Essentials of Entrepreneurship and Small

Business Management
Ninth Edition

Chapter 11
Pricing and Credit Strategies

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Learning Objectives
1. Discuss the relationships among
pricing, image, competition, and
value.
2. Describe effective pricing techniques
for introducing new products or
services and for existing ones.
3. Explain the pricing methods and
strategies for retailers,
manufacturers, and service firms.
4. Describe the impact of credit and
debit cards and mobile wallets on
pricing.

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Introduction
• Setting prices is a business decision that is both an art and a science.
Unfortunately, many small business owners set prices without enough
information about their cost of operations and their customers.
Research shows that proper pricing strategies have a far greater impact
on a company’s profits than corresponding increases in unit volume
and reductions in fixed or variable costs. Refer to Figure 11.1, The
Impact of Pricing and Cost Improvements on Profitability
• Pricing:
– Is governed by both art and science.
– requires balancing a multitude of complex forces.
– Influences every aspect of a small company.
– Is an important signal of value to customers.
– Involves both math and psychology.
– Has a greater impact on profits than corresponding increases in
unit volume or cost reductions.
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Impact of Pricing and Cost Improvements
on Profitability
Figure 11.1 The Impact of Pricing and Cost Improvements
on Profitability

Source: Based on Richard

Hayes and Ranjit Singh, “CFO
Insights: Pricing for Profitability:
What’s in Your Pocket,”
Deloitte, 2013,
[Link]
nt/dam/Deloitte/us/Documents/fi
nance-transformation/uscfo-cfo-
insights-pricing-forprofitability-
[Link].

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Image, Competition, Value
• Companies that take a strategic approach to pricing and
monitor its results can raise their sales revenue between
1% and 8%

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Price Conveys Image
• Price sends important signals to customers: quality,
prestige, uniqueness, etc.
• Common small business mistake: charging prices that are
too low and failing to recognize extra value, service,
quality, and other benefits they offer.
• The key is to understand the target market and identify
how much customers are willing to pay rather than how
much to charge.

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Competition and Pricing
• Must take into account competitors’ prices, but it is not always
necessary to match or beat them.
• Key is to differentiate a company’s products and services.
• Price wars often eradicate companies’ profits and scar an industry for
years.
• Best strategy: Stay out of a price war!
• Today, small companies face competition from local businesses as well
as from online businesses. Unless a small business can differentiate
itself by creating a distinctive image in customers’ minds or by offering
superior service, quality, design, convenience, or speed, then it must
match its competitors’ prices or risk losing sales. Blindly matching
competitors’ prices can lead a company to financial ruin. Refer to
Figure 11.2, The Reality of Setting Prices.

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The Reality of Setting Prices
Figure 11.2 The Reality of Setting Prices

Source: Based on data from William C. Dunkelberg and Holly Wade, “NFIB Small Business Economic
Trends,” National Federation of Independent Businesses, July 2017, p. 8.
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Focus on Value
• The “right” price for a product or service depends on the value it provides
for a customer.

• Two aspects of price:

– Objective value is the price customers would be willing to pay if they
understood perfectly the benefits that a product or service delivers for
them.
– Perceived value: Unfortunately, customers only see its perceived
value, which determines the price they are willing to pay. Value does
not equate to a low price. Setting prices too low is more dangerous
than setting them too high. Raising prices that are too low is much
more difficult and can create the wrong image for a business
– Techniques that companies can use to increase customers’ perception
of value include offering coupons and rebates, offering limited-time-
only discounts, or launching a fighter brand, which is a less
expensive, no-frills version of a company’s flagship product that is
designed to confront lower-priced competitors head-on, satisfy the
appetites of value-conscious customers, and preserve the image of
the company’s premium product
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Dealing with Rising Costs (1 of 3)
• One of the biggest mistakes an entrepreneur can make is underestimating the
company’s actual total cost of a product or service. When setting prices, some
entrepreneurs think strictly about product or service costs and fail to consider
the total cost of providing the product or service, such as rent, insurance, labor
costs, etc. Businesses facing rapidly rising costs should consider the following
strategies:

• Communicate with customers.

• Rather than raise the price of the good or service, include a surcharge (extra
charge).

• Eliminate customer discounts, coupons, and promotions.

• Offer products in smaller sizes or quantities.

• Focus on improving efficiency everywhere in the company.

• Emphasize the value your company provides to customers.

• Raise prices incrementally and consistently rather than rely on large periodic
increases.

