Pricing Decisions

PRICING DECISIONS

Importance of pricing

ü  It contributes to profit maximization

ü  Business makes profit by selling goods and services at a price higher than their cost.

ü  Pricing is one of the four components of marketing mix, the others are: Product, Place and Promotion.

Influences on price

Important factors that influence the pricing of product or service are:

• Costs
• Price Sensitivity
• Competition
• Price-perception-way customers react to prices i.e. Buying more or less.
• Quality
• Intermediaries
• Suppliers
• Inflation
• Newness
• Incomes
• Product range- complementary and substitutes
• Ethics

Markets

The price that an organization can charge for its products will be determined to a greater or lesser degree by the market in which it operates:

• Monopoly: One seller who dominates many buyers. The monopolist can use his market power to set a profit maximizing price.
• Monopolistic Competition: a large number of suppliers offer similar, but not identical products. The similarities ensure elastic demand where as the slight differences give some monopolistic power to the supplier.
• Oligopoly: where relatively few competitive companies dominate the market. Whilst each large firm has the ability to influence the market prices, the unpredictable reaction from the other giants makes the final industry price indeterminable. Cartels are often formed
• Perfect Competition: many buyers and many sellers all dealing in identical product. Neither producer nor user has any market power and both must accept the prevailing market price

Approaches to pricing

1)      Cost based pricing: the accountants approach

“Cost plus” pricing is a much favored traditional approach to establishing the selling price by:

ü  Calculating the unit cost

ü  Adding a mark-up or margin to provide profit

The unit cost may reflect: full cost, manufacturing cost or variable cost (Marginal Cost).

The mark-up is equally subjective and often reflects as:

1. The risk involved in the product
2. Competitor’s mark-ups
3. Desired profit and return on capital employed (ROCE)
4. Type of cost used.
5. Type of product etc.

It is important to understand that:

ü  Profit mark-up is the profit quoted as a percentage of the cost.

ü  Profit margin is the profit quoted as a percentage of selling price.

Example 1

If the full cost of an item is KES 540

Required: calculate the selling price using

a)      25% mark up  

b)      25% profit margin

Example 2

A company budgets to make 20,000 units which have a variable cost of production of KES4 per unit. Fixed production costs are KES60, 000 per annum, if the selling price is to be 40% higher than full cost,

Required: What is the selling price of the product using the full cost-plus method?

Equation for the total cost function

Total cost = fixed cost + variable cost (dependent on the activity level)

y = a + bx

a = fixed cost

b = variable cost per unit (the gradient)

x = activity level (independent variable)

y = total cost.

Example 1

Total Costs ($)	Activity Level (Units)
13500	700
18300	1100

Required:

Calculate the total cost.

a.       Variable cost per unit

b.      Fixed Cost

c.       Formulate the Total Cost Equation

d.      Total cost for 1000 units

Example 2

Month	Activity Level (units)	Total Cost (Kshs)
1	300	3800
2	400	4000
3	150	3000
4	260	3500

Required:

a)      Calculate:

                                i.            Variable cost per unit                                                                           

                              ii.            Fixed cost                                                                                           

                            iii.            Formulate the total cost equation                                                         

b)      Calculate the Total Cost at the following Activity Levels:

                                i.            450 units                                                                                             

                              ii.            550 units                                                                                           

2)      Customers based pricing (the marketer’s approach)

Customer-based pricing reflects customers’ perceptions of the benefits they will enjoy i.e. convenience and status.

Customer-based pricing must ensure that financial objectives are met but exploits the willingness of customer to pay a multiple of the cost price if they perceive the benefits to be substantial i.e. offering of food and drink to tourists on the beach of a remote hot country will be perceived as a benefit and they are prepared to pay more.

3)      Competition-based pricing

Means setting a price based upon the prices of competing products

1. The same type of product-easily distinguished from one’s own products.
2. The same type of product- not easily distinguished from one’s own products.
3. Substitute products i.e. buy ice cream for soft drinks on hot day.
4. Impact of price change will depend on performance of substitutes

4)      Market-skimming pricing strategy

1. An attempt to exploit those sections of the market which are relatively insensitive to price changes.  Initially where high prices may be  charged
2. A skimming policy offers a safeguard against

ü  Unexpected future increases in cost

ü  A large fall in demand

Once markets have matured price can be reduced to attract that part of the market has not been exploited

Conditions for market skimming strategy are:

1. Where the product is new and different
2. Strength of demand and the sensitivity of demand to price are unknown. Where high prices in the early stages of a product’s life might generate high initial cash flow.
3. Where products have a short-life cycle and there is a need to recover their development costs and make profit quickly.

