A business is not set up overnight. It takes a lot of effort, struggles, sleepless nights, sacrificed dinners, and teamwork. After putting a lot of effort into product research, idea generation, execution, and finally launching in the market, the most critical question is pricing strategy.
Pricing strategy is the most critical card of the marketing mix puzzle. However, it doesn’t only relate to the marketing department. The pricing strategy of a company has a direct impact on its accounting, finances, and profitability.
Different pricing strategies bear different fruits. And any business cannot go for a random pricing strategy. The selection of your product’s pricing strategy is highly dependent on your cost accounting, financial management, and budget allocation.
In this article, we will walk through the pricing strategies and, most specifically, economy pricing. This writing piece aims to understand economy pricing, its execution, and what type of businesses can leverage the economy pricing.
Different Pricing Strategies
A price is not the result of the ‘Cost + Certain Percentage’ equation. The pricing strategies are a cumulative product of market positioning, market demand, cost structure, nature of the product, and competition.
A firm use different pricing strategies for choosing the appropriate pricing model for their product.
The pricing strategy mix is an important term of marketing.
There are different types of pricing strategies as a part of this strategy mix. Let’s go through each of them.
The price skimming strategy is artificially setting the price of a product higher to maximize the profit. The skimming strategy is most commonly used in niche positioning when a certain group of people is willing to buy the product at any price.
Most businesses employ price skimming when they have a unique selling point, and they know that soon market will become saturated as new entrants will invade. Therefore, the company offsets its future price drops by charging a high price at present.
Most luxury product selling businesses apply premium pricing. As the name implies, premium pricing is charged for the products having higher value or luxury utility. Most common services and products that employ premium pricing include Five-star and Seven-star Restaurants, Premium Airlines, or any product that make the user feel privileged. Some of the real-life examples of businesses employing premium pricing include Apple, Gucci, Tesla, BMW, etc.
The third pricing strategy used by businesses is penetration pricing. As the name implies, this pricing strategy is mostly used by the newly launched products. The firms set a lower than value price to make a sound entry into the market.
This pricing strategy is applied to appeal to the customers to try the product. Once the customers are convinced by the product, and it becomes their favorite, prices are raised.
I can remember a pizza shop that was opened in my hometown a year ago. The price of a regular pizza was half the price of Pizza Hut or Dominos Pizza. But the taste was not less than those brands. However, the prices have been raised by double in one year because the brand has proven itself and become the choice of customers.
What Is Economy Pricing?
Now let’s understand economy pricing.
The literal definition of economy pricing is,
It is the pricing strategy where the price of products is kept low by decreasing production costs.
In the economy pricing, most marketing and advertising costs are cut to offer a lower price than the competitors. A firm willingly lowers down its price and earns a very minimal margin per product. But the overall profit is not decreased due to high sales volume.
Due to this, economy pricing is often referred to as volume-based pricing.
The most common types of businesses employing this pricing modeling are dealing in generic products like grocery, medications, economic and budget airlines, etc.
How Does It Work?
Let’s go for deeper insights into economy pricing execution and working. The firms and businesses employing this strategy are well aware that they won’t make high profits per unit.
A business that is selling the economy-products keeps the selling volume at the top of anything else. Therefore, they make an effort to bring the product in front of customers at a lower price than competitors.
If we look at the cost accounting perspective of economy pricing, it is a Cost-plus pricing strategy. The products chosen for this model are of lower value and lower production cost. The business launches the products at a small profit per unit.
The formula for the Economy pricing is,
Production Cost + Profit Margin = Price
In the case of this pricing model, only the volume of sales pay. To further understand the working of economy pricing, imagine buying spaghetti instead of Barilla’s spaghetti.
Think of buying the tissue wipes instead of Kleenex or Puffs UltraSoft.
In both these examples, the product is the same, but the price difference will be just due to the brand name attached with Barilla, Kleenex, and Puffs.
Common Business Types That Employ Economy Pricing
Which businesses mostly use the economy pricing strategy to gain a competitive advantage of high sales volume?