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Dealing with Rising Costs (2 of 3)
• Shift to less expensive raw materials if possible.
• Anticipate rising materials costs and try to lock in prices early.
• Consider absorbing cost increases.
• Modify the product or service to lower its cost.
• Differentiate your company and its products and services from the competition.
• Costs impact pricing. It is important that price takes cost into consideration.
These costs should be passed along to customers and communicated
through the value you offer.
• When all is taken into consideration, the factors that small business owners
must consider when determining the price for goods and services includes:
• Product/service costs
• Market factors - supply and demand
• Sales volume
• Competitors' prices
• The company's competitive advantage
• Economic conditions

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Dealing with Rising Costs (3 of 3)

• Business Location
• Seasonal fluctuations
• Psychological factors
• Credit terms and purchase discounts
• Customers' price sensitivity
• Desired image

• For most products there is an acceptable price range, not a single price
for a product. This price range is the area between the price ceiling
defined by customers in the market and the price floor established by the
company’s cost structure. The goal is to position prices within this
acceptable price range. Refer to Figure 11.3, What Determines Price?
•

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What Determines Price?
Figure 11.3 What Determines Price?

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Introducing a New Product (1 of 2)
Pricing strategies must be compatible with the firm’s overall strategy.
Introducing a New Product.
When introducing a new product, the owner should try to satisfy three objectives:
1. Get the product accepted. The acceptable price range depends on the
product’s position:
• Revolutionary products are so new and unique that they transform existing
markets.
• Evolutionary products offer upgrades and enhancements to existing
products.
• Me-too products, despite offering the same basic features as existing
products on the market, have the potential to carve out a significant market
share.

2. Maintain market share as competition grows

3. Earn a profit

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Introducing a New Product (2 of 2)
There are three basic strategies when establishing a new product’s price:
penetration, skimming, and life cycle pricing.
1. Penetration: Set prices below competitors to gain market entry. This
pricing strategy increases market share and makes it less attractive for
new competitors to enter the market.
2. Skimming: This strategy entails setting higher prices for new products
and for markets with limited or no competition. The main advantage of
this pricing strategy is the potential for achieving the best margin with
higher price points.
3. Life Cycle Pricing: Set higher prices initially, and as technological
advances or additional experience enables the firm to lower costs, it
can reduce the product’s price one step ahead of competitors.

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Pricing Established Goods (1 of 4)
• Odd pricing: a pricing technique to set prices in odd numbers to
create the psychological impression of lower prices.
• Price lining: a technique that greatly simplifies the pricing function by
pricing different products in a product line at different price points
depending on their quality, features, and cost.
• Price anchoring: a technique that establishes a price point to which
customers can refer when making decisions.
• Freemium pricing: is a pricing strategy that involves providing
customers a basic product or service for free but charging a premium
for expanded or upgraded versions of the product or service.
• Subscription pricing: – a technique that involves marking down the
normal price of a popular item in an attempt to attract more customers
who make incidental purchases of their items at regular prices.

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Pricing Established Goods (2 of 4)
• Dynamic (customized) pricing: a technique in which a company sets
different prices for the same products and services for different customers
using the information they have collected about their customers.

• Leader pricing: a technique that involves marking down the normal price of
a popular item in an attempt to attract more customers who make incidental
purchases of their items at regular prices.

• Geographical pricing – prices vary according to the costs of shipping

merchandise to customers across a wide range of geographic regions. One
type of geographic pricing is zone pricing, which is a technique that involves
setting different prices for customers located in different territories because of
different transportation costs. Another option is delivered pricing, a
technique in which a company charges all customers the same price
regardless of their locations and different transportation costs. The final
option is F.O.B. factory, in which a small company sells merchandise to
customers on the condition that they (the customers) pay all shipping costs.

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 Pricing Established Goods (3 of 4)
• Discounts – There are five variations of discounts:

o Discount markdowns are reductions from normal list prices.

o Earned discounts, which customers earn by making repeat
purchases at a business.
o Limited-time offers are provided by retailers for a limited amount of
time with the goal of creating a sense of urgency and excitement
among customers.
o A steadily decreasing discount is a limited-duration discount that
declines over time.
o Multiple unit pricing is a technique that offers customers discounts if
they purchase in quantity, encouraging bulk purchases and increasing
sales volume.

