Seller Pricing Strategies A Buyer’s Perspective By David V

seller pricing strategies: a buyer’s perspective by david v. lamm and lawrence c. vose david v. lamm is associate professor of

Seller Pricing
Strategies:
A Buyer’s
Perspective
By David V. Lamm and Lawrence C. Vose
David V. Lamm is Associate Professor of Administrative Sciences at the
Naval Postgraduate School in Monterey, California. He specializes in
the fields of acquisition, contracting, project management, and
logistics. Dr. Lamm earned his D.B.A. degree at the George Washington
University.
Lawrence C. Vose is currently on active duty in the Coast Guard. He
holds an M.S. degree in management from the Naval Postgraduate School.
Lieutenant Vose’s principal specialty is acquisition and contracting
management.
Understanding pricing strategies used by sellers is extremely
important to a successful buyer. Several key variables can be
identified and evaluated in determining the seller’s pricing strategy
and the conditions under which it was developed. Knowing how to
recognize these variables and integrate them into the buying process
Is a challenging and demanding effort. The motivated buyer constantly
hones his or her skills In this area, attempting to obtain the most
advantageous business arrangement for the organization.
This article Identifies various seller pricing strategies and the
principal variables involved in their analysis. The strategies and
variables examined should significantly assist buyers in preparing for
the buying task.
In the institutional, industrial, and governmental buying process,
successful contract negotiation requires knowledge and understanding
of several key elements. The seller’s pricing strategy is one of
these. A perceptive buyer continually explores the factors that
contribute to the development of a seller’s pricing strategy, in an
effort to determine what he or she might do differently by
understanding the strategy.
In preparing for contract negotiations, many buyers typically devote
only modest attention to this area because it is one of the most
difficult in which to obtain valid data. It involves confidential and
proprietary management information. Regardless of the difficulty,
effective buyers must be aware of the types of pricing strategies
sellers are likely to employ, the conditions under which these
strategies generally surface, and the significance of this knowledge
in the buying process. This article identifies some of the more common
pricing strategies and the principal variables that contribute to the
development of the strategy. It concludes with an analysis of the
usefulness of this information to the buyer.
PRICING STRATEGIES
------------------
Copyright November 1988 by thew National Association of Purchasing
Management, Inc.
Pricing strategies exist because, for many hidden as well as obvious
reasons, a seller’s quoted prices are often very dif-
ferent from the prices it actually gets. The following approaches are
commonly used in determining price:
*
Cost-Plus (Penetration) Pricing
*
Demand (Skimming) Pricing
*
Rule-of-Thumb (Myopic) Pricing
*
Buy-in (Foot-in-the-Door) Pricing
Cost-Plus pricing has appeal because it is a logical way to determine
a minimum acceptable price. Although cost is not always a good direct
determinant of price, firms must price their products at a level that
at least recovers operating costs over time.’ This takes on special
significance in new product pricing where a variation known as
“penetration pricing strategy” is used. Greer defines penetration
pricing as a method to diffuse the appeal of the product rapidly
through low initial pricing; then, once the market is “penetrated” to
take ad-vantage of cost reductions and/or price increases to generate
profits.2 This strategy is also aimed at discouraging would-be
competitors from entering the market due to apparently low profit
margins. The buyer’s problem becomes one of determining what cost the
seller is using to price the product.
Demand pricing can be viewed as “charging as much as the market will
bear.” It is based on economic theory which focuses on the concept of
the industry and the finn’s demand curves. A variation of this
strategy, applicable to the introduction of new technology or
innovation in the marketplace, is known as “skimming the cream.”3 The
“skimming” strategy involves high initial pricing in an attempt to
achieve an almost instantaneous return on investment.4 The obvious
risks are that the seller invites competition, that it may not be able
to sell as much as it would like at a high price, and that it may
alienate potential buyers by the apparent profiteering.
Rule-of-Thumb pricing is a middle of the road pricing strategy. Two
general approaches to this strategy include: (1) a leader-follower
concept, allowing competitors to set prices and then following suit,
and (2) a more traditional pricing formula such as direct material and
labor costs plus 40 percent. It is generally considered conservative
and safe by those who use it, often because it has worked in the past.
The Rule-of-Thumb approach greatly simplifies the pricing problem. It
is a way of coping with (by essentially ignoring) uncertainties in the
estimation of demand function shapes and elasticities.5 For the buyer,
it may be much easier to understand and to apply.
