CIMA Paper P2

Advanced Management Accounting

Ian Kusano and Nathi Thela
 Chapter 8 The Pricing Decision

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 The Pricing Decision
Objectives:
- In this chapter we will learn about the alternative strategies that an
organisation may adopt in the pricing of its products or services.
- The price to be charged to customers for the business’s products or
services is often one of the most important decisions to be made by
managers.
- Not all businesses are free to determine their own selling prices
- some are unable to influence the external price and are obliged
to accept the prevailing market price for their goods
- For these businesses cost control is an important factor in
maintaining profitability.
- Other businesses are in a position to select their selling price. The
objectives that they pursue in their pricing policy will affect the price to
be charged for each product or service.
- This chapter, however, concentrates on the link between price and
volume, and its resulting effect on profit.

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 The Pricing Decision
- Considering the impact of a change in price on demand is key to
management.
- The Price elasticity of demand = measures the change in demand as a
result of a change in its price
- Be aware of the factors that influences the price elasticity.

The profit maximisation model

▪ A mathematical model can be used to determine an optimal selling price.
▪ The model is based on the economic theory that profit is maximised at the
output level where marginal cost is equal to marginal revenue.

▪ Basic Principle to understand:

It is worthwhile a firm producing and selling further units where the increase in
revenue gained from the sale of the next unit exceeds the cost of making it (i.e.
the marginal revenue exceeds the marginal cost).

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 Session Content

Economists’ Accountants’
Approach Approach
The Pricing
MR = MC
Decision Cost Plus

Marketing
Strategies

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 Demand Based Approach

Inverse relationship between price and quantity demanded

Q
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 Demand Based Approaches

Tabular Approach Algebraic Approach

• All combinations MC = MR
• Max profit

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 Algebraic Approach Procedure

1. Establish the linear relationship:

P = a – bQ – the basic price equation
2. Marginal revenue, MR = a – 2bQ - is the additional
revenue from selling one extra unit
3. Establish the marginal cost – is the cost from making
one more unit. It is usually the variable cost
4. MC = MR, solve to find Q
5. Substitute Q into price equation to get optimum price
6. Calculate max profit if required

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 Algebraic Approach Procedure
At a price of $200, a company will be able to sell 1,000 units
of its product in a month. If the selling price is increased to
$220, the demand will fall to 950 units. It is also known that
the product has a variable cost of $140 per unit, and fixed
costs will be $36,000 per month.
Required:
(a) Find an equation for the demand function (that is, price as a function
of quantity demanded);
(b) Write down the marginal revenue function;
(c) Write down the marginal cost;
(d) Find the quantity that maximises profit;
(e) Calculate the optimum price;
(f) What is the maximum profit?

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 Example 1.
Maximum demand for a company’s product M is 100,000
units per annum. The demand will be reduced by 40 units for
every increase of $1 in the selling price. The company has
determined that profit is maximised at a sales volume of
42,000 units per annum.
Required:
(a) What is the profit maximising selling price for product M?

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 Example 2.
Another product, K, incurs a total cost of $10 per unit sold, as follows.
$ per unit
Variable production cost 4
Variable selling cost 2
Fixed production cost 3
Fixed selling and administration cost 1
Total Cost 10
The marginal revenue (MR) and demand functions for product K are:
MR = 200 – 0.4x
p = 200 – 0.2x
Where p – price, x = quantity demanded per period.

What is the profit-maximising selling price of product K, and what

quantity will be sold per period at this price?

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 Limitations
1. It is unlikely that organisations will be able to determine the demand
function for their products or services with any degree of accuracy.
2. The majority of organisations aim to achieve a target profit, rather
than the theoretical maximum profit.
3. Determining an accurate and reliable figure for marginal or variable
cost poses difficulties for the management accountant.
4. Unit marginal costs are likely to vary depending on the quantity sold.
For example bulk discounts may reduce the unit materials cost for
higher output volumes.
5. Other factors, in addition to price, will affect the demand, for example,
the level of advertising or changes in the income of customers.

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 Tabular Approach Procedure

The tabular approach is sometimes the best to define

optimum profit and the associated selling price.
$ $ $ $ $ $

Price per unit 22 20 19 18 17 15

Variable Cost per unit (6) (6) (6) (6) (6) (6)

Contribution per unit 16 14 13 12 11 9

Number of units sold 50,000 60,000 70,000 80,000 90,000 90,000

Total Contribution ($000) 800 840 910 960 990 810

Less fixed costs (stepped, $000) (200) (200) (280) (280) (360) (360)

Net Profit ($000) 600 640 630 680 630 450

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 Cost Plus Pricing

Advantages Disadvantages
• Widely used and • Ignores the market
accepted
• Simple • Different absorption
• Can be delegated
methods
• Justification for price • Doesn’t guarantee
increases profit
• Encourages price • Which cost ?
stability
• Inflexible
• Circular reasoning
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 Marketing Based Approaches: New Products

First of its Kind

Penetration Pricing Market Skimming

• Initial low price • Initial high price

• High volumes • High profits

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 Marketing Based Approaches: New Products
Cont.
Following a Competitor

Penetration Discount

Price Differentiation Premium

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 Product Life Cycle

Intro Growth Maturity Decline

Sales
Volume

Time
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