Different types of Pricing 1.

) Penetration pricing is the practice of initially setting a low price for one's goods or services, with the intent of increasing market share. The price may be set so low that the seller cannot earn a profit. Advantages of Penetration Pricing

Entry barrier. If a company continues with its penetration pricing strategy for some time, possible new entrants to the market will be deterred by the low prices. Reduces competition. Financially weaker competitors will be driven from the market, or into smaller niches within the market. Market dominance. It is possible to achieve a dominant market position with this strategy, though the penetration pricing may have to continue for a long time in order to drive away a sufficient number of competitors to do so. Disadvantages of Penetration Pricing

Branding defense. Competitors may have such strong product or service branding that customers are not willing to switch to a low-price alternative. Customer loss. If a company only engages in penetration pricing without also improving its product quality or customer service, it may find that customers leave as soon as it raises its prices. Perceived value. If a company reduces prices substantially, it creates a perception among customers that the product or service is no longer as valuable, which may interfere with any later actions to increase prices. Price war. Competitors may respond with even lower prices, so that the company does not gain any market share.

2.) Price skimming is the practice of selling a product at a high price, usually during the introduction of a new product when the demand for it is relatively inelastic. This approach is used to generate substantial profits during the first months of the release of a product, usually so that a company can recoup its investment in the product. Advantages of Price Skimming

High profit margin. The entire point of price skimming is to generate an outsized profit margin. Cost recovery. If a company competes in a market where the product life span is short, price skimming may be the only viable method available for ensuring that it recovers the cost of developing products. Dealer profits. If the price of a product is high, then the percentage earned by distributors will also be high, which makes them happy to carry the product. Quality image. A company can use this strategy to build a high-quality image for its products, but it must deliver a high-quality product to support the image created by the price. Disadvantages of Price Skimming The following are disadvantages of using the price skimming method:

Competition. There will be a continual stream of competitors challenging the seller's extreme price point with lowerpriced offerings.

Sales volume. A company that uses price skimming is limiting its sales, which means that it cannot lower costs by building sales volume. Consumer acceptance. If the price point remains very high for too long, it may defer or entirely prevent acceptance of the product by the general market. Annoyed customers. Early adopters of the product may be highly annoyed when the company later drops its price for the product, thereby generating bad publicity and a very low level of customer loyalty. Cost inefficiency. The very high profit margins engendered by this strategy may cause a company to avoid making the cost cuts required to keep it competitive when it eventually lowers its prices.

3.) Value based pricing is the practice of setting the price of a product or service at the perceived value to the customer. Advantages of Value Based Pricing

Increases profits. This method results in the highest possible price that you can charge, and so maximizes profits. Customer loyalty. Despite the high prices charged, you can achieve extremely high customer loyalty for repeat business and referrals, but only if the service or product provided justifies the high price. This advantage tends to also derive from the nature of the sales relationship, which needs to be both close and trusting before value based pricing can even be contemplated. Disadvantages of Value Based Pricing

Niche market. The very high prices to be expected under this method will only be acceptable to a small number of customers. It may even alienate some prospective customers. Not scalable. This method tends to work best for smaller organizations that are highly specialized. It is difficult to apply it in larger businesses where employee skill levels may not be so high. Competition. Any company that persistently engages in value based pricing is leaving a great deal of room for competitors to offer lower prices and take away their market share. Labor costs. Assuming that a service is being provided, you are likely offering such a high-end skill set that the employees needed to provide the service will be quite expensive. There is also a risk that they may leave to start competing firms.

4.) Psychological pricing is the practice of setting prices slightly lower than rounded numbers, in the belief that customers do not round up these prices, and so will treat them as lower prices than they really are. This practice is based on the belief that customers tend to process a price from the left-most digit to the right, and so will tend to ignore the last few digits of a price. Advantages of Psychological Pricing

Price bands. If a customer is accessing information about product prices that are segregated into bands, the use of fractional pricing can shift the price of a product into a lower price band, where customers may be more likely to make a purchase. For example, if a customer only wants to consider automobiles that cost less than $20,000, pricing a vehicle at $19,999 will drop it into the lower price band and potentially increase its sales.

