PRICING DECISIONS
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Factors Influences Pricing
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MARKET
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COMPETITION
Competition: If competitors cut prices, a company can react in
the following possible ways:
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DEMAND
Economic theory argues that the higher the price of a
good, the lower will be the quantity demanded.
However there are two extremes to this theory:
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PRICE ELASTICITY OF DEMAND (PED)
It is a measure of the change in sales demand that would
occur for a given change in the selling price.
PED > 1 than demand is elastic: impact on quantity demanded is greater due to
change in price
PED< 1 than demand is inelastic: impact on quantity demanded due to change in
price is nominal
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Elasticity and Pricing
Very Inelastic As price will have no impact on quantity demanded,
Demand company should focus on quality, service, product
design etc to attract customers.
Inelastic Demand As price has nominal impact on demand, increase the
price so that revenue increases and costs reduce due
to smaller quantity being produced.
Elastic Demand Find right balance to ensure that the revenue earned
is greater than the costs incurred.
Very Elastic Demand Try and control elasticity by creating customer
preferences through quality, service etc.
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Demand Influencers:
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Demand Equation
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Example
• 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. Determine the demand equation, which is
assumed to be a straight line equation.
• Determine the demand equation.
Solution
Step 1: Find the price at which demand would be nil
• Assuming demand is linear, each increase of $3 (from $12
to $15) in the price would result in a fall in demand of 15
units (from 60 to 45). For demand to fall to nil, the price
needs to rise from its current level $12 by as many times as
there are 15 units in 60 units (60/15 = 4) ie to $12 + (4 x
$3) = $24..
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a = $12 + [(60/15) × $3)] = $24.
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The Total Cost Function:
Cost behaviour can be modelled using equations.
Total Cost (TC) = Fixed Cost (FC) + [Variable Cost (VC) x
Quantity sold (Q)]
Errors in using these models:
Assume that fixed costs remain constant when in reality
there is a concept of Step Fixed Costs
Assume that Variable Cost per unit remains constant when
in reality they change due to economies/ diseconomies of
scale or Volume Based Discounts (discounts given for bulk
transactions)
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The Profit-Maximizing Price/Output
Level
Profits are maximized when marginal cost (MC) = marginal
revenue (MR).
Microeconomic theory and profit maximisation
Profit Maximisation is the process by which a firm determines
the price and output level that returns the greatest profit.
There are two common approaches to this problem.
The Total revenue (TR) – Total cost (TC) method is based on
the fact that profit equals revenue minus cost.
The Marginal revenue (MR) – Marginal cost (MC) method is
based on the fact that total profit in a perfect market reaches
its maximum point where marginal revenue equals marginal
cost.
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Determining the Profit-Maximising
Selling Price: Using Equations
The optimal selling price can be determined using
equations (ie when MC = MR).
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Example:
It has been determined based on research that if a price of
$400 is charged for product G, demand will be 12,000 units.
Demand will rise or fall by 20 units for every $1 fall/rise in
the selling price. The marginal cost of product G is $120.
Calculate the profit-maximising selling price for product G.
Solution:
The following step-by-step approach can be applied to
most questions involving algebra and pricing.
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Price Strategies
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Full cost plus pricing
Calculate full cost of product and add desired profit to
determine selling price.
Profit is expressed as either:
a percentage of the full cost (a profit 'mark-up') or
a percentage of the sales price (a 'profit margin').
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Advantages:
Quick, simple and cheap method to set product price.
As profit % is added to full cost, all the expenses are easily
recovered.
Disadvantages:
Ignores profit maximisation combination of price and
demand.
In reality the price has to be adjusted to market and demand
conditions.
Relies on budgeted output volume to determine appropriate
absorption rate for overheads.
Suitable basis for overhead absorption rate has to be
selected.
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Marginal Cost plus Pricing (Mark-
Up Pricing)
A mark-up or profit 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.
Advantages:
Simple and easy to calculate.
Mark up % can be varied to reflect demand conditions.
Focuses attention on the contribution of the product, which is a key
factor in decision making.
Useful in industries where the Variable cost per unit is easily available.
Disadvantages:
Apart from demand, other relevant market factors, like prices set by
competitors etc. are ignored.
Ignores fixed overheads in pricing decisions.
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Market Skimming Prices:
Charging a high price when the product is introduced in the
market for the first time, with the hope of skimming the market
for profits. The price of the product is adjusted at a later date.
This is an appropriate approach for:
When the product is new and different.
When its demand elasticity is unknown.
When a company is trying to resolve its liquidity issues.
When a company is aware of market segments that are willing
to pay more.
When a product has a short lifecycle and its costs are to be
recovered as soon as possible.
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Market Penetration Prices
Introducing a product at low costs to establish its
stronghold in the market.
This is an appropriate approach for:
When a company is trying to discourage new entrants in
the market.
When a company wishes to push a product to its growth
and maturity stage quickly.
When a company can enjoy great economies of scale at
high sales volume.
Product demand is highly elastic and so low prices will
generate a lot of demand.
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Complementary Products
Pricing
Setting a single pricing policy for goods that are
complementary i.e. are normally bought together. E.g.
Computer games console and computer games.
Loss Leader: is when a company sells a low price for one
product to attract customers and ends up selling
complementary products with high profit margins. This is
also termed as ‘Captive Product Pricing’.
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Product Lines Pricing:
Setting a consistent pricing policy for a group of products
that are related to each other. E.g. same policy for
shampoos, skin care products etc. of the same brand
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Price Discrimination
(Differential Pricing)
Charging different prices to different groups of buyers for
the same product.
Some bases for price discrimination is:
Market Segment: students get discounted tickets on public
transport.
Product Version: Add-ons/ extras for mobile phones, that
are not reflected in the original price of the phone but
offered as a separate package.
Place: Seating arrangements in cinema halls, with expensive
tickets for more comfortable seats.
Time: Off peak travel discounts.
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Relevant Cost Pricing
(Minimum Pricing):
Calculating a minimum price of the product/ order, at which
the company will neither be better off, nor worse off. If sold
at more than the minimum price, the company will enjoy a
profit.
The minimum price calculated must take into account the
following:
Incremental cost of producing and selling the product
Opportunity costs in the form of resources uses to
produce and sell the product
To earn a profit, the company needs to sell the product/
order at a price higher than the minimum price.
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THANK YOU
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