Chapter 7: PRICING DECISIONS

Session 16 and 17

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Session objectives
At the end of this session, you should be able to:

 Identify the major factors influencing the pricing decisions;

 Explain the relevance of economist’s pricing model in pricing;
 Explain the relevant cost information that should be presented in price-
setting and price taking firms for both short-term and long-term decisions;
 Justify why cost-plus pricing is widely used;
 Explain the limitations of cost-plus pricing;
 Identify and describe the different pricing policies.

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Major Factors Influencing the Pricing Decisions
Internal Factors External Factors

Empirical studies have found that cost-based pricing remains dominant in

pricing practice (Amaral & Guerreiro 2019).
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The Economist’s Pricing Model
The theoretical solution to
pricing decisions is derived from
economic theory, which explains
how the optimal selling price is
determined.

The optimal price where the profits

are maximized is determined by the
intersection of the marginal
revenue and marginal cost
curves.

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Problems with applying economic theory
Reality is different from theoretical context

 Demand is influenced by other factors besides price.

 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.

 Profit maximization assumed – firms may pursue other goals

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Cost Information and Pricing Decisions
Price takers and Price setters

Price taker - Firms that have little or no influence over the

prices of their products or services

(i) when there are many firms in the industry and there is little to
distinguish their products from each other (prices are set by overall market
supply and demand forces)
Ex: Firms selling wheat, rice, sugar
or
(ii) small firms operating in an industry where prices are set by the
dominant market leaders

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Cost Information and Pricing Decisions
Price takers and Price setters

Price setter - firms that have some discretion over setting the
selling price of their products or services

(i) selling products or services that are highly customized or differentiated

from one another by special features

or

(ii) who are market leaders

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Cost Information and Pricing Decisions
Importance of cost information

Price setters – for pricing decisions

Price takers – in deciding on the output and mix of products

and services to which their marketing effort should
be directed, giving more emphasis on the prevailing
market prices

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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 product mix
decisions. There are four different situations to consider as follows:

Price setting Price taking

firms firms

Short-run Long-run Short-run Long-run

pricing pricing product mix product mix
decisions decisions decisions decisions

Scenario 1 Scenario 2 Scenario 3 Scenario 4

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 1. Price-Setting firm facing 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.

 In these situations, only the incremental (relevant) costs of undertaking

the order should be taken into account.

The incremental costs are likely to consist of:

• extra materials that are required to fulfill the order;
• any extra part-time labour, overtime or other labour costs;
• extra energy and maintenance costs for the machinery and equipment
required to complete the order.

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Activity 7.1 and 7.2
Activity 7.1
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 Rs. 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 Rs. 165, 000 of fixed overhead will be incurred per month.
What is the minimum price bid of ABC for supplying 150,000 cases?

Activity 7.2
Consider all information in the activity 7.1 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?

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2. Price-Setting Firm facing Long-run Pricing Decisions

3 approaches are relevant to a price-setting firm facing long-run pricing

decisions.

Approaches:

(i) Pricing customized products/services

(ii) Pricing non-customized products/services

(iii) Target costing for pricing non-customized products/services.

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(i) Pricing Customized Products/Services
Cost-plus pricing with different cost bases and mark-ups

Different Approaches to Cost-plus Pricing

Mark-up Mark-up Cost plus

Cost base Rs. % (Rs.) price (Rs.) Approach

(1) Direct variable costs 200 150% 300 500 Variable cost plus pricing
Direct fixed costs 100
(2) Total direct costs 300 70% 210 510 Direct cost plus pricing
Indirect/Overhead costs 80
(3) Total costs 380 35% 133 513 Full/Long run cost plus pricing

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 (i) Pricing Customized Products/Services
Cost-plus pricing with different cost bases and mark-ups

Cost base Markup – 150%

Direct Variable Direct Fixed Indirect Net Profit

Variable cost pricing costs costs Overheads = Selling Price

Cost base Markup – 70%

Direct Variable Direct Fixed Indirect Net Profit

Direct cost pricing costs costs Overheads = Selling Price

Cost base Markup - 35%

Direct Variable Direct Fixed Indirect Net Profit

Full cost pricing costs costs Overheads = Selling Price

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Pricing customized products using cost-plus pricing

• Mark-ups are related to the demand for a product (A higher mark-up can be added
for a high demand product)

• Mark-ups are also likely to decrease when competition is intensive

• Target mark-up percentages tend to vary from product line to product line to
correspond with well established differences in custom, competitive position and likely
demand.
Ex: luxury goods with a low sales turnover may attract high profit margins whereas
non-luxury goods with a high sales turnover may attract low profit margins.

• Cost-based pricing formulae provide an initial approximation of the selling price.

