Pricing Decisions

Unit 13

LEARNING OUTCOMES

At the end of this unit the student will know:

1. Pricing and economic theory2. The role of cost information3. Long and short term pricing4. Product mix and pricing5. Different pricing policies

Economic Theory and Pricing

• Economic theory can assist in determining pricing decisions of a firm by looking at the demand for the product and also what level of output the firm should produce.

Demand Elasticity

• Elastic demand means that a small increase/decrease in price causes a large decrease/increase in price. Demand is elastic when there are substitutes for the product.

• Inelastic demand means that the quantity demand falls by a smaller percentage than the percentage increase in price.

Concept of Elasticity to Decision

• 1. If inelastic demand exists, prices should be increased because revenues will increase and total costs will reduce.

• 2. If elastic demand exists, increases in prices will bring decreases in revenue, and decreases in price will bring increases in revenue.

Demand Curves

Output and Profit

• Microeconomic theory suggests that as output increases, the marginal cost per unit might rise (due to the law off diminishing returns) and whenever the firm is faced with a downward sloping demand curve, the marginal revenue per unit will decline.

• Profits will be maximised only at the output level where marginal cost has risen to be easily equal to the marginal revenue i.e. MC = MR

Difficulties with applying economic theory

• 1. That a firm can estimate a demand curve for its products. In reality this may be difficult as most companies may have many different products.

• 2. Price influences the quantity demanded. In practice, factors other than place may influence the quantity demanded, i.e. quality, advertising, etc.

The role of cost information in pricing decisions

• Price Taker – this is where firms have little or no influence over the prices of their products or services.

• Price Setter – this is where firms have an input into the setting price of their product or services.

Rule: Price setting firm in the short run

(a) Spare capacity should be available.(b) The bid price should represent a

one-off price that will not be repeated.

(c) The orders will utilise unused capacity.

Rule: Price taker firm facing short run product mix decisions

• Same conditions as for a price setter as stated in the previous example. i.e. for the short run.

Rule: Price setter long run pricing decisions

There are three approaches to pricing here:1. In pricing customised products, it is important that the firm uses

accurate costs. There is, therefore, a strong argument to use ABC. Activity Based Cost information provides a better understanding of cost behaviour.

2. Non customised products pricing based on direct negotiation with the customer.

3. Using target costing for non customised products. Here the selling price is the start of the costing process rather than the cost.

Approach of target costing

1. Determine the target price which customers will be prepared to pay for the product.

2. Deduct a target profit margin from the target price to determine the target cost.

3. Estimate the actual cost of the product.4. If estimated actual cost exceeds the target cost

investigate ways of driving down the actual cost to the target cost.

Rule: A price taker firm facing long run product mix decisions

• A price taking firm accepts the market price. It will, however, need to use activity based profitability analysis to evaluate each product's long run profitability.

Product Mix decisions

Notes1 Consists of expenses dedicated to sustaining specific

product brands or customer segments or regions but which cannot be attributed to individual products, customers or branches.

2 Consists of expenses dedicated to sustaining the product lines or distribution channels or countries but which cannot be attributed to lower items within the hierarchy.

3 Consists of expenses dedicated to the business as a whole and not attributable to any lower items within the hierarchy

Cost-based approaches to pricing

There are a variety of different costing bases. These include:

(i) Total cost + % for profit = selling price

(ii) Variable cost +% for profit = selling price

Problems with full cost-plus pricing

• (a) lt fails to recognise that, since demand may be determining price, there will be a profit-maximising combination of price and demand.

• (b) There may be a need to adjust prices to market and demand conditions.

• (c) A suitable basis for overhead absorption must be selected, especially where a business produces more than one product

Marginal Cost-Plus Pricing

• This method determines the sale price by adding a profit onto either marginal cost of production or marginal cost of sales.

• Advantages• a) Simple and easy method to use.• b) The mark-up percentage can be varied• Disadvantages• It gives fixed overheads in pricing.

Pricing Policies for New Products

Price skimming policy

• an attempt to exploit sections of the market that are relatively insensitive to price changes. A skimming policy should not be adopted when a number of close substitutes are already being marketed.

• Circumstances when skimming is appropriate:(a) A new or different product(b) Firm can identify different market segments for the

product(c) Short life cycle

Penetration pricing policy • based on the concept of changing low prices initially

with the intention of gaining rapid acceptance of the product.

• Such a policy is appropriate when close substitutes are available or when the market is easy to enter.

• Circumstances when penetration price is appropriate:(a) Pending new entrants(b) Firm may want to enter the growth and maturity stage of

theproduct life cycle and therefore reduces the initial stage(c) Elastic demand exists