International Pricing Methods: Cost Based, Demand Based, Competition Based, Value Pricing, Target Return Pricing and Going Rate Pricing

24th November 2021 0 By indiafreenotes

Cost Based

The most frequently used pricing method in exports is cost-plus method. This method is based on the full cost or total cost approach. In arriving at the export pricing under this method, the total cost of production of the article (fixed and variable) is taken into account.

Over and above the fixed and variable costs incurred in the production of exportable articles, all direct and indirect expenses incurred for the development of product such as research and development expenses and other expenses necessary for the export of the articles such as transportation cost, freight, customs duties, insurance etc., are included.

Then a reasonable profit margin is added to the costs and the value of the subsidy and assistance from the Government or other bodies of the country, if any, is deducted. The net result is the total export price for the commodities produced. Price per unit may be calculated by dividing the total price, thus arrived, by the number of units manufactured.

The various elements of cost, forming part of the total cost are:

(i) Direct Costs:

(a) Variable Costs:

Direct materials, direct labour, variable production overheads, variable administrative overheads.

(b) Other Costs Directly Related to Exports:

Selling costs: Advertising support to importers abroad, special packing, labelling, etc., commission to overseas agent, export credit insurance, bank charges, inland freight, forward charges, inland insurance, port charges, export duties, warehousing at port, documentation and incidentals, interests on funds involved, costs of after-sale service.

(ii) Fixed Costs or Common Costs:

It includes production overheads, administration overheads, publicity and advertising (general), travel abroad and after-sale service minus Govt., assistance, duty drawback and import subsidy etc., received and then freight and insurance are added to arrive at the final cost.

Advantages:

(i) Under this method the exporter realises the total cost in marketing the product in a foreign market.

(ii) Marginal targets are thought of.

(iii) No chances of loss.

(iv) This is logical and universally accepted method.

(v) It is easier to understand and calculate.

Disadvantages:

(i) Cost is considered in advance. But there is difference between estimated and real cost. So, this method does not give exact result.

(ii) When a company’s cost is higher than its competitors, this method is of no help.

(iii) In this method only cost and expected profit are considered. Hence, chances of increasing price are often lost.

(iv) Change in demand and supply is not taken care of.

(v) It does not help in competition.

(vi) There is little scope for change according to time and circumstances and hence, this method of pricing is not useful.

Demand Based

Competition Based

Both the methods are based on cost considerations, while under market- oriented pricing, price is changed in accordance with market changes. The costs are, no doubt, important but the competitive prices should also be considered before fixing the export price. Competitive prices mean the prices that are charged by the competitors for the same product or for the substitute of the product in the target market. Once this price level is established, the base price or what the buyer can afford, should be determined.

The base price can be determined by following the three basic steps:

(i) First, relevant demand schedules (quantities to be bought) at various prices should be estimated over the planning period;

(ii) Then, relevant costs (total and incremental) of production and marketing should be estimated to achieve the target sales volume as per demand schedules prepared; and

(iii) Lastly, the price that offers the highest profit contribution, i.e., sales revenues minus ‘all fixed and variable costs.

The final determination of base price should be made after considering all other elements of marketing mix. Within these elements, the nature and length of channel of distribution is the most important factor affecting the final cost of the product?

The above three steps, though appear to be very simple, is actually not so because there are various other factors that should be considered. The most appropriate method to estimate the demand of the product shall be the judgemental analysis of company and trade executives. One other way may be the extrapolation of demand estimates for target markets from actual sales in identical markets in terms of basic factors.

Advantages:

(i) This method is more flexible, hence benefits of market opportunity can be obtained.

(ii) Business unit can face competition as price is fixed as per market position.

(iii) When product life is short, this method is most suitable.

(iv) Capital is regained quickly.

(v) We make sales quickly and cash flow can be maintained.

(vi) Risk of product becoming out of date decreases.

Disadvantages:

(i) It is not easy to estimate market changes.

(ii) It is possible to overlook relation between price and demand.

(iii) If demand is less in a market compared to others, it may mislead.

Value Pricing

Value-based price (also value optimized pricing and charging what the market will bear) is a pricing strategy which sets prices primarily, but not exclusively, according to the perceived or estimated value of a product or service to the customer rather than according to the cost of the product or historical prices. Where it is successfully used, it will improve profitability through generating higher prices without impacting greatly on sales volumes.

The approach is most successful when products are sold based on emotions (fashion), in niche markets, in shortages (e.g. drinks at open air festival on a hot summer day) or for complementary products (e.g. printer cartridges, headsets for cell phones). Goods which are very intensely traded (e.g. oil and other commodities) are often sold using cost-plus pricing. Goods which are sold to highly sophisticated customers in large markets (e.g. automotive industry) have also in the past been sold using cost-plus pricing, but thanks to modern pricing software and pricing systems and the ability to capture and analyze market data, more and more markets are migrating towards market- or value-based pricing.

Value-based pricing in its literal sense implies basing pricing on the product benefits perceived by the customer instead of on the exact cost of developing the product. For example, a painting may be priced as much more than the price of canvas and paints: the price in fact depends a lot on who the painter is. Painting prices also reflect factors such as age, cultural significance, and, most importantly, how much benefit the buyer is deriving. Owning an original Dalí or Picasso painting elevates the self-esteem of the buyer and hence elevates the perceived benefits of ownership.

