Chapter 5: The Pricing of Goods and Services

In the world of cost and management accounting, the pricing of goods and services holds pivotal role in
determining the success and profitability of a business. The price a firm charges for its product or
service is one of the most important business decisions it makes. Setting a price that is too high or too
low will - at best - limit a business growth. At worst, it could cause serious problems for sales and cash
flow.
Most companies carefully analyse their input costs and the prices of their products. To maximise profits
and achieve growth, a firm needs to determine the right price for its products and services. Setting the
right price will ensure that customers are satisfied and that a business stays profitable. They know if the
price is too high, customers will go to competitors; if the price is too low, the company won’t be able to
cover the cost of making the product. A company must also know how its customers will react to
particular pricing strategies.

How companies price a product or a service ultimately depends on the demand and supply for it. Three
major factors that influence pricing decision are customers, competitors, and costs.
1. Customers: customers influence price through their effect on the demand for a product or service,
based on factors such as the features of a product and its quality. As the Tata Motors example
illustrates, companies must always examine pricing decisions through the eyes of their customers
and then manage costs to earn a profit.
2. Competitors: no business operates in a vacuum. Companies must always be aware of the actions of
their competitors. At one extreme, alternative or substitute products of competitors hurt demand and
force a company to lower prices. At the other extreme, a company without a competitor is free to set
higher prices. When there are competitors, companies try to learn about competitors' technologies,
plant capacities, and operating strategies to estimate competitors' costs, valuable information when
setting prices. Because competition spans international borders, fluctuations in exchange rates
between different countries' currencies affect costs and pricing decisions. For example, if the yen
weakens against the U.S. dollar, Japanese products become cheaper for American consumers and,
consequently, more competitive in U.S. markets.
3. Costs: costs influence prices because they affect the supply. The lower the cost of producing a
product, the greater the quantity of product the company is willing to supply. Generally, as
companies increase supply, the cost of producing an additional unit initially declines but eventually
increases. Companies supply products as long as the revenue from selling additional units exceeds
the cost of producing them. Managers who understand the cost of producing products set prices that
make the products attractive to customers while maximizing operating income.
5.1 Target and Minimum Pricing
Target Pricing: Target pricing is a pricing strategy that determines a product's price based on the
maximum price consumers are willing to pay for it, and the desired profit margin. It is the estimated
price for a product or service that potential customers are willing to pay. The goal is to set a price that is
both profitable for the business and affordable for customers. Managers base this estimate on an
understanding of customers’ perceived value for a product or service and how competitors will price
competing products or services. In today’s business context, managers need to understand customers
and competitors for three reasons:
1. Lower-cost competitors continually restrain prices.
2. Products have shorter lives, which leaves companies less time and opportunity to recover from
pricing mistakes, loss of market share, and loss of profitability.
3. Customers are more knowledgeable because they have easy access to price and other
information online and demand high-quality products at low prices.

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Target pricing involves identifying the optimal price point that aligns with customer expectations and
market dynamics. To implement target pricing effectively, businesses conduct thorough market research
to understand customer behaviour, preferences, and competitor pricing strategies. It also takes into
account factors like production costs and desired profit margins. This strategy allows
businesses to set competitive prices while maintaining profitability.
Minimum Pricing: Minimum pricing is the lowest price at which a product or service must be sold to
cover variable costs and avoid financial losses. This is essential for cost management.
Determining the minimum price involves calculating the total variable costs, which typically include
direct materials, direct labour, and variable overhead. While businesses often aim to set prices above the
minimum pricing threshold to generate a profit, understanding the minimum price is crucial for
making informed decisions, especially when facing competitive pricing pressures.
Both target pricing and minimum pricing are effective strategies for businesses to maintain profitability
and competitiveness in the market. However, businesses should carefully consider their pricing strategy
based on factors such as customer demand, competitor pricing, and production costs to ensure that they
are offering attractive prices to customers while also maintaining profitability.
Target pricing helps businesses maintain profitability while also providing customers with attractive
pricing. Minimum pricing, on the other hand, is a pricing strategy where a business sets a minimum
price for a product to ensure profitability.
5.2 Price/Demand Relationships
Understanding the relationship between price and demand is crucial for effective pricing
strategies that maximize revenue and profitability. Key to this understanding is the concept of price
elasticity of demand.
Price Elasticity of Demand: Price elasticity of demand measures how sensitive consumer
demand is to changes in price. It is expressed as a numerical value, indicating the percentage change in
quantity demanded in response to a one percent change in price.
Price Elasticity of Demand = % Change in Quantity / % Change in Price
 High Elasticity: When demand is highly elastic (elasticity > 1), consumers are very responsive to
price changes. Small price increases can lead to a significant decrease in demand, while price
reductions can result in a substantial increase in demand. Companies operating in markets with
highly elastic demand must be cautious when rising prices and may benefit from
price reductions to boost sales.
 Low Elasticity: In contrast, inelastic demand (elasticity < 1) indicates that consumers are less
responsive to price changes. Price increases may result in only small decreases in demand, while

