Pricing Decision

1. Irrespective of the nature, size and complexity of an organization, the

most important strategic decision, senior management face is setting
appropriate selling price.

2. For many products and services, the selling price is the primary
determinant of quantity demanded

3. Pricing decision will afect contribution per unit and volume of demand

4. Pricing as a decision must be made and reviewed regularly. Although a

short -run decision, has long term implications as regards its infuence
on achieving sales growth, market share and proftability

5. Pricing policy can be used as a weapon to achieve or eliminate

competition.

6. Price is an element that create sales revenue; however, several factors

will determine the “correct” price such as: long term corporate
objective of the company; the nature of the company’s product; actual
cost of production; the degree of competition; the elasticity of demand
for the company product; the nature of the market

Factors infuencing pricing

1. Cost

In the long run, the sales price must exceed the average cost of sales of the
product that a business entity sells. If cost is higher than selling price, the
business will make a loss and cannot survive in the long term..A company
may have to decide where it wants to position its product in the market in
terms of quality. Premium pricing (higher-than-average prices) prices can be
used for higher quality products, but customers may prefer lower quality,
lower priced products. A clear understanding of the link between quality and
cost will be needed to help management determine the optimum
price/quality [Link] a company is able to reduce its costs, it should be in a
position if it wishes to reduce its sales prices and compete more aggressively
(on price) for a bigger share of the market infuencing pricing

2. Monopoly pricing

Supply and demand in the diagram above is for the market as a whole, and
within the market there might be many diferent suppliers competing with
each other to win business.A similar situation applies to companies that are
dominant in their particular market, and supply most of the goods or services

1
sold in the market. In these ‘monopoly markets’, the individual company has
a downward-sloping demand curve, which means that:as a monopoly
supplier to the market, it is in a position to set prices for the market, but if it
raises the prices of its products, the demand for its products will fall.

3. Pricing in a competitive market

In contrast to a monopoly market, companies that sell their products in a

highly competitive market will decide their selling prices by comparing them
with those of [Link] order to compete efectively, companies might
use short-term pricing tactics such as price reductions, volume purchase
discounts, better credit terms and so on.

4. Quality

Some customers will often be willing to pay more for better quality and
companies may set prices higher than the market average because their
products have a better-quality design or more features that provide value to
[Link] is often ‘real’, and can be provided by better-quality
materials (for example in clothing products) or by greater reliability of
performance or better performance (for example in motor cars).Quality may
also be ‘perceived’ rather than real, and customers will pay more for a
branded product than for a similar or near-identical product with no brand
name or a ‘cheaper’ brand name.

Other factors infuencing price

There are other infuences on pricing decisions and the general level of
selling

prices in a market.

1. The price of ‘substitute goods’- Substitute goods are goods that

customers could buy as an alternative. Companies might set the price
for their product in the knowledge that customers could switch to an
alternative product if they think that the price is too high. For example,
if the price of butter is too high, more customers might switch to
margarine or other types of ‘spread’.

2. The price of ‘complementary goods’- Complementary goods are items that

customers will have to buy in addition to complement the product. The
pricing of complementary products is explained in more detail later, as a
pricing strategy that companies may use.

3. Consumer tastes and fashion- High prices might be obtained for ‘fashion
goods’.

2
4. Advertising and marketing- Sales demand can be afected by sales and
marketing activities, including public relations activity. Strong consumer
interest in a product or service could allow a company to set a higher price

Theoretical Background to Pricing.

 From micro-economic view point, a frm should set a selling price which
maximizes its proft and thereby obtain the most efcient use of the
economic resources.

 The price is at the level of sales where the marginal revenue =

marginal cost

 Demand function/demand curve explains the relationship selling price

and quantity demanded.

 For many products, the higher the selling price the lower demand.

 Understanding of the elasticity of demand for a product also infuences

the price.

 Elasticity of demand measures the extent to which quantity demanded

is infuenced by changes in those variables which afect demand.
These variables could be price, income etc.

 Marginal cost is the additional cost incurred by the production of one

extra unit. It could also be described as the slope of the cost curve

 Marginal revenue is the additional revenue earned by selling one extra

unit. This could also be described as slope of the revenue curve

 The gradient of the total cost line, marginal cost can be found by
diferentiating the expressions for total cost with respect to quantity

Price elasticity of demand: its meaning and measurement

Within a market as a whole, there is an inverse relationship between selling

price
and sales demand. At higher prices, total sales demand for a product will be
lower. For individual companies in a monopoly position in their market (or
niche
of the market) the same rule applies: if prices are raised, demand will fall.