The “Buy-In” strategy is a short-term approach based on other than
normal cost recovery or profit motives. It involves pricing to recover
variable costs and perhaps some fixed costs to the extent that a low
enough price is offered to beat the competition. In a different form,
this strategy meets the conditions of a depressed market. One analyst
states that “companies neither record nor generally talk about all the
‘under the table’ prices and other valuable concessions they make when
the market is sluggish.”6 Normal business practice finds
a seller cuffing a deal with a buyer at a “certain” price because of
“certain” conditions. If it became public, other buyers would want
deals similar to this most favored customer regardless of the economic
or financial health of the seller. The relationship between cost data
and pricing decisions on a pragmatic level has received very little
attention as far as empirical research is concerned. This is not
surprising in that it concerns very sensitive questions that firms are
generally unwilling to answer.7
PRICING VARIABLES
Sellers consider many factors in determining a pricing strategy. One
useful approach categorizes these as intrinsic and extrinsic factors.8
Intrinsic factors are the baseline needs, such as costs, product
characteristics, and soon, and the regulatory system which places
limitations on how those needs can be met.9 Extrinsic factors are
related to the economic and operating environment of a procurement,
including product differentiation, demand, and the number of firms
involved.10
The following discussion explores what are considered to be the most
identifiable and significant variables that contribute to a seller’s
pricing strategy in terms of both external and internal variables.
External Variables
Variables in this category can be grouped as: (1) the nature of the
product, (2) market characteristics, and (3) the buyer’s control
variables.
Nature of the product. The most significant aspects of this element of
pricing strategy are the maturity, or stage of the product in its life
cycle, and the degree of differentiation inherent in the product.
Pioneering products offer a much greater flexibility in pricing
strategy than do products in their prime or beyond. The implications
are that a buyer can expect a higher probability of the existence of a
demand (skimming) pricing strategy because of the lack of competition,
the lack of product cost history, and other similar factors that
accompany new product introduction.
The degree of innovativeness or differentiation can be very
significant, assuming that a seller in fact is distinguished from
competitors and that this differentiation is aligned with a buyer’s
desires. Technological innovation may lead to significant cost
advantages and the opportunity for a penetration strategy in cases
where a seller capitalizes on the opportunity to deter the entry of
competitors. On the other hand, a buyer might anticipate a skimming
strategy if a particular product attribute is able to command a
premium price well above the marginal cost of providing it. Other
controlling elements are differential advantages in (1) quality and
superiority—the degree to which a seller markets products that meet
customer needs better than competing products; (2) customer impact and
features—products that have a major impact on buyer
behavior, allow buyer cost reductions, and offer unique features; and
(3) product fit and focus—the degree to which a seller’s products are
similar to existing products in use, have similar end uses, fit in an
existing product line, and are closely related to each other.
The scarcity of a needed product or material may also influence
pricing strategy significantly. For example, a buyer might require a
product using a scarce material that is subject to fluctuations in
price and availability. The buyer should be very cautious if he or she
detects a selling strategy that doesn’t reflect how that scarcity will
affect delivery and performance. The degree to which technology and
R&D are invested in a particular product will often influence the
pricing decision. This is distinct from the innovativeness described
above. A seller in an industry on the leading edge of technology,
characterized by rapid product obsolescence, will tend to employ a
strategy designed to recover investments as quickly as possible.
Depending on the actual volatility of product life, this may or may
not be appropriate from the buyer’s point of view.
Seller’s market characteristics. Many consider these the dominant
variables in the pricing strategy process.11 Seller market structure
involves the application of microeconomic theory, with the primary
emphasis on the nature and degree of competition. Most economists
describe market structure and seller behavior in terms of four types
of competition— perfect competition, monopolistic competition,
oligopoly, and monopoly. The important distinctions among them are the
relationship of the seller’s price and long run average cost, and the
degree of choice the seller has in establishing price. Typically, a
seller in a perfectly competitive market is a price taker (one
extreme), while the firm in a monopolistic position is a price setter
(the other extreme). The key implications for a buyer are that sellers
operating in the first two types of competitive situations will tend
to employ penetration pricing strategies, whereas oligopolistic or
monopolistic sellers have a greater potential to utilize a skimming
strategy.
