Chapter 3

The Pricing Decision

BAIBF09013 A DVA N C E D PERFORMANCE M A NAG E M E N T
 CHAPTER
SUMMARY
• Price Elasticity of Demand (PED)

• Market Structures

• Pricing Strategies

• Product Life Cycle

• The Profit Maximization Model

2
 PRICE ELASTICITY OF DEMAND
When a business proposes to change the price of a product or service, the key question to look at is
what impact the change in price will have on the volume of the product sold, in other words, the
demand.

Definition
The price elasticity of demand measures the change in demand as a result of a change in price.

% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑑𝑒𝑚𝑎𝑛𝑑𝑒𝑑

Price Elasticity of Demand (PED)=
% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑝𝑟𝑖𝑐𝑒

*The relationship between price and quantity demanded is inverse, hence, PED is always negative.

Familiarization

Assume that the sales of a retailer fall from 20 per day to 12 per day when the price of a
chocolate bar goes up from 40c to 60c. What is the price elasticity of demand? .
𝟏𝟐−𝟐𝟎
% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑑𝑒𝑚𝑎𝑛𝑑𝑒𝑑 { }
𝟐𝟎
Price Elasticity of Demand (PED) -0.8 = 𝟔𝟎−𝟒𝟎
% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑝𝑟𝑖𝑐𝑒 { }
𝟒𝟎

3
 ELASTIC AND INELASTIC DEMAND
ELASTIC DEMAND

If the percentage change in demand exceeds the percentage change in price, then price elasticity
will be greater than 1. Here, Demand is 'elastic' (very responsive to changes in price)

E.g. if the % change in Qd is 50% and the % change in P is 20%, the PED will be (50%/20% = 2.5)

• Total revenue increases when price is reduced

• Total revenue decreases when price is increased.

Recommended Strategy – Cut prices

Inelastic demand

If the percentage change in demand is less the percentage change in price, then price elasticity will
be lower than 1. Here, Demand is 'inelastic' (not very responsive to changes in price)

E.g. if the % change in Qd is 20% and the % change in P is 50%, the PED will be (20%/50% = 0.4)

• Total revenue decreases when price is reduced

• Total revenue increases when price is increased

Recommended Strategy – Increase prices

. 4
DEPICTS OF
PED
Perfectly Inelastic Inelastic Unitary Elastic

Perfectly Elastic Elastic Kinked Demand Curve

*Price stickiness
5
 FACTORS AFFECTING PED
• Scope of the market - The larger the defined market, the more inelastic is the demand for the
broader definition of product. For example, the total market for transport is relatively inelastic,
whereas the market for pedal cycles is comparatively elastic.

• Information within the market - Consumers may not know of the competing products in
sufficient time to reassess their purchasing behavior.

• Availability of substitutes - The less the differentiation between competing products, the greater
the price elasticity of those products. Differentiated products benefit from customer awareness
and preference. So, their demand patterns tend to be more inelastic.

• Complementary products - The interdependency of products results in price inelasticity because

the volume sales of the dependent good rely on sales of the primary good. The consumer will
make a purchase of the complementary product in order to achieve satisfaction from the primary
good.

• Disposable Income - The relative wealth of the consumers over time affects the total demand in
the economy.

• Luxuries & Necessities - Demand for basic items such as milk, bread, toilet rolls etc. tend to be
very price inelastic. Luxury goods tend to have a high price elasticity, while necessities are usually
inelastic.

• Habits - Items consumers buy out of habit, such as cigarettes are usually price inelastic. 6
 MARKET STRUCTURES
The price that a business can charge for a product or a service is determined by the type of market in
which it operates.
Market Structures

Perfectly Monopolistic
Monopoly Oligopoly
Competitive Competition
• Homogeneous
• Unique product • A combination • Few sellers
product
monopoly of dominate the market
• High entry and exit perfectly and
• No entry and exit
barriers competitive markets • Firms are inter-
barriers
dependent
• No • N umber of each other between
• Perfect
perfect information buyers
information
and sellers E.g. Automobile
• Seller dominated the • D ifferentiated manufacturing
• Companies aim to
buyers products
maximize profits
by increasing sales
E.g. Electricity, Water • Some sellers can
volumes
charge high prices
• Every buyer due
seller to
taker'. or is differentiation
E.g. Salons, Music 7
E.g. Vegetables,
a Eggs,

'price
 PRICING STRATEGIES – COST BASED
Total Cost plus pricing
This involves adding a markup to the total cost of the product in order to arrive at the selling price.

