The cost structure has a greater influence on pricing in International marketing. There is a close relationship between prices, costs and sales volume of a product, because the price charged affects sales volume by increasing or decreasing the overall demand. As a result of producing or marketing larger volumes, the unit cost of an individual product reduces, and so, of all the factors, often this becomes the initial stimulus for firms taking the decision to export.
The relationship between demand and sales volume
The way in which price affects demand is influenced by many factors. Some products are characterized by having elastic demand and being extremely price sensitive, so that sales volumes increase significantly as prices are reduced. In underdeveloped markets, where there is low penetration but considerable desire for Western products such as soft drinks or fast food, sales will increase rapidly if the price is reduced relative to consumers’ ability to pay.
By contrast, other products are characterized by inelastic demand. For example, suppliers of power generation equipment cannot significantly stimulate demand in individual markets by reducing the price. For such firms, an increase in business revenue is largely determined by changes in external factors, such as an improvement in the economy. The potential market for the European power generation equipment suppliers National Power and ABB was increased by the political decision in Malaysia to partially privatize state utilities.
The relationship between cost and sales volume
A second situation of inelastic demand occurs if a firm finds that it has reached saturation in its home market, so that even if prices were reduced, there would not be significant extra sales to off-set the loss of profit. The firm might conclude that exporting would provide an alternative method of increasing sales and thereby generate additional profit.
This decision is based on the concept of full absorption costing. Over-absorption of fixed costs by the export business would be shown as an additional contribution to the general overheads of the business.
The fixed production cost of the product include depreciation of equipment, building rental and business rates. General overheads include advertising, selling, distribution and administration.
In export markets, the firm might choose one of the following four alternatives, setting the selling price at:
- Production cost plus general overhead plus added profit (this would normally be the list price).
- Production cost, but without general-overhead or profit added.
- Below production cost.
- Production cost with specific export costs added.
The choice of alternatives will depend on the firm’s objectives in entering international markets. The first leads to the safest, albeit least competitive, price and is frequently the approach adopted by new exporters who are unwilling to take any significant risk. The firm might even take the list price, including the domestic gross margin, and add to it all the costs of exporting such as marketing, distribution and administration, resulting in the export price being far greater than the domestic price. In most international markets, however, a list price calculated in this way is unlikely to gain significant market share, and so a lower selling price is required.
The arguments for using the second opinion, to set a lower export selling price, are based on the belief that export costs should not include domestic sales costs such as advertising, marketing research, domestic and administration costs. Whilst this option has some merit, it might well fail to take account of high specific export costs.
The third option is clearly quite risky as it is designed to substantially increase volume. The danger, of course, is that if the increased volume generated does not absorb the fixed and general overhead costs, the product will be unprofitable and losses will result. This approach is often used in overseas markets and is based on marginal costing, whereby unused production capacity or extended production runs can provide extra goods for sale with little or no change in fixed costs, so that the extra production can effectively be produced at a lower cost than the original production schedule.
Another risk with this strategy is that the firm could be accused of dumping excess capacity in foreign markets. This sometimes is exacerbated as a result of government policy, particularly in declining industries. For example, in the European steel industry, certain governments, including those of Germany, Italy and Spain, have continued to subsidize their own inefficient steel industries by providing various incentives such as subsidized, low-cost energy, which has had the effect of maintaining unwanted capacity. When the European Union Commission’s plan for steel restructuring was presented, the more efficient private sector companies were unwilling to cut their capacity until the state-owned sector did the same.
The four option begs the question of whether or not export pricing should reflect all the costs specific to export sales, and if so, which costs can be directly attributable to exports. It can be argued that, particularly if a firm intends ultimately to commence manufacture in foreign markets, it is vital to know exactly what are the realistic costs for foreign markets. Allocating costs such as research and development accurately and appropriately, however, can be difficult.
Specific export costs
Whilst export volumes are small in comparison to the domestic market, some experimentation in export pricing is possible, but as exporting becomes a more significant part of the activities of the company, perhaps requiring the allocation of dedicated equipment or staff, it is necessary to reflect all costs that are specific to export sales. These costs include tariffs, special packaging, insurance, tax liabilities, extra transport, warehousing costs and export selling.
The most immediate and obvious result of all these costs being passed on is that the price to the consumer in an export market is likely to be much greater than the price to a domestic consumer.
This raises the question of whether foreign consumers will be prepared to pay a higher price for imported rather than locally produced goods. Justifying the cost of the product on the basis of its added value might be possible in the short term, but is unlikely to provide the international marketer with a basis for long-term viability in each local market. A strategy must be developed to deal with this situation in which the cost to the ultimate consumer is reduced. The main options available to the exporter include:
- aggressively reducing production costs, modifying the product if necessary and sourcing overseas,
- shortening the distribution channel, for example, by selling direct to retailers,
- selecting a different market entry strategy, such as foreign manufacture, assembly or licensing to avoid the additional costs of exporting.