Pricing and Costing Strategies

1. Pricing Decisions
Unit 13

2. LEARNING OUTCOMES
At the end of this unit the student will know:
1. Pricing and economic theory
2. The role of cost information
3. Long and short term pricing
4. Product mix and pricing
5. Different pricing policies

3. Economic Theory and Pricing
• Economic theory can assist in determining
pricing decisions of a firm by looking at the
demand for the product and also what level of
output the firm should produce.

4. Demand Elasticity
• Elastic demand means that a small
increase/decrease in price causes a large
decrease/increase in price. Demand is elastic
when there are substitutes for the product.
• Inelastic demand means that the quantity
demand falls by a smaller percentage than
the percentage increase in price.

5. Concept of Elasticity to Decision
• 1. If inelastic demand exists, prices should be
increased because revenues will increase and
total costs will reduce.
• 2. If elastic demand exists, increases in prices
will bring decreases in revenue, and decreases
in price will bring increases in revenue.

6. Demand Curves

7. Output and Profit
• Microeconomic theory suggests that as output
increases, the marginal cost per unit might rise
(due to the law off diminishing returns) and
whenever the firm is faced with a downward
sloping demand curve, the marginal revenue per
unit will decline.
• Profits will be maximised only at the output level
where marginal cost has risen to be easily equal
to the marginal revenue i.e. MC = MR

8. Difficulties with applying economic
theory
• 1. That a firm can estimate a demand curve
for its products. In reality this may be difficult
as most companies may have many different
products.
• 2. Price influences the quantity demanded. In
practice, factors other than place may
influence the quantity demanded, i.e. quality,
advertising, etc.

9. The role of cost information in pricing
decisions
• Price Taker – this is where firms have little or
no influence over the prices of their products
or services.
• Price Setter – this is where firms have an input
into the setting price of their product or
services.

10. Rule: Price setting firm in the short
run
(a) Spare capacity should be available.
(b) The bid price should represent a
one-off price that will not be
repeated.
(c) The orders will utilise unused
capacity.

11. Rule: Price taker firm facing short run
product mix decisions
• Same conditions as for a price setter
as stated in the previous example. i.e.
for the short run.

12. Rule: Price setter long run pricing
decisions
There are three approaches to pricing here:
1. In pricing customised products, it is important that the firm uses
accurate costs. There is, therefore, a strong argument to use ABC.
Activity Based Cost information provides a better understanding of
cost behaviour.
2. Non customised products pricing based on direct negotiation with
the customer.
3. Using target costing for non customised products. Here the selling
price is the start of the costing process rather than the cost.

13. Approach of target costing
1. Determine the target price which customers will
be prepared to pay for the product.
2. Deduct a target profit margin from the target
price to determine the target cost.
3. Estimate the actual cost of the product.
4. If estimated actual cost exceeds the target cost
investigate ways of driving down the actual cost to
the target cost.

14. Rule: A price taker firm facing long
run product mix decisions
• A price taking firm accepts the market price. It
will, however, need to use activity based
profitability analysis to evaluate each
product's long run profitability.

15. Product Mix decisions

16. Notes
1 Consists of expenses dedicated to sustaining
specific product brands or customer segments or
regions but which cannot be attributed to
individual products, customers or branches.
2 Consists of expenses dedicated to sustaining the
product lines or distribution channels or
countries but which cannot be attributed to
lower items within the hierarchy.
3 Consists of expenses dedicated to the business as
a whole and not attributable to any lower items
within the hierarchy

17. Cost-based approaches to pricing
There are a variety of different costing bases.
These include:
(i) Total cost + % for profit = selling price
(ii) Variable cost +% for profit = selling price

18. Problems with full cost-plus pricing
• (a) lt fails to recognise that, since demand may
be determining price, there will be a profit-
maximising combination of price and demand.
• (b) There may be a need to adjust prices to
market and demand conditions.
• (c) A suitable basis for overhead absorption
must be selected, especially where a business
produces more than one product

19. Marginal Cost-Plus Pricing
• This method determines the sale price by
adding a profit onto either marginal cost of
production or marginal cost of sales.
• Advantages
• a) Simple and easy method to use.
• b) The mark-up percentage can be varied
• Disadvantages
• It gives fixed overheads in pricing.

20. Pricing Policies for
New Products

21. Price skimming policy
• an attempt to exploit sections of the market that
are relatively insensitive to price changes. A
skimming policy should not be adopted when a
number of close substitutes are already being
marketed.
• Circumstances when skimming is appropriate:
(a) A new or different product
(b) Firm can identify different market segments for the
product
(c) Short life cycle

22. Penetration pricing policy
• based on the concept of changing low prices initially
with the intention of gaining rapid acceptance of the
product.
• Such a policy is appropriate when close substitutes are
available or when the market is easy to enter.
• Circumstances when penetration price is appropriate:
(a) Pending new entrants
(b) Firm may want to enter the growth and maturity stage of
the
product life cycle and therefore reduces the initial stage
(c) Elastic demand exists