The Cost-Quality Relationship: Do We Always Get What We Pay For? | JAMA | JAMA Network
One of the secrets to business success is pricing your products properly. competitors are charging, and understanding the relationship between quality and price. Your ability to sell is what drives sales and that means hiring the right sales. The relationship between an item's price and its quality — and The best-case scenario for consumers, a high-quality product with a low price. The Relationship between Cost and Quality Quality gates boost project quality by helping ensure that best practices are followed and measured against.
That's why you own a business. Making money means generating enough revenue from selling your products so that you can not only cover your costs, but take a profit and perhaps expand your business. The biggest mistake many businesses make is to believe that price alone drives sales. Your ability to sell is what drives sales and that means hiring the right sales people and adopting the right sales strategy.
The Seiko is a better time piece. The difference is your ability to sell. There are two main pitfalls you can encounter - under pricing and over pricing. Pricing your products for too low a cost can have a disastrous impact on your bottom line, even though business owners often believe this is what they ought to do in a down economy.
Businesses also need to be very careful that they are fully covering their costs when pricing products. On the flip side, overpricing a product can be just as detrimental since the buyer is always going to be looking at your competitors pricing, Willett says. Pricing beyond the customer's desire to pay can also decrease sales. Toftoy says one pitfall is that business people will be tempted to price too high right out of the gate.
What would be a fair price to you? Understand what you want out of your business when pricing your products. Aside from maximizing profits, it may be important for you to maximize market share with your product -- that may help you decrease your costs or it may result in what economists call "network effects," i.
A great example of a product having network effect is Microsoft's Windows operating system. When more people began to use Windows over rival products, more software developers made applications to run on that platform. You may also want your product to be known for its quality, rather than just being the cheapest on the market.
If so, you may want to price your product higher to reflect the quality. During a downturn, you may have other business priorities, such as sheer survival, so you may want to price your products to recoup enough to keep your company in business. Factors to Consider "There are many methods available to determine the 'right' price," Willett says.
The more you know about your customer, the better you'll be able to provide what they value and the more you'll be able to charge. This type of research can range from informal surveys of your existing customer base that you send out in e-mail along with promotions to the more extensive and potentially expensive research projects undertaken by third party consulting firms.
Market research firms can explore your market and segment your potential customers very granularly -- by demographics, by what they buy, by whether they are price sensitive, etc. If you don't have a few thousand dollars to spend on market research, you might just look at consumers in terms of a few distinct groups -- the budget sensitive, the convenience centered, and those for whom status makes a difference. Then figure out which segment you're targeting and price accordingly.
Know Your Costs A fundamental tenet of pricing is that you need to cover your costs and then factor in a profit. That means you have to know how much your product costs. You also have to understand how much you need to mark up the product and how many you need to sell to turn a profit.
Remember that the cost of a product is more than the literal cost of the item; it also includes overhead costs. Overhead costs may include fixed costs like rent and variable costs like shipping or stocking fees. You must include these costs in your estimate of the real cost of your product. X is your cost of raw materials, labor, rent, and everything it took to make the product so that if you sold it you would break even," advises Toftoy. That may depend on your business.
Restaurants overall make about 4 percent, which is pretty low. If you want 10 percent then you factor that into your costs and that is what you charge. A good rule of thumb is to make a spread sheet of all the costs you need to cover every month, which might include the following: Your actual product costs, including labor and the costs of marketing and selling those products. All of the operating expenses necessary to own and operate the business.
The costs associated with borrowing money debt service costs. A return on the capital you and any other owners or shareholders have invested. Capital for future expansion and replacement of fixed assets as they age.
List the dollar amount for each on your spreadsheet. The total should give you a good idea of the gross revenues you will need to generate to ensure you cover all those costs. Know Your Revenue Target You should also have a revenue target for how much of a profit you want your business to make. Take that revenue target, factor in your costs for producing, marketing, and selling your product and you can come up with a price per product that you want to charge. If you only have one product, this is a simple process.
Estimate the number of units of that product you expect to sell over the next year. Then divide your revenue target by the number of units you expect to sell and you have the price at which you need to sell your product in order to achieve your revenue and profit goals.
If you have a number of different products, you need to allocate your overall revenue target by each product. Then do the same calculation to arrive at the price at which you need to sell each product in order to achieve your financial goals. If so, you can use their pricing as an initial gauge," Willett suggests. Be cautious about regional differences and always consider your costs.
The key here is to compare net prices, not just the list or published price. This information could come from phone calls, secret shopping, published data, etc. Make notes during this process about how your company and products -- and the competition -- are perceived by the market. Be brutally honest in your evaluation. Know Where the Market Is Headed Clearly you can't be a soothsayer, but you can keep track of outside factors that will impact the demand for your product in the future.
These factors can range from something as simple as long-term weather patterns to laws that may impact future sales of your products.
Finally, section VI provides a summary of our conclusions. We investigate a market with a product which possesses but one quality. The quality might be any aspect of the product as long as the presence of the quality provides some benefit to some, but not necessarily all, consumers. Type 1 Consumers Some of the consumers in this market are not concerned with this quality of the product. These consumers are very price sensitive.
They will buy the lowest priced product regardless of the level of the quality. These consumers are called type 1 consumers. We describe the behavior of the price sensitive, type 1 consumer with equation 1. The quantity of the product that type 1 consumers buy, is not influenced by the level of the quality of the product. Type 2 Consumers In order to make our analysis more general, we will allow consumers to exist who do not behave according to the traditional economic model.