Closely related to market structure is the nature of product demand
and elasticity. Some theoreticians believe that the most influential
concept in seller pricing behavior is that of demand elasticity
relative to price.’2 That is, the degree to which buyers’ aggregate
demand for a given product will change as the price is set at higher
or lower levels. A product is said to have an elastic demand if
aggregate demand drops off as the price increases. Practically
speaking, the relevant feature of demand elasticity for a buyer is
that selling firms frequently believe the demand for their product is
much more elastic than is truly the case.13
Other seller market characteristics include things such as competitive
loyalty, market newness, and market segmentation. Competitive loyalty
focuses primarily on establishing and maintaining a long-term
relationship between buyer and seller. The pricing approach utilized
typically is consistent with this objective and involves some form of
cost plus a
“fair” profit return determination. Market newness exploits the
differences between fresh and existing markets, frequently creating
distinctly different pricing strategies. The effect of market
segmentation is the ability to sell to buyers in different markets at
different prices, with no significant repercussions. What really
determines segmentation sensitivity is not the number and similarity
of available substitutes but individual buyer’s perceptions about
these things.14 If a selling firm believes that a buyer may not be
aware of competing products or substitutes, it may be inclined to
increase the profit margin.
The state of the national economy and the extent of industry capacity
utilization at a given time are also influential factors in price
determination. Overcapacity frequently leads to dramatic price
reductions, particularly in capital-intensive industries experiencing
keen competition.15 In such cases, a buyer should expect to see more
cost-plus pricing and should be alert for “buy-in” strategies.
Buyer’s control variables. These factors are unique in the
government-commercial procurement relationship. Most government
procurement is conducted with the buyer functioning in the role of a
monopsony. There are several differences between private and
government procurement that may affect the seller’s pricing strategy.
The most significant of these are the status of parties,
accountability, and process complexity.16 The effect of these
differences is difficult to quantify; however, experience indicates
that the number of hurdles a seller must clear in government
procurement may force that seller’s pricing strategy away from the
penetration approach. The unsteadying influence of the political
process on government programs impacts the seller’s assessment of risk
and long-term relationships. In such a situation, a buyer might expect
either skimming or buy-in pricing.
The type of contract utilized in government procurement will have a
significant impact on a seller’s pricing strategy. Cost reimbursement
contracts encourage the overoptimistic estimation of costs and a
resultant buy-in strategy (particularly in research and development
efforts), while fixed-price contracts tend to promote the
rule-of-thumb or skimming strategy. The implication for a government
buyer is that under a fixed-price contract, the seller attempting to
use a buy-in strategy may be in a difficult position should
performance problems develop. Government buyers may encounter greater
usage of the skimming strategy in the fixed-price contract situation
as the seller evaluates the degree of risk it must assume.
Internal Variables
Variables in this category can be grouped as (1) seller’s internal
characteristics, (2) management orientation, and (3) accounting and
costing methods.
Seller’s internal characteristics. A seller’s current capacity
utilization factor is one of the most significant elements affecting
its pricing strategy. At times, this situation may be tied closely to
the industry and national economic conditions
on the external side. If a seller is operating at or near 100 percent
capacity, it may be able to extract a substantial profit to displace
existing business. Conversely, in periods of underutilized capacity, a
seller’s emphasis shifts from a profit motive to the recovery of fixed
costs and the continued employment of resources. Hence, a buyer can
expect an increased occurrence of buy-in and penetration strategies
when a seller has excess capacity, and a skimming strategy in periods
of full capacity utilization.
A selling firm’s general financial health is another factor that can
influence its pricing strategy. A financially sound seller may use a
buy-in strategy less often than a firm that is financially less
stable. Some observers have noted that turnover and liquidity seem to
be the most important dimensions of financial condition from the
standpoint of bankruptcy. In such cases, profitability clearly is the
factor of least immediate importance.17
The degree to which a firm can control its costs dictates the range of
pricing strategies available. Efficient operation allows a seller to
profitably use a penetration strategy under many circumstances.
Efficiencies often result from economies of scale and from prior job
experience. Economies of scale often are available more frequently to
the larger more oligopolistic selling organizations. In these types of
organizations, economies of scale sometimes are used to create a
barrier to market entry. As such, they may permit the seller to
exercise a wider range of pricing strategies than would otherwise be
possible.
