Pricing decisions

by Ronnie Patton 03 Aug 2007 Diploma in Financial Management Relevant to Module A

Pricing is one of the most difficult decisions faced by organisations. As well as a detailed knowledge of the costs involved in producing a product or delivering a service, the decision maker must also factor in the organisation’s strategic objectives and a range of environmental factors, such as market demand, the expected life cycle and competitors’ actions. Although the quality of any decision will improve with the experience of the decision maker, a combination of reliable information and a structured approach to the problem can be of considerable assistance. This article considers the information needs and techniques which can be applied, as defined in the syllabus for Module A, Performance Management. Candidates should note that there are a number of Study Guide outcomes which relate to pricing. Where the project or Section C of the exam includes a question on the topic of pricing, candidates who demonstrate their managerial ability through awareness and understanding of the wider requirements of the syllabus will inevitably obtain better marks. Study Guide outcomes 8 and 9 clearly relate to the topic of pricing, but outcomes 5, 6, 10, 11, 22 and 29 are also relevant. The section on ‘Adding value to your answer’ outlines how to demonstrate the managerial ability which will lead to better marks. In this context it should be noted that better marks are not obtained by writing everything you know about a topic. Your answer must be related to the specific question which has been asked.

The relevance of costs
It is a fundamental rule of business that selling price must be greater than cost. Although this is a fundamental rule, it is not a rule which is simple to apply in practice. The most basic point about pricing is that in the long run, the revenue earned from selling a product or service must exceed the costs incurred. Therefore a consideration of costs will invariably be included in the process. In theory, the most straightforward approach is to calculate cost and add on a profit margin. Using this approach, ‘cost’ is calculated on the basis of either marginal (this may also be termed ‘variable’) cost or total cost. However, it is important to remember that in many instances, the price will be dictated by the market. If the product or service is provided by a number of competitors, and it is not possible to differentiate between different providers, organisations will have little influence on prices. Only if the product or service is distinctly different from that provided by competitors, will it be possible to set a price at a different level to the market price. One of the key issues to be considered is whether the organisation is able to influence the price level (is it a price setter?) or must it accept the price level as determined by the market (is it a price taker?). Of course whether the organisation is a price setter or price taker, reliable information about costs is required by the decision maker. If the organisation is a price setter, the selling price must

be set at a level which will cover all costs, and allow a reasonable profit to be earned. If the organisation is a price taker, the level of profit which can be earned by charging the market price must be carefully assessed, as there will be little value in achieving high sales volume, but little or no profit. In most exam questions, it will be necessary to differentiate between relevant and non-relevant costs. A cost is only relevant to a decision if the amount of expenditure to be incurred will be influenced by a future decision. Therefore any costs which relate to previous decisions and which cannot be recovered are not relevant. Only costs which arise as a result of future decisions are relevant.

Marginal cost
Marginal cost can be useful for short-run pricing decisions. This may occur if an organisation has excess capacity and can generate additional short-term profit by utilising the excess capacity. In this situation, the additional revenue must exceed the incremental costs which will be incurred as a result of the decision. While the marginal cost of producing the product or service obviously includes the incremental costs, it should also be remembered that any other costs which will be incurred as a result of the decision must be considered. Examples of such costs are additional fixed costs such as marketing or design costs. It should also be remembered that using marginal cost as the basis for pricing decisions is only valid in the short term. A number of conditions must apply for the approach to be used. These can be summarised as: • •

the product or service must be produced using excess capacity the customer must be aware that the price quoted is ‘special’ and will not be sustained in the future the ‘special’ price must not lead to a reduction in the price charged for ongoing sales.

Full cost
As implied by the term ‘full cost pricing’, a share of all costs must be included in the calculation. This means that the impact of fixed costs must be considered. As sales volume increases, the fixed cost per unit will fall. Once again, this will require the decision maker to predict the likely sales volume with reasonable accuracy. If the sales volume is over-estimated, there is a possibility that the sale price could be considerably below cost leading to losses being sustained.

Profit mark up
Whether marginal cost pricing or full cost pricing is used, a further complication is deciding on the mark up which should be applied to arrive at the final selling price. Once again, profitability is directly affected by the quality of the information available to the decision maker. If the mark up is set too high, the selling price will lead to a reduction in demand; if the potential demand is overstated, the selling price will be set at a level which will lead to a reduction in the potential profit.

Market demand
A further aspect of pricing decisions is the relationship between expected sales volume and development costs. This will invariably be a difficult issue, and the quality of the decision will

depend on the ability of the decision maker to understand the market and therefore accurately predict the likely volume of sales and the expected product life cycle. Exam questions will provide the required data and candidates will be expected to apply this data to recommend an appropriate selling price and to discuss the manner in which the selling price may be influenced by the market.

