Setting the price for your product is a strange concept for agricultural producers. They are used to producing commodities where the price is dictated to them (price takers.) Profit is determined by being able to produce it for less than that price. Show
Setting the price for your product should take into account three factors. Start with the cost of producing and marketing your product. It is important to be sure that your price will cover your costs. The cost of production provides you with a minimum or floor price for your product. If you cannot cover your costs, you should not produce the product. Another factor is what the buyer is willing to pay for the product. This provides you with the maximum price you can set for your product. The third factor is the price of competing products. Based on cost of productionThe cost of producing a product is not a fixed number but varies depending on the amount you produce. As production increases, fixed costs are spread over more units of production, reducing the cost per unit. In addition to just covering costs, you may want the cost of production to include a predetermined profit level or a return on investment in the business. Breakeven selling price Breakeven sales volume Cost plus profit pricing Target Return Pricing If you plan to produce and sell 25 units, the sale price is $22 if only a 10 percent return on equity is required. However, price increases to $34 if a 25 percent return is desired. Assume that you sell your product for $30. An equity return of $16 per unit means that the total equity return is $400 ($16 x 25 = $400.) This will create a rate of return on equity of 20 percent. Based on perceived buyer valueWith this approach, price is based on the perceived value of the product in the eyes of the buyer. To use this method, segment the market to identify the type of buyer who will value the product the most. For example, teenagers value video games more than retired people. The market segment that values your product the most is your target market on which you want to focus your marketing and promotional efforts. So it is important to identify the target market for your product. People in the target market will make the decision of whether to purchase your product. If the price is too high, they will not buy it. However, if the price is too low, you are foregoing revenue that the buyer is willing to provide. Actually, the amount of your product that you can sell will change due to changes in your selling price. At a high price you will sell less and you will sell more at a low price. This is the basic concept of Information File Demand. Unfortunately, demand is difficult to quantify. At best you may just have a vague idea of the demand for your product. Type of buyer Intermediaries such as manufacturers are more sophisticated buyers. They are looking for specific attributes and know what they are willing to pay for them. Also, competitor’s prices are more important in the purchasing decision of intermediaries because of the volume involved. So your pricing decision will be more dependent on the price levels of competitors. Consumers are generally less sophisticated in their purchasing decisions. They are more likely to respond to the emotions of the moment. They are less sure of the value of product attributes and are easier to influence as to their value. So pricing decisions, along with the promotion program, will differ depending on whether you are selling to an intermediary or the ultimate consumer. Price as indicator of quality Based on the price of competitor’s productsThe cost of producing and marketing a product provides the minimum price you should charge for your product. Conversely, the demand or perceived value of the product in the eyes of the buyer provides the maximum price you can charge. The actual price you charge within this range will often be dictated by the price of competitor’s products. The importance of the price of competitor’s products depends on whether you are producing a commodity or a differentiated product. See Information File Commodities Versus Differentiated Products, where every unit of production is the same, are highly influenced by the prices of competitors because buyers see no difference between your product and those of competitors. However, the degree to which you convince buyers that your product is unique or different from those of competitors will influence the degree to which competitor’s prices will impact your sales. Differentiation can be expressed in the attributes of the product itself or the services provided with the product. The first level of competition you will experience is directly from competitors producing the same type of product as your own. For example, if you produce organic milk, your direct competitors are other organic milk producers. The price charged by direct competitors will have an important impact on the price you can charge for your organic milk. However, you can lessen the impact by differentiating your organic milk from the competition. The second level of competition is from substitute products. For example, the price you charge for your grass-fed beef is influenced by the price of corn-fed beef. Once again, the more you can differentiate your grass-fed beef from corn-fed beef, the less impact the corn-fed beef price will have on your pricing decision. Value pricing Quality doesn’t need to be real, it can be imagined. Will you really have more fun if you drink one brand of soft drink versus another? Whether the difference is real or imagined is immaterial. The only thing that counts is that the buyer believes it is different. However, price is also an important factor in a buyer’s decision. Buyers prefer a low priced product to a high priced product. So buyers informally take both of these factors into account when evaluating a buying decision by determining a product’s value. Value is computed by dividing the product’s quality by its price as shown in the formula. Value = Quality Buyers use this informal calculation to compare products. Buyers purchase the product with the highest value. In other words buyers purchase the product that provides the most quality per dollar spent. An example of using value to choose among four differentiated products is shown below. As price increases, quality increases also. However, the product that provides the most value (most quality per dollar spent) is product number three with a value of 1.33. So a buyer will purchase