Advantages
• Profits will be met given the budgeted sales volumes are achieved
• A realistic, quick and an easy method if the organization knows their cost structure
• Can be useful in justifying the increase of selling price to customers

Disadvantages
• Issues in selecting a base to charge overheads to products
• Overheads will not be recovered if the actual sales volume is less than the budgeted volume
• Ignores factors such as competitor activity

Marginal cost plus pricing

This involves adding a markup to the marginal cost of the product in order to arrive at the selling
price.

Advantages
• Considered accurate and realistic
• Gives the managers the opportunity to price below the total cost when times are bad to fill capacity
• Can be used in one off contracts because it identifies only relevant costs
Disadvantages
• Ignores market prices
• Does not take the full cost of the product into account
© C hathura Jayasundara 8
 PRICING STRATEGIES – MARKETING BASED
• Premium Pricing
• Premium pricing is pricing above competition on a permanent basis. This can only be done if the
product appears ‘different’ and superior to competition. This normally means establishing a
brand name based on Quality, Image/style, Reliability/robustness, Durability, Aftersales service
and Extended warranties.

• Market skimming
• Skimming is a technique where a high price is set for the product initially so that only those who
are desperately keen on the product will buy it. Then the price is lowered making the product
more accessible. When the next group of customers have had a chance to buy at that price, the
price is lowered again, and so on. The aim of this is to maximize revenue.

• Penetration pricing
• Penetration pricing occurs when a company sets a very low price for the new product initially.
The price will usually be below total cost. The aim of the low price is to establish a large market
share quickly by encouraging customers to try the product and then to repeat buy. This type of
tactic is where barriers to entry are low. It is hoped to establish a dominant market position, which
will prevent new entrants coming into the market because they could not establish a critical mass
easily with prices so low.

9
 PRICING STRATEGIES –
• MARKETING BASED
Differentiation
• If the market can be split into different segments, each quite separate from the others and with its
own individual demand function, it is possible to sell the same product to different customers at
different prices. Segmentation will usually be on the basis of time, quantity, type of customer,
geographical location, product content etc.

• Loss leader pricing

• When a product range consists of one or more main products and a series of related optional
‘extras’ which the customer can ‘add on’ to the main product, the supplier can set a relatively low
price for the main product and a high one for the ‘extras’. Obviously, the aim is to stimulate
sufficient demand for the former to ensure the target return from sales of the latter.

• Discount pricing
• Products are priced lower than the market norm but are put forward as being of
comparable quality. The aim is that the product will procure a larger share of the market than it
might otherwise do, thereby counteracting the reduction in selling price. However, care must be
taken to ensure that potential customers' perceptions of the product are not prejudiced by the
lower price. The consumer will often view with suspicion a branded product that is priced at
even a small discount to the prevailing market rate.

10
 PRICING STRATEGIES – MARKETING BASED
• Controlled Pricing
• Regulation largely takes the form of controlling price so that the monopolistic
companies cannot exploit their unique position. The regulators use selling
price as the means of controlling the volume of supply in the industry. They
may also decide to specify the quality of the product or level of service that
must be achieved or to prohibit the company operating in certain sectors.
When an industry is regulated on selling price, the elasticity is zero. No price
change is allowed.

• Product bundling
• Bundling is putting a package of products together to make, for example, a
complete kit for customers which can then be sold at a temptingly low price.
It is a way of creating value for customers and increasing company profits. It
is a strategy that is often adapted in times of
recession when organizations are particularly keen to maintain sales volume.

