Pricing Decisions

When demand is linear the equation for the demand curve is:
P = a – bQ
where
P = the price
Q = the quantity demanded
a = the price at which demand would be nil
b =(change in price /change in quantity)

Example 1: Deriving the demand equation

The current price of a product is $12. At this price the company sells 60 items a month. One month
thecompany decides to raise the price to $15, but only 45 items are sold at this price. Determine the
demand equation, which is assumed to be a straight line equation

Example 2:
The current price of a product is $30 and it’s the producers sell 100 items a week at this price. One week
the price is dropped by $3 as a special offer and the producers sell 150 items. Find an expression for the
demand curve, assuming that this is a linear equation.

The profit-maximizing price/output level

If we have a demand curve P = a – bQ and a total cost curve that states costs as fixed costs plus
variablecosts (C = F + vQ), we can calculate the selling price that will maximise profit. This is the price at
which marginal cost equals marginal revenue (MC = MR).

When
Demand equation is P = a - bQ
MR = a – 2bQ
where
P = the price
Q = the quantity demanded
a = the price at which demand would be nil
b =(change in quantity/ change in price)

Marginal cost is the cost of producing one extra unit of the product.
Therefore MC=Variable cost

Example: 3 (MC = MR)

AB has used market research to determine that if a price of $250 is charged for product G, demand will
be 12,000 units. It has also been established that demand will rise or fall by 5 units for every $1 fall/rise
in the selling price. The marginal cost of product G is $80.
Required
If marginal revenue = a –2bQ when the selling price (P) = a – bQ, calculate the profit-maximising
sellingprice for product G.

Example 4:
Heat Co is now trying to ascertain the best pricing policy that they should adopt for the Energy Buster’s
launch onto the market. Demand is very responsive to price changes and research has established that,
for every $15 increase in price, demand would be expected to fall by 1,000 units. If the company set the
price at $735, only 1,000 units would be demanded.
The costs of producing each air conditioning unit are as follows:
$
Direct materials 42
Labour 12 (1·5 hours at $8 per hour
Fixed overheads 6 (based on producing 50,000 units per annum)
–––
Total cost 60
–––
(i) Establish the demand function (equation) for air conditioning units;
(ii) Calculate the marginal cost for each air conditioning unit?
(iii) Equate marginal cost and marginal revenue in order to calculate the optimum price and quantity.

Increasing sales and production levels

When an opportunity to increase sales and production levels arises in a business the key question to
answer is:
Whether incremental revenue exceeds the incremental costs or not? If yes accept the offer otherwise
reject it.

Example 5:
An opportunity arises to increase sales by 10,000 units:

•Selling price of additional units = $10

•Variable cost of additional units = $6
•Fixed costs will increase by = $50,000

Required:
Should the opportunity be accepted?

Price Strategies
1) Cost-Plus Pricing
In practice cost is one of the most important influences on price. Many firms base price on
simple cost plus rules (costs are estimated and then a profit margin is added in order to set the
price).The 'full cost' may be a fully absorbed production cost only, or it may include some
absorbed administration, selling and distribution overhead.

Businesses that carry out a large amount of contract work or jobbing work, for which individual
job o rcontract prices must be quoted regularly would find this a useful method to adopt. Since
every job or contract is different, there are no market prices; and in the absence of a market
price, adding a profit mark-up to cost provides a logical way to decide the selling price. The
 percentage profit mark-up, however, does not have to be rigid and fixed, but can be varied to
suit different circumstances

Advantages of Full Cost plus Pricing:

1) It is a quick and simple of method of calculating price.
2) Using the full cost plus pricing the company ensures to recover all cost through selling price.
3) When there is no market price usually this method is preferred.

Disadvantages of Full Cost plus Pricing:

1) It fails to recognize that price does have impact on demand.
2) Price of the product may be adjusted with conditions of the market like competitor price.
3) Needs to estimate budgeted output and overhead cost, thus there comes the issue of
over/under absorbed overheads.

