17 September 2022
What is volume and tiered pricing?
It is common to offer a discount when products or services are bought in higher volumes. This is referred to as volume discounting.
There are two volume discount methods:
- Volume pricing: The unit price for all units purchased is the same. The more units purchased the lower the unit price.
- Tiered pricing: The unit price decreases but only for those units falling in each volume tier. For example, if the first volume price break is for 5 units, the first 4 units would be full price, and all units over 5 would be bought at the discount price.
Common reasons for offering volume discounts are...
To encourage a higher-value sale: A buyer may only need (say) 5 items but might take advantage of the lower unit rate if they buy 10. The disadvantage to the seller is the trade-off between selling at a lower unit profit now when the customer might have come back in the future and paid full price. However, a bird-in-the-hand is worth two in the bush. The customer may never come back or buy from a competitor.
Your competitor is offering volume discounts: Hard to buck the system if volume discounting is standard industry practice and your competitors are offering volume discounts.
Rewards customer loyalty: High value customers are easier to service (sometime it costs much the same to process an order for 5 items as it does 100) and thus businesses would prefer to lock-in high value customers with a price incentive.
Contract rates lock-customers in: Often volume discounts are offered if a customer commits to an agreed level of business over an agreed period of time. This locks the customer in providing a benefit to both the seller and buyer.
Tiered pricing versus volume pricing
Volume pricing and Tiered Pricing vary only in how generously the discount price breaks are applied. However, when setting-up a volume discount price structure you need to take into account the overly effect on profitability...
The price per unit decreases in steps as volume increases. The unit price applies to ALL units purchased.
The price per unit decreases in steps as volume increases. The unit price applies only to those units purchased within the price tier.
In the following table we show the total revenue of a sale based on the two pricing methods . There are 4 price tiers each reducing by $1.00 per unit. The discount structure applied is exaggerated to illustrate the impact of the two pricing methods.
In the above example, the effect of volume breaks has been exaggerated by choosing an aggressive volume discount structure. Choosing a more realistic discount structure (say 5% discount at each break) would stop the sales revenue going backwards. However, doing the analysis with Gross Profit rather than Revenue would once again exaggerate the effect and likely the total GP would be go backwards with each tier.
The lesson is, when developing volume discount structures analysis is required to avoid developing uneconomic pricing strategies.
Volume discount strategies
One method to overcome the stepping problem (the total sale revenue goes backwards when jumping from one tier to the next) is to offer products in fixed pack sizes. It's almost impossible to purchase some common batteries in singles, they invariably come in packs of multiple batteries.
The advantage of selling packs with multiple items is that the uneconomic price break quantities are not available, thus eliminating the problem.