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An organization’s objectives determine the desired results of pricing policies. Strategies are the means by which these objectives are achieved. Before discussing pricing strategies, it is useful to lay the ground work for analyzing the underlying factors that influence price decisions. Four important bases for price determination can be identified:

1. What it costs to produce a service
2. The amount that consumers are prepared to pay for it
3. The price that competitors are charging
4. The constraints on pricing that are imposed by regulatory bodies.

The cost of producing a service represents a minimum price that a commercial organization would be prepared to accept over the long term for providing the service. The maximum price achievable is that which customers are prepared to pay for the service. This will itself be influenced by the level of competition available to the customers to satisfy their needs elsewhere. Government regulation may intervene to prevent organizations charging the maximum price that consumers would theoretically be prepared to pay.

Costs as a basis for pricing

A "cost-plus" pricing system works by using historical cost information to calculate a unit cost for each type of input used in a service production process. Subsequent price decisions for specific service outcomes are based on the number of units of inputs used, multiplied by the cost per unit, plus a profit margin.

There are many reasons why "cost-plus" type pricing methods are so widely used in the services sector:

• Prices are easy to calculate and allow the delegation of price decisions for services which have to be tailored to the individual needs of customers.
• Where an agreement is made to provide a service, but the precise nature of the service which will actually be provided is unknown at the outset, a contract may stipulate that the final price will be based in some way on costs.
• Trade and professional associations often include codes of conduct which allow a service provider only to increase prices beyond those originally agreed in an estimate on the basis of the actual costs involved.

Against these attractions, pricing services on the basis of historic costs present a number of problems:

• In itself, cost-based pricing does not take account of the competition which a particular service faces at any given time, nor of the fact that some customers may value the same service more highly than others.
• Calculating the costs of service can in fact be very difficult, and often more difficult than in the case of goods. One reason for this is the structure of costs faced by many services businesses.
• While it may be possible to determine costs for previous accounting periods, it can be difficult to predict what these costs will be in the future. This is a particular problem for services which are contracted to be provided at some time in the future.

Cost Structures

The costs of producing a service can be divided into those which are variable and those which are fixed. Variable costs increase as service production increases, whereas fixed costs remain unchanged if an additional unit of service is produced. Fixed costs therefore cannot be attributed to any particular unit of output. In between these two extremes are semi-fixed costs which remain constant until a certain level of output is reached, when expenditure on additional units of productive capacity is needed. The particular problem of many services industries is that fixed costs usually represent a very high proportion of total costs, resulting in great difficulty in calculating the cost of any particular unit of service.

Marginal Cost Pricing

A special kind of cost-based pricing occurs where firms choose to ignore their fixed costs. The price which any individual customer is charged is based not on the total unit cost of producing it, but only the additional costs which will result directly from servicing that additional customer. It is used where the bulk of a company’s output has been sold at a full price which recovers its fixed costs, but in order to fill remaining capacity, the company brings its prices down to a level which at least covers its variable, or avoidable costs. Marginal cost pricing is widely used in service industries with low short-term supply elasticity and high fixed costs, like airline industries.

Against the attraction of filling spare capacity and getting a contribution towards fixed costs where otherwise there would have been none, marginal cost pricing does have its own problems. The biggest danger of pricing on this basis is that it can be taken too far, allowing too high a customer proportion to be carried at marginal cost, with insufficient customers charged at full price to cover the fixed costs. Another problem is that it may devalue customers’ perception of a service. If a service promoted for its prestige value can be sold for a fraction of its original price, it may leave potential customers wondering just what the true value of the service is. It may also cause resentment from customers who had committed themselves to a service well in advance, only to find that their fellow consumers obtained a much lower price by booking later (and thereby also make marketing planning much more difficult for many service operators). Companies can try to overcome problems of marginal cost pricing by differentiating the marginally cost product from that which is purchased at full price.

