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I- Introduction

Price is the selling price per unit customers pay for your product or service. Pricing your

product or service is one of the most important business decisions that firms will make.

Firms should offer a price leading to profitability that target market is willing to pay.

There are many approaches to pricing. The price which is set is the cost to the customer.

Ideally, it should be higher than the costs incurred in producing the product. However,

there will be times to set prices at or below cost for a temporary, specific purpose, such as

gaining market entrance or clearing inventory. How the customer perceives the value of

the product determines the maximum price customers will pay. This is sometimes

described as "the price the market will bear." Somewhere between the cost and "the price

the market will bear" is the right price for product or service. Consequently, once you

understand your costs and your maximum price, you can make an informed decision

about how to price your product or service.

The pricing strategy is another marketing technique you can use to improve your overall

competitiveness. The key to success is to have a well-planned strategy, to establish your

policies and to constantly monitor prices and operating costs to ensure profits.

II- Economists’ Approach to Pricing

Price Elasticity of Demand

If a company raises the price of a product, unit sales ordinarily fall. Because of this,

pricing is a delicate balancing act in which the benefits of higher revenues per unit are
traded-off against the lower volume that results from charging higher prices. The

sensitivity of unit sales to changes in prices is called the price elasticity of demand.

A product's price elasticity should be a key element in setting its price. The price

elasticity of demand measures the degree to which the unit sales of a product or service

are affected by a change in price. Demand for a product is said to be inelastic if a change

in price has little effect on the number of units sold. The demand for designer perfumes

sold by trained personnel at cosmetic counters in department stores is relatively inelastic.

Lowering prices on these luxury goods has little effect on sales volume; factors other than

price are more important in generating sales. On the other hand, demand for a product is

said to be elastic if a change in price has a substantial effect on the volume of units sold.

An example of a product whose demand is elastic is gasoline. If a gas station raises its

prices for gasoline, there will usually be a substantial drop in volume as customers seek

lower prices elsewhere.

Price elasticity is very important in determining prices. Managers should set higher

markups over cost where customers are relatively insensitive to price (i.e., demand is

inelastic) and lower markups where customers are relatively sensitive to price (i.e.,

demand is elastic). This principle is followed in departmental stores. Merchandise sold in

the bargain basement has a much lower markup than merchandise sold elsewhere in the

store because customers who shop in the bargain basement are much more sensitive to

price i.e., demand is elastic.

Profit Maximizing Price

Under certain conditions, it can be shown that the profit-maximizing price can be

determined by marking up variable cost using the following formula:

*[Profit-maximizing markup on variable cost = (Price elasticity of demand / 1 + Price

elasticity of demand) – 1]

*The formula assumes that:

• The price elasticity of demand is constant.

• Total cost = Total fixed cost + Variable cost per unit × q

• The price of the product has no effect on the sales or costs of any other product.
The formula can be derived using calculus.

Using the above markup is equivalent to setting the selling price using this formula:

[Profit-maximizing price = (Price elasticity of demand / 1 + Price elasticity of demand)

Variable cost per unit]

The formula for the profit maximizing price also conveys a very important lesson. The

optimal selling price should depend on two factors--the variable cost per unit and how

sensitive unit sales are to changes in price. In particular, fixed costs play no role in setting

the optimal price. Fixed costs are relevant when deciding whether to offer a product but

are not relevant when deciding how much to charge for the period.

Despite the apparent optimality of prices based on marking up variable costs according to

the price elasticity of demand, surveys consistently reveal that most managers approach

the pricing problem from a completely different perspective. They prefer to mark up

some version of full, not variable, costs, and the markup is based on desired profits rather

than on factors related to demand.

Absorption Costing Approach to Pricing

The absorption costing approach to cost plus pricing differs from the economists'

approach (price elasticity of demand) both in what costs are marked up and in how

markup is determined. Under the absorption costing approach to cost plus pricing, the

cost base is the absorption costing unit product cost rather than variable costing.