These consumers are called type 2 consumers and their behavior is described by the equation 2. However, type 2 consumers are insensitive to price. They will buy more of the product as the quality of the product increases regardless of the product's price.
Nevertheless, all consumers do face some budgetary restrictions. We will, therefore, assume that this relationship only holds for prices less than p0.
When the price per unit exceeds p0s type 2 consumer will stop buying the product. Market Behavior with Type 1 and Type 2 Consumers We can study market behavior when the market consists of both type 1 and type 2 consumers. If the number of type 1 and 2 consumers is n1 and n2, respectively, then the behavior of the market will be described by equation 3.
The profit margin for this company would be the product's price minus the COSt of adding quality to the product. In order to simplify the exposition we will assume that the cost function is quadratic.
Our conclusions rely only on the assumption of a convex cost function. This assumption implies that as the level of quality increases it becomes more and more costly for the company to obtain additional quality. Eventual perfection is, indeed, difficult to achieve. With a quadratic cost function, it is in the company's own best interest to adopt the price and the level of the quality given by equations 4 and 5respectively.
That relationship is depicted in figure 1. This result is consistent with the empirical work of McConnell, At low prices, small changes in price correspond to large changes in quality. At higher prices, small changes in price correspond to smaller changes in quality. In all cases, however, higher prices correspond to higher levels of the quality. It is important to remember that we observe a price-quality relationship in the absence of competition between the geographic market segments.
Hence, even without price competition, price levels still reflect the levels of the quality. We can also determine how quality will vary from one geographic segment to another geographic market segment.
Equation 5 tells us that as the relative number of type 1 consumers in the segment increases, the level of the quality decreases. Acting in its own best interest, the company will decrease the product's price as the number of price sensitive type 2 consumers increase. These relationships are depicted by figure 2 and figure 3. Type 3 Consumers In section IIB, we assumed that all consumers who were concerned with the quality of the product were also able to identify that quality.
Some consumers, however, may want the quality but these consumers may be unable to determine whether or not the quality is present.
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We refer to these consumers as type 3 consumers. We must use care in describing type 3 consumers. It could be argued that a consumer has no need for a quality of the product that the consumer cannot detect. For example, if a consumer cannot discriminate between an ordinary meal and a gourmet meal, we might wonder why that consumer would desire a gourmet meal. Of course, we could argue that the consumer is unfamiliar with the product and cannot easily inspect the product to determine the level of the quality.
But this argument is not very compelling after the consumer has had the opportunity to use the product. At that point, the consumer would have learned the level of the quality.
That information, then, could be used in future purchase decisions. Hence, the unfamiliarity argument could only be used for a new product or a durable good whose sales depend mainly on first purchases. Nevertheless, there remain circumstances when a consumer may desire a quality which the consumer cannot detect. One circumstance might occur when the consumer is only a buyer for another consumer who can detect the quality.
For example, a host may be purchasing wine for a party where guests are more discriminating than the host. Another example would be a generous individual who desires to provide a gift for another individual when the gift receiver possesses far more expertise about the gift than the gift giver.
Finally, a consumer might desire a nutritious food product but the consumer may be unable to determine the nutritiousness of a specific food product.
- How to Use the Price Quality Matrix to Optimize Your Product Pricing
Assuming that type 3 consumers exist, these consumers might use the level of price as a surrogate measure of the level of quality. We describe the behavior of type 3 consumers with equation 6.
At prices less than po, type 3 consumers behave contrary to typical economic behavior. Suppose the number of type 3 consumers is n3. In this situation, a company seeking its own best interest will se its price and quality according to equations 7 and 8respectively.
See the appendix for details. We see that as the number of type 3 consumers increases, the price charged for the product increases. We also see that as the number of type 3 consumers increases, the level of the quality also increases. Even though these consumer cannot detect quality, their desire for quality causes the company to increase the level of the quality.
This conclusion may seem, at first glance, somewhat counter-intuitive. We might question how consumers, who cannot detect quality, can encourage the company to provide more quality.
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Upon reflection, however, the answer is simple. Without type 3 consumers, i. The quality-sensitive type 2 consumer wants quality at almost any cost. The company would provide high quality at a high price if it were not for the price-sensitive type 1 consumer. These price-sensitive consumers depress the price and, because they place no value on quality, they also depress quality levels.
With the introduction of type 3 consumers, the effect of type 1 consumers is diminished. With this effect diminished, the company is pleased to raise the price of the product while simuLtaneously persuading quality-sensitive type 2 consumers to increase their purchases by increasing the quality of the product.
How to Use the Price Quality Matrix to Optimize Your Product Pricing
We should note that type 3 consumers could vastly outnumber type 9 consumers and the integrity of equations 7 and 8 would not be impugned. Only when the number of type 3 consumers exceeds the number of type 1 consumers would the price-quality relationship be destroyed. Hence, even when very few consumers are able to detect quality, price-quality relationships exist.
It is only when few price sensitive consumers exist that price-quality relationships are destroyed. This fact may explain why even when we find few consumers can detect quality, companies still find drastic decreases in sales when they lower quality levels.
Moreover, we found that the existence of type 3 consumers, who use price as a surrogate measure of quality, actually cause the level of the quality to increase. In this section, we examine the effect of competition on the price-quality relationshiP.
High-Priced Low-Quality Competition In section II, we found the level of the price and the level of the quality that a company would adopt if there were no competitive brands in the market. These levels are given by equations 7 and 8. Substituting the quality level given by equation 8 into equation 7we obtain the level of ,rice given by equation 9.