Demand-based Pricing

The upper limit to the price of a service is determined by what customers are prepared to pay. In fact, different customers often put differing ceilings on the price which they are prepared to pay for a service. Successful demand-oriented pricing is therefore based on effective segmentation of markets to achieve the maximum price from each segment. Price discrimination, as it is often called, can be carried out on the basis of:

• discrimination between different groups of users
• discrimination between different points of use
• discrimination between different types of use

Price discrimination between different groups of users

Effective price discrimination requires groups of consumers to be segmented in such a way that maximum value is obtained from each segment. Sometimes, this can be achieved by offering the same service to each segment, but charging a different price. The rationale could be that this segment is more price-sensitive than other segments, and therefore additional profitable business can only be gained by sarcificing some element of margin. By creating more sales, even at lower price, the service provider may end up having increased total revenue from this segment, while still preserving the higher prices charged to other segments.

On other occasions, the service offering is slightly differentiated and targeted to segments who are prepared to pay a price which reflects its differential advantages. This is particularly important where it is impossible or undesirable to restrict availability of lower price to certain predefined groups.

The intangibility and inseparable nature of services make the possibilities for price discrimination between different groups of users much greater than is usually the case with manufactured goods. Goods can be purchased easily by one person, stored and sold to another person. Because services are produced at point of consumption, it is possible to control the availability of services to different segments.

Price discrimination between different points of consumption

Service organizations frequently charge different prices at different service locations. The inseparability of service production and consumption results in service organizations defining their price segments both on the basis of the point of consumption and the point of production.

Some production locations may offer unique advantages to consumers. Unlike goods, service offering cannot be transferred from where it is cheapest to produce to where it is most valued, hence service providers can charge higher prices at premium sites.

Price discrimination by time of production

Goods produced in one period can usually be stored and consumed in subsequent periods. Charging different prices in each period could result in customers buying goods for storage when prices are low, and running down their stockpiles when prices are high. Because services are instantly perishable, much greater price discrimination by time is possible.

Services often face uneven demand which follows a daily, weekly, annual, seaonsal, cyclical, or random pattern. At the height of each peak, pricing is usually a reflection of:

• the greater willingness of customers to pay higher prices when demand is strong
• the greater cost which often results from service operators trying to cater for short peaks in demand.

Auctions and one-to-one pricing

Price discrimination between groups sound fine in theory, but there can be problems in actual implementation. First, it can be very difficult to identify homogeneous segments in terms of individuals’ responsiveness to price changes. Second, it can be very difficult to predict just what level of price will be acceptable to that group and a lot of trial and error may be necessary to establish the most appropriate price. One alternative adopted by some companies is to leave price determination to a process of individual negotiation between buyer and seller. For high-value commercial goods and services, individual negotiation of prices has been quite commonplace. But in the case of mass-market services, the existence of a published price list has simplified the process of exchange for buyer and seller who do not need to spend time negotiating a price on each occasion that a relatively low-value service is sought. Auctions have been used for some consumer sales, but mainly for high-value goods such as antiques. The emergence of Internet-based auction sites has offered new opportunities for services to set prices of relatively low-value services.

While auctioning of services to the highest bidder has numerous attractions, there are also problems. An auction may be fine in the short term for clearing spare capacity, but in itself does nothing to develop strong brand values. In fact, auctions may treat a service like a commodity in which the only distinguishing feature is price. Auctions can be administratively difficult to administer, even with the use of Internet. It can be difficult to control auction sites that bidders actually buy the services they have successfully bid for. Many consumers would prefer the certainty of fixed prices rather than take a chance with an auction where neither the availability of a specific service or its price can be guaranteed.

Customer lifetime pricing

The development of ongoing buyer-seller relationships is becoming a much more important part of business strategy. Rather than seeing each transaction in isolation, companies are trying to view each transaction with a customer in the context of those that have gone before, and those that they hope will occur in the future. Information technology is increasingly allowing companies to track individual customers and to charge a price which is appropriate to their position in the relationship life cycle.

A very low price may be needed to tempt a customer to try a supplier in the first place. With repeated transactions, a company can build up a picture of a customer’s price sensitivity with regard to different types of services. As the relationship develops, the nature of the service may become tailored to the precise needs of the customer, such that the customer will be quite happy to pay a higher price in return for the benefit received. To switch to a lower cost provider would involve the psychological cost of searching and explaining their needs to a new supplier and understanding their service production systems.

