How Do Busines's Decide What to Sell an Item For?

Factual Questions
1

I’ve got ‘zero’ business education or experience.
The year was 1989, I was hired as a prison guard at 21 years old, and my g/f & I moved into our own place. We needed a television desperately.
We had no money, but my credit was good so I went to “The Hudson Bay Company” and charged one on my Visa card. It was a 27 inch RCA tube TV, and the cost was $799.99 + taxes (about 2 week’s net salary)

I always thought companies made a product, tacked on a little profit, and that was that.
Today as I was coming out of the local grocery superstore, they had 27 inch RCA tube TV’s on sale for $149.99
So my question is: I’m assuming they wouldn’t sell these things at a loss, so if you compare the price for the same television from now being $150, and 20 years ago being $800, it makes me wonder how they decide what price to put on their products? Is there a formula they use? How is it done?

I took early retirement recently, but if I were still working, my net salary today would be about $1,750 every 2 weeks. My pay would be more than double, but the same TV is now 1/5th of what it cost 20 years ago. What the heck does the grocery store pay for these TV’s? How can they sell them so cheap and still make a profit?

Thanks
Gus

2

It’s based on two items: What the manufacturer charges for the item (the “cost” or “wholesale” price) and what everyone else (“competitors” or “the marketplace”) are charging for it.

I used to sell electronics (including TVs and DVD players and laptops) and the more expensive the wholesale price, the smaller our markup, as a general rule.

On a $1000 (tax inclusive*) laptop, for example, the cost price was usually around $900 or so. So that $1000 just covered the cost of the laptop, shipping it to the store, our time putting it on display, demonstrating it to the customer, and sales tax. The “profit” was actually in software(MS Office etc), accessories (laptop bags), and extended warranties.

The same was true with TVs and DVD players- the profit was really in antenna cables, RCA cables, HDMI cables, warranties, and so on.

Some items, on the other hand, had a fairly low cost price and a hefty markup; the cost of an antenna cable was around AUD$10 for 2m (6ft), and the cost price on them was, IIRC, about $3.50. Blank CDs and DVDs were also had fairly decent markups on them, from what I recall, as did printer cartridges. (Low-end inkjest printers usually cost less than their replacement cartridges, ironicially)

Of course, sometimes retailers aren’t making a profit when they sell an item- they’re taking a loss on it in the hope you’ll get those profit-boosting extras, or find something else in the store.

Hope that helps answer your question! :slight_smile:

*All prices in Australia are legally required to be tax inclusive

3

All businesses try to get the most profit out of their merchandise as possible. Sometimes, it’s a buyer’s market, sometimes it’s a seller’s market.

I remember going car shopping with my husband, and we were told that the car models that we wanted were not for sale at the sticker price, that the dealership could and did charge a premium over that price. We boggled at the salesman, boggled at each other, and got the hell out of that dealership. However, we knew that this dealership made a LOT of money (we had a friend who worked there) so they must have been doing something right.

I worked in a women’s clothing store for a while. Usually, the formula for pricing the garments was wholesale cost X 2 = retail price, rounded to the nearest dollar and then have a penny knocked off. So, if the buyer got the brand name slacks made of bulletproof polyester at 3 for $25, that was $8.33 per pair, so going by the formula, those pants should have been priced at $16.99. However, we advertised this particular style at $14.99 a pair, so that’s what we sold them as. If we hadn’t done that advertising (and a LOT of women loved those pants, and we had them the cheapest), we certainly would have sold them at seventeen bucks a pair. We didn’t lose money on them, we just didn’t make as much as we could have. Usually, a woman who came in to buy a pair or two also bought a blouse, or some undergarments, or pantyhose, so the slacks were a good way to get women into the store. On the other hand, the buyer was bedazzled by a shipment of sweaters from China, which had zodiac signs embroidered on them. The sweaters looked pretty nice, but they ran extremely small. And by “extremely small” I mean that a size 24 was more like a size 12. They also felt very flimsy, and the workmanship was very shoddy, when one looked at the seams. She was convinced that we could sell these sweaters at seventy five bucks a pop…and we did sell a few at that price. Then we had to lower the price to $49.99, then lower, and lower, and lower…until finally we were giving the sweaters away as a bonus for purchasing a certain dollar amount. The buyer paid $2.50 per sweater, and I think that we actually LOST money on the whole shipment, as she bought an amazing amount of those sweaters, which meant that we had the money tied up in inventory that wasn’t moving, and also that we had to store those damned sweaters in the back AND have them on display in front, which cost us display space. We (salesclerks) also were spending our time trying to persuade people to buy the sweaters, instead of selling them other things. We were told to move the sweaters, and we did our best, but if a product is crappy, and it’s obviously a crappy product, then most people are (barely) smart enough not to buy that product.