Economies stemming from prior job experience frequently are visible in
the form of a learning or improvement curve. Greer has identified a
relationship between the slope of a firm’s learning curve and the
particular pricing strategy employed for major airframe manufacturers.18
He has correlated a steeper sloped curve with a skimming strategy and
a flatter curve with the penetration strategy. In such procurement
situations, it appears the buyer may have a fairly definitive
indicator of the seller’s pricing strategy.
The nature of a seller’s costs and the type of business also influence
its pricing strategy. A firm with heavy capital investment often can
produce at relatively low variable costs per unit. An understanding of
a seller’s capital structure can provide valuable insights into the
particular pricing strategy the seller is employing. For a firm with a
high cost of capital, the type of contract contemplated can combine to
significantly influence the strategy pursued. Likewise, a firm that
basically is an assembler rather than a manufacturer may not be able
to predict its costs accurately due to increased reliance on
subcontractors. Clearly, this situation will influence the pricing
process.
Management orientation. Management objectives, such as sales targets,
target levels of employment, designated rate of return, and the
preference for risk avoidance, all affect pricing strategies.
The initial influence of a seller’s management orientation is revealed
in the firm’s interest in obtaining contract work. Some sellers are
willing to accept new business only if the rate of return is
substantial enough to compensate them for any added risks and
requirements. Others emphasize repeat business. The importance of
repeat business is directly related to perceived market stability. If
top management feels that a certain type of business activity as a
regular percentage of the contract base is necessary, the pricing
strategy will be adjusted to ensure a higher probability of success in
obtaining such contracts. The pricing strategy will reflect
management’s estimated probability of winning the award, the value it
places on the work, and the cost of not getting the contract in terms
of employment, contribution margin, com-petitors’ advantage, and total
sales volume. Inherent in this element is management’s stated
objectives of cost recovery, profit, and capital employment.
Accounting and costing methods. The more a buyer knows about a
seller’s internal accounting system, the greater will be his or her
ability to diagnose the seller’s pricing strategy. For example, the
depreciation of tangible assets by a seller can have significant
impact on the firm’s stated operating costs. An accelerated method of
depreciation will produce higher costs early in a product’s life
cycle. Similarly, the use of LIFO (last in, first out) inventory
accounting in a period of rising costs will result in the earlier
recognition of costs. The use of full absorption costing obscures what
it actually costs a firm to produce on the margin. At the same time,
however, the true nature of a seller’s costs may be hidden from its
competitors.
The significance of these considerations to a buyer is that the
accounting method used in reporting cost data may not be the
accounting method the pricing strategy is based on. Closely related to
the seller’s accounting for costs is the method the seller uses to
estimate future costs. The validity of a seller’s cost estimating
relationships will affect the perception of expected costs and
therefore influence the strategy to price for cost recovery.
CHALLENGES FOR THE BUYER
Four common pricing strategies and the key variables to be considered
in evaluating these strategies have been identified. The understanding
that comes from the process of trying to determine a seller’s pricing
strategy will significantly assist a buyer in his or her effort to
obtain fair and reasonable prices. An analysis of the factors and the
conditions involved in a particular buy will contribute to the
preparation so necessary to successful contract negotiation.
In examining the potential pricing methods a seller might use, buyers
must place themselves in the “seller’s shoes” and attempt to evaluate
the relative significance of both external and internal variables.
They should ask themselves,
What pricing approach is most likely to fulfill the objectives and the
needs of the seller, given the economic structure and the extent of
competition found in its industry?” This requires the buyer to make an
assessment of the seller’s objectives and needs to sufficiently
understand the motivations and incentives involved. For example, at
the present time a seller may not be motivated by profit maximization
on a given contract, but rather may be seeking an expansion of its
sales volume and is employing a pricing strategy that recognizes this
need.
Of the four pricing strategies, penetration (cost-plus) pricing and
rule-of-thumb pricing are perhaps the easiest for a buyer to
understand and to deal with. They are also the strategies in which
sellers are willing to divulge how costs were estimated and to provide
data supporting these estimates. Skimming and buy-in pricing are
difficult to detect and even more difficult to counter. Sellers
typically are unwilling to admit such strategies have been used
because the buyer might feel that excessive profits are generated in
the former case and that extreme caution during contract performance
is necessary in the latter case.
