Lusaka Business and Technical Collge

Department of Business and Education Studies

Course Module: Principles of Purchasing and Supply

UNIT 1.5 Pricing Concepts (Ideas, thoughts)

PRICING METHODS
Pricing and market structures, competition, monopoly, oligopoly.

Market conditions has a major factor on price, the factors affecting Market
conditions are not always easy to predict. The environment is often driven by the
number of competition in the industry. So understandably not all markets are the
same or similar. We can characterize market structures based on the
competition levels and the nature of these markets.

Types of Market Structures

A variety of market structures will characterize an economy. Such market structures

essentially refer to the degree of competition in a market.

One thing to remember is that not all these types of market structures actually exist.
Some of them are just theoretical concepts. But they help us understand the principles
/or rules behind the classification of market structures.

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1] Perfect Competition

In a perfect competition market structure, there are a large number of buyers and
sellers. All the sellers of the market are small sellers in competition with each other.
There is no one big seller with any significant influence on the market. So all the
firms in such a market are price takers.

There are certain assumptions when discussing the perfect competition. This is the
reason a perfect competition market is pretty much a academic concept.
These assumptions are as follows,

 The products on the market are homogeneous, i.e. they are completely identical
 All firms only have the motive of profit maximization
 There is free entry and exit from the market, i.e. there are no barriers
 And there is no concept of consumer preference

2] Monopolistic Competition

This is a more realistic scenario that actually occurs in the real world. In monopolistic
competition, there are still a large number of buyers as well as sellers. But they all do
not sell homogeneous products. The products are similar but all sellers sell slightly
differentiated products. E.g Samsung, HP, Apple Deal and many more

Now the consumers have the preference of choosing one product over another. The
sellers can also charge a marginally higher price since they may enjoy some market
power. So the sellers become the price setters to a certain extent.

For example, the market for cereals is a monopolistic competition. The products are
all similar but slightly differentiated in terms of taste and flavours. Another such
example is toothpaste.

3] Oligopoly

In an oligopoly, there are only a few firms in the market. While there is no clarity
about the number of firms, 3-5 dominant firms are considered the norm. So in the
case of an oligopoly, the buyers are far greater than the sellers.

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The firms in this case either compete with another to collaborate together, they use
their market influence to set the prices and in turn maximize their profits. So the
consumers become the price takers. In an oligopoly, there are various barriers to
entry in the market, and new firms find it difficult to establish themselves.

4] Monopoly

In a monopoly type of market structure, there is only one seller, so a single firm will
control the entire market. It can set any price it wishes since it has all the market
power. Consumers do not have any alternative and must pay the price set by the
seller.

Monopolies are extremely undesirable. Here the consumer lose all their power and
market forces become irrelevant. However, a pure monopoly is very rare in reality.

Pricing is the process of determining what a company will receive in exchange

for its products. Pricing factors are:
 Manufacturing cost
 Market place
 Competition
 Market condition and
 Quality of product
Relationship between price and cost
Price is what the company charges for goods or services from its customers; Cost
is the what the company pays to acquires goods and services from the
manufacturer/or seller, whereas and Value is what goods or services pay to the
customers.

There are Two types of pricing concepts under Target pricing

I. The cost – plus approach

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 This is the approach which builds up the cost of the product by first analysing its
components step by step to come up with the total production cost. This is a forward
approach where customer feedback is required. In some cases, this a reactive approach
E.g
If the production cost to construct a warehouse for company A is k100,000.00, the profit
margin is k30,000.00, the total cost of this contract for the project will be k130,000.00

II. Target pricing

In the manufacturing and retail environment a target costing approach starts at the other
end of the equation. The supplier estimates the minimum selling price which the market
will be willing to pay for a particular product with a particular feature. A maximum price
including an agreed profit is then negotiated with a particular buyer. The supplier then
works backwards to calculate the production cost that must be achieved in order to
provide a reasonable profit, by making sure costs are reduced to a required level.
The approach requires close relationships between the two parties (buyer and suppliers)
working closely to identify opportunities for cost reductions.

1. Target costing can work where the scope and specification of the project cannot be
fully defined at the outset of the contract.
2. When a reasonable degree of flexibility is required in the management of the project
to accommodate changes in designs of the programme.
3. Where the purchaser and the contractor can contribute to decreasing the target price
through reducing the risks presented in the specifications.
4. For sharing the risks presented in the project as the contractor will be motivated to
manage costs and the purchaser motivate not to place excess risks in the contractor.
Margin and Markup

It starts with deciding on how to price your products (which is a big deal). How you price your
goods will depend on whether you buy your products in bulk, or if you buy them from different
vendors at differing prices. However, once you have a system in place to figure out the cost of
goods sold or your purchase price, you can use cost to calculate your price.