For example, let us assume that the management of Ritter Company wants to set the

selling price of a product that has just undergone some design modification. The

accounting department has provided cost estimates for the redesigned product as shown


Per Unit Total

Direct materials $6
Direct labor 4
Variable manufacturing overhead 3
Fixed manufacturing overhead $70,000
Variable selling, general, and administrative expenses 2
Fixed selling, general and administrative expenses 60,000

The first step in the absorption costing approach to cost plus pricing is to compute the

unit product cost. For Ritter Company, this amounts to $20 per unit at a volume of 10,000

units as calculated below:

Direct materials $6
Direct labor 4
Variable manufacturing overhead 3
Fixed manufacturing overhead ($70,000 / 10,00 units) 7
Unit product cost $20

Ritter Company has a general policy of marking up unit product costs by 50%. A price

quotation sheet for the company prepared using the absorption costing approach is

presented below:
Direct materials $6
Direct labor 4
Variable manufacturing overhead 3
Fixed manufacturing overhead (based on 10,000 units) 7
Unit product cost 20
Markup to cover selling, general, and administrative expenses and desired
profit--50% of unit manufacturing cost
Target selling price $30

Note that selling, general and administrative (SG&A) costs are not included in the cost

base. Instead, the markup is supposed to cover these expenses. Let us see how some

companies compute these markup percentages.

Disadvantages and Limitations with the Absorption Costing Approach:

Using the absorption costing approach, the pricing problem looks deceptively simple.

All you have to do is calculate cost, decide how much profit you want, and then set your

price. It appears that you can ignore demand and arrive at a price that will safely yield

profit whatever profit you want. However, as noted above, the absorption costing

approach relies on a forecast of unit sales. Neither the markup nor the unit product cost

can be computed without such a forecast. The absorption costing approach essentially

assumes that the consumers need the forecasted sales and will pay whatever price the

company decides to charge. However, customers have a choice. If the price is too high,

they can buy from a competitor or they may choose not to buy at all. Suppose, for

example, that when Ritter Company sets its price at $30, it sells only 7,000 units rather

than the 10,000 units forecasted. As shown in above calculations, the company would

then have a loss of $25,000 on the product instead of a profit of $20,000. Some managers

believe that the absorption costing approach to pricing is safe. This is an illusion. This
approach is safe only as long as customers choose to buy at least as many units as

managers forecasted they buy.

Rather than focusing on costs--which can be dangerous if forecasted unit volume does

not materialize--many managers focus on customer value when making pricing decisions.

Target Costing Approach to Pricing:

In traditional costing system it is presumed that a product has already been developed,

has been costed, and is ready to be marketed as soon as a price is set. In many cases, the

sequence of events is just the reverse. That is, the company already knows what price

should be charged, and the problem is to develop a product that can be marketed

profitably at the desired price. Even in this situation, where the normal sequence of

events is reversed, cost is still a crucial factor. The company can use an approach called

target costing.

Target costing is the process of determining the maximum allowable cost for a new

product and then developing a prototype that can be profitably made for that maximum

target cost figure. A number of companies--primarily in Japan--use target costing,

including Compaq, Culp, Cummins Engine, Daihatsu Motors, DaimlerChrysler, Ford,

Isuzu Motors, ITT, NEC, and Toyota etc.

The target costing for a product is calculated by starting with the product's anticipated

selling price and then deducting the desired profit. Following formula or equation

further explains this concept:

Target Cost = Anticipated selling price – Desired profit

The product development team is then given the responsibility of designing the product

so that it can be made for no more than the target cost.

Following set of activities further explains the concept of target costing technique:


Determine Customer Wants and Price Sensitivity

Planned Selling Price is Set

Target Cost is Determined As: Selling Price Less Desired

Teams of Employees from Various Areas and Trusted
Vendors Simultaneously

Determine Determine
Design Product Manufacturing Necessary Raw
Process Materials

Costs are Considered Throughout this Process. The Process
Requires Trade-offs to Meet Target Costs

Once Target Cost is Achieved the Manufacturing Begins and
Product is Sold

The target costing approach was developed in recognition of two important

characteristics of markets and costs. The first is that many companies have less control
over price than they would like to think. The market (i.e., supply and demand) really

determines prices and a company that attempts to ignore this does so at its peril.

