Effective Pricing Strategies for Small Businesses: Some Guidelines

Effective Pricing Strategies for Small Businesses: Some Guidelines by Prof. James Gaius Ibe, Ph.D., CAE. 

What are the primary goals of a small business? What are the primary goals of effective pricing strategies? What are the core elements of effective pricing strategies? The answers to these questions are markedly different depending on whom you ask. For example, many graduate business students and practitioners identify profit maximization as the primary goal of a business. Therefore, they assume in error that effective pricing strategies must focus on profit maximization. While profit maximization is a legitimate strategic business goal, for several reasons the primary goal of a business is survival at least in the short run. Indeed, when businesses overlook this reality and make profit maximization their primary goal, they tend to engage in conduct and strategies that threaten their very existence. The relevant literature is replete with modern examples such as Enron, Global Crossing, Ameriquest, etc. The overriding aim of this article is to highlight some basic economic theory and practice of effective pricing strategies. This article provides general guidelines for establishing effective pricing strategies. For specific pricing strategy formulation and execution please consult a competent professional.

In practice, management attempts through pricing to recover the costs of the core elements in the marketing mix-the product, promotion, related advertising and personal selling expenses; and the various services provided to the customers by the members of channels of distribution as well as to generate adequate cash flows to profitably operate the business. Further, price sends differing signals to various stakeholders-customers, existing competitors, potential competitors, employees and regulators. For example, if the price is too low profit margin may be unsustainably low and prospective customers might think the product is inferior; and if it is too high the firm might price its products out of the relevant market segment. Establishing appropriate pricing policies and strategies is a critical part of the overall corporate and marketing strategies and requires adequate knowledge of the key pricing objectives and the price elasticity of demand. The core elements of effective pricing strategy should include the value of the product to prospective customers, the price charged by key competitors, and the costs incurred by the firm from new product idea generation to commercialization.

Some Key Pricing Guidelines:

Effective pricing strategies depend on various factors such as pricing objectives, the price elasticity of demand, competitive position and the stage of the product life cycle. Key pricing strategies may include penetration, parity and premium or skimming. Penetration pricing strategy is most effective when demand is elastic and involves charging below competitors’ prices to create scale economies as a key method for building a mass market or to deter potential market entry due to low price and profit margin. Parity pricing strategy is most effective when demand is unitary and the product is a commodity; and involves charging identical prices with competitors. Premium pricing strategy is most effective when demand is inelastic and involves charging above competitors’ prices to recover R&D costs quickly or to position the product as superior in the minds of the customers. When survival is the primary goal-for instance during a recession or initial entry into a market segment, a business may seek to simply break-even: P = AR = ATC. The business sets its price-average revenue equal to average total cost or cost per unit of output. Break-even analysis is a common technique for evaluating the potential profitability of a marketing alternative. The break-even point is that level of sales in either revenues or units at which the firm covers all its costs. Indeed, at break-even total sales revenue equals the total cost necessary to generate these sales: FC/CM that is, fixed cost divided by the contribution margin or SP-VC (selling price-variable cost).

Alternatively, break-even may be computed in terms of sales revenue by simply multiplying the breakeven units times the selling price or FC/ [1- (VC/SP)]. Additionally, if a firm wants to know how many units or sales revenue that will produce a given level of profit, profit (P) may be added to the fixed cost as follows: (FC + P)/CM or (FC + P)/ [1-(VC/SP)]. Further effective pricing strategy should carefully evaluate the various product attributes that influence pricing such as the competitive position in the market segment, uniqueness, perishability and the stage in the product life cycle. And while cost oriented pricing methods have the advantage of simplicity, marketing practitioners point to obvious drawbacks such as ignoring demand factors, competition and a high probability of starting a price war. Careful appraisal of price elasticity of demand may minimize these deficiencies. However, as in all business decisions there are costs and benefits, the relevant economic calculus is whether the benefits justify the costs.

Regardless of market structure-degree of competition, t he output level where MR = MC is always best, whether the firm is making an economic profit, breaking even, or operating at a loss. A small business seeking to minimize costs should operate at the output level where P = MR = MC = minimum ATC -the price is equal to marginal revenue, and the marginal cost; and to the minimum of average total cost. This is a very useful economic principle because when a small business is incurring profits-it maximizes profit where MR = MC and when a small business is incurring losses, it minimizes loss where MR = MC. Finally, a small business should not automatically shut down because it is incurring economic losses. The shut-down principle: P< AVC -the price (average revenue) is less than the average variable cost. That means the business is not generating sufficient cash flows to cover variable costs and make positive contributions to the fixed costs. Indeed, by shutting down the small business limits its losses to its fixed costs. Please note that fixed cost is sunk in the short run, whether the firm produces or shuts down.

ABOUT THE AUTHOR: Dr. James Gaius Ibe, is the Principal-at Large of the Global Group, LLC: Political Economists and Marketing Management Consultants; and a senior professor of Economics, Finance and Marketing Management at one of the local universities.