Non-rational pricing. If customers are swayed by the incremental price reductions advocated under psychological pricing (which is a debatable premise) then sales should increase.

Control. It is much more difficult for an employee to create a fraudulent sales transaction and remove cash when product prices are set at fractional levels, since it is more difficult to calculate the amount of cash to steal. Discount pricing. If a company is having a sale on selected goods, it can alter the ending digits of product prices to identify them as being on sale. Thus, any product ending with a ".98" price will receive a 20% discount at the checkout counter. Disadvantages of Psychological Pricing

Calculation. It can be difficult for cashiers to calculate the total amount owed when fractional prices are used, as well as to make change for such purchases. This is less of a problem when credit card and other types of electronic payments are used.

Rational pricing. If customers are more rational than psychological pricing gives them credit for, then they will ignore fractional pricing and instead base their purchases on the value of the underlying products.

5.) Premium pricing is the practice of setting a price higher than the market price, in the expectation that customers will purchase it due to the perception that it must have unusually high quality or reputation. In some cases, the product quality is not better, but the seller has invested heavily in the marketing needed to give the impression of high quality. Advantages of Premium Pricing

Entry barrier. If a company invests heavily in its premium brands, it can be extremely difficult for a competitor to offer a competing product at the same price point without also investing a large amount in marketing. High profit margin. There can be an unusually high gross margin associated with premium pricing. However, a company engaging in this strategy must attain sufficient volume to offset the hefty marketing costs associated with it. Disadvantages of Premium Pricing

Branding cost. The costs required to establish and maintain a premium pricing strategy are massive, and must be maintained for as long as this pricing strategy is followed. Otherwise, the premium brand recognition by consumers will falter, and the company will have difficulty maintaining its price points.

Competition. There will be a continual stream of competitors challenging the top tier pricing category with lowerpriced offerings. This can cause a problem, because it increases the perception in the minds of consumers that the entire product category is worth less than it used to be.

Sales volume. If a company chooses to follow a premium pricing strategy, it will have to confine its selling efforts to the top tier of the market, which limits its overall sales volume. This makes it difficult for a company to pursue aggressive sales growth and premium pricing at the same time. The strategy can be followed as long as the company is expanding into new geographic regions, since it is still pursuing the top tier in these new markets.

High unit costs. Because the company using this strategy is restricting itself to low sales volume, it can never generate the cost reductions that a high-volume producer would be able to achieve.

THE BOTTOMUP APPROACH TO PRICING Generally, pricing theory suggests that a hospitality operation should price its rooms and its food and beverage menu items to control costs and maximize profit, while at the same time offering guests an appropriate value for their money. The reasoning behind the pricing theory is that owners should be provided with a satisfactory return on investment if the products being sold are properly priced. The method used to price products will, to a degree, dictate whether financial goals will be achieved. If prices are too high, customers will come to believe they are not receiving adequate value for their money and seek other sources to provide the product and services. On the other hand, if prices are too low, sales potential is not maximized. In either event, profits can be expected to be lower than they should be. As will be seen, hospitality operators establish price structures using a number of different methods, each with their advantages and disadvantages. INTUITIVE METHOD The intuitive method requires no real knowledge of the business or research into costs, profits, prices, competition, or the market. The operator just assumes that the prices established are the right ones because customers are willing to pay them. This method has no advantages. Its main disadvantage is that the prices charged are unrelated to profits. RULE-OF-THUMB METHOD Rule-of-thumb methods (such as that a restaurant should price its menu items at 2.5 times food cost to achieve a 40% cost of sales) may have had validity at one time but should not be relied on in todays highly competitive environment because they pay no attention to the marketplace (competition, value for money, and so forth). TRIAL-AND-ERROR METHOD With the trial-and-error method, prices are changed up and down to see what effect they have on sales and profits. When profit is apparently maximized, prices are established at that level. However, this method ignores the fact that there are many other variables (such as general economic conditions, seasonality of demand, and competition) that affect sales and profits apart from prices, and what appears to be the optimum pricing level might later be affected by these other factors. This method can also be confusing to customers during the price-testing period. PRICE-CUTTING METHOD Price cutting occurs when prices are reduced below those of the competition. This can be a risky method if it ignores costs, because if variable costs are higher than prices, profits will be eroded. Some restaurant operators set their food menu prices below costs on the risky assumption they will more than make up the losses by profits on alcoholic beverage sales. To use this method, selling additional products must more than compensate for the reduction in prices. If the extra business gained is simply taken away from competitors, they will also be forced to reduce their prices, and a price war may result. HIGH PRICE METHOD Another pricing method is to deliberately charge more than competitors and use product differentiation, emphasizing such factors as quality, which many customers equate with price. If this strategy is not used carefully, however, it can encourage customers to move elsewhere when they realize that high price and high quality are not synonymous.