Therefore, the anticipated market price is taken as a given in target costing. The second

observation is that most of the cost of a product is determined in the design stage. Once a

product has been designed and has gone into production, not much can be done to

significantly reduce its cost. Most of the opportunities to reduce cost come from

designing the product so that it is simple to make, uses inexpensive parts, and is robust

and reliable. If the company has little control over market price and little control over

cost once the product has gone into production, then it follows that the major

opportunities for affecting profit come in the design stage where valuable features that

customers are willing to pay for can be added and where most of the costs are really

determined. So that it is where the effort is concentrated--in designing and developing the

product. The difference between target costing and other approaches to product

development is profound. Instead of designing the product and then finding out how

much it costs, the target cost is set first and then the product is designed so that the target

cost is attained.

Advantages and Disadvantages of Target Costing Approach:

Target costing has the following main advantages or benefits:

1. Proactive approach to cost management.

2. Orients organizations towards customers.

3. Breaks down barriers between departments.

4. Implementation enhances employee awareness and empowerment.

5. Foster partnerships with suppliers.

6. Minimize non value-added activities.

7. Encourages selection of lowest cost value added activities.

8. Reduced time to market.

Target costing approach has the following main disadvantages or limitations:

1. Effective implementation and use requires the development of detailed cost data.

2. its implementation requires willingness to cooperate

3. Requires many meetings for coordination

4. May reduce the quality of products due to the use of cheep components which

may be of inferior quality.

Pricing objectives of service firms

Profit maximization  Achievement of satisfactory

Sales maximization  Achievement of satisfactory sales
Market share maximization  Achievement of a satisfactory market
Market share increase  Cost coverage
Return on investment (ROI)  Return on assets (ROA)
Coverage of the existing capacity  Liquidity maintenance and achievement
Price differentiation  Service quality leadership
Distributors’ needs satisfaction  Creation of prestige image for the company
Price stability in the market  Price wars avoidance
Sales stability in the market  Market development
Discouragement of new competitors’  Price similarity with competitors
Maintenance of the existing customers  Customers’ needs satisfaction
Determination of “fair” prices for customers  Attraction of new customers
Long-term survival  Achievement of social goals

Time and Material Pricing in Service Companies:

Some companies--particularly in service industries-- use a variation of cost plus pricing

called time and material pricing. Under this method, two pricing rates are established--

one based on direct labor time and other based on the cost of direct materials used. This

pricing method is used in repair shops, in printing shops, and by many professionals such

as physicians and dentists. The time and material rates are usually market determined. In

other words, the rates are determined by the interplay of supply and demand and by

competitive conditions in the industry. However, some companies set the rates using a

process similar to the process followed in the absorption costing approach to cost plus

pricing. In this case, the rates include allowances for selling, general and administrative

expenses; other direct and indirect costs; and a desired profit. This page will show how

the rates might be set using the cost-plus approach.

Time Component:

The time component is typically expressed as a rate per hour of labor. The rate is

computed by adding together three elements:

1. The direct costs of the employee, including salary and fringe benefits.

2. A pro rata allowance for selling, general, and administrative expenses of the


3. An allowance for a desired profit per hour of employee time.

In some organizations (such as a repair shop), the same hourly rate will be charged

regardless of which employee actually works on the job; in other organizations, the rate

may vary by employee. For example, in a public accounting firm, the rate charged for a
new assistant accountant's time will generally be less than the rate charged for an

experienced senior accountant or for a partner.

Material Component:

The material component is determined by adding a material loading charge to the

invoice price of any materials used on the job. The material loading charge is designed to

cover the costs of ordering, handling, and carrying materials in stock, plus a profit margin

on the materials themselves.

Example of Time and Material Pricing:

To provide a numerical example of time and material pricing, consider the following:

Quality Auto Shop uses time and material pricing for all of its repair work. The following

costs have been budgeted for the coming year:

Repairs Parts
Mechanics' wages $300,000
Service manager--salary 40,000
Parts manager--salary $36,000
Clerical assistant--salary 18,000 15,000
Retirement and insurance--16% of salary and wages 57,280 8,160
Supplies 720 540
Utilities 36,000 20,800
Property taxes 8,400 1,900
Depreciation 91,600 37,600
Invoice cost of parts used 400,000

Total budgeted cost

The company expects to bill customers for 24,000 hours of repair time. A profit of $7 per

hour of repair time is considered to be feasible, given the competitive conditions in the

market. For parts, the competitive markup on the invoice cost of parts used is 15%.

