Chapter 7

PRICINING DECISIONS

Learning Outcomes
● Explain the relevant cost information that should be
presented in price-setting firms for both short- term and
long-term decisions;
● Describe the target costing approach to pricing;
● Describe the different cost-plus pricing methods for
deriving selling prices;
● Explain the limitations of cost-plus pricing;
● Justify why cost-plus pricing is widely used;
● Identify and describe the different pricing policies.
 MAJOR INFLUENCES ON PRICING DECISIONS

Internal Factors External Factors

Costs Competition
Organizational goals Price elasticity of demand
Organizational Factors Competitor’s Pricing Policies
Distribution channel Suppliers of raw materials
Pricing objectives Economics conditions
Product characteristics The consumers and businesses
Marketing mix. Legal and Regulatory issues
Product differentiation
The Economist’s Pricing Model
 Activity 7.1
A company manufactures a single product, product Y. It has
documented levels of demand at certain selling prices for
this.
Demand Selling price per unit Cost per unit
Units Rs. Rs.
1100 48 22
1200 46 21
1300 45 20
1400 42 19

Required:
• Using a tabular approach, calculate the marginal
revenues and marginal costs for product Y at the
different levels of demand, and determine the selling
price at which the company profits are maximized
 Problems with applying economic theory

 Difficult and costly to derive reasonably accurate estimates of

demand.

 Difficult to estimate cost functions to determine marginal cost at

different output levels for many different products.

 Demand is influenced by other factors besides price.

 Profit maximization assumed – firms may pursue other goals.

 Cost Information and Pricing Decisions
• Price takers and Price setters
For both price takers and price setters, the decision time
horizon determines the cost information that is relevant for
product pricing or output mix decisions. We shall therefore
consider the following four different situations:
1. a price-setting firm facing short-run pricing decisions;
2. a price-setting firm facing long-run pricing decisions;
3. a price-taking firm facing short-run product mix
decisions;
4. a price-taking firm facing long-run product mix decisions.
 Short-run Pricing Decisions
• Companies can encounter situations where they have
temporary unutilized capacity and are faced with the
opportunity of bidding for a one-time special order in
competition with other suppliers.
• Incremental costs of undertaking the order should be
taken into account.
The incremental costs are likely to consist of:
• extra materials that are required to fulfil the order;
• any extra part-time labour, overtime or other labour
costs;
• the extra energy and maintenance costs for the
machinery and equipment required to complete the
order.
 Activity 7.2 and 7.3
Activity 7.2
ABC Company operates a plant with a monthly capacity of 500,000
cases of tomato sauce. The company is presently producing 300,000
cases per month. A normal customer has asked to bid on supplying
150,000 cases each month for the next four months. Cost per case:
Variable manufacturing Rs 38, Variable marketing and distribution Rs 13,
Fixed manufacturing Rs 14, and Fixed marketing and distribution 15. If
ABC Company makes the extra 150,000 cases, the existing total fixed
manufacturing overhead (Rs 4,200,000 per month) would continue, plus
an additional Rs165, 000 of fixed overhead will be incurred per month.

What is the minimum price bid of ABC for supplying 150,000 cases?
Activity 7.3
Consider all information in the activity 7.2 is same except that the ABC
operates in full capacity. You are also informed that the selling price per
case is Rs 100.

What is the minimum price bid of ABC for supplying 150,000 cases?
 Long-run Pricing Decisions
Approaches:
1 pricing customized products/services
2 pricing non-customized products/services
3 target costing for pricing non-customized
products/services.
 1. Pricing Customized Products/Services
• Cost-plus pricing and Different cost bases and mark-ups
• Look at the Table: Different Approaches to Cost-plus Pricing

Cost base Rs Mark- Cost-plus price Approaches

up %  
Direct 40 150% 100 Variable Cost Plus
variable
Direct fixed 20      

Total direct 60 70% 102 Direct Cost Plus

Indirect 15      
costs
Total cost 75 40% 105 Full Cost or Long-
run Cost
 Pricing customized products using cost-plus pricing
 Target mark-ups seek to provide a contribution to non-
assigned costs and profit, which are then adjusted to reflect
demand, types of products, industry norms, competitive
position, etc.
 An accurate costing system is required since undercosting
will result in acceptance of unprofitable business and
overcosting in the loss of profitable business.

 To determine the selling price a full cost/long-run cost should

be calculated and a mark-up added.

 Cost assignment for pricing should be based on direct cost

tracing or cause-and-effect assignments.