Matching the external and internal variables to these strategies
becomes the important step in determining buyer ne­gotiation leverage
and flexibility. It is also important to understand that a change in
one variable is generally not an isolated event, but that it can
modify the parameters of most other variables leading to significant
shifts in the pricing approach. Certainly the buyer must have fairly
good knowledge of the seller’s costs, the earnings needed, and the
competitive nature of the company’s markets.
The buyer should aggressively and continually pursue data helpful to
assessing the external variables affecting pricing strategy.
Information concerning new versus mature products, product
differentiation, product life cycle, the competitive environment,
product demand, and industry capacity can all be obtained through
careful attention to various industry, trade association, financial,
and government publications. Factoring each of these external
variables into the process which favors one pricing approach over the
others allows the buyer to draw conclusions regarding the seller’s
proposed price.
Data on internal variables are more difficult to obtain and to assess.
Data may be nonexistent or expensive to acquire. Several of these
variables require the buyer to pay close attention to “signals”
provided by the seller during periods of buyer-seller interaction.
Such things as capacity levels, financial health, cost control,
capital structure, expected rates of return, internal accounting
methods, and estimating methods are all areas in which the seller may
be unwilling overtly to supply enough information for the buyer to
make legitimate assessments. The astute buyer must develop a feel for
each of these areas, particularly during the fact-finding portion of
negotiations and more generally during contract performance. In the
case of federal government contracts, data from many
of these areas must be provided as a condition of contract award.
Regardless of the difficulty involved, these variables are key to
understanding seller pricing behavior.
CONCLUSION
If the capability of a buyer is even slightly enhanced by an improved
ability to forecast a seller’s objectives, through an evaluation of
seller pricing strategy, then it seems clear that the use of this tool
is warranted. Many factors enter into the pricing decision, and there
are no simple formulas that can solve the pricing problem. A buyer may
not be able to investigate and examine each of these factors.
Nevertheless, a general awareness of their existence and their impact
will contribute significantly to preparation for contract
negotia­tions.
REFERENCES
1.
Stewart A. Washburn, “Estimating Strategy and Determining Costs in
the Pricing Decision,” Business Marketing, July 1985, p. 54.
2.
Willis R. Greer, Jr., “Early Detection of a Seller’s Pricing
Strategy,” Program Manager, November-December 1985, pp. 6-12.
3.
Joel Dean, “Pricing Pioneering Products,” Journal of Industrial
Eco­nomics, July 1969, pp. 165—79.
4.
Ibid., p. 167.
5.
F. M. Scherer, Industrial Pricing—Theory and Evidence (Berlin:
Rand McNally, 1970), p. 46.
6.
Gilbert Burck, “The Myths and Realities of Corporate Pricing,”
For­tune Magazine, April 1972, pp. 84-89.
7.
Wulif Plinke, “Cost-Based Pricing,” Journal of Business Research,
Vol. 13, 1985, pp. 447—60.
8.
Nancy S. Topic, “Fair and Reasonable Prices in Noncompetitive
Pro­curements. Unpublished research paper, Florida Institute of
Technol­ogy at Army Logistics Management Center, Fort Lee,
Virginia, June 1985, p. 6.
9.
ibid., p. 6.
10.
Frederic S. Lee, “The Marginalist Controversy and the Demise of
Full Cost Pricing,” Journal of Economic Issues, Vol. XVIII, No. 4
(De­cember 1984), pp. 1107—32.
11.
Alfred R. Oxenfeldt, “A Decision-Making Structure for Pricing De­cisions,”
The Journal of Marketing, January 1973, pp. 46-53.
12.
Thomas Nagel, “Economic Foundations for Pricing,” The Journal of
Business, Vol. 57, No. 1, Part 2 (January 1984), pp. 13-38.
13.
A.J. Burkart, “Pricing Policy,” Journal of Industrial Economics,
July 1969, pp. 180—87.
14.
Nagel, “Economic Foundations,” p. 29.
15.
Washburn, “Estimating Strategy and Determining Costs,” p. 64.
16.
Stanley N. Sherman, Government Procurement Management
(Gaith­ersburg, MD: Wordcrafters Press, 1985), p. 6.
17.
Douglas Moses and Shu S. Liao, “Predicting Bankruptcy of Private
Firms: A Simplified Approach,” Naval Postgraduate School Working
Paper No. 86- 18, July 1986.
18.
Greer, “Early Detection,” p. 10.