11
 PRODUCT LIFE CYCLE

Introduction Growth Maturity Decline

• Low demand • Growth in demand • Growth in demand • Sales volumes
starts slowing down start declining
• High unit cost • Growth in profits
• Profits • Product
• Low profits due to • Cost per unit start shrinking prices decline
high fixed costs reduces due to
such as marketing Economies of scale • Differentiated • The product could
costs products either be sold at very
• Competitors are required to low prices, or could
• Market start remain in the be discontinued
penetration, entering the market market
skimming • Competitive pricing
or premium can be adopted • Differentiated or
pricing can be 12
Discounted pricing
used can be used
 THE PROFIT MAXIMIZATION MODEL
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 (the marginal revenue exceeds the
marginal cost). However, if the cost of the next unit outweighs the revenue that could be earned
from it (the marginal cost exceeds the marginal revenue), production would not be worthwhile.

A firm should therefore produce units up to the point where the marginal revenue equals the
marginal cost (MR = MC)

Conceptualization
No of Cost per Price per Total Marginal
units unit unit Revenue Revenue

1 $30 $70 $70 $70

2 $30 $60 $120 $50 Profit Maximizing Output
3 $30 $50 $150 $30
4 $30 $40 $160 $10
5 $30 $30 $150 ($10)
Marginal revenue is the additional revenue from
selling one extra unit.

Marginal cost is the cost from making one

more
unit. It is usually just the variable cost 13
ESTABLISHING THE OPTIMUM PRICE FOR A
PRODUCT
1. Establish the linear relationship between price (P) and quantity demanded (Q)
P = a + bQ

P = Price
a = the price at which q = 0 (intercept)
b = change in p/ change in Q (slope)
Q = quantity demanded

* b (slope) is always a minus (-) the relationship between price and quantity is
negative

2. Double the gradient to find the marginal revenue

M R = a + 2bQ

3. Establish the marginal cost M C . This will simply be the variable cost per unit

4. To maximize profit, equate M C and MR and solve to find Q

5. Substitute this value of Q into the price equation to find the optimum price
14
6. Calculate the maximum profit
FAMILIARIZAT
ION
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.

1. Establish the linear relationship between price (P) and quantity demanded (Q)
P = a + bQ
200 = a + {(20/-50) ×
1000} a = 600
P = 600 – 0.4Q

2. Double the gradient to

find the marginal revenue
M R = a + 2bQ
M R = 600 – 0.8Q

3. Establish the marginal

cost M C . This will
simply be the variable
cost per unit.
M C = 140

4. To maximize profit,
equate M C and MR and
solve to find Q
M R = 600 –
0.8Q 140 = 600
– 0.8Q
Q = 575
15
5. Substitute this
value of Q into
the price
 LIMITATIONS
THE PROFIT MAXIMIZATION MODEL DOES MAKE SOME ATTEMPT TO TAKE ACCOUNT OF THE
RELATIONSHIP BETWEEN THE PRICE OF A PRODUCT AND THE RESULTING DEMAND, BUT IT IS
OF LIMITED PRACTICAL USE BECAUSE OF THE FOLLOWING LIMITATIONS.

• It is unlikely that organizations will be able to determine the demand function for their products
or services with any degree of accuracy.

• The majority of organizations aim to achieve a target profit, rather than the theoretical
maximum profit

• D etermining an accurate and reliable figure for marginal or variable cost

poses
difficulties for the management accountant

• 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

• Other factors, in addition to price, will affect the demand, for example, the level
of
advertising or changes in the income of customers

16
 THE TABULAR
APPROACH
When data in the exam is given in tabular form and there is no indication about the demand function,
and/or when there is no simple linear relationship between output and profit,
the tabular approach is likely to be the best to define optimum profit and the associated selling price.

Price per unit $22 $20 $18 $16

Variable cost per unit (xx) (xx) (xx) (xx)

Contribution per unit xx xx xx xx

No of units sold xxx xxx xxx xxx

Total contribution xxxx xxxx xxxx xxxx

Total Fixed Cost (xxx) (xxx) (xxx) (xxx)

Net Profit xxx xxx xxx xxx

17
THANKYOU

18