COMPETITIVE METHOD Competitive pricing means matching prices to those of the competition and then differentiating in such areas as location, atmosphere, and other nonprice factors. When there is one dominant operator in the market that generally takes the lead in establishing prices, with its close competitors matching increases and decreases, this method is then referred to as the followthe-leader method. Competitive pricing tends to ensure there is no price-cutting and resulting reduction in profits. In other words, there is market price stability. This might be a useful method in the short run. However, if competitive pricing is used without knowledge of the differences that exist (in such matters as product, costs, and services) between one establishment and another, then this method can be risky. MARKUP METHOD The markup method is used, for example, when a restaurants traditional food cost percentage (as it appears on past income statements) is applied to determine the price of any new menu items offered. For example, if traditionally the restaurant has

been operating at a 40 percent food cost, any new menu items offered would be priced so that they also result in a 40 percent food cost. The major problem with this method is that it assumes that 40 percent is the correct food cost for the restaurant to achieve its desired profit. USING THE RIGHT METHOD Many of the pricing methods just reviewed are commonly used because operators understand them and find them easy to implement. Unfortunately, if the establishment is not operating as efficiently as it should, these methods simply tend to perpetuate the situation, and sales and profits will not be maximized. Owners or managers who use these methods are not fully in control of their operations and are probably failing to use their income statements and other financial accounting information to guide them in improving their operating results. Pricing is a tool that can be used effectively to improve profitability. The dilemma is often a matter of finding the balance between prices and profits. In other words, prices should only be established after considering their effect on profits. For example, a restaurant can lower its prices to attract more customers, but if those prices are lowered to the point that they do not cover the costs of serving those extra customers, profits will decline rather than increase. LONG-RUN OR STRATEGIC PRICING Over the long run, price is determined in the marketplace as a result of supply and demand. When prices are established to compete in that marketplace, they must be set with the establishments overall long-term financial objectives in mind. A typical objective could be any one of the following: To maximize sales revenue To maximize return on owners investment To maximize profitability To maximize business growth (in a new operation) To maintain or increase market share (for an established operation) TACTICAL PRICING In addition to a long-run pricing strategy, a hospitality operation needs shortrun, or tactical, pricing policies to take advantage of situations that arise from day to day. These situations might include any of the following: Reacting to short-run changes in price made by competitors Adjusting prices because of a new competitor Knowing how large a discount to offer group business while still making a profit Knowing how much to increase prices to compensate for an increase in costs Knowing how much to increase price to compensate for renovations made to premises Adjusting prices to reach a new market segment Knowing how to discount prices in the off-season to attract business Offering special promotional prices Many of the remaining chapters in this book are concerned with using accounting- oriented approaches to provide managers with information to help them make decisions about operating cost activities of the operation and to maximize net income and return on investment. However, it is equally important to control sales revenuethat is, to control the prices that are established for the products and services offered. Since there is a relationship between prices charged and total sales revenue, prices will, therefore, affect the general financial results, such as the ability to cover all operating costs and provide a net income that yields an acceptable return on investment. Price levels also affect such matters as budgeting, working capital, cash management, and capital investment decisionsall of which will be discussed in later chapters. The traditional method of looking at an income statement is from the top downthat is, by calculating sales revenue and the costs associated with that revenue in order to determine if there is a net income. A different approach might be to start with the net income that is required, calculate costs, and determine what sales revenue is required and what prices are to be charged in order to achieve the desired net income. This bottom-up approach assumes that net income is a cost of doing business, which indeed it is. If a mortgage company lends money at a particular interest rate to a hotel or food service operation, the interest expense is considered to be a cost. The mortgage company is an investor. Another group of investors are the owners of the company (either stockholders or unincorporated individuals). They also expect interest on their investment of money and/or time, except that their interest is called net income. Therefore, net income is just another type of cost. This concept, and the bottom-up approach to calculating revenue, can be useful in deciding prices.