The following schedule shows the calculation of the billing rate and the material loading

charge to be used over the next year.


Time Component: Parts: Material

Repairs Loading Charge
Total Total Percent**
Cost of mechanics' time:
Mechanics' wages $300,000
Retirement and insurance (16% of wages) 48,000
Total cost 348,000 $14.5
For repairs--other cost of repair service. For
parts--cost of ordering handling, and storing
Repairs service manager--salary 40,000
Parts manager salary $36,000
Clerical assistant salary 18,000 15,000
Retirement and insurance (16% of salaries) 9,280 8,160
Supplies 720 540
Utilities 36,000 20,800
Property taxes 8,400 1,900
Depreciation 91,600 37,600
-------- ---------
Total cost 204,000 8.50 120,000 30%
-------- --------
Desired profit:
24,000 hours × $7per hour 168,000 7.00
15% × $400,000 60,000 15%
------- ------- ------- -------
Total amount to be billed $720,000 $30.00 $180,000 45%
====== ===== ====== ====
*Based on 24,000 hours
**Based on $400,000 invoice cost of parts. The charge for ordering, handling, and
storing parts, for example, is computed as follows: $120,000 cost / $400,000 invoice
cost = 30%

Note that the billing rate, or time component, is $30 per hour of repair time and the

material loading charge is 45% of the invoice cost of parts used. Using these rates, a

repair job that requires 4.5 hours of mechanics time and $200 in parts would be billed as


Labor time: 4.5 hours $30 per hour $135

Parts used:
Invoice cost $200
Material loading charge: 45% $200 90 290
-------- ------
Total price of the job $425

Rather than using labor hours as the basis for calculating the time rate, a machine shop, a

printing shop, or a similar organization might use machine-hours.

This method of setting prices is a variation of the absorption costing approach. As such, it

is not surprising that is suffers from the same problem. Customers may not be willing to

pay the rates that have been computed. If actual business is less that the forecasted 24,000

hours and $400,000 worth of parts, the profit objectives will not be met and the company

may not even break even.

According to Mckinsey Company’s consultants, the fastest and most effective way for a firm to

achieve maximum profit is to get its price right (Marn and Rosiello, 1992). These consultants

reported that a 1 percent price improvement generates an average of 11.1 percent increase in

profits among the 2,462 companies they studied. Given the importance of price in generating
revenues and profits for a company, the approach used by service firms in price setting has

been relatively unsophisticated. In an attempt to identify problems and strategies in service

marketing, Zeithaml et al. (1985) found that cost-oriented pricing was the most popular

approach used by service firms. Although this method offers some advantages, the simplistic

nature of cost-oriented pricing is not effective in a complex and competitive business world. As

consumers have become more sophisticated and demanding, it is imperative that service firms

be adapted to this changing environment when setting prices. The objective of this paper is to

develop a service pricing approach by which price setting can be related more closely to the

realities of business complexity such as market competition, cost structure, price/demand

sensitivity and unique service characteristics. First, we will review the advantages and

disadvantages of six service pricing approaches, which have been presented and discussed in

the service literature. These pricing approaches include:

(1) Traditional cost-oriented approach;

(2) Traditional competitive-oriented approach;

(3) Extended cost-oriented approach (Hoffman and Arnold, 1989);

(4) Differentiation premium approach (Arnold et al., 1989);

(5) client-driven approach (Ratza, 1993); and

(6) Bundle pricing approach (Guiltinan, 1987).

Then, based on the review, a multi-step synthetic pricing approach for service marketing

will be developed.

Pricing approaches of service marketing

There are more than the above six pricing approaches in service marketing literature. For example,

skimming pricing strategy and penetration pricing strategy are suggested for new services (Dean,

1970). This paper only covers these six pricing approaches because of their managerial implications
for price setting in service firms. We will first describe briefly each pricing approach and then

evaluate its strengths and weaknesses.

