THE PRICING

DECISION
PERFORMANCE AND DECISION MANAGEMENT

Prepared and presented by Dr Patricia Shewell

Relationship between price and volume:
Some basics you are expected to know:
Price elasticity of demand =
Inelastic < 1; Elastic > 1; Perfectly inelastic = 0; Perfectly elastic = ∞
Slope of demand curve generally downward sloping
Important point on page 251 – where cost inflation is higher than price inflation, and
demand is elastic, firms have difficulty putting up prices to cover increases in costs.
Factors that influence the degree of elasticity –Pg. 253
• Scope of market, Information in the market, Income, Degree of necessity, Availability
of substitutes, Complementary products
Other factors influencing price:
• Product life cycle
• Quality
• Marketing (the 4 P’s – Product, Price, Place, Promotion) – more emphasis on non-price
factors in demand
• Markets
• Competition
Optimal pricing (Economic theory) a.
Estimating the demand curve:
Slope = b
When demand is linear the equation for the demand curve is:
P = a – bx
Where:
P = the selling price
a = theoretical maximum price (price above which demand
will be zero)
b = change in price required to change demand by one unit

a = current price + x $b
(OR: a = current price + (current quantity x b)

b =
Solve for demand curve (linear relationship between price and quantity
demanded) – illustration 2 (a.) on Pg. 258:
Current price $300, current sales 500 units; Change price to $330 led to drop in
demand to 400 units. (Also, for interest, what price would yield demand of 550
units?)

• Find the gradient of line b first – change in price that would lead to 1 unit
change in demand: b = $30 ÷ 100 units = 0.3
• Estimate the value for a – the price at which demand will equal 0
a = $300 + (500 x 0.3) = $450
• The demand equation P = a – bX can now be determined as:
P = 450 – 0.3X
• And therefore the price that would yield a demand of 600 units is:
P = 450 – 0.3(550)
P = $285
Solution to Illustration 2 (b.) and (c.):
Find optimum quantity and optimum price. In terms of Economic theory profit maximizing
quantity is point where MC = MR. Variable cost = MC = $90 in this case. Equation for
Marginal revenue is: MR = a – 2bX
• The demand equation P = a – bQ was determined as:
P = $450 – 0.30Q
• MR = a – 2bQ and therefore MR = $450 - 0.60Q in this case
• Profit maximizing demand is where MC = MR, therefore
90 = 450 – 0.60Q
0.60Q = 450 – 90
Q = 600 = The profit maximizing demand
• Substituting Q into the demand formula,
P = a – bQ
P = 450 - 0.30 (600)
P = $270 = The price you would charge to achieve profit maximizing demand

Now complete examples2 and 3 on page 259 yourself.

The Tabular approach and Limitations

• Where there is no simple linear relationship between price and demand, or where the
relationship cannot be established, then a tabular approach can be used.
• See example 5 on Page 260/261. Tabulate forecast contribution and profit across all
possible forecast price and demand levels, select profit maximizing price.

• Limitations of profit-maximizing model are on page 261. Can you think of any?
Relationship between cost and price:
Total cost-plus pricing
• A method of determining price by calculating the full cost of the product, including a share of
overheads, and adding a percentage mark-up.
• Setting full cost prices – what is ‘full cost’? Can only include production cost but can also include
some admin costs. Percentage mark-up does not need to be fixed, can be varied to suit demand
• Problems with determining full-cost price shown in Example on page 262/263.
• Reasons for predominance include:
• Intuitively logical – need to cover costs to make a profit.
• Required profit achieved if budgeted volumes achieved
• Useful where business has few contracts and high variable cost relative to fixed costs
• Problems include:
• Fails to recognize demand/price relationship – market factors, product life cycle. (See
illustration 3 Pg. 264/265.
• May have to adjust price for demand conditions
• Budgeted output volume needs to be established – if actual is lower overheads will not be
fully recovered
• Suitable basis for overhead absorption – inaccurate apportionment (ABC?)
Marginal-cost plus pricing
• Method of setting price by adding a mark-up to marginal (variable) cost of
production or marginal cost of sales.
• Mark up must be set at a level that will ensure that the overheads of the
company are covered

Marginal cost based pricing especially pertinent to Relevant cost plus based
pricing
• Short term pricing strategy for once off contracts – normally utilizing spare
capacity. If capacity has to be redirected from existing business then an
opportunity cost arises
• Requires identifying the ‘relevant costs’ (chapter 4) – that is the incremental
costs from accepting the order
• Example from pg. 266– next slide
Example page 260
• Company sells Product A for $15. Now have identified a market for B, which requires no
additional investment, but uses the same material as A, material C, which is in short
supply
• Cost estimates:
Cost type A B
Direct material C @$0.60 (6 units A and 5 units C) 3.60 3.00
Direct labour: ½ hour @ $6.00 (both products) 3.00 3.00
Variable production overhead (Given) 2.40 1.00
9.00 7.00
Selling price (Given for A, ?? For B) 15.00
Contribution 6.00

• Because of a shortage of material C– the company must only redirect resource to product B if it
makes a higher contribution per Unit of C than product A.
• Contribution per unit of C for product A is $6/6units = $1 per unit of C
• Selling price for B must therefor be $7 + (5 units C x $1) = $12
• That is it must equal the marginal cost ($7) plus the opportunity cost from lost sales of A.
Relationship between price and required (Target) cost:
(Not covered in the text but relevant here)

• The market price at which the firm wishes (must) sell can affect the cost at which the
company must/should produce – this is called the ‘target cost’
• We covered target costing before in chapter 3
• This is an approach to cost based pricing which, instead of starting with the cost and
adding a mark-up to arrive at a selling price, starts with the established market price, and
subtracts the required mark-up (profit %) to arrive at a target cost.
• If you remember – in chapter 3 we then said that if actual cost is higher than target cost we
call the difference the ‘target cost gap’ and the company needs to examine ways in which
the cost gap can be eliminated.
Market based pricing
strategies:

First to market:
• What does this mean and what do you
think its impact on pricing of new products is?

Market penetration:
• Setting low prices initially (gains faster traction in the market, discourages new entrants, high
volume faster – economies of scale, elastic demand so that low price has greater impact on
demand)

Market skimming:
• Setting high initial prices (where the product is new and different, high initial profits, short
life cycle, where sensitivity is not known – prices can be reduced later)
Other pricing strategies:
Price discrimination:
• Charging different prices for the same product
• Can be based on market segment, product version, place, time.
• Can you think of examples in practice?
• Own-label pricing is a variant of price discrimination
Premium pricing:
• Making a product appear different through product differentiation by means of quality,
reliability, durability, after sales service, extended warranties etc. Normally means
establishing a brand.
• Can you think of examples in practice?
Product bundling:
• Selling a number of products or services as a package at a price less than sum of the total
individual prices. Encourages customers to buy more.
Pricing with optional extras:
• Similar to price discrimination by product version – sales revenue from increased price
that can be charged is greater than the increased cost of the ‘optional extra’s’
Other strategies continued:

Loss leader pricing:

• Low price for one or small range of products intending to draw customers in and buy
other products as well
• Or for a product in a range, intended to make customers buy the other products in the
range at a higher mark-up (printers and their cartridges is the example in the book)
Discounted pricing:
• To get rid of products at their sell-by date, to increase sales in the ‘off season’, to
generate cash quickly
Controlled prices:
• Government/regulator control over prices
• South African example??