 ABC provides a better understanding of cost behaviour for

negotiating with customers the price and size of the orders.
 Pricing Non-customized Products/Services

• Large and unknown volumes of a single

product that is sold to thousands of
different customers.
• May apply cost-plus pricing
• The circular process occurs
• Selling price and sales volume
• Lack of market data for making a pricing
decision –Case A
• Data available for market shares and sales
volumes – Case B
 Case A
The Auckland Company is launching a new product. Sales volume will be
dependent on the selling price and customer acceptance but because the product
differs substantially from other products within the same product category it has
not been possible to obtain any meaningful estimates of price/demand
relationships. The best estimate is that demand is likely to range between 100
000 and 200 000 units provided that the selling price is less than Rs100. Based
on this information the company has produced the following cost estimates and
selling prices required to generate a target profit contribution of Rs2 million from
the product
Sales volume (000s) 100 120 140 160 180 200
Total cost (Rs000s) 10 000 10 800 11 200 11 600 12 600 13 000
 
Required profit contribution 2 000 2 000 2 000 2 000 2 000 2 000
(Rs000s)  
Required sales revenues 12 000 12 800 13 200 13 600 14 600 15 000
(Rs000s)
Required selling price to 120.00 106.67 94.29 85.00 81.11 75.00
achieve target profit  
contribution (Rs)
Unit cost (Rs) 100.00 90.00 80.00 72.50 70.00 65.00
 
 Case B
Assume now an alternative scenario for the product in Case A. The same cost schedule
applies but the Rs.2 million minimum contribution no longer applies. In addition, Auckland
now undertakes market research. Based on this research, and comparisons with similar
product types and their current selling prices and sales volumes, estimates of sales
demand at different selling prices have been made. These estimates, together with the
estimates of total costs obtained in Case A are shown below:

Potential selling price (Rs.) 100 90 80 70 60

Estimated sales volume at the 120 140 180 190 200
potential selling price (000s)  

Estimated total sales revenue 12 000 12 600 14 400 13 300 12 000

(Rs000s)  

Estimated total cost (Rs000s) 10 800 11 200 12 600 12 800 13 000

 

Estimated profit (loss) 1200 1400 1800 500 -1000

contribution (Rs000s)
 Activity 7.4
NCC Company manufactures two brands of computers: Simple Computer (SC)
and Complex Computer (CC). The company uses a long-run time horizon to
price Complex Computer (CC). Direct materials costs vary with the number of
units produced. Direct manufacturing labor costs vary with direct manufacturing
labor-hours. Ordering and receiving, testing and inspection, and rework costs
vary with their chosen cost drivers. What is the cost of producing 100,000 units
of Complex Computer?
Cost and other information:

Cost Rs Other information

 
Ordering 78 per order Number of orders placed 17,000

Testing 2 per inspection hour Number of testing hours 3,000,000

Rework 38 per unit reworked Number of units reworked 8,000

Cost per Unit Rs    

Direct materials 450.00    

Direct labor 66.50 (3.50 hours @ Rs19 per    

hour)
The direct fixed costs of machines used exclusively for the manufacture of CC total Rs
7,000,000
 Pricing non-customized products (Target costing)

 Target costing is the reverse of cost-plus pricing.

 Marketing factors and customer research provide the basis for

determining selling price (Not cost).

 Emphasizes a team approach to achieving the target cost.

 Four stages are involved:

Stage 1: Determine the target price which customers will be prepared to pay
for the product.
Stage 2: Deduct a target profit margin from the target price to determine the
target cost.
Stage 3: Estimate the budgeted cost of the product.
Stage 4: If estimated cost exceeds the target cost investigate ways of
driving down the actual cost to the target cost.
 Activity 7.5

In activity 7.4, NCC management wants a 15% target operating income

on sales revenues of CC. Target sales revenue is Rs 750 per unit.
What is the target cost per unit?
 A price taker firm facing short-run product-mix
decisions

 Applies where opportunities exist for taking on short-term

business at a market determined selling price.

 Cost information required and the same conditions apply as

those specified for a price setter facing short-term pricing
decisions.

 If short-term capacity constraints apply the product mix

should be based on maximizing contribution per limiting
factor.
 Pricing Short-run Product Mix Decisions

• Sufficient capacity is available for all resources that are

required from undertaking the business (If some
resources are fully utilized, opportunity costs of the
scarce resources must be covered by the selling price).
• The company will not commit itself to repeat longer term
business that is priced to cover only Short-term
incremental costs.
• The order will utilize unused capacity for only a short
period and capacity will be released for use on more
profitable opportunities.
 A price taker firm facing long-run product-mix
decisions

 In the long-term a firm can adjust the supply of resources.

Therefore the sales revenue from a product or service
should be sufficient to cover all of the resources that are
committed to it.

 Periodic profitability analysis is required to ensure that only

profitable products/services are marketed.

 Profitability analysis can be facilitated by ABC.