Sometimes, there may be financial as well psychological switching costs when a relationship develops into some form of structural tie between the buyer and the seller. A commercial customer may have invested heavily in a computer software system and switching to another company for service support or upgrades may be very expensive.

Sometimes, inertia sets in and a supplier may try to raise its prices in the expectation that the buyer could not be bothered to shop around. Many customers of telephone companies do not switch to cheaper alternatives because the psychological cost of doing so is seen as too great in relation to the likely financial benefits.

Competitor-based Pricing

There are very few situations where an organization can set its prices without taking account of the activities of its competitors. Just who the competition is against which prices are to be compared needs to be carefully considered, for competition can be defined in terms of the similarity of the service offered, or merely similar in terms of the needs which a product satisfies.

Having established what market it is in and who the competition is, an organization must establish what price position it seeks to adopt relative to its competitors. This position will reflect the service’s wider marketing mix strategy, so if the company has invested in providing a relatively high-quality service whose benefits have been effectively promoted to target users, it can justifiably pitch its price level at a higher level than its competitors.

For services targeting similar subsegments of a market, the pricing decisions of competitors will have a direct bearing on an organization’s own pricing decisions. Price in these circumstances is used as a tactical weapon to gain short-term competitive advantage over rivals. In a market where the competitors have broadly similar cost structures, price cutting can be destabilizing and result in costly price wars with no sustainable increase in sales or profitability.

Going rate pricing

In some service markets which are characterized by a fairly homogeneous service offering, demand is so sensitive to price that a firm would risk losing most of its business if it charged just a small amount more than its competitors. On the other hand, charging any lower would result in immediate retaliation from competitors. For example, an area where a number of restaurants cluster closely together and offering a basically similar service at a similar price, the "Dish of the Day" may be set at the going rate for the price sensitive diner while more specialized dishes for which there is less direct competition are priced at a premium rate.

Where cost levels are difficult to establish, charging a going rate can avoid the problems of trying to calculate costs. For example, it may be very difficult to calculate the cost of renting a video film, as the figure will be very much dependent upon the assumptions made about the number of uses which the initial purchase cost can be spread over. It is much easier to take price decisions on the basis of the going rate among nearby competitors.

Sealed-bid pricing

Many industrial services are provided by means of a sealed-bid tendering process where interested parties are invited to submit a bid for supplying services on the basis of a pre-determined specification. In the case of many government contracts, the organization inviting tenders is often legally obliged to accept the lowest priced tender, unless exceptional circumstances can be proved. Price therefore becomes a crucial concern for bidders, regardless of their efforts to build up long-term brand values which in other markets might have allowed them to charge a premium price. The first task of a bidding company is to establish a minimum bid price based on its costs and required rate of return, below which it would not be prepared to bid. The more difficult task is to try to put a maximum figure on what it can bid. This will be formed on expectations of what its competitors will bid, based on an analysis of their strengths and weaknesses.

New Service Pricing Strategy

In developing a pricing strategy for a new service, two key issues need to be addressed:

1. What price position is sought for the service?
2. How novel is the service offering?

The choice of price position cannot be separated from other elements of the marketing mix. For many consumer services, the price element can itself interact with the product quality element of a positioning strategy. This can happen where consumers have difficulty in distinguishing between competing services before consumption, and the price charged is seen as an important indication of the quality of the service. Private consumers choosing a painter or decorator with no knowledge of their previous work record may be cautious about accepting the cheapest quotation on the basis that it may reflect an inexperienced decorator with a poor quality record.

The novelty of a new service offer can be analyzed in terms of whether it is completely new to the market, or merely new to the company providing it, but already available from other sources. In the case of completely new innovative services, the company will have some degree of monopoly power in its early years. On the other hand, the launch of a "me too" service to compete with established services is likely to face heavy price competition from its launch stage. The distinction between innovative services and copycat services is the basis of two distinct pricing strategies — "price skimming" and "saturation pricing".

Price skimming strategy

Most completely new product launches are aimed initially at the segment of buyers who can be labelled as "innovators". These are the buyers who have the resources and inclination to be the trend setters in purchasing new goods and services. This group includes the first people to buy innovative services such as telephone banking and mobile phone services. Following these will be a group of early adopters, followed by a larger group often described as the "early majority". The subsequent "late majority" group may only take up the new service once the market itself has reached maturity. Laggards are the last group to adopt a new service and only do so when the product has become a social norm and/or its price has fallen sufficiently.