Two traditional approaches: cost-oriented pricing approach and competitive-oriented pricing


cost-oriented approach and competitive-oriented approach are the two traditionally dominant pricing

approaches in the service industry. A cost-oriented pricing approach sets a service price based on

all the costs plus a desirable profit margin (Beard and Hoyle, 1976; Dearden,1978). It is usually based

on full cost, but it can also be a contribution and incremental basis. For competitive-oriented pricing

approach, the price is set to meet the market competitive situation (Kotler and Bloom, 1984). The

simplistic nature of these two pricing approaches provides the advantage of a useful and quick pricing

method. On the other hand, the simplicity of these two pricing approaches also causes them to lose

their effectiveness as the business world becomes more dynamic and complex (Guiltinan, 1987). In

general, a competitive-oriented service pricing approach provides no guidance on how much higher or

lower than a competitor’s price a service provider should set its price (Arnold et al., 1989). Also most

cost-oriented service pricing strategies suffer several limitations including:

• not considering supply and demand;

• not maximizing profit; and

• not incorporating unique service characteristics and selling conditions into the decisions (Hoffman

and Arnold, 1989).

Extended cost-oriented pricing approach

Hoffman and Arnold (1989) proposed an extended cost-oriented pricing approach for professional

service providers. The model included the traditional cost-oriented pricing factors of fixed costs,

variable costs and the firm’s profit goals, along with the factors that make up the extended model:

essentiality – the extent to which the purchase of the service is postponable, durability, value added,

and the percentage of performance capacity. The factors influencing service pricing can be partitioned

into three parts:

(1) Traditional factors: variable cost (VC), fixed cost (FC) and profit goal (PG);
(2) Unique premium characteristics: essentiality (Ep), durability (DURp) and tangibility (value


(3) Percentage of performance capacity used.

To formulate a service price, first, a service manager needs to determine a proper cost basis (FC +

VC) for a particular service. Second, the cost used in the pricing basis should be adjusted by the

percentage capacity of fixed cost actually consumed for delivering a service. For example, if a service

performance consumes less than 100 percent capacity, then a marginal or contribution cost basis

should be used rather than a full cost basis. Third, add a differentiated service characteristics premium

(SCP), which is derived by comparing service characteristics with average market competitors or a

target competitor, into the adjusted pricing basis. The term “premium” is used to indicate pricing

above the market. Hoffman and Arnold (1989) summarized their model as follows:

Pc(SL) = { VC + (PC * FC) + PG } * { 1 + SCP }

|–– pricing basis –––| |–– SCP ––|

|–– pricing basis –––| |–– SCP ––|

(Ep) + (DURp) + V*

SCP = ––––––––––––––––––– (it assumed equal weights)


Pc = professional service price based on the extended cost approach;

(SL) = standard limits;

VC = variable costs;

FC = fixed cost;

PC = production capacity needed for delivering service;

PG = profit goal;
SCP = service characteristics premium;

Ep = essentiality premium;

DURp = durability premium;

V* = tangible intrinsic value-added.

In contrast to traditional cost-oriented approaches, the major advantage of the extended cost-oriented

approach is that it incorporates premium factors into managerial profit-pricing consideration. Also, the

extended approach, to a certain extent, considers the competitive advantages of product differentiation

in service pricing. The major disadvantage is that the service characteristic premium increases the

complexity of the pricing task. Premium factors are very difficult to evaluate objectively with a

monetary term. Also, it is reasonable to believe that there should be more than the three premium

factors shown in the model.

Differentiation premium pricing approach

Arnold et al. (1989) also proposed a premium service pricing approach which incorporates into the

firm’s pricing strategy recognition of the ability to differentiate the firm’s competitive advantages

from those of competitors. The differentiation premium (DP) comes from four factors:

(1) Availability premium (Ap);

(2) Reputation testability premium (Rtp);

(3) Commitment incentive premium (CIp); and

(4) Price sensitivity premium (Psp).