COST MANAGEMENT Most of the sales revenue in a hotel or food service enterprise is consumed by costs: as much as 90 cents or more of each revenue dollar may be used to pay for costs. Therefore, cost management is important. Budgeting costs and cost analysis is one way to control and manage costs to improve net income. Another way to improve net income is to cut costs, without regard to the consequences. The latter course of action may not be wise. Perhaps a better way is to look at each cost (expense) and see how it contributes toward net income. If advertising cost leads to higher net income than would be the case if we did not advertise, then it would not pay to cut the advertising expense. One of the ways to better manage costs is to understand that there are many types of costs. If one can recognize the type of cost that is being considered, then better decisions can be made. Some of the most common types of cost are defined in the following sections. TYPES OF COST DIRECT COST A direct cost is one that is traceable to and the responsibility of a particular operating department or division. Most direct costs are variable by nature and will increase or decrease in relation to increases and decreases in sales revenue. For this reason, direct costs are considered to be controllable by, and the responsibility of the department or division manager to which they are charged. Examples of these types of costs are cost of salesfood and beverages, wages and salaries, operating supplies and services, and linen and laundry. INDIRECT COST An indirect cost is one that cannot be identified with and traceable to a particular operating department or division, and thus, cannot be charged to any specific department or division. General building maintenance could only be charged to various departments or divisions (such as rooms, food, or beverage) with difficulty. Even if this difficulty could be overcome, it must still be recognized that indirect costs cannot normally be considered the responsibility of operating departments or divisions managers. Indirect costs are frequently referred to as undistributed costs. CONTROLLABLE AND NONCONTROLLABLE COSTS If a cost is controllable, the manager can influence the amount spent. For example, the kitchen manager can influence the amount spent on food. However, it is unlikely the kitchen manager can influence the amount spent on rent, especially in the short term. The mistake is often made of calling direct costs controllable costs and indirect costs noncontrollable costs. It is true that direct costs are generally more easily controlled than indirect costs, but in the long run all costs are controllable by someone at some time. JOINT COST A joint cost is one that is shared by, and thus is the responsibility of, two or more departments or areas. A dining room server who serves both food and beverage is an example. The servers wages are a joint cost and should be charged (in proportion to revenue, or by some other appropriate method) partly to the food department and the remainder to the beverage department. Most indirect costs are also joint costs. The problem is to find a rational basis for separating the cost and charging part of it to each department. DISCRETIONARY COST This is a cost that may or may not be incurred based on the decision of a particular person, usually the general manager. Nonemergency maintenance is an example of a discretionary cost. The building exterior could be painted this year, or the painting could be postponed until next year. Either way sales revenue should not be affected. The general manager has the choice, thus it is a discretionary cost. Note that a discretionary cost is only discretionary in the short run. For example, the building will have to be painted at some time in order to maintain its appearance. RELEVANT AND NONRELEVANT COSTS A relevant cost is one that affects a decision. To be relevant, a cost must be in the future and different between alternatives. For example, a restaurant is considering replacing its mechanical sales register with an electronic one. The relevant costs would be the cost of the new register (less any trade-in of the old one), the cost of training employees on the new equipment, and any change in maintenance and material supply costs on the new machine. As long as no change is necessary in the number of servers required, the restaurants labor cost would not be a relevant cost. It would make no difference to the decision.

