Perreault−McCarthy: Basic
Marketing: A
Global−Managerial
Approach, 14/e- Price Setting in the
Business World
Text © The McGraw−Hill
Companies, 2002524 Chapter 18
more common in rapidly growing markets because cumulative production volume
(experience) grows faster.
If costs drop as expected, this approach works. But it has the same risks as
regular average-cost pricing. The price setter has to estimate what quantity will
be sold to be able to read the right price from the experience-based average-cost
curve.^5Another danger of average-cost pricing is that it ignores competitors’ costs and
prices. Just as the price of a firm’s own product influences demand, the price of avail-
able substitutes may impact demand. We saw this operate in our Wal-Mart case at
the start of this chapter. By finding ways to cut costs, Wal-Mart was able to offer
prices lower than competitors and still make an attractive profit.Some Firms Add a Target Return to Cost
Don’t ignore
competitors’ costs
Target return pricing—adding a target return to the cost of a product—has
become popular in recent years. With this approach, the price setter seeks to earn
(1) a percentage return (say, 10 percent per year) on the investment or (2) a specific
total dollar return.
This method is a variation of the average-cost method since the desired target
return is added into total cost. As a simple example, if a company had $180,000
invested and wanted to make a 10 percent return on investment, it would add
$18,000 to its annual total costs in setting prices.
This approach has the same weakness as other average-cost pricing methods. If
the quantity actually sold is less than the quantity used to set the price, then the
company doesn’t earn its target return—even though the target return seems to be
part of the price structure. In fact, we already saw this in Exhibit 18-3. Remember
that we added $18,000 as an expected profit, or target return. But the return was
much lower when the expected quantity was not sold. (It could be higher too—but
only if the quantity sold is much larger than expected.) Target return pricing clearly
does not guarantee that a firm will hit the target.Managers in some larger firms who want to
achieve a long-run target return objective use
another cost-oriented pricing approach—long-run
target return pricing—adding a long-run average
target return to the cost of a product. Instead of
estimating the quantity they expect to produce in
any one year, they assume that during several years’
time their plants will produce at, say, 80 percent of
capacity. They use this quantity when setting their
prices.
Companies that take this longer-run view
assume that there will be recession years when
sales drop below 80 percent of capacity. For exam-
ple, Owens-Corning Fiberglas sells insulation. In
years when there is little construction, output is
low, and the firm does not earn the target return.
But the company also has good years when it sells more insulation and exceeds the
target return. Over the long run, Owens-Corning managers expect to achieve the
target return. And sometimes they’re right—depending on how accurately they
estimate demand!Target return pricing
scores sometimes
Hitting the target in the
long run