Price skimming strategies seek to gain the highest possible price from the early adopters. When sales to this segment appear to be approaching saturation level, the price level is lowered in order to appeal to the early adopter segment which has a lower price threshold at which it is prepared to purchase the service. This process is repeated for the following adoption categories.

The art of effective pricing of innovative services is to identify who the early adopters are, how much they are prepared to pay and how long this price can be sustained before competitors come on the scene with imitation service at a lower price. A price skimming strategy works by gradually lowering prices to gain access to new segments and to protect market share against new market entrants. Pricing strategy is therefore closely related to the concept of the product life cycle.

While the above analysis may be true of services bought by private consumers, is the same effect likely to be true for services bought by businesses? Business buyers are less likely to want be a trend setter for its own sake, although individuals within an organization may gain status by being the first to have an innovative service. Sometimes, using a new service ahead of competitors can give a forward-thinking firm a cost advantage over its competitors.

For many innovative services, the trend of falling prices may be further enhanced by falling costs. Lower costs can occur due to economies of scale and also to the experience effect. The latter refers to the process by which costs fall as experience in production is gained. It is of particular strategic significance to service industries, since by pursuing a strategy to gain experience faster than its competitors, an organization lowers its cost base and has a greater scope for adopting an aggressive pricing strategy.

Saturation pricing strategy

Many "new" services are launched as copies of existing competitors’ services. In the absence of unique features, a low initial price can be used to encourage people who show little brand loyalty to switch service suppliers. Once an initial trial has been made, a service provider would seek to develop increased loyalty from its customers, as a result of which they may be prepared to pay progressively higher prices.

The success of a saturation pricing strategy is dependent upon a sound understanding of the buying behavior of the target market, in particular:

• The level of knowledge which consumers have about prices.
  For some services, such as the rate of interest charged on credit cards, consumers typically have little idea of the charge which they are currently paying, or indeed of the "going rate" for such charges. There is now considerable research showing the effects and consumers’ knowledge of prices on their buying behavior. Any attempt to attract new customers on the basis of a differential price advantage may prove unsuccessful if knowledge of prices is low. Other incentives may be more effective at inducing new business. Sometimes, companies offering a diverse range of services may offer low prices on services where price comparisons are commonly made, but charging higher prices on other related services where consumer knowledge is lower.
• The extent to which the service supplier can increase prices on the basis of perceived added value of the service offering.
  The purpose of a low initial price is to encourage new users of a service to try a service and return later, paying progressively higher prices. If the new competitor’s service is perceived to offer no better value than that of the existing supplier, the disloyalty which caused the initial switching could result in a switching back at a later date in response to tactical pricing. Worse still, a new service could be launched and experience teething troubles in its early days, doing nothing to generate a perception of added value.
• The extent to which the service supplier can turn a casually gained relationship into a long-term committed relationship.
  Incentives are frequently offered to lessen the attractiveness of switching away from the brand. This can take the form of a subscription rate for regular purchase of a service, or offering an ever-increasing range of services which together raise the cost to the consumer of transferring their business elsewhere. Banks may offer easy transfers between various saving and investment accounts and in doing so, aim to reduce the attractiveness of moving one element of the customer’s business elsewhere.

In some cases, a high initial uptake of a new service may itself add value to the service offering. This can be true where coproduction of benefits among consumers is important. A low initial price may be critical to gain entry to a market, while raising prices is consistent with increasing value to the users of the service.

Evaluating strategic pricing options

In practice, pricing strategies often contain elements of skimming and saturation strategies. The fact that most new services are in fact adaptations and are easy to copy often prevents a straight-forward choice of strategy. Even when a price strategy has been adopted and implemented, it may run off target for a number of reasons:

• Poor market research may have misjudged potential customers’ willingless to pay for a new service. A service provider may have misjudged the effect of price competition from other services, which although in different form, satisfied the same basic needs.
• Competitors emerge sooner or later than expected. The fact that new services can often be easily and quickly copied can result in a curtailment of the period during which an organization can expect to achieve relatively high prices.
• The effects of government regulation may be to extend or shorten the period during which a company has a protected market for its new market.