5)      Penetration pricing strategy

Policy of low prices when a product is first launched in order to obtain/gain rapid acceptance.  A penetration policy may be appropriate in the cases below:

1. The firm wishes to discourage new entrants into the market
2. Shorten the initial period of the product’s life cycle in order to enter the growth and maturity stages as quickly as possible.
3. Significant economics of scale to be achieved from high-volume output (cost reductions)
4. Demand is highly elastic and so would respond well to low prices.

6)      Complementary product pricing

Complementary products are goods that tend to be bought and used together.

Complementary products are sold separately but are connected and dependant on each other for sale i.e. electric toothbrush and toothbrush heads.

ü  Provide suppliers  additional power over the consumers

ü  Enable suppliers lock consumers

ü  Enable suppliers to increase the consumer’s switching cost (sell old and buy new printer cartridges).

7)      Product-line pricing

A product line is a group of products that are related to one another. All products within the product line are related but may vary in terms of style, color, quality, price etc

Ø  Capitalizing on consumer interest in a number of product’s with a range

Ø  Making the price entry point for the basic product relatively cheap

Ø  Pricing other items in the range more highly-in order to complete.

8)      Volume-discounting pricing strategy

A volume discount is a reduction in price given for larger than average purchases.

Quantity discounts for customers that order large quantities.

Benefits:

1. Increased customer loyalty
2. Attracting new customers
3. Lower purchasing costs
4. Lower sales processing costs
5. Help to sell items that are bought primarily on price.
6. Competitive advantage
7. Clearance of surplus stock
8. Increased use of off-peak capacity.

9)      Price discrimination

Practice of changing different prices for the same product to different groups of buyers when these prices are not reflective of cost differences .i.e.

1. Market segment
2. Product version
3. Place/location
4. Time
5. Age and gender
6. Type of customer

10)  Relevant Costing Pricing Strategy

Special orders require a relevant cost approach to the calculation of the price. Relevant costs can be used to arrive at a minimum tender price for a one –off tender or contract. The minimum price = total of all relevant cash flows.

Further Examples on Pricing Strategies

Example 1

X Ltd has budgeted to make 50, 000 units of its product, K.  The variable cost of product K is KES5 and annual fixed costs are expected to be KES150, 000.

The financial director of X Ltd has suggested that a profit margin of 25% on full cost should be charged for every product sold.

The marketing director has challenged the wisdom of this suggestion and has produced the following estimates of sales demand for product K.

            Price per unit                                 Demand

                   KES                                       Units

9                                                                                            42,000

10                                                                                        38,000

11                                                                                        35,000

12                                                                                        32,000

13                                                                                        27,000

Required:

a)      Calculate the profit for the year if a full cost price is charged

b)      Calculate the profit-maximizing price.

Assume in both (a) and (b) that 50,000 units of product K are produced regardless of sales volume.

Example 2

A company produces and sells one product and its forecast for the next financial year is as follows:         

                                                                             KES’000         KES’000

Sales 100,000 units @ KES8                                                              800

Variable costs

Material                                                                       300

Labour                                                                         200                  500

Contribution (3 per unit)                                                                     300

Fixed costs                                                                                          150

Net profit                                                                                            150

As an attempt to increase net profit a proposals has been put forward. Lunched advertisement campaign costing KES14, 000 this will increase the sales to 150,000 units, although the price will have to be reduced to KES7.

Required:

Decide whether these proposals should be pursued.

Example 3

X Ltd manufactures and sells a single product.  The following data have been extracted from the current years’ budget.

            Contribution per unit                          KES8

            Total weekly fixed costs                     KES10, 000

            Weekly profit                                      KES22, 000

            Contribution to sales ratio                   40%

The company’s production capacity is not being fully utilized in the current year and three possible strategies are under consideration each strategy involves reducing the unit selling price on all units sold with a consequential effect on the budgeted volume of sales.  Details of each strategy are as follows:

Strategy                      Reduction in unit                   Expected increase

                                    Selling price                           in weekly sales

                                    %                                            Volume over budget

                                                                                    %

A                                 2                                              10

B                                 5                                              18

C                                 7                                              25

The company’s does not hold stocks of finished goods.

Required:

a)      Calculate for the current year:

1. The selling price per unit for the product
2. The weekly sales (in units)

b)      Determine, with supporting calculations, which one of the three strategies should be adopted by the company in order to maximize weekly profits.

DEMAND

Factors influencing demand

Demand is influenced by:

1)      Price of other goods: substitutes and complements

§  Substitutes: increase in demand of one is likely to cause a decrease in demand for the other.

§  Complements: increase in one results in increase in the other.

2)      Income: rise in income gives households more to spend.

§  Normal goods: those which rise in income increases demand.

§  Inferior goods: demand falls as income rises eg cheap wine

§  For some goods, demand rises up to a certain point and then remains unchanged, because there is a limit to what consumers can want or consume eg salt and bread.

