400 divided by 80 = R42,50 per chair.

• Marginal costing - Marginal costing studies the behavior of expenses in a business. It distinguishes between those costs which directly affect production and which increase as production increases (known as variable expenses) and those costs which have to be paid irrespective of whether any units are produced (known as fixed expenses). So if we look at the above example we can, to a degree, differentiate between fixed and variable expenses.

Thus, based on 80 chairs Mr.X knows he requires a price of R10 more per chair to break even. Over and above that he is making a contribution to his profit, as well as meeting all fixed costs. The interesting point at this stage is that the "cost" arrived at is markedly different depending on which method was used. It can be seen from the above example that             Sales - variable costs = fixed costs + profit

Thus, in order for a business to operate on at least a break even basis, sales minus variable costs must equal fixed costs. Once this happens any further turnover generated results in pure profit, unless the cost structure changes.

• The behavior of costs - We have seen that costs do behave differently according to the business in question. We have lightly classified these as fixed costs if they remain unmoved by output changes; variable costs if they vary in accordance with production. Classification into these two categories is not quite so easy in practice. For one thing, it should be remembered that all costs are variable over a period of time. This is to be expected in an inflammatory climate. However, the cause of the variation is not as a result of change in production. All that has occurred is that the fixed costs in the business have increased. This does not change their character; they remain fixed costs. To sum up: costs do behave differently in different situations. However, each business manager should have a good idea of how each category reacts. It is essential for planning purposes, and ultimately for profit, that this study is undertaken. It is also necessary to find a cost prior to making the pricing decision. Sometimes the costing is of paramount importance in setting the right price, particularly where there is severe competition or where one has to put in a quote. In such situations if one does not know the cost then one does not know whether one can match the competition and still remain profitable. On the other hand, the pricing decision may be unrelated to the cost. The product may, for example, be innovative and the customers prepared to pay a higher price for its uniqueness. Such was the case with ballpoint pens when they arrived on the market. Higher prices can be based on better quality and workmanship, reliable and faster delivery or simply in return for personal service.

Sometimes a buyer will argue that he can purchase from a competitor for less than your current best offer. Are you prepared to match this price or not ? When this happens it is often argued (usually by your own salesmen) that prices, geared to marginal costs, should be quoted since any price above this will make a contribution to overheads. If you lose the business, on the other hand, you will get nothing at all. Although such arguments appear superficially attractive they can also be extremely dangerous. There is the danger that if all prices were to be set on the basis of marginal cost, then in the long run your company would be out of business. What is more, the long run may not be very long. Ultimately, prices must be high enough to cover the variable costs of lab our, materials and overheads and still leave a satisfactory balance of profits.

Selling at less than the full overhead recovery rate can have its uses - but only in strictly defined and well controlled circumstances, e.g.:

• To utilize idle manufacturing capacity;
• to provide work for a specialized lab our force;
• to dispose of genuinely obsolete stocks;
• to introduce new products.

• Only use this technique sparingly, preferably to dispose of excess products outside of your normal markets.
• Never adopt marginal pricing with major customers when this may set a precedent.
• Never use it if the information will leak to your customers and spoil your normal markets
• Never let marginal pricing decisions become dispersed throughout your business or delegated too far down the line.
• Never use marginal pricing if this means foregoing other full-profit business.
• Never use marginal pricing if it is likely to undermine your position in the market place.
• In short, never use it unless you absolutely have to.

Many pricing methods - for instance the percentage mark-up on costs - tend to concentrate unduly on one particular aspect and neglect others. Getting your prices right for an existing product is fairly straightforward. All you need is the time - and he courage - to go on increasing the price until sales drop off to such an extent that total contribution is also falling. At this point, you have clearly gone far enough, maybe too far. Try to look for cost savings first if you can. Otherwise, hold your prices constant until the competition catches up, or offer bigger discounts or other promotions, if you cannot afford to wait that long. Setting new prices is not so easy. However, the following guidelines may be useful:

• Consider costs - make up your own mind about the lowest price you are prepared to consider. Whatever you are trying to achieve - even if it is buying your way into the market - there must be a minimum price below which sales are simply not worth pursuing. However this is the only stage at which costs enter the price setting equation.
• Watch the customer - Prices should be related to demand in the market place and not solely to costs. Try to take account of the non-price benefits that your customers will gain by using your products, and estimate what they will be prepared to pay for them. If possible, obtain field research information from potential customers, but treat the findings with caution since surveys on buying intentions can be extremely hard to interpret.
• Watch the competition - Whilst it can be very useful to look at competitors prices, do remember that you do not have to undercut everybody in sight to break into the market. Carry out a careful analysis, weighing up the good and bad points about your product, and compare them with others on the market. Then decide on where to position your product on the market and where its price should be relative to others. Price cutting should be the last resort, not the first.
• Do not underprice - If you are offering a genuinely better product than others on the market, you should be charging a premium price for it. Anything else, whilst maybe not a defeat, is certainly a reflection of weak "non-price" marketing. Remember that service can be an important part of the benefits which your customers are prepared to pay for.

It is much easier to set prices relatively high to start with and reduce them later, than to have to increase prices sharply on unprofitable lines. It is a fact that very few companies go out of business through over-pricing - under-pricing on the other hand can and does lead to disaster.