3
The price elasticity of demand (PED) is a measurement of the change in
sales
demand that would occur for a given change in the selling price.

Elastic and inelastic demand

Sales demand for a product could be either elastic or inelastic in response to

changes in sales price.

Demand is elastic if its value is above 1. (More accurately, demand is

elastic if its elasticity is a fgure larger than – 1.)

Demand is inelastic if its value is less than 1. (More accurately, demand is

inelastic if its elasticity is a fgure below – 1, between 0 and – 1.)

The signifcance of elasticity

Price elasticity of demand afects the amount by which total sales revenue
from a
product will change when there is a change in the sales price.
If demand is highly elastic (greater than 1, ignoring the minus sign):

increasing the sales price will lead to a fall in total sales revenue, due to a
large fall in sales demand, and

a reduction in the sales price will result in an increase in total sales

revenue, due to the large rise in sales demand.
Proft might increase or decrease when the sales price is changed,
depending on

4
changes in total costs as well as the change in total revenue.
If demand is inelastic (less than 1, ignoring the minus sign):

increasing the sales price will result in an increase in total sales revenue
from the product, because the fall in sales volume is fairly small, and
reducing the sales price will result in lower total sales revenue, because the
increase in sales demand will not be enough to ofset the efect on revenue
of the fall in price.

A product does not necessarily have high or low price elasticity of demand at
all
price levels. The same product might have a high price elasticity of demand
at
some sales prices and low price elasticity at other prices.© Emile Woolf
International

Elasticity and setting prices

An understanding of the price elasticity of demand for products can help
managers to make pricing decisions:

If demand is inelastic, raising selling prices will result in higher sales

revenue. Since fewer units will be sold, it should be expected that total costs
will fall. Higher revenue and lower total costs mean higher profts. If
management believe that sales demand for their product is price-inelastic,
they might therefore consider raising the sales price.

If demand is inelastic, reducing the sale price will lead to lower total sales
revenue. Sales demand will increase, and so the costs of sales are also likely
to increase. Profts are therefore likely to fall.

If demand is elastic, an increase in the sales price will lead to a fall in total
sales revenue. Sales demand will also fall. If managers are thinking about an

5
increase in the sales price, they will have to consider whether the fall in total
costs (due to the lower volume of sales) will exceed the fall in total revenue.

If demand is elastic, reducing the sales price will increase total sales revenue
from the product, but total sales volume will increase. The efect, as with
raising sales prices for a product with high price elasticity of demand, could
be either higher or lower total profts. There is a risk that if
one company reduces its sales prices and elasticity of demand is high, this
could lead to a ‘price war’ in which all competitors reduce their prices too. At
the end of a price war, all sellers are likely to be worse of. Companies might
try to reduce the price elasticity of demand for their products by
using non-price methods, such as improving product quality, improving
service
and the use of advertising and sales promotions.

PRICE STRATEGIES
 The nature of pricing strategies
 Full cost-plus pricing
 Marginal cost-plus pricing (mark-up pricing)
 Return on investment (ROI) pricing
 Market skimming prices
 Market penetration prices
 Pricing of complementary products and product line pricing
 Volume discounting
 Price discrimination (diferential pricing)

The nature of pricing strategies

Although sales prices in a market are determined largely by factors such as
supply and demand and competition, companies might use a variety of
diferent pricing strategies, depending on the nature of their business, the
nature of the markets in which they operate and the particular
circumstances in which a pricing decision is made. For example: For

6
companies in a jobbing industry or contracting industry, each new job or
contract might be diferent, and this means that a separate price has to be
calculated for each individual job or contract. Some form of cost-plus pricing
is therefore often used in these industries. When a company brings an
entirely new product to the market, can decide whether to set the price high
or low, because there are no rival products on the market.

Several diferent pricing strategies are described in this section.

4.2 Full cost plus pricing

Full cost plus pricing involves calculating the full cost of an item (such as a
job or contract) – or the expected full cost – and adding a proft margin to
arrive at a selling price. Proft is expressed as either:
a percentage of the full cost (a proft ‘mark-up’) or
a percentage of the sales price (a ‘proft margin’).