price reductions may not significantly boost sales. Industries with inelastic demand can
potentially raise prices without a significant drop in sales, thereby increasing revenue
and profitability.
Adjusting Prices Based on Elasticity: Price elasticity of demand guides pricing decisions.
Products or services with highly elastic demand may benefit from lower prices to increase
market share and maintain or boost sales volume. For products with inelastic demand, there may be
opportunities for price increases, leading to higher margins. Understanding price elasticity of
demand, alongside the cost structure, assists businesses in determining optimal pricing points that
maximize profitability.
5.3 The Pricing of Special Orders and Short-Life Products

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Special orders and short-life products require unique pricing strategies to address specific market
conditions and operational challenges.
Special Orders: A special order is a one-time order/request made for one of the company's regular
products. Special orders often involve large or non-standard requests from customers, varying from the
typical offerings of a business. Pricing these orders requires considering factors such as production
costs, impact on regular sales, and profit margins.
-Pricing Bulk Orders: In the case of bulk orders, companies may offer discounts to incentivize
customers to place large orders. The key is to calculate the cost of producing the additional units and
ensure that the price covers these costs while providing a reasonable profit.
-Customized Products: Customized products are products that have been modified to meet a
customer's specific needs and preferences. Customization can involve: changing the product's design,
changing the product's features, changing the product's functionality, adding personalized engravings,
and uploading custom designs. Special orders for customized products are more complex. Pricing must
account for the additional costs involved in customization, ensuring the customer covers these expenses
while allowing for a profit margin.
Short-Life Products: For short-life products, businesses may need to set prices that reflect
the limited availability of these products. This can involve charging a higher price to compensate for
the shorter production and sales cycle of these products. Alternatively, businesses may
need to offer discounts or promotions to encourage customers to purchase these products before
they become obsolete.
These are items with limited shelf life or relevance in the market, such as seasonal products, perishables,
or technology products with a short lifecycle. Pricing strategies for short-life products aim to optimize
revenue and manage inventory effectively.
- Seasonal Products: Companies often employ pricing strategies like seasonal discounts or
promotions to sell these products quickly, creating a sense of urgency and encouraging consumer
purchases during specific times of the year.
-Perishable Goods: Pricing for perishable goods may involve gradual markdowns as the expiry date
approaches. This strategy seeks to find a balance between minimizing waste and
maximizing revenue by tracking inventory levels and monitoring consumer behaviour.
-Technology Products: Short-life technology products often require tiered pricing, launching products
at premium prices and gradually reducing them as newer models become available.
Pricing strategies for special orders and short-life products require a deep understanding of the cost
structure, market dynamics, and customer behaviour. Tailoring pricing strategies to these specific
scenarios ensures businesses make informed decisions that align with their objectives.
5.4 Pricing in Service Industries
Pricing in service industries differs significantly from pricing tangible goods. It involves
considering factors such as labour costs, overhead, and perceived value. Service providers must craft
pricing strategies that reflect the unique characteristics of their offerings.
Labour Costs and Overhead: In service businesses, labour costs and overhead are significant
components of the cost structure. Pricing should ensure that these costs are covered and provide room
for profit.
Perceived Value: Unlike tangible products, services are intangible, making the concept of
perceived value central to pricing.
Perceived value is how customers assess the worth of a service based on their expectations, past
experiences, and the quality of service provided.