 Pricing long-run product mix decisions

  Product line A   Product line A   Product line A    

Rs 000 Rs 000 Rs 000 Total
  A1 A2 A3 Total B1 B2 B3 Total C1 C2 C3 Total Rs
000

(1)Sales 100 200 300 600 400 500 600 1500 700 800 900 4500
2400
(2) Less 20 60 120 200 200 550 360 1110 680 240 600 1520 2820
direct
variable and
fixed costs
 
(3) 80 140 180 400 200 -50 240 390 20 560 300 880 1670
Contribution
to product
line
fixed costs
(4) Fixed costs directly 350       300       500 1150
attributable to the product
line
(5) Contribution to business 50       90       380 520
sustaining fixed costs
 
(6) Business/facility sustaining fixed costs 200
 Reasons for using cost-plus pricing

1. May encourage price stability

2. Simplicity
3. Difficulty in applying sophisticated procedures where a firm
markets hundreds of products/services.
4. Used as a guidance to setting the price but other factors
are also taken into account.
 Limitations of cost-plus pricing
• Ignores demand
For example, a cost-plus formula may suggest a price of Rs.20 for a product
where the demand is 100 000 units, whereas at a price of Rs.25 the demand
might be 80 000 units. Assuming that the variable cost for each unit sold is
Rs.15, the total contribution will be Rs.500 000 at a selling price of Rs.20,
compared with a total contribution of Rs.800 000 at a selling price of Rs.25.
Thus, cost-plus pricing formulae might lead to incorrect decisions.
• Pricing ‘floor’
Consider a hypothetical situation where all of the costs attributable to a product
are fixed in the short term and amount to Rs1 million. Assume that the cost per
unit is Rs.100 derived from an estimated volume of 10 000 units. The selling
price is set at Rs.130 using the cost-plus method and a mark-up of 30 per cent.
If actual sales volume is 7000 units, sales revenues will be Rs.910 000
compared with total costs of Rs.1 million. Therefore, the product will incur a
loss of Rs.90 000 even though it is priced above full cost.
• Circular reasoning —Volume estimates are required to estimate
unit fixed costs and ultimately price.
Activity 7.6

A producer of high-quality executive motor cars has developed a new model that it knows to be very advanced
both technically and in style by comparison with the competition in its market segment. The company’s
reputation for high quality is well established and its servicing network in its major markets is excellent.
However, its record in timely delivery has not been so good in previous years, although this has been improving
considerably.
In the past few years it has introduced annual variations/ improvements in its major models. When it launched a
major new vehicle some six years ago, the recommended retail price was so low in relation to the excellent
specification of the car that a tremendous demand built up quickly and a two-year queue for the car developed
within six months. Within three months a second-hand model had been sold at an auction for nearly 50 per cent
more than the list price and even after a year of production a sizeable premium above list price was being
obtained.
The company considers that, in relation to the competition, the proposed new model will be as attractive as was
its predecessor six years ago. Control of costs is very good so that accurate cost data for the new model are to
hand. For the previous model, the company assessed the long-term targeted annual production level and
calculated its prices on that basis. In the first year, production was 30 per cent of that total. For the present
model, the company expects that the relationship between first-year production and longer term annual
production will also be about 30 per cent, although the absolute levels in both cases are expected to be higher
than previously.
 The senior management committee, of which you are a member, has been asked to recommend the pricing
approach that the company should adopt for the new model.
You are required: (a) to list the major pricing approaches available in this situation and discuss in some detail
the relative merits and disadvantages to the company of each approach in the context of the new model;
(b) to recommend which approach you would propose, giving your reasons;
(c) to outline briefly in which ways, if any, your answers to (a) and (b) above would differ if, instead of a high-
quality executive car, you were pricing a new family model of car with some unusual features that the company
might introduce.

 
 Pricing reviews
1. Sales, in units and value: 3. Market shares in individual markets
  (a) previous years comparisons; 4. Price complaints
  (b) different markets/channels   (a) From customers
comparisons;
  (c) budget versus actual comparisons;   (b) From salesmen
  (d) forecast verse budget comparisons; 5. Number of lost customers
  (e)forecast versus actual comparisons; 6. Number of enquiries
2. Present and forecast product cost: 7. Sales at ‘below list’ prices
  (a) production, marketing, etc; 8. Competitors’ prices and conditions for
sale
  (b) fixed, variable; 9. Enquiries and subsequent sales
10. Types of customers getting the most and largest price reductions
11. Product unit and total contribution in different market

12. Stocks of finished goods at different points in distribution chain

13. Customers’ attitudes to company’s prices, packaging, etc

 Pricing policies

 Price-skimming
Charging high prices in order to maximize short-term profitability by
spending heavily on advertising and sales promotions to obtain sales

 Penetration pricing
A policy of charging low prices in order to obtain sufficient penetration
into the market

 Pricing policies may vary depending on the different stages of a

product’s life cycle.
Thank you