Let’s look into common business types employing the economy pricing model.
Grocery Stores And Super Markets
Grocery stores and supermarkets are the best illustrations of the economy pricing model. Every grocery store features different brands, and they have their own catalog of famous brands. However, the grocery stores can leverage economic pricing by cutting the promotion, overhead, and marketing costs to offer a lower price than the competitors.
Generic Drugs and Pharmaceuticals
The drugs and pharmaceuticals industry work similar to the grocery store. Several generic drugs and medications are perfect substitutes for the branded medications with the same chemical composition.
The airplane has to incur the same costs as a single flight, whether it’s filled or empty. Therefore, budget airlines use economy pricing to fill the seats and lower the cost per unit.
Big Box Stores
Big box stores are the retail stores that occupy a large physical space and offer a wide range of products in multiple niches. The most renowned big box stores are Walmart, Costco, Home Depot, IKEA, etc.
Advantages Of Economy Pricing
Every pricing strategy has certain advantages that make it stand out from others. Here are some of the key advantages economy pricing offers.
Best Technique During Economic Recessions
Economy pricing is the most successful pricing strategy for any business during economic downturns and recessions. When there is an economic recession, people are less conscious about the brand name and more concerned about saving money on every purchase. If a business put this strategy in place, they can increase their sales exponentially.
A Strategy To Increase Market Share
Most businesses applying an economy pricing strategy win the competitive edge of providing the same product at a lower price. Therefore, the volume sales and revenues help a business to increase its market share in the relevant industry.
Fixed Costs Are Well Covered
It is a good strategy to cover the fixed costs for large business units. If a company facing operational losses shut down its operations, it is a total failure. However, if they do some cost cuts and provide the same product at a lower price than market competitors, they can fairly cover the fixed costs.
Disadvantages Of Economy Pricing
There are some downsides of this strategy, which a business must be aware of before putting the strategy into practice.
Customer Loyalty Is A Dream
Most customers looking for the best deals and best prices go for the products with economy pricing. The top priority of such customers is the maximum saving. They won’t bother to switch any brand if they are getting the best price somewhere else. This is one major downside of the economy pricing. Despite large volume sales, the customer loyalty of such businesses is low. To succeed in the long run, you need to have a steady stream of new customers.
Large business units can adopt the economy pricing strategy despite lower profit margins. The reason is that they are well versed in attaining economies of scale and make profits. However, this pricing strategy is a big no for the small businesses trying to leverage this policy. Small businesses looking for scaling opportunities cannot make enough profits by using this policy. All they can earn is restricted profits.
When the businesses see that a large unit is earning a lot of profit and market share by applying economy pricing, they find it easy to replicate the model. As a result, there are a lot of players in the market.
Low Product Quality
When the companies cut their overhead costs, the result is sometimes an inferior product with low value. In the short run, a company might make a lot of profit, but the quality problems might increase in the long run.
High Exposure To Risk
The businesses using economy pricing are operating on very narrow profit margins. A major economic or social event triggering the change in demand, consumer behavior, purchasing patterns, or economic slowdown can lead to a big disaster for the business. Therefore, the economy pricing strategy exposes the business to high risk.
Economy pricing is a great strategy for the necessities and in times of economic downturn. A business should have a very good understanding of the industry-specific operational costs to be able to apply economy pricing. With very thin profit margins, there is less room for making mistakes. Therefore, you must put all the cards in the right spot to complete the profit by economy pricing puzzle.
In any business, production costs are the foundation of the pricing strategy, profit margins, and market positioning. The most important costs incurred in any manufacturing operation are material, labor, and factory overhead.
Material is often existing as a cushion between production and consumption of the goods. In any inventory, you will find material in various shapes and sizes. The materials are waiting for processing, semi-processed material, finished goods at the site, in transit, at the warehouse, in retail outlets. In all these forms, there must be a legit economic justification for the inventories or material.
Each unit carried is costing something to the business, and all costs have to be incurred in the financial statements. Therefore, material planning is used to determine material levels and procurement.
