Compiled by CA.

nirmal shrestha Pricing Decisions

CHAPTER 4
PRICING DECISIONS

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

There are several factors underlying all pricing decisions, including the following:
1. Organizational goals 2. Price and demand relationship
3. Competitors 4. Cost
5. Product mix 6. Quality
7. Inflation 8. Product life cycle

Ways of calculating the price

There are three ways in which we may calculate the price of the product:
A. Cost-plus pricing – marginal cost or full cost as a base.
B. Marketing based pricing – the aim to generate profit maximisation in the longer term.
C. Demand based pricing – the application of economic theory to maximize profit in the short-term.

A. 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
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 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 a guess work therefore the strategy will produce different selling prices
using different bases.
 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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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
 This strategy ensures that fixed costs are covered.
 The size of the mark-up can be adjusted to reflect demand.
 Maximum capacity utilisation.
 Efficient and most economic use of scarce resources.

Disadvantages
 Ignore profit maximisation.
 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.

Example 1: A new product is being launched, and the following costs have been estimated:
Materials $10 per unit
Labour $8 per unit
Variable overheads $5 per unit
Fixed overheads have been estimated to be $50,000 per year, and the budgeted production is
10,000 units per year.
Calculate the selling price based on:
(a) full cost plus 25% [Hints: $35]
(b) marginal cost plus 40% [Hints: $32.2]

B. MARKETING APPROACHES
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.
 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 high initial
development costs.
Features
1 Low price, mass market.
2 Substantial investments required.

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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.

Going rate pricing or average pricing

Where the product is a leading brand (in market share terms) and any change in price made that company
will lead to a change by other competitors. Competition will continue in other forms.
Example 2: Identify three industries/companies which use going rate pricing.
Hints: Intel, Unilever, and Procter and Gamble.

Premium pricing
The product is able to command a premium due to specific and identifiable features of the product. The
premium may be payable for a number of differing reasons such as:
1. Prestige
2. Reliability
3. Longevity
4. Technology
5. Style.
Example 3: Identify the manufacturers which use each feature to command a premium for their product.
Hints: BMW, Bentleys, Iphones

Discount pricing (loss leaders)

The product is sold at a discount to encourage higher sales. This often has the effect of reducing the image
of the product because customers equate price with quality.
Example 4: Identify three industries/companies that use discount pricing.
Hints: Supermarket economy range, 99p shops.

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.

Captive product pricing

Where products have complements, companies will charge a premium price where the consumer is captured
(family of brands).

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.

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Relevant cost pricing
Special orders may require a relevant cost approach to the calculation of the price. A relevant cost approach
is to identify a price at which the organisation will be no better off, but no worse off, if it sells the item at
that price. Any price in excess of this minimum price will add to net profit.
A special order is a one-off revenue-earning opportunity. These may arise in the following situations.
(a) When a business has a regular source of income but also has some spare capacity, allowing it to
take on extra work if demanded.
(b) When a business has no regular source of income and relies exclusively on its ability to respond to
demand.

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.

C. 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.
The optimum selling price occurs at the point where marginal revenue = marginal cost.

Total
Demand SPPU/MR Cumulative Revenue VCPU/MC
Cost Cumulative Profit
1 20 20 10 10 10
2 18 38 10 20 18
3 16 54 10 30 24
4 14 68 10 40 28
5 12 80 10 50 30
6 10 90 10 60 30
7 8 98 10 70 28

Deriving the demand curve

Formula sheet extract
Demand curve
P = a − bQ
b=
a = price when Q = 0

or = a= 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑃𝑟𝑖𝑐𝑒($) + ∗ $𝑏
$

Example 5: A product sells 500 units at a price of £25 and 700 units at a price of £20.
Required: Assuming a unitary demand curve, what is the formula for the demand curve?
Hints: P = 37.50 – 0.025Q
Example 6: A company presently sells 20,000 units at £12.50 each. The managing director believes that
they will be more revenue if they sell 20% more unit at a price of £11 each.
Required:

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(a) Derive the demand curve.
(b) Calculate the total revenue in each circumstance.
Is the managing director necessarily correct in her assumption?
Hints: (a) P = 20 – 0.000375Q; (b) £250,000; £264,000
Example 7: At a selling price of $100 p.u. the company will sell 2,000 units p.a. For every $2 change in
the selling price, the demand will change by 50 units. The costs comprise a fixed cost of $10,000, together
with a variable cost of $4 p.u. Calculate the selling price p.u. that will result in maximum profit p.a., and
the amount of that profit.
Hints: R = PxQ = 180Q-0.04Q2; MR = 180-0.08Q; Maximum profit = $183,600 when Q = 2,200 units.
Example 8: Suppose that the monthly demand equation for a product is P = 40 – 0.0005Q. Fixed costs
per month are $500,000 and the variable cost per unit is $2.
Required: Calculate the sales price and output quantity that maximise the profit each month, and
calculate the amount of that profit.
Hints: Maximum profit = $222,000 when Q = 38,000 units at Selling price of $21.

Factors influencing demand

The demand for a particular company’s goods will be influenced by 3 main factors:
1. The Product Life Cycle (PLC). If life cycle is short, a high price strategy is adopted.
2. Quality of the product. High quality of product can support a high price.
3. Marketing (Price is one of the 4 P’s). Can capture a higher market share by adopting a particular
pricing strategy.

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. When a small change in price results in more than a proportionate change in demand,
the product is said to be elastic, where a change in price results in less than proportionate change in demand,
we have price inelastic (e.g. salt). However, where a change in price results in an equal change in demand,
we have unitary elastic demand.
%
Elasticity of demand (PED) =
%
( )/
Price elasticity of demand =
( )/
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.

Other factors affecting elasticity

 Availability of substitutes.
 Complementary products.
 Disposable income.
 Necessities.
 Tastes and fashions.
 Advertising and Marketing.
 Price.
 Local laws.

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Example 9: 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 10pence per unit will result in a fall in annual demand of
75,000 units.
Required: What is the price elasticity of demand?
Hint: 1.125
Example 10: The price of a good is £16 per unit and the annual demand is 100 units. Market research
indicates that a decrease in price of 0.5 pence per unit will result in a rise in annual demand of 200 units.
Required: What is the price elasticity of demand?
Hint: 32

Advantages of demand-based pricing

1. A consideration of the market.
2. It considers only incremental costs.
3. Relationship between Price and Demand.

Limitations of demand-based pricing

1. Degree of accuracy to determine price and demand relationship.
2. Accuracy to determine true variable / marginal cost.
3. Many companies aim to achieve a target profit, rather than the theoretical maximum profit.
4. Less focus on other factors such as quality, advertising, packaging, credit facilities and after sales services
also affect the quantity demanded of a product, not just the Price.

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