3)      Tastes or Fashion: a change in taste or fashion will alter demand for a product.

4)      Expectations: if consumers have expectations that prices will rise or that shortages will occur, they will stock more.

5)      Obsolescence: many products have to be replaced periodically because of obsolescence.

Demand of an individual firm

Demand of an individual firm is influenced by:

1)      Product life cycle: most products pass through a 5 stage life cycle

2)      Quality: one firm’s products may be perceived to be a better quality than the other.

3)      Marketing: the four P’s of marketing normally influence demand. Price, Product, Place and Promotion.

Price-elasticity of demand (PED)

Economic theory argues that the higher the price of goods/products, the lower will be the quantity demanded.

The price elasticity of demand can be calculated as follows:

% change in demand

% change in selling price

NB:

a)      If the % change in demand > the % change in price, then price elasticity > 1

Demand is “elastic” i.e. very responsive

ü  Total revenue increases when price is reduced

ü  Total revenue decreases when price is increased

b)      If the % change in demand < the %change in price, then price elasticity < 1

Demand is “inelastic” i.e. not very responsive

ü  Total revenue decreases when price is reduced

ü  Total revenue increases when price is increased.

c)      If the % change in demand = the % change in price, then price elasticity = 1.  Demand is neither  “elastic” nor “inelastic”

Total revenue remains the same:

ü  When price is reduced- the price reduction is offset by increased demand.

ü  When price is increased-the price increase is offset by reduced demand.

Example 1

The price of a book goes from 40cents to 60cents. Sales of a retailer fall from 20 per day to 12 per day.

Required: Calculate the price elasticity of demand.

Example 2

The price of a product is $1.2 and annual demand is 800000 units. Market research indicates that an increase in price of 10 cents per unit will result in a fall in annual demand of 75000 units

Required: what is the PED

The Demand Equation

When demand is linear, the equation for demand is;

P= a – bQ

Where:

P = Price

a = Price at which demand is zero

b = Change in Price

      Change in quantity ie the gradient of the demand curve.

Steps in determining demand equation

Step 1: Calculate b

Step 2: Substitute the known value of b into the demand function to find a

Step 3: check your equation

Example 1

The current price of a product is $12. At this price the company sells 60 items a month. One month the company decides to raise the price to $15 but only 45 items are sold at this price.

Required: Determine the demand equation

Example 2

The current price of a product is $30 and a producer sells 100 items a week at this price. One week, the price is dropped by $3 as a special offer and the producer sells 150 items.

Required: The demand equation

Profit Maximizing Price/ output level

• The overall objective of an organisation should be profit maximization. Profits are maximized using marginalist theory when Marginal Cost (MC) = Marginal Revenue (MR).
• The Marginal Revenue equation can be found by doubling the value of b in the demand curve equation. The MC is the variable cost of production.
• The optimal selling price can also be determined using tabulation.

MR = a – 2bQ

Where:

P = price

Q = quantity demanded

a = price at which demand would be zero

b = Change in price

      Change in quantity

 

a = $ (current Price) +                Current Q at current Price               * $b

                                         Change in Q when price is changed by $b

 Example 1

AB has used market research to determine that if a price of $250 is charged for product G, demand will be 12000 units. It has also been established that demand will rise or fall by 5 units for every $1 fall/ rise in the selling price. The MC of the product G is $80.

Required: If MR = a – 2bQ when the selling price (P) = a – bQ, calculate the profit maximizing selling price for product G.

Determining the Profit Maximizing Selling Price by Tabulation

Optimal selling price can also be determined by tabulation.

To determine the profit maximizing price:

1)      Work out the demand curve, and hence the price and the Total Revenue (PQ) at various levels of demand.

2)      Calculate Total Costs and hence Marginal Costs at each level of demand.

3)      Calculate Profit at each level of demand, thereby determining the price and level of demand at which profits are maximized.

Example 1

An organization operates in a market where there is imperfect competition, so that to sell more units of output, it must reduce the sales price of all the units it sells. The following data is available for price and costs.

Total Output Units	S.P/ Unit (AR)	Average Cost of output (AC) per Unit
	$	$
0	-	-
1	504	720
2	471	402
3	439	288
4	407	231
5	377	201
6	346	189
7	317	182
8	288	180
9	259	186
10	232	198

The Total Cost (TC) of zero output is $600

Required: At what output level and price would the organisation would maximize its profits, assuming that fractions of units cannot be made.

Solution

Units	Price (AR) $	TR $	MR $	TC $	MC $	Profit $
0
1
2
3
4
5
6
7
8
9
10

Key

TR= Units * Price

MR = The difference between TRs

TC = Units * AC

MC = Difference in TC

Profits = TR - TC