SOLUTION: Pricing strategies | My Assignment Tutor

24/02/20201LO1: Pricing strategiesDr Fidelis AkangaLearning outcomesBy the end of this unit Define and explain the Different pricingstrategies Understand how organisations set theirprices24/02/20202Pricing Decisions• Pricing decisions are often the most difficultdecisions that managers face• Pricing decisions examined include Profit-maximizing price from the standpoint ofeconomic theory Pricing of special orders Marking up costs and target costing Measuring customer profitability and activitybased pricingEconomic Theory• Economic theory suggests that the quantitydemanded is a function of the price that ischarged• The price for any specific good/service isthe relationship between the forces ofsupply and demand.• Generally, the higher the price, the lower thequantity demanded If managers can estimate the quantity demandedat various prices, determining the optimal price isstraight forward24/02/20203Economic Theory• The point at which the benefit gained from those who demandthe product (marginal revenue) meets the seller’s marginalcosts is the most optimal market price.• For example:suppose that market forces determine that it costs £5 for awidget. This suggests that widget buyers are willing to forgothe utility in £5 in order to possess the widget and that thewidget seller perceives that £5 is a fair price in exchange forgiving up the widget.Problems with applying economictheory1. Difficult and costly to derive reasonablyaccurate estimates of demand.2. Difficult to estimate cost functions todetermine marginal cost at different outputlevels for many different products.3. Demand is influenced by other factorsbesides price.4. Profit maximization assumed – firms maypursue other goals.24/02/20204Role of cost information in pricingdecisions Price takers are those firms that have little control overthe prices of their products or services. For price takers cost information is of vital importance indeciding on the output and mix of products and services. Price setters are those firms that have some discretionover the setting of selling prices for their products orservices. Cost information is of vital importance to price setters inmaking pricing decisions. Firms may be price setters for some of their products/services and price takes for others.Role of cost information in pricingdecisions Four situations will be considered:1. A price setting firm facing a short-run pricingdecision2. A price setting firm facing a long-run pricingdecision3. A price taker firm facing a short-run product-mixdecision4. A price taker firm facing a long-run product-mixdecision24/02/20205A price setting firm facing shortrun pricing decisions Applies where companies are faced with theopportunity of bidding for one time specialorders in competition with other suppliers. In this situation only the incremental cost ofundertaking the order should be taken intoaccount. Given the short-term one-off nature of theopportunity many costs will be nonincremental.A price setting firm facing shortrun pricing decisions• Bids should be made at prices that exceed theincremental cost and must meet the followingconditions:1. Sufficient capacity must be available to meet theorder.2 The bid price should not affect future selling pricesand the customer should not expect repeat businessat short-term incremental cost.3. The order will utilize unused capacity for only a shortperiod and capacity will be released for use on moreprofitable opportunities.24/02/20206A price setting firm facing longrun pricing decisions• Three scenarios considered:1. Pricing customized products using cost-plus pricing.2. Pricing non-customized products using cost-plus pricingor demand estimates.3. Pricing non-customized products using target costing. In the long-term a firm can adjust the supply of resourcesthat are committed to it – therefore a product or serviceshould be priced to cover all of the resources that arecommitted to it.• Price setters have stronger grounds for adopting ABC.Cost-plus vs. Target costing• Price setting firms sell customized products, wheredemand is virtually impossible to be estimated, costplus pricing should be used. Price = cost + a mark-up short term pricing decision vs. long-term pricingdecision Easy and speedy in deciding on the price Help in predicting the price of other companies Adjust the mark-up to consider changes in thesales demand24/02/20207Pricing customized productsusing cost-plus pricing1. An accurate costing system is required sinceunder costing will result in acceptance ofunprofitable business and over costing in theloss of profitable business.2.To determine the selling price a full cost/longrun cost should be calculated and a mark-upadded (i.e. a cost-plus selling price isdetermined.Pricing customized productsusing cost-plus pricing3. Cost assignment for pricing should be basedon direct cost tracing or cause-and-effectassignments —Arbitrary allocations (e.g.some business/facility-sustaining costs)should be allocated using behavioural driversor covered within the mark-up.4. ABC provides a better understanding of costbehaviour for negotiating with customers, theprice and size of the orders.24/02/20208Advantages of cost-plus pricing1. May encourage price stability2. Demand can be taken into account by adjusting thetarget mark-ups.3. Simplicity4. Difficulty in applying sophisticated procedureswhere a firm markets hundreds ofproducts/services.5. Used as a guidance to setting the price but otherfactors are also taken into account.6. Applied to only the relatively minor revenue items.Criticisms of cost-plus pricing1. Ignores demand2. Does not necessarily ensure that total salesrevenue will exceed total cost.3. Can lead to wrong decisions if budgetedactivity is used to unitize costs.4. Circular reasoning —Volume estimates arerequired to estimate unit fixed costs andultimately price.24/02/20209Cost-plus vs. Target costing Price taking firms sell non-customizedproducts, the target costing pricing should beused. Target costing is the reverse of cost-pluspricing —The target selling price is thestarting point.Cost-plus vs. Target costing1. Four stages are involved:Stage 1: Determine the target price which customerswill be prepared to pay for the product.Stage 2: Deduct a target profit margin from the targetprice to determine the target cost.Stage 3: Estimate the actual cost of the product.Stage 4: If estimated actual cost exceeds the target costinvestigate ways of driving down the actual cost to thetarget cost.2. Marketing factors and customer research provide thebasis for determining selling price (Not cost).24/02/202010A price taker firm facing short-runproduct-mix decisions• Applies where opportunities exist for taking onshort-term business at a market determinedselling price.