SUNK COST A sunk cost is a cost already incurred and about which nothing can be done. It cannot affect any future decisions. For example, if the same restaurant had spent $250 for an employee to study the relative merits of using mechanical or electronic registers, the $250 is a sunk cost. It cannot make any difference to the decision. OPPORTUNITY COST An opportunity cost is the cost of not doing something. An organization can invest its surplus cash in marketable securities at 10 percent, or leave the money in the bank at 6 percent. If it buys marketable securities, its opportunity cost is 6 percent. Another way to look at it is to say that it is making 10 percent on the investment, less the opportunity cost of 6 percent; therefore, the net gain is a 4 percent interest rate. FIXED COST Fixed costs are not expected to change in the short run of an operating period of a year or less, and will not vary with increases or decreases in sales revenue. Examples are management salaries, fire insurance expense, rent paid on a squarefoot basis, or the committed cost of an advertising campaign. Over the long run fixed costs can, of course, change, but in the short run they are not expected to change. If a fixed cost should change over the short run, the change would normally result only from a decision of specific top management. VARIABLE COST A variable cost is one that changes in direct proportion to a change in sales revenue. Very few costs are strictly linear, but two that are (with only a slight possibility that they will not always fit this strict definition) are the cost of sales of food and beverages. The more food and beverages sold, the more costs will be incurred. If sales are zero, no food or beverage costs are incurred. SEMIFIXED OR SEMIVARIABLE COSTS Most costs do not fit neatly into the fixed or the variable category. Most have an element of fixed cost and an element of variable cost. As well, they are not always variable directly to sales on a straight line basis. Such costs would include payroll, maintenance, utilities, and most of the direct operating costs. In order to make some useful decisions, it is advantageous to break down these semifixed or semivariable costs into their two elements: fixed or variable. STANDARD COST A standard cost is what the cost should be for a given volume or level of sales. Other uses would be in budgeting, in pricing decisions, and in expansion planning (Chapter 12). Standard costs need to be developed by each establishment since there are many factors that influence standard costs and that differ from one establishment to another.

YIELDMANAGEMENT
The hospitality industry has recently adopted a practice called yield management. Using calculated yield statistics and basic principles of supply and demand, managers seek to allocate services to patrons in such a way as to maximize sales revenue.

HOTEL PRACTICES The main goal of the rooms department in many hotels is to sell hotel rooms to increase the occupancy percentage. Managements objective is to maximize the sales revenue (or yield) from the rooms available. Unfortunately, many of the methods used to measure a hotels marketing effort do not generate sales decisions that maximize revenue. Traditionally, marketing effort has been judged in terms of either the occupancy percentage or the average room rate achieved. The problem with occupancy percentage is that it does not show whether sales revenue is being maximized. For example, a hotel may be 100 percent occupied, but many of those room occupants might be paying less than the maximum (rack) rate for the room. In other words, managers whose performance is measured by room occupancy are tempted to increase occupancy at the expense of room rate. Other managers are judged by the average room rate. Again, the average room rate can be increased by refusing to sell any rooms at less than the rack rate, turning away potential customers who are unwilling to pay this rate. Average room rate will be maximized at the expense of occupancy.

Average room rate can be slightly more meaningful if it is expressed as a ratio of the maximum potential average rate, as discussed in an earlier section of this chapter, but by itself, it does not provide a complete picture. Instead of focusing on a high occupancy or a high average rate, a better measure of a managers performance is the yield statistic: Yield = Actual Revenue/Potential Revenue x 100 Potential revenue is defined as the room sales that would be generated if 100 percent occupancy was achieved and each room was sold at its maximum rack rate. For example, if a hotel has 150 rooms, each of which has a maximum rack rate of $100, potential sales revenue is 150 _ $100 _ $15,000, and if actual sales revenue on a particular night is $10,000, then yield is $10,0000 / $15,000 x 100 = 66.7% Yield thus combines two factors: the number of rooms available (inventory) and rooms pricing. Rooms inventory management is concerned with how many rooms are made available to each market segment and its demand for rooms. Pricing management is concerned with the room rate quoted to each of these market segments.