The most critical factors managed by material planning are:
The quantity of material
Time to purchase material
To answer these two questions of how much and when is dealt by two conflicting costs that are:
Cost of carrying inventory
Cost of inadequate carrying
The cost of carrying the variable costs that vary with the change in the amount ordered is included. The most common costs are interest, tax, warehousing, or storage. The cost of inadequate carrying, on the other hand, is also an important consideration for the calculation of order quantity.
One most popular and common method of calculating the quantity to be ordered is Economic Order Quantity (EOQ). In this article, EOQ, its formula, calculation, importance, and limitations will be discussed.
What is EOQ?
Economic Order Quantity is defined as,
It is the ideal or optimal quantity of inventory that can be ordered at a time to minimize the annual costs of inventory.
This quantity and production-scheduling model was developed by Ford W. Harris in 1913. Over the time of one century, there have been further developments and refinements in the model to make it more relevant
Suppose a business firm purchases materials once or twice a year, but the order sizes are big. In that case, they are incurring too much cost for carrying the inventory. It increases the annual inventory cost.
Conversely, if the business firm buys smaller quantities in too many orders during a year, the ordering cost goes up. Ultimately, it will also increase annual inventory costs.
Therefore, an optimal quantity of inventory to be ordered at a time requires balancing two factors of the equation.
Cost of carrying or possessing material
Cost of ordering or acquiring material
Assumption Of EOQ
The Economic Order Quantity model works on certain assumptions.
In EOQ, it is assumed that the demand for the material is always the same. The constant demand implies that the seasonal fluctuations and consumer behavior will not affect the demand over the year.
The second assumption is related to constant holding and ordering costs. According to the assumption, ordering costs and carrying cost is always same. The change in transportation costs, interest rates, warehouse rent do not impact the ordering and holding costs of the material.
The final assumption is the absence of any discounts. The EOQ model doesn’t encompass the rebates or trade discounts offered to the business.
Now let’s jump to the formula of EOQ.
The differential calculus has been employed to devise a formula for the calculation of EOQ. The formula is as follow:
Following costs are components of the Economic Order Quantity.
Ordering cost represents the cost of one order. It is calculated by dividing the annual demand by the number of orders annually.
Number Of Orders = D/ Q
The annual ordering costs are found by multiplying the number of orders by the fixed cost of each order.
Annual Ordering Cost = (D/Q) x S
Holding costs of inventory if often expressed as cost per unit multiplied by interest rate. The holding costs can be direct costs of financing the inventory purchase or the opportunity cost of not investing the money somewhere else.
The formula of Holding cost is expressed as,
Holding cost = H = iC
Since the inventory demand is assumed to be constant in EOQ, the annual holding cost is calculated using the formula.
Annual Holding Cost = (Q/2) X H
Total Cost And Economic Order Quantity
By adding the holding cost and ordering cost gives the annual total cost of the inventory. For calculation of the EOQ, that is, optimal quantity, the first derivative of the total cost with respect to Q is taken.
Annual Total Cost = [(D/Q) X S] + [(Q/2) X H]
How To Calculate EOQ?
Let’s calculate the EOQ by example.
Suppose a company has an annual demand of 2500 units. The total cost to place one order is $1200. The per-unit cost is $250. According to the calculations, the carrying costs of the company are 12% of the per-unit cost.
It is required to find the Economic Order Quantity.
If we arrange the data, it will look like this,
EOQ = 408 units per order.
Why Is Economic Order Quantity Model Important?
The economic order quantity model is an important consideration because it helps to find the optimal number of units per order. The firms can minimize their material acquisition costs by applying the EOQ model.
There can be modifications in the EOQ formula to find other production levels or order intervals. According to the economies of scale, the larger quantities of order result in decreased per-unit cost of ordering.