• Cost information required and the sameconditions apply as those specified for a pricesetter facing short-term pricing decisions.• If short-term capacity constraints apply theproduct mix should be based on maximizingcontribution per limiting factorA price taker firm facing short-runproduct-mix decisions• In the long-term a firm can adjust the supply ofresources that are committed to it – Thereforethe sales revenue from a product or serviceshould be sufficient to cover all of the resourcesthat are committed to it.• Periodic profitability analysis is required toensure that only profitable products/services aremarketed.• Profitability analysis should be used as anattention-directing mechanism.24/02/202011Factors affecting prices of goods• Price Sensitivity How customers react to the change in price e.g. change cinema prices: someone who rarely goes tothe cinema vs. someone who goes to every new release. e.g. change in train tickets price: someone who can claimtravel expenses back vs. someone who travel with family.• Price Perception Customers may react to threatened price increases by buyingmore as they could be expecting further price increases e.g.petrol. Alternatively, they might put off buying a product if theyexpect further price decreases (e.g. flat-screen televisions).Factors affecting prices of goods• Competitors Organisations must keep an eye on the pricing policy oftheir competitors, especially where there is little productdifferentiation. In petrol retailing, prices tend to move inunison and a price cut by one oil company can indicate thelaunching of a damaging price war.• Price setters vs. Price takers• Suppliers For example: The UK annual budget normally increases theprice of a pint of beer by a penny or two but pubs use this toincrease the price by 5p a pint. The breweries then chargean extra couple of pence to the pubs in order to take ashare of this increase24/02/202012Factors affecting prices of goods• Inflation For example: if inflation is 3% and the price of sandwichis increased from £2 to £2.06 then the real increase iszero while the nominal increase is 6p (in reality, whatoften happens is that the price is increased by 10p to£2.10).• The Economic Wealth / Income of a Region In times of rising incomes, price may be less importantto consumers than product quality. In recessionary times, price increases are often lower ascompanies try to increase sales by limiting suchincreases.Factors affecting prices of goods• Product Range• For example: the printer that is sold for a low price with acartridge of ink supplied. When the cartridge needs to bereplaced it may cost as much as the original printer (the printera “loss leader”).• Ethics• While recent experience has shown that gas companies fullyexploit shortages, some pharmaceutical companies havereduced the prices of their medicines supplied to African andAsian markets.24/02/202013Factors affecting prices of goods• Substitute Products• For example, the channel tunnel has helped to constrain priceincreases imposed by ferry companies while the Eurostar fromLondon to Paris and Brussels has helped reduce the planefare between the cities.Pricing Policies24/02/202014Pricing Policies• Market Skimming Pricing Charging a high price when a product is first launched and spendingheavily on advertising and sales promotion to obtain sales. Recovering R & D costs as quickly as possible and earning highprofits early in the product’s life. This policy is only appropriate where: New and different products and customers are prepared to payhigh prices in the expectation that it carries an exclusive cachet. The strength of demand and the sensitivity of demand to priceare unknown. Products have a short life cycle and need to recover theirdevelopment costs and make a profit quickly.Pricing Policies• Market Penetration Pricing This policy sets a low price when a new product is launched. Thisenables the product to obtain a foothold in the market. This policymay be used by an organisation which: Wishes to dissuade new entrants from coming into the market Wishes to shorten the initial period of a product’s life cycle inorder to enter the growth and maturity stages more quickly. Can take advantage of economies of scale by producing inlarger quantities Expects demand to increase as prices fall24/02/202015Pricing Policies• Full Cost Plus Pricing• The full cost of production or absorb non-production costs into the product.The % mark-up or percentage margin does not have to be fixed but canvary according to circumstances and demand.• It is simple, quick and cheap.• Working at full capacity will cover all its fixed costs and make a profit.• It can be used to justify selling prices to customers• Pricing can be delegated to lower levels of management• The relationship between supply and demand may be ignored• However, supply/demand relationship is ignored• The market and demand conditions are ignored• Requires accurate forecasting about costs and production levelsPricing Policies• It ignores what competitors are doing• It ignores where the product is in its life cycle• It is fairly inflexible and ignores short term considerations• It does not take opportunity costs into account24/02/202016Pricing Policies• Variable Cost Plus Pricing• Many retail organisations use this method.• For example, a clothes retailer might add a 200% mark-up to apair of jeans costing £15 and sell them for £45. The mark up canbe adjusted to reflect demand conditions.• It attracts management attention to contribution and the effects ofhigher or lower sales volumes on profits through theContribution/Sales ratio that we saw in Breakeven analysis. (Forexample: A selling price of £2 and a variable cost of £1.50 implythat the contribution is 50p and the c/s ratio is 0.25. This meansthat for every additional £1 of sales 25p is added tocontribution/profit.)Pricing Policies• However, it does not ensure that sufficient attention is paid to theactions of competitors or the market conditions. Also, even thoughfixed costs must be covered to ensure a profit, fixed costs areignored in the pricing decision.24/02/202017Pricing Policies• Opportunity Cost Pricing The concept of ‘relevant cost’ applies The opportunity of bidding for one time special orders in competitionwith other suppliers. Only the additional cost of undertaking the order should be taken intoaccount.Pricing Policies Bids should be made at prices that exceed the incremental cost andmust meet the following conditions: Sufficient capacity must be available to meet the order. The bid price should not effect future selling prices and thecustomer should not expect repeat business at short-termincremental cost. The order will utilize unused capacity for only a short period andcapacity will be released for use on more profitable opportunities.24/02/202018Reading List Drury, C. (2018), Management & CostAccounting, 10th Edition. Chapter 10.