The value of a thing is whatever someone will pay for it, on the open market. In the case of the sweaters, a few people would pay $74.99 for them, more people would buy them at $49.99, and we had to keep cutting the prices to move them.

In the case of the TV prices, too, you have technology advances. A TV that had vacuum tubes had a lot more expensive labor put into it. These days, everything is made in China for pennies a day, and a lot of stuff is made by robots, too, which don’t need breaks, don’t need to stop working after one shift, and really don’t give the manufacturers nearly as much trouble as humans do. Robots do need to be maintained and occasionally repaired or replaced, but they’re usually a lot cheaper than human labor.

We are capable of just plain DOING more, too. We can build more advanced machines. In the fall of 1975, I received a calculator for my birthday. I was fascinated by it, and it was definitely a luxury gift, it was quite expensive. I can pick up a “mathbox” today, which will do essentially the same functions, for under five bucks. Possibly under a dollar, if I get lucky. And today’s calculator will run on sunlight or artificial light, no batteries needed. Back when America actually had a space program, computers were huge, inefficient, and incredibly expensive. Most businesses didn’t have computers, because the computers were very limited in what they could do, and because they were very expensive. Today, a new computer is…almost in the toy realm, for a basic computer. I dreamed of having a computer for years, and just accepted the fact that I’d never really be able to own one. Now, well, I don’t even know how many computers, working and non-working, are in this house. At least half a dozen, possibly more.

4

That is the worst example of a misplaced apostrophe I have seen in a long time.

Anyways… one of the terms I hate, because I think it’s wrong but seems to be what the whole of capitalism is based on, is “what the market will bear”. That is, charge what you think will get you the most profit and won’t scare away your customer.

It can be a delicate balancing act, but with every new product or service it seems to still be a healthy amount of guesswork.

I do enjoy watching very expensive items go down in price over a period of years (unless I bought one myself at a premium - then it just galls).

5

Because their costs have dropped so far that everyone is still earning a decent margin.

Theoretically the best way to set prices is based on elementary economic concepts. If you drop your price you’ll sell more but earn less profit per sale. If you raise your price less people will buy but you’ll make more profit on each sale. It’s impossible to perfect to the dollar but as much as it sounds like economics class homework it really is the best way to price. I don’t believe many companies give a lot of thought to this. Possibly because the only way to do it is to rely on other methods for data.

For instance, a completely different approach is to look at what competitors are doing and price similarly. You should always consider how you’re priced relative to the market but it’s a simplistic method to base all your pricing on.

In my experience most companies set pricing based on margins. For simplicity’s sake let’s say HBC buys their TVs direct from you, the manufacturer. You know it costs $40 to make the television and you know that HBC wants a 50% markup on their televisions. So you bring your new TV to a HBC buyer and tell him your MSRP is $150 and you’re willing to sell it to them for $75. So you and HBC both get a nice profit from the sale.

In the end you and your channel partners need to be earning a decent margin, which is why it’s sort of the last stop approach for most businesses I’ve known. What hopefully has been happening is that during the product’s creation some product manager was giving some serious thought to what MSRP would be most profitable vs. never giving it any thought and literally adding margin to the fully absorbed cost.

To get back to the crux of your question though I think the real answer is that yes, the television is really that much cheaper to make, and no it probably wasn’t al that much more profitable before.

6

It’s common for some products for the store to buy an item for 50% of the list price. For example a guitar that lists at $1000 costs the store $500. They then sell it for about $700 so their profit is $200 . (and people think they get a $300 discount) I recently heard the same is true with books - list price $30, store cost is around $15.

7

Out of curiosity, suppose you were moving and thus selling a house you own: would you set the price based on the current market, or by some other method?

8

my girlfriend runs a small clothing label and in most cases shops will double her sell price to them as the retail but in high rent area’s, eg central london, triple the wholesale cost is normal.

similarly she has to double her manufacturing cost as the wholesale price in order to cover all her other overheads. Thats pretty normal in the fashion industry and I’d imagine thats pretty normal in most industries, eg wholesale = double manufacturing cost and retail = double wholesale cost.

tech industries including consumer electronics is a special case and has different rules as others have explained above.

9

And why be upset with the system which brought the price of TVs down from $800 to $150?

It’s not that the TVs only cost $120 to manufacture and distribute (including marketing, etc.) back in the 80s, with insane profits for the players. Manufacturing costs for many consumer electronics have decreased tremendously over the last 20 years. Look at computers. Also, twenty years ago, 27” was a reasonably sized TV, now it’s reserved for the kid’s bedroom.

