Chapter-6 pricing

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Chapter-6

Pricing:

Pricing of Services:

Price policies for the services are quite different from what is called Product pricing. We have seen a

wide variety of terms service organizations use to describe the prices they set. Universities talk

about tuition, professional firms collect fees, and banks charge interest on loans or add service

charges. Some bridges and highways impose tolls, transport operators collect fares, clubs charge

subscriptions, utilities set tariffs, insurance companies establish premiums, and hotels establish room

rates. These diverse terms are a signal that service industries have historically taken a different

approach to pric ing than manufacturers. Answer ing the quest ion, what price should we charge

for our service? is a task that can't be left solely to financial managers. The challenges of

service prici ng require active partic ipation from marketers who underst and customer needs

and beha vior a nd from operat ions managers who r ecognize t he impor tance of matching

demand t o available capacity

W hat M ak es Service Pricing Different?

Let¶s consider ho w s ome of the differ ences bet ween goods and services marketing that we

discussed in Chapter 1 may affect pricing strategy.

No Ow ne rs hip o f S ervi ce s: It's usual ly harder for managers to ca lculate the financial

costs involved in creat ing an intangible perfor mance for a customer than it is to identify the

labor, materials, machine time , storage, and shipping costs associated with pr odu ci ng a

physical good . Yet wit hout a g o o d u n d er s t a n d i n g of costs, ho w can managers hope to

price at levels sufficient to achieve a desired profit margin?

Hi gh er Ra tio of Fixed Cos t s to Vari able Cos ts: Because of the labor and

infrastructure needed to create performances , many service organizations have a much

higher ratio of fixed costs to variable costs than is found in manufacturing firms.

Service businesses with high fixed costs include those with an expensive physical facility (e.g., a

hotel , a hospital, a university, or a theat er), or a fleet of vehicles (e.g., an air line, a bus

company, or a trucking company) , or a network dep endent on compa ny-owned

infrastructure (e.g., a tel ecommunicat ion s company, an Inter ne t provider, a railroad, or a gas

pipeline).While the fixed costs may be high for such businesses, the variable costs for serving

on e extra customer may b e mi nimal.

Variability of Bo th Inp ut s an d Out puts : It's no t always easy to define a unit t of service

, raising ques tion s a s t o what should be the basis for service pricing . An d seemingly

similar units of service may no t cost t he same to produce no r may t hey be of equal value t o a l l

cus tomer s. The potenti al for variability in service perf orma nce s (especially those that

involve interactions with employees and other customers) means that customer s ma y pay the

same pr ice for a service but receive different levels of quality an d value. Alternatively, the y





space that it occupies, (2) the percentage of employee hours or payroll that it

accounts for, or (3) the percentage of total patient contact hours involved.

Each method is likely to yield a totally different fixed-cost allocation. One

method might indicate that the emergency unit is very profitable, another

might make it seem like a break-even operation, and a third might suggest

that the unit is losing money.

Break-even analysis. Managers need to know at what sales volume a service

will become profitable. This is called the break even point. The necessary

analysis involves dividing the total fixed and semi variable costs by the

contribution obtained on each unit of service. For instance, if a 100-room hotel

needs to cover fixed and semi variable costs of $2 million a year and the average contribution per room-night is

$100, then the hotel will need to sell 20,000 room-nights per year out of a total annual capacity of 36,500. If

prices are cut by an average of $20 per room night ( or variable costs rise by $20), then the contribution will drop

to $80 and the hotel's break-even volume will rise to 25,000 room nights.

FOUNDATIONS OF PRICING STRATEGY:

The foundations underlying pricing strategy can be described as a tripod, with costs to the

provider, competit ion, and value to t he cust omer as the thr ee l egs (see Figure). The costs that a

firm needs to recover usually impose a minimum or floor price for a specific service offering.

The perceived va lue of the offering to customers sets a maximum, or ceiling. The price char ged

by comp eti tors for similar services typically determine s where , within the floor- to-ceiling

range, the price should actually be set. Let's look at each leg of the prici ng tr ipod in more

detail.

Cost-Based Pricing:

Cost-based pricing involves setting prices relative to financial costs. Companies seeking to

make a profit must set a price sufficient to recover the full costs²variable, semi- variable, an d

fixed²of producing and marketing a service. A sufficient margin must also be added to provide

the desired level of profit at the predicted sales volume. Wh en fixed costs are high and the

variable costs of serving an additional cus to mer are very low, manager s may feel that t he y

have tr emen dous pricing flexibility an d be tempt ed to pr ice low in order to make an extra

sale. Howev er, there can be no profit at the en d of the year unless all relevant costs have been

recover ed. Firms that comp ete on the basis of lo w prices nee d to analyze t heir cost structure

and identify the sales volume needed to break even at particular prices.

Activity-Based Costing: It's a mistake t look at costs from just an accounti ng per spect ive

. Progress ive managers view them as an integr al part of th eir company's efforts to crea te

value for customers. Customer s aren't interested in what it costs the firm to produce a

service; instead, they focus on the relationship bet ween pr ice and value. Activity-based

costing (ABC) provides a structured way of thinking about activities and the resources that

they consume.