number three. However, another buyer may make a different assessment of quality and therefore choose a different product. Because quality is a subjective assessment, companies try to influence the buyers perception of quality. The buyer’s assessment of quality is only relevant at the time of purchase. The other example is for a commodity product. By definition, commodity products are identical to each other. So the quality is the same for all products. The product with the lowest price is the one with the highest value. In this example, it is product number one with a value of 1.25. This is why lowering cost per unit is so important for commodity producers because having a low sale price is critical to a buyer’s purchase decision. New product pricing strategiesPricing a new product that you are introducing to the market provides additional advantages and challenges. Educating the buyers on what your product is and why they want to purchase it is important. However, pricing your product when the buyer is just learning about your product and before you have competitors (at least not yet) is unique. Two strategies you may want to employ are discussed below. Skimming A skimming strategy works best where your buyers are relatively insensitive to the price level. In other words, demand is inelastic. It also works best in situations where fixed costs are relatively small because fixed costs are only spread over a small number of units. Skimming is sometimes used during the business start-up phase where only a small quantity of the product is produced. As production is ramped-up, the price can be lowered to expand the number of buyers. Penetration Pricing Penetration pricing works well when the buyer is sensitive to price. In other words, demand is elastic. It is also a good strategy if your cost of production involves high fixed costs because these costs can be spread over many units creating economies of scale. Although this strategy might appear to work for small, value-added enterprises, few will have the infrastructure and size to operate at economies of scale. Markup pricing by intermediariesThe price you set for your product may not be the price paid by the consumer; the consumer’s price may be much higher. If you plan to use intermediaries such as distributors, wholesalers and retailers to distribute and market your product, they will mark up the price to cover their costs. Assume you price your product at $20 per unit. A wholesaler may add $5 to the price to cover its costs. So the price to the retailer is $25. Assuming the retailer also charges a markup of $5, the sale price to the consumer is $30. Markup is often stated as a percentage. For example, a wholesaler’s markup may be 20 percent. However, the actual size of the 20 percent markup will differ depending on whether the percentage is based on the purchase price or the selling price. For example, a markup of 20 percent on a product the wholesaler buys for $10 is $2 (20% x $10) for a sale price of $12. However, if markup is figured as a percentage of sale price, the sale price is now $12.50 ($12.50 x 20% = $2.50 markup) ($10 + $2.50 = $12.50). Although basing markup on purchase price is easier to compute, both methods are used in the industry. Table 1 shows the percentage markup (based on purchase price) that generates the same dollar markup as the corresponding percentage markup (based on selling price). As shown on page 6, a 19 percent markup based on purchase price generates the same dollar markup as a 16 percent markup based on selling price. For example, 19 percent of a purchase price of $10.00 is $1.90 ($10 x 19% = $1.90). So the selling price is $11.90 ($10.00 + $1.90 = $11.90). If the markup is based on selling price, 16 percent of $11.90 is $1.90 ($11.90 x 16% = $1.90). So selling price is $11.90 ($10.00 + $1.90 = $11.90). Note in the table that the percentage difference between purchase price percentage markup and the selling price percentage markup gets larger as the markup gets larger. So the gain or penalty from mistaking how the intermediary is computing markup gets more significant. Computing markup based on selling price is difficult when you don’t know selling price. A formula for computing selling price markup based on purchase price is shown above. First convert the percentage markup based on selling price to a decimal (e.g. 16% = .16). Then use the formula. Using this example; markup = $10 /(1 - .16) so markup = $10 / .84, so markup = $1.90. SummarySetting the price for your product or service is a critical decision for business success. The product and its price are the linkages between the buyer and your business. The price is the source of the funds flowing into your business. The minimum price you can charge for your product is the cost of producing and marketing it. The most you can charge is what the buyer is willing to pay for it. So you need to set your price somewhere in this range. The price of this product, when offered for sale by competitors, will influence where you set your price within this range. Don Hofstrand, retired extension value added agriculture specialist, Which of the following refers to the costs of production that fluctuate depending on the number of units produced?Variable costs are expenses that change with production volume. These costs arise when production increases and fall when it decreases. With a production volume of zero, there are no variable costs.
Which of the following refers to the costs of production that do not change with the number of units produced?The term fixed cost refers to a cost that does not change with an increase or decrease in the number of goods or services produced or sold. Fixed costs are expenses that have to be paid by a company, independent of any specific business activities.
Which of the following is an illegal pricing strategy in which a company sets a very low price for the purpose of driving competitors out of business?Predatory pricing is the illegal act of setting prices low to attempt to eliminate the competition. Predatory pricing violates antitrust laws, as it makes markets more vulnerable to a monopoly.
Which of the following refers to an amount added to the cost of a product to create the price?Definition: Mark up refers to the value that a player adds to the cost price of a product. The value added is called the mark-up. The mark-up added to the cost price usually equals retail price.
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