The EOQ is also used by companies as a cash flow tool. By the calculations, a business firm can control the amount of cash tied up to acquire the inventory. Besides, the companies are in a better position to manage their inventories more efficiently. In the absence of this technique, the companies might end up sticking too much cash into large amounts of inventories. Otherwise, the smaller orders will result in an unwanted surge in the annual ordering costs.
The investors can also calculate the EOQ for assessment of a firm’s efficiency in managing its inventory.
Advantages Of EOQ
There are certain benefits the firms can reap by using the EOQ as a cost-scheduling and production-scheduling model. Some of them are mentioned here.
Inventory Costs Are Minimized
Using the EOQ model, the companies are saving them from the unnecessary warehousing costs resulting in the case of extra stocks of inventory. Other factors can be the reason behind the surge in inventory costs.
For instance, damaged products, unsold inventory, the pattern of ordering affects costs. But suppose you’re business deals in low-velocity products. In that case, EOQ can be a beneficial tool to help you find an optimal level of order quantity.
Optimized Inventory Means Minimum Stockouts
EOQ is the most efficient model that tells you how to minimize inventory stockouts without holding unnecessary inventory for longer periods. The essence of the EOQ model is the quantity a firm needs re-ordering and how often to re-order.
Every business is different. Different industries have different requirements. For some businesses ordering smaller amounts more often can be a cost-effective solution. For others, the case might be the complete opposite. You can optimize your inventory management by EOQ.
Overall Efficiency of Handling Inventory Is Improved
The carrying costs and ordering costs are the two most important considerations in EOQ. When a company is using EOQ, its overall efficiency of handling the inventory is increased. You can smartly calculate the EOQ by taking into consideration of all important cost variables.
Limitations Of EOQ
The limitations of the EOQ model are based on the assumptions made in the formula derivation. The EOQ assumes consumer demand, ordering costs, and holding costs to be constant. These assumptions affect the efficiency of the model.
The unpredictable and uncertain events that every business might face are totally ignored. The change in transportation fares, consumer demands, economic recession or boom, or seasonal fluctuations is some events that affect the demand and costs of ordering as well as holding inventory. Any purchase discounts are also not taken into account for the calculation of EOQ.
EOQ might not be a 100% accurate tool to calculate the optimal order quantity, but it helps the business improve its inventory management. Despite its limitations, EOQ is a powerful production-scheduling technique to make inventory-related decision-making more smooth.
However, one thing should be understood that EOQ is just one of the many inventory management techniques used by businesses. The EOQ will be higher if the business’s set-up costs increase or there is a demand surge. However, the EOQ will be lower when the cost of holding inventory is high.
Diseconomy happens when the entity wants to decrease production costs or direct costs through increasing labour force and machinery but the result is not as what they want.
The productions costs per unit increase while entity deploy more labor force and machineries. The main reason is the marginal cost increase while the production increase.
How diseconomy is affect to the costs of products?
There are many reason why marginal cost increase while the productions increase. For example, increase workforce lead to insufficient supervision and lead to low productivities and well as quality.
Increase labor force may also need to increase the supervisory level and this lead to increase the more labor cost.
Small number of machine might produce the same productivities, yet increasing more machines might be different.
Machine will not produce the same units of products as what the entity want and this lead to poor control on large number of machines. Cost will also increases base on this inefficiency of machine management.
When there are large number of people, the communication will automatically become less effective. Some people, group of people in units, department, and division will feel isolate.
Others costs that are not related to productions costs are increasing while the productions are increasing. For example, transportation costs for delivering goods from factories to the store locations.
When diseconomy is happened?
Some business growth very fast and entity face such situation normally deploys more people or and machines. They expected the cost of products or services will decrease due to increasing the production line and people.
However, managing large workforce and machine is not the same like managing the small group of people and small number of machine. They normally face the problem like we stated above. Therefore, di economic of scale happen.
High Price Competition Industry:
There are a lot of competitors in the market, some entity look into the production costs to let them stay at the competitive price.
Increasing the production believe to be one of the options that help entity decrease marginal costs therefore, entity decided to deployed more people or machines. As the result, diseconomy of scale happen.