Competition-Based Pricing:

If customers see little or no difference between the services offered in the marketplace, they

may just cho ose the ch ea pe st alt erna tiv e. Under conditions of competition - base d

pricing , the fir m wi th t he lowest cost per unit of service enjoys an enviable mar keti ng

advanta ge . It has the opti on o f eit her comp et ing o n pri ce a t levels that higher -cost

competi tor s cannot afford to match , or char ging the going market rate and earning larger

profits than competing firms.

Value-Based Pricing:

Service pricing strategies are often unsuccessful because they lack any clear association

between price and value. There are three strategies for captur ing a nd communi cat ing the

value of a service: u ncertainty reduction , relationship enhanc ement , and cost leadership.

Pricing Strategies to Reduce Uncertainty: If customers are unsure about how mu ch

value they will receive from a particular service, they may remain with a know n suppl ier or

not purchase at all. Benefit-driven pricing helps reduce uncertainty by focusing on thataspect of the service that directly benefits cust omer s (requir ing marketers to research

what aspects of the service the cus tomers do and do not value). Flat-rate pricing involves

quot ing a fixed price in advance of service delivery so that there are no surpr ises. This

approach transfers the risk from the customer to the supplier in the event that service

product ion costs more than anticipated.

Relationship Enhancement: In general, discounti ng to win new business is not the best way

t o att ract cust omers who will remain loyal over time , since those who are att racted by

cut-rate pricing are easily enticed away by compet ing offers. However , offering discounts

wh en customers purchase two or more services tog ether may be a viable relationship-

building strategy. The gr ea t er t he nu mb er o f different services a custo mer purchases from a

single supplier, the closer the relationship is likely to be.

Cost Leadership: This strategy is based on achieving the lowest costs in an industry. Low-

price d services have particular appeal to customers w ho are on a tight financial budget .

They may also lead purchasers to buy in larger volumes.

Pricing and Demand

Demand V ari at ion & C a paci ty Const r aint s:

Fluctuating demand for service, like that experienced by the retailers, movie theaters, motels,restaurants etc is found everywhere. It's a problem for a huge cross-section of businesses serving

both individual and corporate customers. These demand fluctuations²which may be as long as a

season of the year or as short as an hourly cycle²play havoc with efficient use of productive

assets. Unlike manufacturing, service operations create a perishable invento r y that cannot be

stockpiled for sale at a later date. That's a problem for any capacity-constrained service that

faces wide swings in dema nd. T he probl em is most com mo nly f ound among services that process

people or physical possessions, like transportation, lodging, food service, repair and



maintenance, entertainment, and health care. It also affects labor-intensive information-

processing services that face cyclical shifts in demand. University education and accounting

and tax preparation are cases in point.

F rom Excess Demand t o Excess C a paci ty:

At any given moment, a fixed-capacity service may face on e of four condition s( See figure below)

y Excess demand ²the level o f demand exceeds maxi mum available capacity, with the

result that some customers are denied service and business is lost

y Demand e xceeds optimum capacity ²no on e is actually t urned away, but condi tions are

crowded and all customer s are likely to perceive a decline in service quality

y Demand and supply are well balanced at the level of optimum capacity ²staff and facilities

are busy without being overtaxed, and customers receive good service without delays.

y Excess capacity ²demand is below opt imum capacity and product ive resources are

underuti lized , resulting in lo w pr oductivity. In s ome instances, this poses a risk that

customer s may find the exper ience disappointing or have doubts about the viability of

the service

F ig: Implication of variations in demand relative to capacity

Wh en demand exceeds the maxi mum available capacity, some potential customers may be

tur ned away and their business cou ld be lost forever. When the demand level is bet weenoptimum and maximum capacity, all customers can be served but there's a risk that they may

receive inferior service and thus become dissatisfied.

Th ere are two basic solut ion s to the problem o f fluctuat ing demand . One is to adjust the

level of capacity to meet varia tions in deman d. This appr oach , whi ch involves cooperation

between operat ions and human resource mana gement ,requires an understanding of what

cons ti tut e s product ive capacity and how it may be i ncreased or decreased on an



incr ement al basis. The second approach is to ma nage the l evel of demand, using

marketing strategies to s mooth out the peaks and fill in the valleys to genera te a more

consis tent flow of requests for service. Astute firms employ a mi x of both s trategies, which

requires close collaboration between operations and marketing.

Measuring and M ana ging C a paci ty:

Many service organiza tions are capacity cons tr ained .Ther e's an upp er limit to their capacity to

serve additiona l customers at a particular point in time . Th ey may also be const rained in

ter ms of bei ng unab le to r educe t heir productive capacity dur ing peri od s of low demand. In

genera l, organizat ions that engage in physical processes like peop le process ing and

possession process ing are more likely to face capacity constraints than those that engage in

informat ion-base d processes. A radio stat ion, for instance, may b e constrained in its geographic

reach by the strength of its s ignal. Bu t wi thin that radius, any numb er of listeners can t une in

to a broadcast.

There are various ways of managing capacity. Some of important are being discussed here.