2) Marginal/ Variable Cost plus pricing:

The use of marginal cost is simpler as there is no need for the absorption of fixed overheads and could
be argued to be more consistent with the use of contribution in decision making. The main difficulty lies
in setting an appropriate margin or markup as this will need to ensure that fixed costs are covered. In
practice the danger is often that prices are set too low. Marginal costing is particularly useful in short
term decisions concerning the use of excess capacity or one off contract.

Advantages of Marginal Cost plus Pricing:

1) It is a simple and easy method to use.
2) The mark-up percentage can be varied, and so mark-up pricing can be adjusted to reflect
demand conditions.
3) It draws management attention to contribution, and the effects of higher or lower sales volumes
on profit.

Disadvantages of Marginal Cost plus Pricing:

1) Although markup can be adjusted to reflect demand conditions yet it doesn’t fully focus on
competitive or market pricing.
2) It ignores fixed overheads and in the pricing decision, but the sales price must besufficiently high
to ensure that a profit is made after covering fixed costs.

3) Market skimming:
Market skimming is a strategy that attempts to exploit those areas of the market which are relatively
insensitive to price changes. Initially, high prices for the product would be charged in order to take
advantage of those buyers who want to buy it as soon as possible, and are prepared to pay high prices in
order to do so.
The existence of certain conditions is likely to make the strategy a suitable one for Company. These are
as follows:
a) Where a product is new and different, so that customers are prepared to pay high prices in
order to gain the perceived status of owning the product early.
b) Where products have a short life cycle this strategy is more likely to be used, because of the
need to recover developmentcosts and make a profit quickly.
c) Where high prices in the early stages of a product’s life cycle are expected to generate high
initial cash inflows. If this were to be the case, it would be particularly useful for Company if they
are having liquidity problems.
 d) Where barriers to entry exist, which deter other competitors from entering the market; as
otherwise, they will be enticedby the high prices being charged. These might include
prohibitively high investment costs, patent protection or unusuallystrong brand loyalty.

4) Market Penetration:
With penetration pricing, a low price would initially be charged for the product. The idea behind this is
that theprice will make the product accessible to a larger number of buyers and therefore the high sales
volumes will compensate for the lower prices being charged. A large market share would be gained by
using this policy.
The circumstances that would favor a penetration pricing policy are:
a) Highly elastic demand for the product i.e. the lower the price, the higher the demand.
b) If significant economies of scale could be achieved by company, then higher sales volumes
would result in sizeablereductions in costs.
c) The life cycle of the product is relatively long and hence the company does not need to recover
the initial development cost so quickly.
d) The company is producing a product that is similar or identical to the competitor’s product
therefore to attract the customers the company might implement penetration policy.

5) Complementary products:
Complementary products are sold separately but are connected and dependent on each other for sales,
forexample, an electric toothbrush and replacement toothbrush heads. The electric toothbrush may be
priced competitively to attract demand but the replacement heads can be relatively expensive.
A loss leaderis when a company sets a very low price for one product intending to make consumers
buyother products in the range which carry higher profit margins. Another example is selling razors at
very low prices whilst selling the blades for them at a higher profit margin.

6) Price discrimination:
Price discrimination is the practice of charging different prices for the same product to different
groupsof buyers.
There are a number of bases on which such discriminating prices can be set:
a) By age:
For example, some products are sold at a lower price to students or old individuals.
b) By market segment:
Different products are sold in different markets at different prices, e.g. McDonald products etc.
c) By place:
Theatre seats are usually sold according to their location so that patrons pay differentprices for
the same performance according to the type of seat and its location in the theatre auditorium.
d) By time:
This is perhaps the most popular type of price discrimination. Off-peak travel bargains,hotel
prices and telephone charges are all attempts to increase sales revenue by covering variablebut
not necessarily average cost of provision. Airline companies are successful pricediscriminators,
charging more to rush hours whose demand is inelastic at certaintimes of the day.

7) Relevant cost plus pricing:

Relevant cost is the cost that is incurred by taking a particular decision. Hence first calculate
relevant cost and then add markup on it to get the selling price. It is also known as minimum
price or bid price charged. When company has spare capacity or the company wants to quote
minimum price it calculates price using relevant costing techniques.