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 Pricing Established Goods (4 of 4)
• Bundling is grouping several products or services into a package that
offers customers extra value at a special price.
• Optional-product pricing is a technique that involves selling the base
product for one price but selling the options or accessories for it at a
much higher markup.
• Captive product pricing is a technique that involves selling a product
for a low price and charging a higher price for the accessories that
accompany it.
• By-product pricing is a technique in which a company uses the
revenues from the sale of by-products to be more competitive in pricing
the main product.
• Suggested retail prices. This practice eliminates the need for small
businesses to make a pricing decision. However, it can create problems
such as prices being inconsistent with the company’s image, cost
structure, or competitive situation.
• Follow-the-leader pricing

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 Pricing Strategies: Markup 1 of 2
Markup (or markon) pricing is the difference between the cost of a product or service and its
selling price. It is a calculation of the additional amount charged in addition to the cost to
procure. It must be large enough to produce a profit.
Dollar Markup = Retail price − Cost of the merchandise
Dollar markup
Percentage (of retail price) markup =
Retail price
Dollar markup
Percentage (of cost) markup =
Cost of unit
If a shirt costs $14 and a retailer plans to sell it for $30, the markup would
be as follows:

Dollar Markup = $30 − $14 = $16

$16
Percentage (of retail price) markup = = 53.3%
$30
$16
Percentage (of cost) markup = = 114.3%
$14
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 Pricing Strategies: Markup 2 of 2

• Once entrepreneurs create a financial plan, including sales estimates

and anticipated expenses, they can compute their companies’ initial
markup.
• The initial markup is the average markup required on all merchandise to
cover the cost of the items, all incidental expenses, and a reasonable
profit. Operating costs, such as rent, utilities, depreciation and reductions,
must also be taken into consideration.
• Finally, retailers must verify that the retail price they have calculated is
consistent with their companies’ image. Perhaps most importantly,
customers must be willing and able to pay this price.

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Table 11.1 Costs and Markup Calculations for
Samsung’s Galaxy S6 Edge and Apple’s iPhone 7 (1 of 2)
Component Samsung Galaxy Apple iPhone 7
S6 Edge (32GB)
Display and touchscreen $85.00 $43.00
Processors $29.50 $26.90
Cameras $21.50 $19.90
User interface and sensors $14.75 $14.00
Memory $52.50 $16.40
Modules and processors $31.50 $43.20
Case and enclosure elements $12.00 $18.20
Power management device $5.40 $7.20
Lithium polymer battery $3.50 $2.50
Mechanical/Electromechanical components $23.00 $16.70

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Table 11.1 Costs and Markup Calculations for
Samsung’s Galaxy S6 Edge and Apple’s iPhone 7 (2 of 2)
Component Samsung Galaxy Apple iPhone 7
S6 Edge (32GB)
Box contents $6.20 $11.80
Assembly and testing cost $5.60 $5.00
Total Cost $290.45 $224.80
Retail price (no contract) $799.99 $849.99
$ Markup = Price − Cost $509.54 $625.19
Percentage (of cost) markup = 175.4% 278.1%

Source: Based on “iPhone 7 Materials Cost Higher Than Previous Versions, HIS Markit Teardown Reveals,” Business
Wire, September 20, 2016, [Link]/news/home/20160920006782/en/iPhone-7-Materials-Costs-Higher-
Previous-Versions; “Samsung Galaxy S6 Edge Pricier to Build, Cheaper to Buy Than Comparable iPhone 6 Plus, IHS
Teardown Reveals,” IHS Markit, April 14, 2015, [Link]
edge-pricier-build-cheaper-buy-comparable-apple-iphone-6-.

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Initial Dollar Markup and Retail Price

Operating expenses + Reductions + profit

Initial dollar markup =
Net Sales + Reductions
Dollar cost
Retail Price =
(1 − Percentage of retail price markup)

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Pricing for Manufacturers
• The most commonly used pricing technique for
manufacturers is cost-plus pricing:
– A manufacturer establishes a price that covers the cost
of direct materials, direct labor, factory overhead,
selling and administrative costs, and a desired profit
margin. While it is a simple way to determine prices, it
does not encourage the manufacturer to use resources
efficiently. In addition, it fails to consider the
competition and market forces.

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Cost-Plus Pricing Components

Figure 11.5 Cost-Plus Pricing Components

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 Direct Costing and Pricing (1 of 2)
• Successful pricing for manufacturers requires a reliable cost accounting
system that can generate timely reports.
• Absorption costing:
– Traditional method of product costing in which all manufacturing and
overhead costs are absorbed into the product’s total cost.
• Variable or direct costing:
– The product costing method includes in the product’s costs only
those costs that can vary directly with the quantity produced.
Variable costing encompasses direct materials, direct labor, and
factory overhead costs that vary with the level of the company’s
output of finished goods. Overhead costs that are fixed (rent,
depreciation, and insurance) are not included.