Price leader or follower?

Many services markets are characterized by a small number of dominant suppliers and a large number of smaller ones. Perfect competition and pure monopoly are two extremes which rarely occur in practice. In markets which show some signs of interdependency among suppliers, firms can often be described as price makers or price followers. Price makers tend to be those who as a result of their size and power within a market are able to determine the levels and patterns of prices which other suppliers then follow. Price takers tend to have a relatively low size and market share and may lack product differentiation, resources or management drive to adopt a proactive pricing strategy. Smaller firms in a local area may find it convenient to simply respond to pricing policies adopted by dominant firms — to take a proactive role themselves may bring about a reaction from the dominant firms which they would be unable to defend on account of their size and standing in the market.

Service Portfolio Pricing

Multi-output service providers usually set the price of a new service in relation to the prices charged for other services within their portfolio. A number of product relationships can be identified as being important for pricing purposes:

• Optional additional services
  These are services which a consumer chooses whether or not to add to the core service purchase, often at the time that the core service is purchased. As a matter of strategy, an organization could seek to charge a low lead-in price for its core service, but to recoup a higher margin from the additional optional services. Simply breaking a service into core and optional components may allow for the presentation of low price indicators, which through a process of rationalization may be more acceptable to buyers. Research may show that the price of the core service is in fact the only factor which buyers take into account when choosing between alternative services. In this way, many travel agents and tour operators cut their margins on the core holiday which they sell, but make up some of their margin by charging high mark-ups for optional extras such as travel insurance policies and car hire.
• Captive services
  These services occur where the core service has been purchased and the provision of additional services can only be provided by the original provider of the core service. Where these are not specified at the outset of purchasing the core service, or are left up to the discretion of the service provider, the latter is in a strong position to charge a high price. Against this, the company must consider the effect which the perception of high exploitative prices charged for these captive services will have on customer loyalty when a service contract comes due for renewal.
• Competing services
  These occur where a new service targets a segment of the population which overlaps the segments served by other products within the portfolio. By a process of "cannibalization", a service provider could find that it is competing with itself.

Price bundling

Price bundling is the practice of marketing two or more services in a single package for a single price. Bundling is particularly important for services on account of two of their principal characteristics. First, the high ratio of fixed to variable costs which characterize many service organizations makes the allocation of costs between different services difficult and sometimes arbitrary. Second, there is often a high level of interdependency between different types of service output from an organization.

Price bundling of diverse services from an organization’s service porfolio is frequently used as a means of building relationships with customers. Where the bundle of service represents ease of administration to the consumer, the service organization may be able to achieve a price for the bundle which is greater than the combined price of the bundle’s components.

"Pure" bundling occurs where services are only available in a bundled form (e.g. where a tour operator includes insurance in all of its package holidays) whereas "mixed" bundling allows customer to choose which specific elements of the service offering they wish to purchase. As service forms expand their range of service outputs, simple cost-based or price-follower strategies become too simplistic for two reasons. First, as the number of services offered increases, the opportunities for differentiation and bundling are enhanced. Second, the high ratio of fixed to variable costs typical of many service industries make average costing increasingly arbitrary as fixed cost allocations change with the expansion of the service range. Bundling reduces the need to allocate fixed costs to individual service.

A service provider may feel compelled to bundle services in a way which is in accordance with consumers’ expectations, leading to the development of a dominant pricing model. Sometimes, this standard pricing model is challenged by a new entrant, with the result that consumers’ expectations are changed.

Although price bundling may appear attractive to many service organizations, there are dangers that may fall foul of competition legislation. Firms can be held responsible for abusing their position to sell additional services.

