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High Quality vs Low-Cost Bargain: The Current Dichotomy! (VIII). Formulating the concept of pricing.

Have a beautiful Friday. Today it is my aim to explain to you the most simple basics of pricing. Formulation of the concept of price is extremely crucial. But understanding it will help us to solve the current issues of global commerce policies.

“Jump!”. This watercolor was painted meanwhile I was waiting for a car repair a few weeks ago. It is made with love on Paper Fabriano 5. Size: 7 inches x 5 inches. Photo reference: Alamy Stock Photo.

I believe that many of our price-wars should have been avoided if we could understand the basics. And this post is dedicated to it. This post article is cleverly a key one under this saga. So let’s begin.

What is price? According to my heavy “American Heritage College Dictionary”, price is nothing else than the amount of money or goods, asked for or given in exchange for something else. Philosophically this definition throws us 6 key elements when it comes to the word price:

  1. A buyer of a product or service. Someone who needs or wants that product and is able to pay for it using something in return (usually money).
  2. A seller of a product or service: Someone who is the owner of the product and offers it (the product belongs to him or her or it is an intermediary), and is able to exchange this product or deliver it for money or its equivalent.
  3. A perceived value settlement amount: This is the amount (number in money currency) of the product or service and it is negotiated and agreed between the buyer and the seller.
  4. An existing competitive context (of other sellers and buyers) that affects the perceived value of the product and services.
  5. A degree of a dynamic variation and/or change: The definition of price is linked to its variation. Today a product can be priced at 20 dollars, and tomorrow at 16.50 dollars and the next month at 22 dollars.
  6. A profit: There is no price without a mark-up or profit. Otherwise if we sell it below costs, that is considered a loss.

Without these 6 elements, the term “price” wouldn’t be qualified to be defined.

Price and profits. To set a price is more than an art. It requires an understanding of what is behind a price. By setting prices, any seller has the power to affect its firm’s profitability in the short, medium, and long run. To set a price has an impact on your own profit and loss statements, and also it has an impact on the industry to which your product/service belongs, and it has an impact on your community, country of reference, and the whole society.

Pricing, therefore, has the greatest impact on the sanity of societies, it has an impact on the poor, middle-class, and high-end social groups; beyond the immediate performance of your business. In consequence, if pricing is so crucial, why are we unaware of it? Why aren’t we smart enough or if we don´t know, at least try to study the dynamics of pricing (at least in your own industry), and try to comprehend how relevant it is for the long run of our sustaining future?

Any price that you see in a department store, supermarket, or Dollarama store, or in a gallery, or a music/theater entrance, or the bus ticket, or the tuition that you pay month by month to your kid´s university; shows a value in numbers of a currency (expressed in dollars, yen, sterling pounds, Italian liras, pesetas, pesos, etc) that is perceived by those who can pay for it, and those who can´t. And this degree of price perception (which is unique for each of us) is composed of two elements: the psychological part of the buyer and a realistic constituent (the cost) plus the profit. For decades, the fundamental goal of business strategy is to offer customers an enhanced value so that prices can be raised substantially above costs. For centuries, the maximum aim of any business has been to charge customers the higher price they can pay. And at the minimum, the aim for any business is to achieve a mix of volume (quantity of goods sold) and market share gains without eroding the minimum level of profitability required to keep the business afloat. But during the last 30 years, this philosophy of business strategy started to change.

How do companies increase the perceived value to customers? By adding a certain superior degree or advantages and enhancements, that impact the client at a psychological level, in a way that the client decides if it is convenient, purposeful, or at least useful to buy it.  For example, companies invest in marketing, public relations and packaging, in order to transmit to the customers all these advantages, with the objective to seek or to render a higher offer based on:

  1. Innovation
  2. Quality
  3. Speed of Delivery
  4. Customer service
  5. Guarantee
  6. Repair and Maintenance (post sales)
  7. Discounts and allowances when buying per bulk.
  8. Others

Pricing Decisions. Pricing matters. When it comes to established companies with a lot of employees, usually there is a team that is or at least a senior manager that is hired to do pricing calculations. But many of these managers do not understand the importance of pricing decisions in the “societal context”, but only for the company objectives. During the last 30 years, particularly in the current context of low-cost pricing strategies coming from Asia to everywhere, pricing decisions went down, but down the drain. The business strategy of low-cost is now a philosophy of the cheap, which is having repercussions in the global society as a whole.

