How should managers at Astel use product cost information to price Provalue in 2020? Two different approaches for pricing decisions are
The market-based approach to pricing starts by asking, “Given what our customers want and how our competitors will react to what we do, what price should we charge?” Based on this price, managers control costs to earn a target return on investment. The cost-based approach to pricing starts by asking, “Given what it costs us to make this product, what price should we charge that will recoup our costs and achieve a target return on investment?”
Companies operating in competitive markets (for example, commodities such as steel, oil, and natural gas) have to use the market-based approach. The products produced or services provided by one company are highly substitutable with products produced or services provided by others. Companies in these markets must accept the prices set by the market.
Companies operating in less competitive markets offer products or services that differ from each other (for example, automobiles, computers, management consulting, and legal services) and can use either the market-based or cost-based approach as the starting point for pricing decisions. Some companies use the cost-based approach: They first look at costs because cost information is more easily available and then consider customers and competitors. Other companies use the market-based approach: They first look at customers and competitors and then look at costs. Both approaches consider customers, competitors, and costs. Only their starting points differ. Managers must always keep in mind market forces, regardless of which pricing approach they use. For example, building contractors often start bidding on a cost-plus basis but then reduce their prices during negotiations to respond to other lower-cost bids.
Companies operating in markets that are not competitive (for example electric utilities) follow cost-based approaches. That’s because these companies do not need to respond or react to competitors’ prices. The margin they add to costs to determine price depends on the ability and willingness of customers to pay for the product or service. In many of these noncompetitive markets, though, regulators intervene to set prices to limit the profits that companies can earn.
We consider first the market-based approach.