Target Return Pricing

The Target-Return Pricing is a method wherein the firm determines the price on the basis of a target rate of return on the investment i.e. what the firm expects from the investments made in the venture.

Target-Return Pricing = Unit cost + (Desired return x invested capital) /Unit sales

The target-return pricing is easy to calculate and understand. Also, it gives direction towards which the efforts of all the team members should be directed, to accomplish the set ROI.

But however, the major limitation of this method is the accuracy with which the amount of sales is estimated. It is not necessary that the quantity for which the set ROI is achievable will be same for all the other quantities.

Going Rate Pricing

The Going-Rate Pricing is a method adopted by the firms wherein the product is priced as per the rates prevailing in the market especially on par with the competitors.

Basically, the company sets a price of its products and services in line with the competitor’s prices, and may sometimes charge more or less depending on the value, product offers.

This type of pricing is mostly followed in Oligopolistic industries where they deal in homogenous goods, and in which less variation is seen from one producer to another. Such products are steel, aluminium, paper, fertilizer, etc., the firms dealing with these usually charge the same price from the customers.

With a going-rate pricing method, companies feel secure as they are sure to get the customers because of the same rates prevailing in the industry. But however, it is difficult to determine the changing trends of the competitor and often it is not possible to match the cost of a product with the price that others are following.

Advantages

  • Competitor’s price is taken as base.
  • Uniform price in market.
  • Misguiding customers is protected.

Disadvantages

  • Only competitor price is considered.
  • Inaccurate decisions.
  • Production costs etc. are ignored.

Marginal Cost Pricing:

Another cost oriented method of pricing in international market is to determine the price on the basis of variable cost or direct cost. In this method fixed cost element in the total cost of production is totally ignored and the firm is concerned only with the marginal or incremental cost of producing the goods which are sold in foreign markets.

We know that the fixed cost remains fixed up to a certain level of output irrespective of the volume of output. Variable costs, on the other hand, vary in proportion to the volume of production. Thus, it is the variable or direct or marginal costs that set the price after a certain level of output is achieved, that is, output at Break-Even Point (BEP).

This method is based on the assumption that the export sales are bonus sales and any return over the variable costs contributes to the net profit. Under this system it is assumed that the firm has been producing the goods for home consumption and the fixed costs have already been met or in other words, Break-Even Point has been achieved.

Thus, if the manufacturers are able to realise the direct costs, including those involved in export operations specifically, they would not affect the profitability of their firms. The profitability of firms should be assessed with reference to marginal cost which should normally constitute the basis for export pricing. Other elements in calculating price will remain the same.

Advantages:

(i) Export sales are additional sales hence these should not be burdened with overhead costs which are ordinarily met from the domestic trade.

(ii) This method is advocated for firms from developing countries who are not well-known in foreign markets as compared to their competitors from developed countries, and therefore, lower prices based on variable costs may help them enter a market. Price may be used as a technique for securing market acceptance for products newly introduced into the market.

(iii) Since the buyers of products from developing countries usually are in countries with low national income, it is advisable for the firm to serve a large segment of the market at low prices.

(iv) When fixed cost can be gained from domestic market, total profit can be raised by exporting at a price higher than marginal cost price.

(v) An order which may be refused on the basis of total cost can be accepted on the basis of marginal cost and profit can be increased.

Disadvantages:

(i) Generally, this method is applied only when a company has idle production capacity in addition to optional cost.

(ii) Developing countries might be charged for dumping their products in foreign markets because they would be selling their products below net prices and thus may attract anti-dumping provisions which will take away their competitive advantage.

(iii) The use of this method may give rise to cut-throat competition among exporting firms from developing countries resulting in loss in valuable foreign exchange to the exporting countries.

(iv) Marginal cost pricing is not advisable in the following cases:

(a) If the importers are regularly purchasing the product at a low price, it will be difficult for exporters to increase the price of the commodities later on. It may result in loss of market.

(b) This policy is not useful or is of limited use to industries which are mainly dependent upon export markets and where overheads or fixed costs are insignificant.

Feasibility:

The system of marginal cost pricing is feasible in the following circumstances:

(i) There must be a large domestic market for the product so that the overheads may be charged from products manufactured for domestic market.

(ii) Mass production techniques must have been adopted so that the gap between the full and marginal costs may be reduced.

(iii) The home market has a capacity to bear the higher prices.

(iv) Additional production for exports is possible without increasing overhead costs and within permissible production capacity.

Marginal Cost Sets the Lower Limit:

It is generally advocated that marginal cost should be the basis for export pricing. This method based on marginal cost only sets the lower limit up to which a firm can sell its product without affecting its overall profitability. It does not follow that one should invariably charge the variable cost.

The situation in different markets may be different and in many a case, contribution towards fixed cost might be possible and all efforts should be made to take advantage of this possibility. Even in cases where only marginal cost is possible to realise, the long-term objective of the firm should be to recover direct costs plus some contribution towards overhead costs as well.