Selling for “what the market will bear” helps the consumers in the long run, because if there are healthy profits then other companies will enter. Someone will figure out how to reduce costs and will sell for less, which helps keep prices low.

10

With electronics, prices go down over time for several reasons:

  1. R&D is paid off. If I spend $10 million on research and development to create a new gizmo, and I figure on selling 100,000 of them per year, I’m going to make sure there’s an extra hundred bucks in my selling price (wholesale, that is), to recover that ten million. After a year, I can drop the price.

  2. Economies of scale. If I’m making 10,000 gizmos per year, they may cost me $100 to make. When they become wildly popular, and people are buying 10 million per year, I can set up an automated production line, design custom components, and crank 'em out a lot cheaper.

  3. Advances in technology. The electronics in modern televisions are all solid-state, and far cheaper to manufacture than the tubes, coils, and other analog devices in the old sets. That TV you’re buying today for $149 is nothing at all like the one you paid 800 bucks for way back then.

Most book distribution is based on a 40% discount to the store, so a bookstore will pay $18.00 for a $30.00 book. It can get better under various circumstances (buying direct from a publisher nets you a few percentage points, buying large quantities helps, and so forth), but it rarely gets better than 46% or so.

11

Here is a nice article about the various factors involved in setting the profit-maximizing price for a product.

Note that the product being sold is a software program, so the producer has a legal monopoly on that product: there may be plenty of other programs doing more or less the same thing, but nobody else is selling the exact same product, so there is some leeway in setting the price. On the other hand, if you’re selling a commodity product in a market where the customers mostly base their selection on price, then you have little choice other than setting your price at the level where your company can just barely cover its costs – and if that price isn’t as low or lower than your competitors’, you’ll go out of business. Bad for you, good for your customers.

Or maybe they did indeed make insane profits for a while – and they deserved it!

Doing research and development on a new kind of product involves costs and risks. In order to get back those one-time investments, and hopefully make a little extra money on top of it for your trouble, you need to make an amount of profit from the early adopters which is far above the kinds of profits which can be expected from more mature industries. The expectation of such above-market profits is what causes people to invest into speculative new technologies in the first place.

Imagine a law forbidding companies to make more than a specific, probably single-digit, profit on any sale. Certainly, the prices on some products would go down. On the other hand, investors and inventors would be a lot less likely to take a gamble on some cool new technology; they would be better off trying to find some small efficiency improvement in the production of a mature product, thereby temporarily increasing its profit margin from 2 to 3 percent until the competitors have caught on.

But why would you? As long as people are willing to pay the old price, why would you voluntarily drop the price and lower your profit margin?

The only reasons to do that would be either:
a) Competitors have entered your market, forcing you to lower your prices because otherwise nobody will buy from you. But that can happen either before or after you have recouped the initial investment.
b) Your marketing team has discovered that lowering the price will increase the number of customers to the point where the extra volume more than makes up for the reduced margin. But again, that argument does not depend on whether or not you have already recouped your investment.

12

I didn’t say I do drop the price. I said I can drop the price. In addition to the reasons you listed, I may do it to substantially increase marketshare prior to releasing a new product at high price, because I foresee a short lifespan for the product and want to squeeze whatever I can out before it dies, because I need to build volume so that I can lower cost-per-unit thanks to economies of scale, or for whatever other reason.

Once the R&D is paid off, I have freedom.

13

Freedom is an illusion. :smiley:

Once the R&D has been done, it’s a sunk cost. The question of whether or not you have already recovered that cost, should not have any influence on your pricing and marketing decisions. If lowering the price to increase market share is the right thing to do, then you should do it whether or not the R&D has been paid for.

In other words: the strategy to try and maximize the amount of money coming in, will be exactly the same irrespective of whether that money will go into paying off your investments or into buying gold-plated sports cars for you and your fellow investors.

The only decision where it makes sense to consider how long it will take to recover the R&D costs, is the decision of whether or not to do the R&D in the first place. If you don’t expect to make enough temporary above-market profits to recover the investment costs, then obviously you shouldn’t do the investment in the first place.

But once the costs has been made, all you can do is try to maximize your income given the current market conditions. If you are pricing your product $100 higher than your competitors because you haven’t recovered your R&D yet, nobody will buy it and you will never recover your investment.

14

In most retail stores (excluding grocery and electronics), small merchants mark up prices 40-50% over what they paid for it wholesale. Thus if an item cost them $5, they’ll sell it for $9.95.

Note that this markup is not profit. It includes all the merchant’s costs – rent, utilities, salaries, payroll taxes, property taxes, shrinkage due to shoplifting, etc. It also compensates for items that don’t sell (i.e., if you buy ten of something but only one sells. The difference is made up from selling all ten of a similarly priced item).

