INTRODUCTION TO PRICING

The pricing of products or services is one of the more difficult and more important
decisions for the organisation. The prices adopted by a company will have an
immediate effect on the profitability of an organisation and longer term implications
on the marketing of the product.

Factors affecting pricing decisions

Factors underlying pricing decisions

There are several factors underlying all pricing decisions, including the following:

1.Price and demand relationship

2.Competitors

3.Cost

4.Product mix

5.Quality

6.Inflation

7.Product life cycle

Ways of calculating the price

There are three ways to calculate the price of a product:
1. Cost-plus pricing – marginal cost or full cost as a base.
2. Demand based pricing – the application of economic theory to maximise
profit in the short-term.
3. Marketing based pricing – the aim to generate profit maximisation in the
longer term.
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COST-PLUS PRICING
The simplest form of pricing, it is still widely used particularly in the retail industry
and in specific/job order situations. The price is based on the cost plus a margin.
Cost-plus pricing may be based on:
1. full cost (calculated using absorption costing or ABC), or
2. marginal / variable cost.
The rationale behind this method is that if the price is greater than the cost then a
profit must be made (providing that the expected volumes are achieved).

1. Full cost-plus pricing

Advantages of full cost-plus pricing strategy:

● Easy to use.
● Ensures that all costs are covered.
● Ensures that the firm can generate profits and survive in the future.
● Avoids costs of collecting market information on demand and competitor
activity.
● It is believed to establish stable prices.

Disadvantages of full cost-plus pricing strategy:

● It does not consider the demand pattern of the product.
● The absorption of overheads is guess work, therefore the strategy will
produce different selling prices depending on which costing system is used.
● Takes no account of market conditions since its focus is entirely internal.
● By using a fixed mark-up it does not permit the company to respond to the
pricing decisions of its competitors.
● It is not appropriate for making special decisions involving use of spare
capacity.
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An example of typical total cost plus price calculation is as follows

$ $
Direct materials 10
Direct labour 15
Prime cost 25
Factory overheads:
Fixed 10
Variable 5 15
Total production cost 40
Non production costs:
Fixed 10
Variable 0 10
Total cost 50
Add profit (20% x 50) 10
Selling price 60

2. Marginal cost-plus pricing

Pricing strategy in which a profit margin is added to the budgeted marginal or
variable cost of the product.

Advantages
● Can price below total cost when demand is low if there is spare capacity.
● Efficient and most economic use of scarce resources.

Disadvantages
● Ignores fixed overheads. The price may not be high enough to ensure that a
profit is made after fixed overheads are covered.
● Lack of consideration of overall market and customers.
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OTHER PRICING STRATEGIES

Market skimming
The price is set at a high level to generate maximum return per unit in the early
units. The aim is to sell to only that small part of the market which is not price
sensitive. For market skimming to be effective the company must have a barrier to
entry in the form of a patent, brand, technological innovation or other.

Features
1 Low volume, high price.
2 Low initial investment in production capacity.
3 Low risk, if strategy fails price can be dropped.

Limitations of market skimming strategy

● It is only effective when the firm is facing an inelastic demand curve (market
is not price sensitive).
● Price changes by any one firm will be matched by other firms resulting in a
rapid growth in industry volume.
● Skimming encourages the entry of competitors as margins are high.
● Skimming results in a slow rate of diffusion and adaptation. This results in a
high level of untapped demand. This gives competitors time to either imitate
the product or leap frog it with a new innovation.

Market penetration pricing

The price is set at a level which should generate demand from the whole market
and by so doing encourage an acceleration of the life cycle quickly into growth and
maturity phases. Necessary if the market skimming approach is not possible
because of a lack of barriers to entry or customer sensitivity to price.

Features
1 Low price, mass market.
2 Substantial investment required.
3 High risk, the low price is used to deter other competitors.

Penetration pricing strategy is appropriate when:

● Product demand is highly price elastic so that demand responds to price
changes.
● Substantial economies of scale are available.
● The product is suitable for a mass market and there is sufficient demand.
● The product will face competition soon after introduction.
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Complementary product pricing

Complementary products are products that are goods that tend to be bought and
used together. For example: computers and software. If sales of one increase,
demand for the other will also increase. Also referred to as joint demand.

Product line pricing

A product line is a group of products that are related to each other.
Product line pricing strategies include setting prices that are proportional to full or
marginal cost with the same profit margin for all products in the product line.
Alternatively, prices can be set to reflect demand relationships between products in
the line so that an overall return is achieved.