Advantages of full cost plus pricing

A business entity might have an idea of the percentage proft margin it

would like to earn on the goods or services that it sells. It might therefore
decide the average proft mark-up on cost that it would like to earn from
sales, as a general guideline for its pricing decisions. This can be useful for
businesses that carry out a large amount of contract work or jobbing
work, for which individual job or contract prices must be quoted regularly to
prospective customers and there is no obvious ‘fair market’ price. The
percentage mark-up or proft margin does not have to be a fxed percentage
fgure. It can be varied to suit the circumstances, such as demand conditions
in the market and what the customer is prepared to pay. There are also
other possible advantages in using full cost-plus pricing: If the budgeted
sales volume is achieved, sales revenue will cover all costs and there will be
a proft. It is useful for justifying price rises to customers, when an increase
in price occurs as a consequence of an increase in costs.

Disadvantages of full cost plus pricing

The main disadvantage of cost-plus pricing is that it is calculated on the

basis of cost, without any consideration of market conditions, such as
competitors’ prices. Cost plus pricing fails to allow for the fact that when the
sales demand for a product is afected by its selling price, there is a proft-
maximizing combination of price and demand. A cost-plus based approach to
pricing is unlikely to arrive at the proft-maximizing price for the product.

In most markets, prices must be adjusted to market and demand

conditions. The pricing decision cannot be made on a cost basis only.

7
There are also other disadvantages:

The choice of proft margin or mark-up is arbitrary. How is it decided?

When a company makes and sells diferent types of products, the

calculation of a full cost becomes a problem due to the weaknesses of
absorption costing. The method of apportioning costs between the diferent
products in absorption costing is largely subjective. This afects the
calculation of full cost and the selling price. For example, full cost per unit
will difer according to whether a direct labour hour absorption rate or a
machine hour absorption rate is used. Full cost will also difer if activity-
based costing is used.

Marginal cost-plus pricing (mark-up pricing)

With marginal cost-plus pricing, also called mark-up pricing, a mark-up or
proft margin is added to the marginal cost in order to obtain a selling price.
The method of calculating sales price is similar to full-cost pricing, except
that marginal cost is used instead of full cost. The mark-up represents
contribution.

Advantages of marginal cost plus pricing

The advantages of a marginal cost plus approach are as follows:

1. It is useful in some industries such as retailing, where prices might be

set by adding a mark-up to the purchase cost of items bought for
resale. The size of the mark-up can be varied to refect demand
conditions. For example, in a competitive market, a lower mark-up
might be added to highvolume items.
2. It draws management attention to contribution and the efects of
higher or lower sales volumes on proft. This can be particularly useful
for short-term pricing decisions, such as pricing decisions for a market
penetration policy
3. When an organisation has spare capacity, marginal cost plus pricing
can be used in the short-term to set a price which covers variable cost.
This approach is used by hotels, airlines, railway companies and
telephone companies to price of-peak usage. As long as fxed costs
are covered by peak users and the lower price set does not afect the
main market, a marginal cost price can be set of-peak to increase
demand and therefore contribution. It is more appropriate where fxed
costs are low and variable costs are high.

Disadvantages of marginal cost plus pricing

8
A marginal cost plus approach to pricing also has disadvantages.
Although the size of the mark-up can be varied according to demand
marginal cost plus pricing is a cost-based pricing method, and does not
properly take market conditions into consideration.
It ignores fxed overheads in the pricing decision. Prices must be high
enough to make a proft after covering all fxed costs. Cost-based pricing
decisions therefore cannot ignore fxed costs altogether. A risk with marginal
cost plus pricing is that the mark-up on marginal cost might not be sufcient
to cover fxed costs and achieve a proft.

4.4 Return on investment (ROI)pricing

This method of pricing might be used in a decentralised environment where

an
investment centre within a company is required to meet a target return on
capital
employed. Prices might be set to achieve a target percentage return on the
capital invested. With return on investment pricing, the selling price per unit
may be calculated as:

When the investment centre makes and sells a single product, the budgeted
volume is sales volume. When the investment centre makes and sells several
diferent products,
budgeted volume might be production volume in hours, and the mark-up
added
to cost is then a mark-up for the number of hours worked on the product
item.
Alternatively, the budgeted volume might be sales revenue, and the mark-up
is
then calculated as a percentage of the selling price (a form of full cost plus
pricing).

Advantages of ROI pricing

The advantages of an ROI approach to pricing are as follows:

ROI pricing is a method of deciding an appropriate proft margin for cost
plus pricing.

The target ROI can be varied to allow for difering levels of business risk.

Disadvantages of ROI pricing

An ROI approach to pricing also has disadvantages.

Like all cost-based pricing methods, it does not take market conditions into
sufcient consideration, and the prices that customers will be willing to pay.