Places like Wal-Mart can sell for less because they can negotiate a lower price from vendors. A small merchant may be charged $5 wholesale, but Wal-Mart can get it from $2 direct from the manufacturer (small stores buy from a wholesaler, not the manufacturer. The wholesaler takes a cut).

15

The article I linked to above also goes into price discrimination, a.k.a. market segmentation. This basically means charging a higher price to those customers willing to pay it, even though you could have still made a profit at the lower price. (Of course, you never go below cost, except in unusual circumstances such as when using the product as a loss leader to attract people into your store, where they will then hopefully also purchase some high-margin items.)

There are many different ways to do market segmentation:
[ul]
[li]Discounts for groups who are likely to have a limited income, such as students and old people. Giving them a discount will bring in a lot of people who would not have paid the full retail price. (And here you thought the shop was doing it as an act of charity!)[/li][/ul][ul]
[li]Selling ‘home’ and ‘professional’ versions of the same software product, with minor differences in actual functionality. Since the feature has been developed anyway, it wouldn’t cost anything to enable it in the low-end version of the product, but the professional market is more likely to accept the higher price.[/li][/ul][ul]
[li]Selling basically identical products with different brand names and packaging, through different stores, marketed at different segments of the population.[/li][/ul][ul]
[li]Books are sold in hardcover and softcover versions, with the hardcovers typically being available several months earlier. Some of the price difference reflects the higher production cost of the cardboard cover, but most of it is simply a way to identify the part of the audience willing to pay a premium for the latest book from their favorite author.[/li][/ul][ul]
[li]Airlines charge much lower prices for round-trip tickets which include a Saturday stay. Why is that? Because the people buying those tickets are usually tourists, who are much more price-sensitive than business travellers. Likewise, a one-way ticket is much more expensive than one-half of a roundtrip; in fact, it used to be the case that buying a round-trip and not showing up for the return flight was cheaper than a one-way ticket! The reason is that round-trips tend to be tourists and other people who will simply decide not to travel at all if it’s too expensive, whereas one-way trips are less price-sensitive: if you have decided to move to another country to be with your sweetheart, you’re not going to call the whole thing off just because the plain ticket is $100 more than you expected.[/li][/ul]

16

Thanks everyone,

I really enjoyed reading those helpful and informative replies.
Sorry about my bad apostrophe in my OP, wasn’t my intention to offend anyone.

Regards
Gus

17

Don’t rain on my freedom :wink:

It may be a sunk cost, but in many firms paying off the R&D on your previous product determines whether your next product will get funded or not. It does matter.

18

Which is reasonable enough. However, we were talking about pricing strategy. And there, the question of whether or not the past R&D investments have already been paid off, should have zero influence on any decisions. But taking it into account when making decisions about future investments, is perfectly valid.

19

You are probably getting the idea that this is a complicated problem which is completely true. I have worked in the headquarters of several large retailers, some of them national and it is a pretty elaborate game to set prices. I worked in two headquarters of New England supermarket companies. The people that negotiate the deals with vendors and have strong influence over the ultimate sales price are called “Mechandisers” or “Buyers” and I worked directly with them to give them all the data they needed to make a decision.

It is both a business science and an art. The first supermarket chain that I worked strongly discouraged low-ball pricing even if some competitors were doing it. The Chief Operating Officer would offer say “This is NOT a discount supermarket operation!”. They wanted a specific kind of customer and not all people are very price aware or price sensitive and they are willing to pay a premium not to have to deal with the riff-raff. It wasn’t boutique or unusually expensive, they just wanted to cater to the middle-class market and above and were not disturbed when the prices were a little higher than the competition. Their priorities were very nice stores and good customer service with a good shopping experience.

There is some weird psychology involved in all of this. Some people are happier when they pay a little more for something because they think it is “better” even though it is easy to demonstrate that isn’t always the case by far. There is also the concept of “focal items”. No one can remember the prices of the tens of thousands of items in a typical supermarket but people do notice the price of things like milk, bread, eggs and soft drinks. Those are closely monitored against to the competition and kept in fairly close sync. There really is such a thing as loss-leaders too but some skilled people, especially older people, are known as “cherry-pickers” and can make you lose money just by walking through the door and that always has to be taken into account when setting up pricing and weekly specials.

20

If I could, I would sell it for what I think it’s worth. But realistically, I would have to recover the cost of buying it originally, and take into account the cost of the new house I was buying.

I just think (unfortunately it appears foolishly and unrealistically) that house prices in particular should not be skyrocketing out of control, and ought to remain within the realms of general affordability, based on the cost of building it, maintaining it, and inflation, rather than as an “investment” I can gouge from potential unwitting saps.