Decisions on pricing are influenced by both internal and external factors. Some of the internal factors that are taken into consideration are costs and profit goals. There are many external factors to consider, including competitor pricing, regulatory pricing guidelines, and economic trends.
A major factor in establishing prices is the market in which the business operates and the goods and services are traded. There are several types of markets that have been identified by economists, including perfectly competitive markets, monopolistic competition, oligopoly, and monopoly. Prices in perfectly competitive markets are mandated by supply and demand. Monopolistic competition means that many sellers of similar products are operating in the market. Monopoly means that one company is the only supplier of some specific product, so no competition exists. There is an oligopoly when a large number of major sellers dominate the market while competing amongst themselves.
The practice of price skimming means that you price your goods very high when the product is new and your production level is low. The idea is to take advantage of customers willing to pay a high price to be one of the first to own a new product. Often, price skimming serves to recover research and development costs in the time period before competition begins to force prices down.
The practice called market penetration means that you price your goods low for the purpose of growing a solid customer base prior to competitors beginning to sell competing products, or in the case where competitors are already well established in the market. Offering free samples of a product is an example of an attempt to penetrate the market. Another example is offering low-priced memberships for a new sports club for a limited time.
Management may use different models for product pricing. There are cost-based and cost-plus pricing models. There are also contribution approach pricing models that can be used. A cost-plus model uses the cost plus some percentage or amount in order to determine the selling price. When using a contribution margin approach model, only variable costs are used in determining pricing.
Setting prices for special orders can be tricky. Often, management decides to set the price lower than the total cost, provided the variable costs are covered. In these cases, management needs to keep in mind the danger of alienating regular customers, or possibly violating the law.
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