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-Premium Pricing: Service providers with strong reputations for high-quality service often
employ premium pricing strategies, setting prices at a premium to signify superior quality.
Customers who value top-tier service are willing to pay more for the perceived value.
-Value-Based Pricing: Value-based pricing aligns the price with the value delivered to the customer. It
involves understanding the specific benefits and outcomes a customer receives and pricing accordingly.
For instance, a consulting firm might charge fees based on the financial improvements it brings to a
client's business.
-Bundle Pricing: Service providers often bundle various services together into packages,
allowing customers to access multiple services at a discounted rate compared to purchasing each service
individually. This can be an effective way to increase the overall value of service
offerings and encourage customers to buy more.
- Dynamic Pricing: Some service industries use dynamic pricing, which adjusts prices in real-time
based on factors such as demand, time of day, or other market conditions. This strategy can maximize
revenue by charging higher prices when demand is high and lower prices during off-peak times.
Pricing in service industries is multifaceted, often dependent on the nature of the service offered.
Companies must carefully consider their cost structures, competitive landscape, and customer
perceptions to determine effective pricing strategies.
5.5 Transfer Pricing
Transfer pricing is a critical consideration for organizations with multiple divisions or
subsidiaries, where goods or services are transferred between different departments or divisions.
It involves determining prices when one division transfers goods or services to another within the same
organization. It is the price charged for goods produced by one division and transferred to another. It is
the price at which these goods or services are transferred within the organization, and it plays a
significant role in determining the profitability of each department or division. The transfer price also
affects the managerial performance measures of both divisions.
A transfer price is the price one subunit (department or division) charges for a product or service
supplied to another subunit of the same organization. If, for example, a car manufacturer like BMW or
Ford has a separate division that manufactures engines, the transfer price is the price the engine division
charges when it transfers engines to the car assembly division. The transfer price creates revenues for
the selling subunit (the engine division in our example) and costs for the buying subunit (the assembly
division in our example), affecting each subunit’s operating income. These operating incomes can be
used to evaluate the subunits’ performances and to motivate their managers. The product or service
transferred between subunits of an organization is called an intermediate product. The receiving unit
(the assembly division in the engine example) may work on the product further or the product may be
transferred from production to marketing and sold directly to an external customer.
Methods of Transfer pricing:
-Marginal Cost Pricing: One common approach is setting transfer prices at the marginal cost of the
supplying division, without considering fixed costs. This approach simplifies pricing and aligns with
optimizing divisional performance. It minimizes the potential for profit manipulation by divisions.
-Negotiated Pricing: Divisions often negotiate transfer prices. This approach allows divisions to
consider their unique circumstances and reach mutually acceptable agreements. However,
negotiated pricing may lead to suboptimal outcomes if divisions do not fully understand the
organization's goals.
-Market-Based Pricing: In some cases, external market prices are used as a reference for transfer
pricing. This method assumes that the price of the transferred goods or services would be similar to what

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the division could obtain on the open market. Market-based pricing is effective when the market for the
product or service is well-established and competitive.
-Cost-Plus Pricing: Cost-plus pricing involves adding a mark-up to the cost incurred by the supplying
division, typically including a percentage profit. Cost-plus pricing ensures that divisions are
adequately compensated for their contributions.
5.5.1 Transfer Pricing: General Rule for Optimal Transfer Pricing
The general rule for optimal transfer pricing aims to balance divisional autonomy with the
organization's overall benefit. It prevents suboptimal decision-making by individual divisions that might
negatively impact the company. Autonomy is the degree of freedom to make decisions by subunit
managers. Subunit is any part of an organization.
The general rule for optimal transfer price is to set it equal to the marginal cost of producing the product.
This means that the transfer price should be the same as the cost of producing the product, excluding
any external costs or profits. This approach ensures that each department or division is compensated for
its costs and contributes to the overall profitability of the organization.
By setting the transfer price equal to the marginal cost, the company can achieve several
benefits. Firstly, it ensures that each department or division is compensated for its costs, which can
help maintain morale and motivation among employees. Secondly, it helps the company
optimize its resource allocation, as departments or divisions that are more cost-effective can
be rewarded with higher transfer prices, while less cost-effective ones can be compensated
with lower transfer prices. Lastly, it helps the company maintain its competitive edge in the market,
as it ensures that each department or division is pricing its products or services competitively.
This approach helps the company optimize its resource allocation, maintain employee morale and
motivation, and remain competitive in the market.
Optimal transfer pricing depends on various factors, including the nature of the goods or services being
transferred, relationships between divisions, and the organization's strategic objectives. It requires a
careful balance between divisional autonomy and overall organizational goals.
5.5.2 Transfer Pricing: Imperfectly Competitive Intermediate Product Market
In cases where the intermediate product market is imperfectly competitive, determining transfer prices
can be challenging due to the absence of perfect competition conditions.
- Imperfect Competition: In an imperfectly competitive market, firms have some degree of
market power, allowing them to influence prices. This can lead to pricing behaviour that differs from the
competitive market model.
- External Market Prices: In such markets, external market prices may not be readily available or may
not accurately represent the economic realities of the division. This can make it difficult to use market-
based pricing as a reference.
-Negotiation and Internal Coordination: In cases of imperfect competition, transfer pricing often
involves negotiations between the divisions involved. Divisions must work together to ensure that the
prices set do not harm the overall organization's performance.
-Cost-Based Pricing: When external market pricing is not practical, cost-based pricing, such as cost-
plus pricing, is often used. This method relies on internal cost structures to establish transfer prices,
making it less dependent on market dynamics.
Understanding the complexities of transfer pricing in imperfectly competitive markets requires a deep
understanding of the organization's specific circumstances and the nature of the products or services

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being transferred. Balancing the need for fairness and profitability is crucial for the organization's
success.

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