It is a mistake to base prices upon cost-plus formulas.  To calculate a price for something is more than just calculating the costs incurred and then add a profit. This is a mechanical cost-plus method that is used by everyone. It is used naturally by retailers, by manufacturers, by professionals, by banks, by educational entities, by transportation and warehousing companies, by media communications enterprises, by art entertainment and recreation industries. By all.

For example, let’s imagine that you are a watercolorist. And one day, when watching the daily news on TV, the energy company AES of your country, advertises an art call for entry, to promote the visual artists of your town.  AES’s call for entry is very specific: AES requires proposals of watercolors (size 60 inches W x 40 inches H) or 1.50 meters wide x 1-meter height because they want to embellish the entrance of its office lobby hall. You are interested, and decide to apply. Your proposal has to be priced accordingly, and your oeuvre will have to compete with the other 50 participants. Each of the artists has to write a proposal, to include all the elements that make it unique for your client, and in consequence, you must calculate your price.

If you utilize a mechanical cost-plus formula, you calculate first the costs of the materials (paper, pigments, frame), add the costs of your direct manufacturing labor (all the time that will take for you to conceptualize the painting, draw and make it from scratch), in addition, you prorate and charge a tiny percentage of your fixed costs that are linked to your studio maintenance (which is your home) such as rental, electricity, water, internet. Let´s say that by adding all these costs, your total cost of the painting is US$ 6,000 dollars. You estimate that your painting will be done in 15 days.

To calculate the final price: Your cost-plus formula is to charge 25% of the profit. So you calculate US$ 6,000 x 0.25 = US$ 1,500. Your final price offer to AES will be US$7,500 dollars (in square inches: US$ 3.25/inches2). It is a reasonable offer, and you know your quality of work is well recognized by your local peers and internationally, so you leave it as such.

The day to introduce your proposal arrives. AES wants to make the bidding open and public for the sake of transparency. During the bidding session, in which your offer and all the artists’ proposals are shared, surprise,  your proposal is the higher of all. All your competitors exposed their art prices to AES for less than US$2,500 dollars per painting. Sadly, your offer is three times above the rest. You ask yourself: How could it be that the watercolor industry of your town is eroding its own survival and detracting from exploiting the market opportunity that AES is opening? Many of those artists and yourself won’t be able to sell any piece of art to any other international company during the next 6 months, so it is incredible for you to believe how low is the current pricing strategy of your local competitors?

By the end of the bidding process, the AES country representative expresses thankfulness to everyone participating. To close the session, he releases that in Washington DC, the AES global director had previously established a policy that stated the budget for this painting up to a maximum of US$12,500 dollars. This information has impacted everyone. This means that the watercolor industry in your country (including yourself) has devalued its work. Even yourself (who charged the higher offer) had left US$ 5,000 dollars in possible profits at the AES table! What is worst is that the rest of the multinational companies located in your country will get the message from AES that art in your hometown is cheap, and for further calls for art entries, these companies will decrease their budgets to help the visual artists. Reducing further possibilities for artists that are experiencing huge economic pressures because of digitalization.

We wonder why do we get used to low-cost cheap pricing strategies, even when the value of our work is seen outside by international standards as greater and worthy? When we are poor at pricing, we do not know our own value, and it is important to face pricing strategies appropriately. I hope with this example you start to understand why formulating pricing is so remarkable and essential for everyone participating in industry.

Next week we will continue exploring subject number 6: Pricing policies and objectives.

To be continued.

Sources of information to write this article:
Some ideas derived from Peter Doyle book, “Marketing Management and Strategy” 2nd Edition. Prentice-Hall, 1998.

Disclaimer: Illustrations in Watercolor are painted by Eleonora Escalante. Other types of illustrations or videos (which are not mine) are used for educational purposes ONLY.  Nevertheless, the majority of the pictures, images, or videos shown on this blog are not mine.  I do not own any of the lovely photos or images posted unless otherwise stated.


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