Most organizations are reluctant to set prices too low or too high because exceeding the boundaries on either side yields damaging consequences. If we accept that, to succeed in the long run, a firm should make decisions that result in positive economic profit (in this case “economic profit” is calculated as revenue minus all direct and indirect costs, plus the opportunity cost of capital employed), then this objective ought to be reflected in product pricing decisions. Regardless of what pricing strategy or objectives a firm may have, the price must fall somewhere between the minimum price the firm is able to sell at (i.e., the price floor), and the maximum price that the customer is willing to buy at (price ceiling).
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This all seems logical and obvious. However, many companies struggle when held to the fire and asked to produce quantitative evidence to support their claimed understanding of appropriate price floors and ceilings for their products.
Pricing too low is detrimental to a company because it results in a negative return on investment (ROI), which in the long term could easily lead to severe problems and even bankruptcy.The price floor equals the sum of all direct and indirect costs required to produce the product. At this level, the company exactly covers costs but does not gain any retained earnings. The margin is zero at this price level. Obviously, no company wants to sell at this level. The importance of understanding the dollar value of the price floor is that a company can avoid pricing so low that it does not cover all costs, and the margin can be easily and accurately understood by subtracting the dollar value of the price floor from the actual selling price, and finding the percentage that the difference represents with respect to the price floor.
The danger in pricing too high is that the resulting sales volume will be too low to support the fixed costs experienced by the company during a given time period. This is also expressed as a negative ROI, and it can hurt and could potentially shut the firm down in the long run.
Admittedly, understanding a firm’s price ceiling is not as easy as understanding its price floor. To quantify the maximum price at which buyers would be willing to buy (or buy in sufficient quantities to support production of the product), the firm must understand as much about its market environment as possible. The price ceiling is rarely, if ever, likely to be exactly known; however, the more understanding the firm has of its environment, the fewer the assumptions and the narrower the margin of potential error. Gaining the necessary information to estimate the price ceiling can be done in no other way than in-depth research, performed solely by the company or together with a hired outside agency. Following are a few examples of the knowledge needed:
Number of competitive firms. Allows knowledge of the level of market fragmentation, which leads to necessary strategic decisions that will give clues to the price elasticity of demand (i.e., the slope of the demand curve).
Competitor cost structures. This allows your company to gain knowledge of the level of costs in a competing firm, as well as where it may be gaining advantages or suffering disadvantages in comparison to your company. This will prove difficult and in some cases impossible. Remember that in all cases, the more information your research can reveal, the better, but complete transparency is quite rare.
Competitor pricing. Understanding competitors’ pricing levels as well as underlying objectives will allow you to see which competitors may be gaining the business that you lose, and why. This also helps to identify areas of the market that are not being targeted, which offers pricing and marketing opportunities.
The demand curve. It is important to try as accurately as possible to estimate this by using all the knowledge gained in your market environment research. The demand curve reveals customer price sensitivity (i.e., price elasticity of demand) in your market by visually depicting the relationship between product price and quantity demanded, given the market environment factors.
Figure 1: Price floor and price ceiling
In the graph in figure 1, S = supply, D = demand, Q = quantity demanded, and P = price. The price floor is equal to the total of all costs that a company expends to produce a product. The company will not supply the product for a price lower than this. The price ceiling shows the maximum price that the customer will accept and demand in sufficient quantities to support the firm’s cost structure. Any price higher than this will result in insufficient sales for the firm.
Based on the logic underpinning the price floor and price ceiling, it makes sense that if a company decides to pursue a cost leadership strategy, it will attempt to make its cost floor as low as possible in order to offer the lowest price and still gain the desired margin. To support a differentiation strategy, the company should then attempt to maximize the price ceiling. To do this, a company in an economically level industry would set itself apart by determining the customer’s needs and problems, and incorporating innovative solutions and features into the product to gain a higher price in exchange for a higher perceived value.
The lesson here is that no matter what strategy or position in the marketplace your company decides to take, it must be supported by appropriate understanding of the market environment, costs, and consequently price. Companies must be willing to invest time and effort to gain adequate market knowledge to understand their price floors and price ceilings. With this information, a firm gains vital intellectual power that is advantageous for price setting that is logically tied to its strategic plan. I encourage companies to learn common pricing objectives and policies, and be willing to work hard to understand the environment in which they operate.
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