Each of these factors ranges from +1 to –1. The service differentiation premium price (Pdp) is equal to

this differentiation premium plus an average competitors’ price (ACP). The relationships can be

shown as follows:
DP = f (Ap, Rtp, CIp, Psp)

Pdp(SL) = ( 1 + DP ) * (ACP)


Pdp = differentiation premium price after SL adjustment;

DP = differentiation premium;

Ap = availability premium;

Rtp = reputation testability premium;

CIp = commitment incentive premium;

Psp = price sensitivity premium;

ACP = average competitor’s price;

(SL) = governmental or industrial price standard limit

According to Arnold et al. (1989) availability refers to the number of services as well as the types of

services available to the consumers. Reputation testability refers to the degree to which the service

performance can be evaluated objectively prior to consummation. Arnold et al. (1989) used the term

reputation testability, therefore, we used the same term. Reputation testability would be related to

search, experience and credence qualities (Darby and Karni 1973; Nelson, 1974) with reputation being

of greater importance for credence quality services. Commitment incentive refers to the relationship

between profitability and the duration of the commitment between the service provider and its

customer(s). This relationship can have a major influence on a pricing strategy. Price sensitivity

depends on the number of service alternatives of which consumers are aware. In general, the positive

differentiation premium is associated with:

• Higher service availability;

• Better reputation and less perceived risk of services;

• Stronger commitment incentive of customer loyalty and long-term relationship; and

• Less price sensitivity resulting from service customerization and product differentiation
Client-driven pricing approach

Ratza (1993) developed a client driven model for service pricing. The model is based entirely on

clients’ response to price, namely the quantity of service used and the number of clients gained or lost.

The major advantages of this model are: consideration of the relationship between market share

(demand) and price; and maximizing short-term and long-term profit. The major disadvantage of his

model is that it is built on the economic assumption of static equilibrium along with zero marginal cost

and constant/or linear consumption. Because service firms compete in dynamic and changing

environments, this approach has the problem of being too simplistic. In addition, it is not easy for a

firm to acquire complete chronological firm based sales (demand) and price data for simulation

purposes, especially for a service innovation or a newly offered service. Besides, stabilizing market

price is one of the major tasks of marketing managers. A frequently fluctuating pricing strategy may

damage the company’s image. For future model modification, instead of depicting the relationship

between price and the entire firm’s demand, it is more practical to focus on individual client’s

price/demand relationships, particularly for institutional customers or large volume customers.

Bundle pricing approach

According to Guiltinan (1987), “Broadly defined, bundling is the practice of marketing two or more

products or services in a single package for a special price”. The rationales for service bundling are:

the cost structure consists of a high degree of cost sharing and a high ratio of fixed cost to variable

cost (Dearden, 1978); and the demand for a firm’s services is generally interdependent. From an

economic viewpoint, Schmalensee (1984, p. 277) stated:

The advantage of pure bundling is its ability to reduce effective buyer

heterogeneity, while the advantage of unbundled sales is its ability to collect a

High price for each good from some buyers who care very little for the other.

Mixed bundling can make use of both of these advantages by selling the bundle

to a group buyers with accordingly reduced effective heterogeneity, while

changing high markups to those on the fringes of the taste distribution who are

mainly interested in only one of the two goods.

Operationally, a firm ultimately must determine a specific price discount which is computed from the

combined prices of two or more individual service items. Thus, before a “package price” of bundled

services can be formed, the individual price of each service has to be formulated. This approach

requires more knowledge of specific costs, demand elasticity and cross-elasticity and reservation price

distributions. Although the bundle pricing approach is much more complicated than the previous five

pricing approaches, the use of bundle pricing appears to have been expanded significantly in recent

years, especially for consumer services (Guiltinan, 1987).

None of the above service pricing approaches fulfills simultaneously the considerations of

demand/supply, profit, unique service characteristics and cost structure. This does not mean the above

pricing approaches are not useful. Rather, it reflects the complexity and difficulty of pricing in the real

business world. In fact, pricing is one of the most critical pressures of top executives (Anonymous,

1987). Although it may be too much to expect a single pricing approach to include all the pricing

considerations, there exists a need for a better pricing approach. Two observations can be made from

the pricing approaches reviewed in previous sections. First, a complete pricing model is likely to be

complicated because more pricing variables have to be included. Second, instead of using one single

pricing approach, a better way may be the use a group of pricing approaches to set service prices. The

following section discusses a multi-step synthetic approach to service pricing.

