Pricing Process: Ever Wondered How Businesses Set Their Prices?

How Do They Set Their Prices?

 
While sitting in a Cafe and drinking a cup of Coffee, have you ever wondered why that cup of coffee costs so much?

Businesses just won't come up with a figure by magic to set their prices.

It is not a simple job for the producers or sellers to set a particular price for their products. It involves a lot of calculations that involve science, math, and customer feelings.

Businessmen have to consider many factors before arriving at a price. They are doing business to earn their living. They have to earn some extra income beyond what they are spending on their business. 

So, how do they arrive at their price tags?

Let us take a peek into the process of setting the prices. For this purpose, I am taking the example of a recipe, say, idli and its side dish, chutney.

Determining the Cost of Idli

Ingredients required for preparing this breakfast recipe (for 10 idlis) are as follows:

• Black gram (split lentil) 100 grams = Rs 40
• Idli Rawa                        200 grams = Rs 20
• Coconut pieces (for chutney) 50 grams = Rs 30
• Green chili & ginger (for chutney) approx. = Rs 10
• Roasted chana dal 20 grams             = Rs 10
• Salt & spices used for topping chutney = Rs 10

Total Cost of Ingredients (Raw Materials)    = Rs 120

Now, add your time and labour invested, say   Rs  50

Add the fuel cost and rent for utensils, say       Rs  30

                          

                  Total cost of preparing 10 idlis   = Rs 200

                                                                       ________

                  So, cost of one idli is  200/10     = Rs 10

This is how businesses determine prices for products.

The above is a single example for your understanding. In actual practice, the process can be more complex. 

1. The cost of raw materials is the primary input.
2. Thereafter, add other costs like power and fuel consumed during production.
3. Add the labour cost involved.
4. Add the rent/depreciation for machinery and equipment used.
5. Calculate other expenses incurred in producing the output and include them also in the total cost.
6. Total up the expenses cited above and divide by the quantity produced. 
7. The average cost is the basic price for your product.
8. But you are doing the business to earn your livelihood. Your income/profit is the main objective.
9. Increase the sale price by the minimum average amount of that profit margin. This is the Price at which you should sell your product.

From the above example, I hope it is clear to you in understanding the pricing process of goods and services.

Many external factors also need to be considered while determining the prices. Let us look into them.

Factors Influencing Price Determination

The following are some of the most important factors affecting price determination:

1) Cost of production
Cost of production is the basic element of price, as discussed above.

But there should be a periodic review of the cost. The prices of the ingredients are ever-fluctuating. Salaries and wages keep changing. Other overhead expenses also keep fluctuating. A continuous moniteering should be done to ascertain that you are recovering the costs from the sales.

2) Competition in Market

You are not the only businessman for your products. The same products are produced and sold by many others. 

If there are many sellers of the same commodity, each one of them will be trying to maximise his sales by giving incentives to buyers. 

Buyers generally buy from a dealer who offers the products at comparatively lower prices. Even a small fraction of a rupee charged less can allure the buyers. 

So, the producer or seller needs to pay attention to this factor of market competition while setting his prices.

3) Value of Product to the Buyer
This is another important element in fixing the price. 

The value that buyers attach to the product is a very sensitive element of price. 

Necessities like food grains, salt, and sugar are more important for consumers. So, they cannot live without these products. 

Similarly, bridal wear, birthday gift items, and children's toys can be important items for the customers. They would like to pay a little more than foregoing such items. 

The producer or supplier can set the prices of such goods with ample margins without losing market share.

4) The Forces of Supply and Demand

The forces of demand and supply play a major role in price determination. 

Buyers normally tend to purchase products at reasonably lower prices to get maximum satisfaction.

Similarly, sellers try to maximise their profits by selling things at higher prices. 

So, when both these forces clash, buyers try to restrict their purchases whenever prices rise, or try to increase their purchases when prices fall. 

Naturally, when there are no buyers at increased prices, the supplier is forced to reduce their price a little to attract buyers. 

Similarly, when prices fall too much, there will be excessive demand for products, but the supplier may not have enough supply to meet that demand. The markets may become out of stock. Under such circumstances, buyers will be ready to pay a slightly higher price. Thereby, the prices will increase. 

In this way, the price level settles at a point of equilibrium where quantity demanded and quantity supplied match up.

Thus, the forces of supply and demand have an effect on the price structures of markets.

5) Government Policies

The government can always try to regulate prices through its policies and laws to safeguard the interests of consumers. So, producers and sellers have to set their prices in accordance with those policies and guidelines, or else they may face legal proceedings and bans.