Target cost and pricing
Cost plus pricing techniques use the organisation’s costs as the starting point in the pricing decision. Although demand should be considered, it is often the case that the effort applied to the calculation of cost is not replicated when estimating demand. Target pricing seeks to overcome this problem by making demand the key factor in the pricing decision. Based on market research, the first step is to estimate the price that customers will pay for the product or service. The target cost is determined by deducting the desired profit margin from this price. The task for the design and production sections of the organisation is to achieve this target cost. If the anticipated cost is greater than the target cost, steps must be taken to reduce the cost. This reduction may be achieved by amending the design or by improvements in production techniques. The major advantage of this approach is that rather than being an uncertain element in the decision, market information becomes the decisive factor. The increased importance of market information means that an effort will be made to ensure that appropriate research has been undertaken in order to obtain reliable and relevant information, which will contribute to better decision making.

Pricing policies
From the above discussion it can be seen that demand will affect the final selling price, independent of whether cost plus pricing or target cost pricing is applied. The problem for decision makers is that the selling price will affect demand. Economists refer to this as the price elasticity of demand - a measure of how demand responds to changes in price. Demand is elastic if it is affected by the selling price. This will be the case for many products and services - particularly those which may be provided by a number of competitors. In order to discourage the entry of competitors, an organisation may choose a low initial price level (the low profit per unit will discourage the initial entry of competitors). This will allow a large market share to be built up, which in turn will further discourage potential competitors from entering the market. Demand is inelastic if it is likely to be relatively unaffected by the selling price. This means that if the initial selling price of the product or service is set at a high level, there will be little impact on sales volumes. The elasticity of demand will be one of the influences on the selection of a pricing strategy. The Study Guide specifically refers to market skimming and market penetration. Market skimming is the term used to describe a strategy in which the initial selling price is set at a high level. The intention is to ‘skim’ off the profit which can be earned due to the fact that the selling price is significantly greater than cost. This will be more appropriate for products or services for which demand is relatively inelastic.

Market penetration is the term used to describe a policy in which the initial price is set at a lower level to build a strong market share, and is more likely to be successful when demand is elastic. As well as elasticity, the pricing strategy will be influenced by the product life cycle and the organisation’s strategic objectives, particularly with regard to profitability and return on investment.

Adding value to your answer
As noted in the introduction, answers which demonstrate a candidate’s managerial ability will attract better marks. The way to do this is to add value to your answer, through the application of theory. Often candidates seem to think that ‘application’ means ‘illustration’. In such cases, the answer will refer to real examples. While this can be very useful, such examples will only attract marks if they apply the theory and demonstrate an understanding of why the example is relevant to the specific question which has been asked. Another aspect of adding value to your answer is to include material from a number of Study Guide outcomes in your answer. Essentially this means making sure that your answer clearly shows why your example is relevant and how it has been used by an actual business. Example 1 shows how this might be done.

Example 1 - adding value to your answer
Consider a question which requires a comparison of market penetration and market skimming, and a recommendation as to which approach may be more appropriate in a particular context. While some marks will be awarded for correctly describing the two approaches, the key issue is that the question included the need to compare. Thus more marks will be awarded to answers which draw out the differences between the two approaches. The starting point for this may be to refer to the key difference in the two approaches - skimming seeks to generate strong profits quickly, while penetration seeks to build market share. However, better answers will go on to discuss how managers in the organisation will decide on which of the two approaches might be more appropriate. This could be done by considering elasticity and the product life cycle, and the likely reaction of customers to the product. One example which could be referred to is digital cameras. When these were introduced, the initial selling price was high. The manufacturers sought to build profit early in the product life cycle - and to recover the development costs over a relatively short period. This is an example of market skimming. Having established the product, the approach to pricing has changed. As development costs have been recovered, the relevant costs for future pricing decisions have been reduced. A further factor is that potential customers have become more aware of the benefits offered by the product. For example, the ability to view photographs immediately provides much more fun for the user. It also means that the quality of the picture can be checked and if necessary, it can be replaced. This means that the customer no longer has the dissatisfaction of developing a roll of film, only to discover that the ‘must have’ photo opportunity was wasted. This has led to the market being segmented. There is a distinct difference between the demands of professional photographers and the demands of the mass market of ‘fun’ photography.

A further influence is the growth in the number of potential customers with access to computers, making it much easier to store photographs, and reduce the need for a large memory capacity on the camera. In addition, customers are much more ‘techno-savvy’. The effect of these developments can be seen in the way in which the product is now promoted and priced. Promotion emphasises the fun and immediacy of the product. The fact that development costs have been recovered means that the price can be reduced, providing access to a significantly expanded market. This expanded volume provides further opportunities for price reductions. Customers’ awareness of the benefits, access to computers and greater technical knowledge allows the product to be marketed differently, so that the camera and the storage media are now treated as separate products. As a result, the current price of a camera can be as low as 30% of the price for a similar camera a few years ago. The significant difference is that the memory media is now sold separately, which allows cameras to be promoted on the basis of price, while allowing customers to choose how much they wish to spend on memory media. If the information in the question referred to a product that shares some of the features of digital cameras - and the comparisons are clearly drawn out and used as the basis for a recommendation, this would be a good example of an answer which would attract a high mark. Ronnie Patton is examiner for Module A

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