Volume discounting
A volume discount is a reduction in price given for purchases of large volume. The
objective is to increase sales from large customers. The discount differentiates
between wholesale and retail customers. The reduced cost of a large order will
compensate for the loss of revenues from offering the discount.

Price discrimination
This is the practice of selling the same product at different prices to different
customers. Examples: off peak travel bargains; theatre tickets sold at different
prices based on location so that customers pay different prices for the same
performance.
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DEMAND BASED PRICING

The preparation of a price in relation to the demand for a product.
This technique considers the demand for a product at a given price by developing a
demand curve. Demand based pricing assumes that as the price of the product
increases, the quantity demanded will decrease.

P = Price

Q = Quantity Demanded

Deriving the demand curve

Formula sheet extract

Demand curve

P=a−bQ
change in price
b=
change in quantity
a=price whenQ=0

Example 1 Biscan
A product sells 500 units at a price of $25 and 700 units at a price of $20.

Required:
Establish the equation of the demand curve.
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Example 2 Mellor
A company presently sells 20,000 units at $12.50 each. The managing director
believes that they will be more profitable if they sell 20% more unit at a price of
$11 each.

Required:
(a) Derive the demand curve.
(b) Calculate the total revenue in each circumstance.
(c) Discuss the belief of the managing director that selling more units at a
lower price will increase profits.

Price elasticity of demand

Price elasticity of demand is the measure of the extent of change in market demand
for a good in response to a change in its price. For some products, even when the
price increases demand does not change significantly (eg petrol). Other products
would be very sensitive to price, ie a small increase in price will result in a larger
decrease in demand (eg luxury goods such as jewellery).
% change in demand of good X
Elasticity of demand (PED) = % change in price of good X
( Q 2−Q 1 )÷Q 1
Price elasticity of demand = ( P 2−P 1 )÷P1
If the PED is greater than one, the good is price elastic. Demand is responsive to
a change in price. If for example a 15% fall in price leads to a 30% increase in
quantity demanded, the price elasticity = 2.0.
If the PED is less than one, the good is inelastic. Demand is not very responsive
to changes in price. If, for example, a 20% increase in price leads to a 5% fall in
quantity demanded, the price elasticity = 0.25.
If the PED is equal to one, the good has unit elasticity. The percentage change in
quantity demanded is equal to the percentage change in price. Demand changes
proportionately to a price change.
If the PED is equal to zero, the good is perfectly inelastic. A change in price will
have no influence on quantity demanded. The demand curve for such a product
will be vertical.
If the PED is infinity, the good is perfectly elastic. Any change in price will see
quantity demanded fall to zero. This demand curve is associated with firms
operating in perfectly competitive markets.
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Example 3 Spearing
The price of a good is $1.20 per unit and the annual demand is 800,000 units.
Market research indicates that an increase in price of 10cents per unit will result in
a fall in annual demand of 75,000 units.

Required:
What is the price elasticity of demand?

Advantages of demand based pricing

1. A consideration of the market.
2. Company understands how sensitive customers are to changes in the price.

Limitations of demand based pricing

1. It may be difficult to accurately establish the relationship between price and
demand.
2. Other factors will affect the demand for the product (not just price). These
factors include quality, advertising, disposable income, tastes and fashions.
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PROFIT MAXIMISING PRICE AND QUANTITY

It is important to understand cost behaviour in many business decisions. The rate
of increase in total cost as a consequence of increase in volume may increase or
decrease due to price changes, inflation, and discount factors etc.
The same principle applies to the rate of increase in revenues as a result of
increase in volume.
Profit maximising price and quantity can be determined by using the idea of
marginal revenue and marginal cost.
Marginal revenue is the additional revenue earned from selling one more unit.
Using a demand based approach, we assume that for one extra unit to be sold, the
selling price would have to drop by a certain amount. Therefore, as quantity sold
increases, the marginal revenue will decrease.
Marginal cost is the additional cost incurred from producing one more unit. We
can assume that this is equal to the variable cost per unit.

Marginal
Revenue

Cost/revenue $

Quantity demanded

The profit maximising price and quantity will be at a point where:

Marginal revenue (MR) = marginal cost (MC)
Where MR = a – 2bQ (given in the exam)

Example 4 Kozma
A company sells 1,000 units at $10 per unit and 1,500 units $8 per unit. Variable
costs are $5 per unit.

Required:
(a) Derive the demand function for this company, and explain its
usefulness.
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(b) Equate Marginal Revenue and Marginal Cost to determine the optimal
quantity and optimal price.
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