9
Since it is a form of full cost plus pricing, it shares most of the other
disadvantages as full cost plus pricing

Market skimming prices

When a company introduces a new product to the market for the frst time, it
might choose a pricing policy based on ‘skimming the market’. When a new
product is introduced to the market, a few customers might be prepared to
pay a high price to obtain the product, in order to be one of the frst people
to have it. Buying the new product gives the buyer prestige, so the buyer
will pay a high price to get it. In order to increase sales demand, the price
must be gradually reduced, but with a skimming policy, the price is reduced
slowly and by small amounts each time. The contribution per unit with a
skimming policy is very high, although unit costs
of production could also be quite high, since sales volumes are low. To
charge high prices, the frm might have to spend heavily on advertising and
other marketing expenditure.
Market skimming will probably be more efective for new ‘high technology’
products, such as (in the past) fat screen televisions and laptop computers.
Firms using market skimming for a new product will have to reduce prices
later as new competitors enter market with rival products. A skimming
strategy is therefore a short-term pricing strategy that cannot usually be
sustained for a long period of time.

Skimming prices and a product diferentiation strategy

It is much more difcult to apply a market skimming pricing policy when

competitors have already introduced a rival product to the market.
Customers in the market will already have a view of the prices to expect, and
might not be persuaded to buy a new version of a product in the market
unless its price is lower than prices of existing versions. However, it may be
possible to have a policy of market skimming if it is possible to diferentiate a
new product from its rivals, usually on the basis of quality. This is commonly
found in the market for cars, for example, where some manufacturers
succeed in presenting new products as high-quality models. High
quality cars cost more to produce, and sales demand may be fairly low:
however,
profts are obtained by charging high prices and earning a high contribution
for
each unit sold.© Emile Woolf International

Market penetration prices

Market penetration pricing is an alternative pricing policy to market

skimming, when a new product is launched on to the market for the frst
time. With market penetration pricing, the aim is to set a low selling price for
the new product, in order to create a high sales demand as quickly as

10
possible. With a successful penetration pricing strategy, a company might
‘capture the market’ before competitors can introduce rival products. A frm
might also use market penetration prices to launch its own version of a
product into an established market, with the intention that ofering low
prices will attract customers and win a substantial share of the market.

Penetration pricing and a cost leadership strategy

A cost leadership market strategy is a strategy of trying to become the

lowest cost producer of a product in the market. Low-cost production is
usually achieved through economies of scale and large-scale production and
sales volumes.
Penetration pricing is consistent with a cost leadership strategy, because low
prices help a company to obtain a large market share, and a large market
share
means high volumes, economies of scale and lower costs.

4.7 Pricing of complementary products and product line pricing

Complementary products
Complementary products are products that ‘go together’, so that if
customers buy
one of the products, they are also likely to buy the other. Examples of
complementary products are: computer games consoles and computer
games; mobile telephones (portable phones) and telephone calls from
mobile phones. Occasionally if a company sells two or more complementary
products it could sell one product at a very low price in the knowledge that if
sales demand for the frst product is high, customers will then buy more of
the second product(which can be priced to provide a much bigger proft
margin).

Product lines

A product line is a range of products made by the same manufacturer (or a

range of services from the same service provider) where the products have
some similarity or connection so that customers see them as belonging to
the same ‘family’. Examples of a product line are: a brand and design of
tableware manufactured by the same company (such as a range of
tableware items in Dresden china);

a brand and range of sports items (such as rackets or golf equipment)

made by the same manufacturer.
When manufacturers produce a line of related items, the pricing strategy for
all
items in the product line might be the same (for example, a product line
might be
sold as a high-price, high-quality branded range)

11
Chapter review

Volume discounting
A price strategy of volume discounting involves selling at reduced prices to
customers who buy in large volumes over a period of time, or for large-value
sales orders. Volume discounting can have either of the following purposes:

To persuade customers to buy a product, by ofering a lower price (on

condition that the order is above a given size)

To increase profts by selling in larger volumes, even though the sales price
is lower.

Price discrimination (diferential pricing)

With price discrimination (or diferential pricing), a frm sells a single

identical
product in diferent segments of the market at diferent prices. A market
segment is simply a separately-identifable part of the entire market.
Customers in one market segment have diferent characteristics, buying
habits, preferences and needs from the customers in other segments of the
same total market.

For price discrimination to work successfully, the diferent market segments

must
be kept separate. It might be possible to charge diferent prices for the same
product:

in diferent geographical areas – for example, it would be possible to sell

the same product at very diferent prices in the US and in China;

at diferent times of the day – for example, travel tickets might be priced
diferently at diferent times of the day or the week;

to customers in diferent age groups – for example, ofering special prices

to individuals over a certain age,

12