Stretching and Shrinking the Level of Capacity:

Measures of capacity utilization include the number of hours (or percentage of total

available time) that facilities, labor, and equipment are productively employed in revenue

opera tion , an d the percentage o f available space (e.g., seats, cubic freight capacity,

telecommunica tion s bandwidth ) that is actually utilized in revenue operat ions . Some

capacity is elastic in its ability to absorb extra demand.

Strategy for stretching capacity within a given time frame is to utilize the facilities for longer periods. Examples of this include restaurants that are open for early dinners and late meals,

universities that offer evening classes and summer semester programs, and airlines that extend

their schedules from 14 to 20 hour s a day. Alternatively, the average amou nt of ti me that

customer s (or their possessions) spend in the process may be reduced . Sometime s this is

achieved by minimi zing slack time , as when the bill is present ed prompt ly to a group of

diners relaxing at the table after a meal. In other instances, it may be achieved by cutting back

the level of service² like offering a simpler men u at busy times of day

Changing Demand: Another set of options involves tailoring the overall level of capacity to

mat ch varia tions in demand. This strategy is known as chase dema nd.There are several actions

that managers can take to adjust capacity as needed.

y S chedule downtime during periods of low demand.

y U se part-time employees.

y Rent or share e xtra facilities and equipment.

y C ross-train employees: employees can be cross-tra ined to perform a variety of tasks, they

can be shifted to b ott leneck point s as needed to help increase tota l system capacity.



Creating Flexible Capacity:

Somet imes t he problem is no t in the overall capacity but in the mi x that's available to serve

the needs of different market segments. For example, on a given flight, an airline may have to

few seats in economy even though there are empty places in the business- class cabin.

good ex ample of highly flexible capacity comes from an eco -t our ism oper ator in the

South Island of New Zealand . Dur ing the spr ing, summer , and early autumn months the

firm provides guid e d walks and treks, and dur ing the snow season it offers cross- country

skiing lessons an d tr ips. Bookings all year round are processed thr ough a contracted telephone-

answering service. Guides and instructors are employed on a part-time basis as required. The

firm has the capacity to pr ovide a wide range of services, yet the own ers ' capita l

inv est ment in the business is remarkably low..

Strategies forManaging Demand:

In a well-designed, well-mana ged service oper at ion, the capacity of the facility, suppor ting

equip ment and service p ersonn el will be in ba lance. Sequent ial operat ion s will be designed tomini mize the risk of bot tl enecks at any point in the process. This ideal, however , may prove

difficult to achieve. The level of demand may vary, often randomly, and the time and effort

required to process each person or thing may vary widely at any point in the process.

Various approaches are used to manage the demand and the shaping demand using effective

pricing.

Managing Demand under Different Conditions: There are five basic approaches t o managing

demand.

y T aking no action and leaving demand to find its own levels.

y Reduce demand in peak periods

y Increase demand when there is e xcess capacity

y Inventorying demand until capacity becomes available by introducing reservation system.

y C reating formalized queuing systems

UsingMarketing Strategies to Shape Demand Patterns: Price is often the first variable companies use

to bri ng demand and supply into balance, but changes in product , distribution strategy, and

communicat ion efforts can also play an impor tant role. Although we discuss each element

separa tely here , effective demand management efforts often require changes in two or

more elements simultaneously.

y Price and Other Us er Out lay s: One of the most direct ways of reducing excess

demand at peak period s is to charge customers more mon ey to use the service dur ing

those times. Increases in nonfinancial outlays may have a similar effect. For instance, if

customers learn that they are likely to spend more time and physical effort during peak

periods, this information may lead those who dislike waiting in crowded and unpleasant

conditions to try later (or to use an arm's length delivery alternative like the Internet or

self-service machines) . Similarly, the lure of cheaper prices and an expecta tion of



no waiting may encourage at least some people to change the timi ng of their

consu mption behavior

y Changing Product Elements: Although pricing is often a commonly advocated

method of balancing supply and demand, it is no t quite as universally feasible for services

as for goods.

y Modi fying the Place an d Ti m e o f Del iver y:y Some firms at tempt to modify demand for a service by changing the t ime and place

of delivery by choosing one of two basic options. The first strategy involves varying the

times when the service is available to reflect changes in customer preference by day of week,

by season, and so forth. Theaters and cinema complexes often offer matinees on

weekends when people have more leisure time. During the summer, cafes and restaurants

may stay open later because of daylight savings time and the general inclination of people

to enj oy the longer, warmer evenings outdoors. Retail shops may ext end their hours in the

pre-holiday season or dur ing school holiday periods. A second strategy involves offering the

service to customers at a new location. One approach is to operate mobile units that take the

service to customers rather than requiring them to visit fixed-site service locations.

y Pro mot ion an d Educ ati on: Co mmun ic at ion efforts alone may b e able t o help

smooth demand even if the other variables of the market ing mix rema in unchanged .

Signage, advertising, publicity, and sales messages can be used to educate customers

about the t iming of pea k periods and encourage the m to use the service at off-peak

times when there will be fewer delays

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Chapter-6 pricing