A multi-step synthetic service pricing approach

A multi-step synthetic service pricing approach is proposed to deal with the complexity of market
competitiveness, cost structure, profit goals, price/demand sensitivity and service unique

characteristics. To set a proper service price, the proposed pricing approach combines the pricing

decision process and the other pricing approaches rather than using a singular

approach. Thus the term “synthetic” is used.

Pricing scenario

The multi-step synthetic pricing approach contains six steps as shown in Figure 1. The first step is to

determine market positioning for the service and to identify competitors. As is well known, price

setting cannot be formulated solely without considering marketing objectives, market competitiveness

and other marketing variables. Market positioning and targeting competitors can clarify the directions

of price setting and verify the role of price in the marketing mix. The main objective of this step is to

decide a proper comparable pricing basis for further calculation of a differentiation premium price. In

their model, Arnold et al. (1989) suggested using the average competitors’ price as a pricing basis.

Certainly, many different pricing bases can be used as long as they are logical and reasonable.

However, for discussion purposes, the average competitors’ price is adopted. The pricing basis can be

either an unbundled price or a bundled-package price. The second step is to formulate a market

premium service price (MPC). Essentially, the same concept of differentiation premium approach

suggested by Arnold et al. (1989) is used. Based on some chosen criteria of service performance, a

service provider can examine the target competitors’ strategies to develop a unique service

differentiation premium (SDP), which is superior (or inferior) to the competitors.

The market premium price (MPC) is then formulated as:

MPC = ( 1 + SDP ) * (target/or competitors’ average price)


MPC = market premium price;

SDP = service differentiation premium.

MPC actually is a competitive-oriented price approach. This reflects the market competitiveness

through market comparison. To form a differentiation premium, many unique service characteristics

can be used. For example, those unique service characteristics such as availability, reputation,

commitment incentive, price sensitivity (Arnold etal., 1989), essentiality, durability, tangible value

(Hoffman and Arnold, 1989), access, communication, courtesy, reliability, security, responsiveness

(Parasuraman et al., 1985), and industrial unique attributes (Bonnici, 1991;Parasuraman et al., 1985;

Segal, 1991) can be considered.

The third step is to formulate a cost-plus price (CPP). CPP is computed by the traditional cost-oriented

pricing approach along with the adjustment ofHoffman and Arnold’s (1989) percentage of production

capacity used in a particular service delivery. The formula can be written as:

CPP = { VC + ( PC * FC ) + PG }


CPP = internal cost-plus price;

VC = variable cost;

FC = fixed cost;

PC = production capacity needed for the delivering purpose;

PG = profit goal.

CPP serves the role of internal profit-cost control. Essentially, CPP is a managerial expected price

which contributes a desirable profit to a service firm. CPP is only an internal planning result and needs

to be balanced with external market feedback (price competition). The fourth step is to compare MPC

with CPP. If MPC is greater than or equal to CPP, then MPC is the chosen service price (SP) and then

moves to the adjustment of price standard limits (SL). Conversely, if MPC is smaller than CPP, a

service provider has two choices. One is to take MPC as a chosen service price. After all, CPP is only

an internal goal and a self guidance item for managerial purposes. MPC, rather than CPP, represents

the reality of market competition. The other option is to improve the service differentiation premium
(SDP) to achieve the desirable profit-pricing goal. The SDP premium can be increased through either

marketing efforts or service improvement. After a SP is chosen, it needs to be checked whether or not

the SP fits within the range of price standard limits (SL). If the chosen SP does not lie within standard

pricing limits, then the SP will be replaced by either a SL ceiling price (if the SP is higher than SL

ceiling price) or a SL floor price (if the SP is lower than SL floor price). Therefore, the SP after SL

adjustment can be expressed as:

SP(SL) = f (SP, SL-ceiling price, SL-floor price)


SP(SL) = service price after adjusted by price standard limits;

SL = governmental or industrial price standard limits.

In the last step, SP(SL) is modified by a client–driven consideration derived from Ratza’s (1993) pricing

concept. The objective is to pursue maximum profit from individual clients or a homogeneous group

of clients. Instead of using the entire company’s demand, it is suggested that the clients be segmented

into at least two categories: institutional or large-volume clients; and general clients. It is logical to

believe that heterogeneous groups will have different price elasticities. The more homogeneous groups

are segmented, the more precise price sensitivity can be estimated.