Tactical Pricing

In practice, manoeuvrability around the central pricing strategy will be needed to allow detailed, local application of the overall strategy. This is the role of tactical pricing. The distinction between strategic and tactical pricing can sometimes be difficult to draw. In highly competitive, undifferentiated services markets, the development of tactical plans can be all important and assume much greater importance than for a service where an organization has more opportunity for developing a distinctive strategic price position. Some of the tactical uses of pricing are analyzed below:

• Tactical pricing can provide short-term competitive advantage. Periodic price reductions can be a means for inducing potential customers to try a service, whether it is new or established. The price cut can be a general across the board reduction, or it could be targeted (e.g. by the use of vouchers). The extent of the uptake will be dependent on the importance of price comparisions, the extent to which consumers of that type of service typically make casual purchases and are not tied to a relationship with another supplier (e.g. lower single bus fares may result in little additional demand if a large population of travellers are tied to a season ticket with another operator) and consumers’ perceptions of the price offer. Economic rationality may expect that sales of a service will increase as its price is reduced. However, the price reduction may reduce the perceived value of a service, leading to a feeling that its quality has been eroded. Subsequent price increases may lead to the feeling that the service is over-priced if it could be offered previously at a lower price. There may also be significant price points at which a service is perceived as being of good value.
  Even if economic rationality is assumed on the part of the consumers, it can be difficult to predict the effects of a price change. Comparison with previous occasions when price was adjusted assumes that all other factors are the same, whereas in reality, many factors such as the availability of competitors’ services and general macro-environmental considerations require some judgement to be made about how a similar price change might perform this time round.
• Tactical pricing can be used to remove unplanned excess supply. The strategic price position sought by an organization may be incapable of achievement on account of excess supply, both within an organization and within the market generally. A temporary price cut can be used to bring demand and supply back into balance. Pricing can also be used to capitalize on excess demand relative to supply. In addition to removing discount and increasing prices, firms can remove low margin elements from their service portfolio in order to maximize their returns from high margin lines.
• Short-term tactical pricing can be used to protect markets against new entrants. Where a new entrant threatens the existing market of an established supplier, the latter may react with short-term price reductions where price comparisons are commonly made. If the new entrant is a small, opportunist company seeking to make inroads into the larger, dominant firm’s market, a low price may force the new company to respond with low prices, putting strain on its initial cash flow and possibly resulting in its withdrawal from the market, if not ceasing to trade completely.
• Discriminatory pricing with respect to time which may have been part of the strategic pricing can be implemented by a number of tactical programs. Off-peak discounts are frequently used in industries like rail travel, telephone communications and hotels. The converse of peak surcharges can also be employed. Other options like offering added value price bundles at certain periods and subtly altering a price offering and making it available only at certain times (e.g. a restaurant may slightly differentiate lunch from dinner and charge more for the latter on account that customers are more willing to pay more for a social meal in the evening).
• Similarly, discriminatory pricing with respect to place must be translated from a strategic plan to a tactical program. Implementing differential pricing by area is relatively easy for services on account of the difficulty in transferring service consumption. Hotels and ships — among others — often use different price lists for different locations, depending upon the local competitive position, and such lists are often adjusted at short notice to respond to local competitive pressure. Sometimes, a common base price is offered at all of an organization’s service outlets, and tactical objectives are achieved by means of discounts which are only available at certain locations. In some cases, companies advertise a number of core services nationally at a fixed rate, while related services are priced accordingly to local market conditions.
• For discriminatory pricing between different consumer segments, the problem of turning a strategy into a tactical program hinges on the ease with which segments can be isolated and charged different prices. Because services are consumed at point of production, it is often easy to confine price differences within a small segment of the market. Sometimes, the implementation of a highly segmented pricing program can cause problems for service providers where compromise needs to be made between the desire for small, homogeneous segments and the need for segments which are of a worthwhile size to service.
• Tactical pricing programs are used to motivate intermediaries. Where a service is provided through an intermediary, the difference between the price that a customer pays and the amount that the service principal receives represents the intermediary’s margin. In some cases, price sensitivity of the final consumer is low, but awareness of the margins by the intermediary high, requiring tactical pricing to be directed at maintaining the intermediaries’ margins relative to those offered by the competitors. Price charged to the final consumer can also affect an intermediary’s motivation to sell a principal’s service — if the agent perceives the selling price is too high, they may give up trying to promote it in favor of a more realistic and attractive competitor. On the other hand, if the price is too low, the intermediaries working a percentage commission basis may consider that the reward for them is not worth their effort.