• Target selling price calculated on cost information, can be adjusted based on future
capacity available, competition and management’s general knowledge of the market.

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(ii) 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

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 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 Rs.100 or less than Rs.100. Based on this information the company has
produced the following cost estimates and selling prices required to generate a target profit
contribution of Rs. 2 million from the product.

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 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 potential selling price (000s) 120 140 180 190 200
 
Estimated total sales revenue (Rs000s) 12 000 12 600 14 400 13 300 12 000
 
Estimated total cost (Rs000s) 10 800 11 200 12 600 12 800 13 000
 
Estimated profit (loss) contribution (Rs000s) 1200 1400 1800 500 -1000

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(iii) 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 that 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 the estimated budgeted cost exceeds the target cost, investigate ways of
driving down the actual cost to the target cost.
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Activity 7.3
NCC Company manufactures two brands of computers: Simple Computer (SC)
and Complex Computer (CC). The cost of producing a CC is budgeted as Rs.
592.80
NCC management wants a 15% target profit on sales revenues of CC. Target
sales price is Rs. 750 per unit. What is the target cost per unit?

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(iii) Pricing non-customized products - Target costing

Case based activity

https://www.youtube.com/watch?v=VWnI1sTf-IA

Question
Discuss the options available for the Hotel to drive down
the budgeted cost of the Health SPA to the target cost?

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(iii) Pricing non-customized products - Target costing

Real world views case

How TATA Nano reduced it’s cost to achieve the

target costing?

https://www.youtube.com/watch?v=LfWgQxhKHok

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3. A price taking 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.

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3. A price taking firm facing short-run product-
mix decisions
The following conditions should be satisfied in order to accept a short term
business:

 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

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4. A price taking firm facing long-run product-mix
decisions

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

product.

 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.

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4. A price taking firm facing long-run product-mix
decisions

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4. A price taking firm facing long-run product-mix
decisions
Activity 7.4
What are the possible decisions that can be made out of the profitability analysis?

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Reasons for using cost-plus pricing
 May encourage price stability
May help a firm to predict the prices of other firms. For example, if a firm has been operating in an
industry where average mark-ups have been 40 per cent in the past, it may be possible to predict that
competitors will be adding a 40 per cent mark-up to their costs. If all the firms in an industry price their
products in this way, it may encourage price stability.

 Simplicity

 Difficulty in applying sophisticated procedures where a firm markets hundreds of

products/services.

 Used as a guidance to setting the price but other factors are also taken into account

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Limitations of cost-plus pricing

 Ignores demand
The price is set by adding a mark-up to cost and this may bear no relationship to
the price–demand relationship.
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.

 Circular reasoning
Volume estimates are required to estimate unit fixed costs and ultimately price.

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Limitations of cost-plus pricing

 Pricing ‘floor’
It is often claimed that cost-based pricing formulae serve as a pricing ‘floor’ shielding
the seller from a loss.
if sales demand falls below the activity level that was used to calculate the fixed cost
per unit, the total sales revenue may be insufficient to cover the total fixed costs.
Ex: Consider a hypothetical situation where all of the costs attributable to a product are
fixed in the short term and amount to Rs. 1 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 7,000 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.

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Pricing policies
Cost information is only one of many variables that must be considered in the pricing decision.
The final price that is selected will depend on the pricing policy of the company.

 Price-skimming policy
Charging high initial prices in order to maximize short-term profitability by spending heavily on
advertising and sales promotions to obtain sales, when demand is not very sensitive to price
changes.
Once the market becomes saturated, the price can be reduced to attract that part of the market
that has not yet been exploited.

 Penetration pricing policy

A policy of charging low prices initially in order to obtain sufficient penetration into the market.

Pricing policies may vary depending on the different stages of a product’s life cycle.

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Real world example - Apple

https://www.youtube.com/watch?v=t6VYByDYg7c

Question
1. What is the pricing policy adopted by Apple?

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Pricing reviews

Once a selling price has been established, it should be reviewed at regular intervals, and a new price
should be arrived.

Few factors to be considered under pricing reviews are as follows.

 Comparison of actual sales with previous year sales and budgeted sales (in units and values)
 Present and forecast product cost
 Market share in individual markets
 Price complaints
 Competitor prices

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Conclusion
 Many factors influence pricing decision
 The Economist’s Model can be used for pricing, however, it has its own limitation.
 Pricing decisions were discussed under both short- term and long-term: price
taker and price setter perspective.
 The target costing approach to pricing is much more effective.
 The different cost-plus pricing methods can be used for deriving selling prices.
 There are limitations of cost-plus pricing, despite the limitation cost –plus pricing
is widely used due to various reasons.
 The different pricing policies are important when making a pricing decision
 Management and accounting Information is useful when price reviews is taken
place

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Questions