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Direct Costing and Pricing (2 of 2)
• Contribution margin is the amount left over out of a dollar
of sales after variable expenses are paid, which
contributes to covering fixed expenses (cost of materials,
direct labor, and overhead for each service unit) and
earning a profit.

productive hour
Price Total cost per hour =
(1 − net profit as a % of sales)

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 Break-Even Pricing
• The break-even selling price allows a manufacturer to determine at what point
revenues equal expenses. This is the break-even point , and the next unit sold
represents the first dollar of profit.
• Service firms must establish prices based on the materials used to provide the
service, the labor employed, an allowance for overhead, and profit. Most
service firms base their prices on an hourly rate, usually the actual number of
hours required to perform the service. Others base their feeds on a standard
number of hours, determined by the average number of hours needed to
perform the service

Break - even selling price =

Profit + (Variable cost per unit  Quantity produced) + Total fixed cost
Quantity produced

Pocket price is the price a company receives for a product or service

after deducting all discounts and purchase incentives.

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Impact of Credit and Debit Cards and
Mobile Wallets on Pricing
• Customers expect to make purchases with credit cards.
– However, companies incur additional costs when
offering this service.
• E-commerce and credit cards
• Debit cards
• Mobile wallets
• Installment credit
• Trade credit
• Layaway

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Top Three Payment Preferences
Figure 11.6 Top Three Payment Preferences Among
Shoppers

Source: Based on 2016 U.S. Consumer Payment Study, Total Systems Services, 2016, p. 12.

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Consumer Credit (1 of 2)
• Credit cards: Accepting credit cards broadens a small company’s customer
base and closes sales that would normally be lost if customers had to pay in
cash. However, companies incur additional expenses for offering this
convenience

• A typical consumer has 4 credit cards.

– Research: Customers who use credit cards make purchases that are 12–
18% higher than if they had used cash.
– On a typical $100 credit card purchase, cost to business = $1.85.
Businesses must pay to use the system, typically 1percent to 6 percent of
the total credit card charge, which they must factor into the prices of their
products or services. They also pay a transaction fee of 5 to 25 cents per
charge
– Interchange fee is the fee banks collect from retailers whenever
customers use a credit or debit card to pay for a purchase. This fee can
significantly impact retailers, prompting some entrepreneurs to offer
customers incentives to pay with cash to avoid these financial challenges.

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Typical Credit
Card Transaction
Figure 11.7 How a
Typical Credit Card
Transaction Works

Sources: Based on “Credit Card Processing,” Card Fellow, 2013, [Link]/content/creditcard-processing-

[Link]#MoneyGo; “Credit Cards,” U.S. Government Accounting Office, September 2006, pp. 73–74.

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 E-Commerce and Credit Cards
• E-commerce companies reject about 2.8% of orders because
of suspicion of fraud.
• To minimize credit card fraud:
– Use an address verification system
– Require a CVV2 number
– Check customers ' IP addresses
– Pay close attention to international orders
– Monitor Web site activity with analytics
– Verify large orders
– Post notices on the web site that your company uses anti-fraud
technology
– Contact the credit card company or bank that issued the card

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 Consumer Credit (2 of 3)
• Debit cards: In 2003, shoppers first used credit and debit cards more
often than cash or checks. Compared to credit cards, the equipment to
accept debit cards is easy to install, and the cost to the company is
negligible. Interchange fees are lower.
– Shoppers make almost 70 billion debit card transactions, totaling $2.6
trillion annually.
• Mobile wallets:
– Mobile wallet applications link a smartphone or tablet to a credit or
debit card, transforming the device into a digital wallet. Shoppers
download software and then swipe the devices over a near-field
communication (NFC) or Quick Response (QR) reader to complete a
purchase. The technology speeds up the checkout process and allows
merchants to recognize customers when they walk into the store, send
personalized coupons, incentives, and rewards to them, and generate
useful reports.

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 Consumer Credit (3 of 3)
• Installment credit. Small companies that sell big-ticket consumer
durables (major appliances, cars, boats, etc.) rely on installment credit.
Customers are typically required to make an initial down payment and
then finance the balance for the life of the loan. Because installment
credit absorbs a small company’s cash, many rely on financial institutions
to provide installment credit.
• Trade credit. Trade credit is essentially customer charge accounts offered
by the business; customers are billed each month. To speed collections,
some offer cash discounts if customers pay their balances early; others
impose penalties on late payers.
• Layaway. Although technically not a form of credit, layaway plans enable
customers to purchase goods over time. The customer selects an item,
pays a deposit on it, and makes regular payments until it is paid in full.
The retailer keeps the item until the customer has finished paying.

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Conclusion
• Pricing has a significant impact on many aspects of business. Price
communicates an image of the business with a direct impact on
customer behavior.
• Price then sets the stage for cash flow and ultimately business profits.
• Pricing decisions are some of the most important decisions an
entrepreneur will make. Setting the price structure needs to be
strategic and intentional.
• Pricing techniques impact every aspect of a company including:
– Image
– Customers
– Cash flow
– Profits

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