Chapter 20

Pricing and product

mix decisions

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 Outline
• Major influences on pricing decision
• Economic profit-maximising models
• Pricing strategies
– Value-based, economic and cost-plus
pricing
• Strategic pricing of new products
• Pricing for competitive bidding
• Legal restrictions on pricing
• Product mix decisions
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 Major influences on
pricing decisions
• Market positioning
– Companies position themselves in certain
markets and this may influence their
product prices
– A firm with a reputation for very high
quality prestigious products may set a high
price consistent with that image

(cont.)

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 Major influences on
pricing decisions (cont.)

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 Product costs
• In the long term, firms must produce
at a cost below selling price
• The importance of product cost in
price setting varies across industries
• Even when market forces influence a
company to price its products, it is still
important to have an awareness of
product cost

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 Customer value
• The value that a customer places on
particular features of a product
• The overall net value to the customer
• Understanding customer value is a
critical aspect to price setting and
product creation
• Businesses must understand the
specific aspects that provide customer
value
(cont.)
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 Competitors’ behaviour
• Competitors’ pricing behaviour can
affect a company’s pricing decisions
• Management must take care to define
its product and market it correctly
when considering the reaction of
competitors and customers
• Predicting competitors’ reactions to its
products and pricing strategy

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Legal, political and ethical issues
• Managers must adhere to the laws
when setting prices
• The law generally prohibits
companies from discriminating
between customers in setting prices
• Political pressures may lead to
intervention in the setting of prices
• Ethical considerations
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 Economic profit-maximising
models
• Economic models focus on the optimal
price and sales quantity that will maximise
profit
• Price elasticity is the impact of price
changes on sales volume
• Demand is elastic if a price increase has a
large negative impact on sales volume
• Demand is inelastic if a price change has
little or no impact on sales volume (cont.)
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 Economic profit-
maximising models (cont.)
• Cross-elasticity is the extent to which a
change in a product’s price affects the
demand for other substitute products
• Measuring price elasticity is an
important objective of market research
into pricing

(cont.)
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 Economic profit-maximising models (cont.)

(cont.)
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 Economic profit-maximising models (cont.)

MR=MC

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 Limitations of the economic
model
• Difficult to precisely determine the firm’s
demand curve and marginal revenue
curve
• Many factors affect product demand in
addition to price
• Not valid for all forms of markets
• Difficulty of measuring marginal cost;
most costing systems are not designed to
do this
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 Pricing strategies
• Value-based pricing
– Where customers’ perceptions of the
product or service value guide pricing
– A firm needs to understand customers’
needs and their perceptions of value
• Economic-value pricing giá dựa vào giá trị kinh tế

– Estimates the costs and benefits

experienced by the customer, which extend
beyond the initial purchase price
– Often used in industrial markets
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 Cost-plus pricing
• Reasons for considering product costs
when setting prices
─Difficult to do a thorough market analysis
for all products so need quick,
straightforward methods to set price
─Costs give management a starting point
─Costs provide a floor below which prices
cannot fall in the long run
(cont.)

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 Cost-plus pricing (cont.)
• Cost-plus pricing formulas
– Price = cost + (markup percentage × cost)
• Markup percentage is dependent on
the definition of product cost used
• Two issues
– What is the best definition of cost to be
used in the cost-plus pricing formula?
– How will the desired markup be
determined?

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 Product costing definitions
• Absorption cost pricing formulas
– Provide a justifiable price, which may be
perceived to be equitable to all parties
– Usually provided by a firm’s product
costing system
– Cost-effective to use in pricing
– Disadvantages
§ Obscures the cost behaviour patterns of the
firm
§ Not consistent with CVP analysis (cont.)

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 Product costing definitions
(cont.)
• Variable cost pricing formulas
– Does not obscure the cost behaviour pattern
by unitising fixed costs
– Variable cost data is useful for short-term
pricing decisions
– Disadvantages
§ In the long term, prices must be set to cover all
costs and to achieve a normal profit margin
§ Managers must use high markups when using
variable cost

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 Determining the markup
• Return on investment (ROI) pricing
– Selling price is determined by using the
required rate of return to determine the
markup on cost
– The profit margin is based on the firm’s target
return on investment
– Average investment × target ROI = target
profit

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 Time and material pricing
• Cost-plus pricing using separate
labour and materials charges
• Labour charge includes a charge for
labour-related overhead and profit
margin
• Material charge includes a charge for
material-related overhead

(cont.)
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Time and material pricing (cont.)

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 Cost-plus pricing: summary
and evaluation
• Effective price setting requires a
constant interplay between market
considerations and cost awareness
• Cost-plus pricing may be used to
establish a starting point for setting
prices
• Cost-plus pricing formulas

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 Product cost distortion and
pricing: the role of activity-
based costing
• Traditional volume-based product
costing fails to capture the cost
implications of product diversity
• When cost-plus pricing is used
– High-volume and relatively simple products
– Low-volume and complex products
• ABC
– Measurement and accuracy
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Strategic pricing of new products
• The newer the concept of the product,
the more difficult is the pricing decision
• Skimming pricing
– A high initial price for the new product
– ‘Must have it’ technology products
– Quality and image
– Over time, the price may be lowered
• Penetration pricing
– The initial price of a new product
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Pricing for competitive bidding
• Two or more companies submit sealed
bids (or prices) for a product or project
to a potential buyer for the
product/project
• For the supplier, cost analysis involves
similar issues to that of accepting or
rejecting a special order
• The supplier has spare capacity
(cont.)
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Pricing for competitive bidding
(cont.)
• The supplier has no spare capacity
– Incremental costs are relevant
– Opportunity costs must be assessed
– A bid price should cover the opportunity cost
– The bid price may be higher than when
spare capacity exists
• Marketing and strategic issues are
difficult to quantify
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 Legal restrictions on pricing
• Australian Competition and Consumer
Commission (ACCC) has power to
outlaw the following behaviours
– Predatory pricing

– Resale price maintenance

– Price-fixing contracts

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 Product mix decisions
• Determining the most appropriate
range of products to offer to consumers
• Product mix decisions are linked to
pricing as prices influence
– Profitability, which may lead to decisions
to change the product mix
– Customer behaviour
– Competitor reactions
(cont.)
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Product mix decisions (cont.)

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Tactical product mix decisions
involving limited resources
• Tactical product mix
• Limited resources may include floor
space, machine time, raw materials,
labour hours
• Multiple scarce resources  linear
programming
• Consideration of the Theory of
Constraints may help identify and
manage sources of constraints
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 Long-term product
mix decisions
• All relevant costs are considered in the
final decision, as well as strategic issues
• For loss-making products, firms may
choose from a range of options including:
– Increase the product price
– Try to reduce the cost of the product
– Offer customer incentives to purchase
greater quantities of the product

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 Summary
• Prices are influenced by market positioning,
product cost, customer value, competitor
behaviour and legal, political and ethical issues
• Pricing strategies include value-based pricing,
economic pricing and cost-based pricing
• Cost-based pricing involves defining the
relevant product cost and determining a
markup
• For some new products skimming pricing and
penetration pricing may be used
(cont.)
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 Summary (cont.)
• Pricing special orders and determining
competitive bid prices involves an analysis of
relevant costs
• Pricing special orders and determining
competitive bid prices involves an analysis of
relevant costs
• In tactical product mix decisions, the focus is
on maximising profitability, within the
constraint of a scarce resource
• In long-term product mix decisions, full costs
are relevant, as are strategic considerations
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