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 The margin
What is the margin?
Profit margin refers to the revenue (or a profit) a company makes after paying Cost of goods sold
(CGOS). The profit margin is calculated by taking revenue minus the cost of goods sold.
However, the difference is shown as a percentage of revenue. The percentage of revenue that is
gross profit is found by dividing the gross profit by revenue.: Margin uses price as the divisor

Let’s use the following example to calculate the margin. Let’s say the cost for one phone
products is set at $18. That $18 is how much it costs Lusaka Business Technical College (LBTC)
to create a single phone. They will then turn around and sell each phone for the price at $36. If
we run through that calculation, we arrive at a markup of 100%:

If we want to calculate the margin on the LBTC phones it sales, here is what that looks like

Formula

The Markup

What is the markup?

The markup is the extra percentage that you charge your customers on top of your cost or the
amount added to the cost price of goods to cover overheads and profit. Markup usually
determines how much money is being made on a specific item relative to its direct cost

The markup formula:

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Let’s use the following example to calculate the markup. Let’s say the cost for one of phone
products is set at $18. That $18 is how much it costs Lusaka Business Technical College (LBTC)
to create a single phone. They will then turn around and sell each phone for the price of $36. If
we run through that calculation, we arrive at a markup of 100%:

Pricing products based on markup

However, some businesses might set their prices based on a certain pre-defined
markup percentage. They’d have the costs ready and have particular markup percentages in mind
to help them calculate a price.
How would we express the markup formula in this case? Let’s write this out:

Given a markup of 100% on the Zealot, the price would be $36.00:

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Expressing markup as a percentage is useful because you can guarantee that you are generating a
proportional amount of revenue for each item you sell, even as your cost fluctuates or increases.
This means that the markups you set up at the beginning should scale well as your business
grows.
Markup is perfect for helping ensure that revenue is being generated on each sale. Markup is
good for getting started because, as you are getting things set up, you are keenly aware of the
costs for your business, and you’re still learning about the kind of revenue you can bring in
through sales. 
As you get to know your business better and you start to look at reports on your sales, margin
can be helpful for examining how much actual profit you’re making on each sale.
Transfer pricing

Transfer pricing is the process of pricing that takes place within the organisation whenever the
unit or department buy goods or services from one another. The transfer prices are inevitably
needed whenever a business is divided into more than one department or division. The transfer
prices are normally negotiated by the head offices with the aims of cost reduction and improves
goods working relationships within the organisation.

Types of Pricing Agreements for contracts

 Incentive pricing

What Is an Incentive Fee?

An incentive fee is a fee charged by a fund manager based on a fund's performance over a given
period. The fee is usually compared to a benchmark. For instance, a fund manager may receive

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an incentive fee if their fund outperforms the S&P 500 Index over a calendar year, and may
increase as the level of outperformance grows.

Key areas to note:

A fund manager might receive an incentive fee if a fund performs well over a given period. The
fee amount can be based on net realized gains, net unrealized gains, or net income generated. A
20% incentive fee is typical for hedge funds.
Critics of these fees suggest that they encourage managers to take outsized risks to boost returns. 

Normally the contract will include payment of allowed costs plus a higher fee for meeting or
exceeding performance or most target KPIs. The incentive arrangement is established as a means
of motivating the supplier to reduce costs.

 Cost plus contracts

What Is a Cost-Plus Contract?

A cost-plus contract is an agreement to reimburse a company(contractor) for expenses
incurred plus a specific amount of profit, usually stated as a percentage of the contract’s full
price. These type of contracts are primarily used in construction where the buyer assumes some
of the risk but also provides a degree of flexibility to the contractor. In such a case, the party
drawing up the contract anticipates that the contractor will make good on his or her promises to
deliver, and agrees to pay extra so that the contractor can make additional profit upon
completion.

Cost-plus contracts can be contrasted with fixed-cost contracts, in which two parties agree up
front to a specific cost regardless of the actual expenses incurred by the contractor. Cost-plus
contracts may also be known as cost-reimbursement contracts.

Key takeaways

 In a cost-plus contract, one party agrees to reimburse the contracting party for expenses
plus a specified profit proportional to the full value of the contract.

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  Cost-plus contracts are often used in construction when the budget is restricted or when
there is a high probability that actual costs might be less than anticipated.
 Contractors must provide proof of all related expenses, including direct and indirect
costs.

Understanding Cost-Plus Contracts

Cost-plus contracts are generally used if the party drawing up the contract has budgetary
restrictions or if the overall scope of the work can't be properly estimated in advance.

In construction, cost-plus contracts are drawn up so contractors can be reimbursed for almost
every expense actually incurred on a project. The cost-plus contract pays the builder for direct
costs and indirect or overhead costs. All expenses must be supported by documentation of the
contractor’s spending in the form of invoices or receipts. The contract moreover allows the
contractor to collect a certain amount above the reimbursed amount, so he or she may be able to
make a profit—hence, the "plus" in cost-plus contracts.

Some contracts may limit the amount of reimbursement, so not every expense would be covered.
This is especially true if the contractor makes an error during the course of the project or is found
to be negligent in any part of the construction.

Cost-plus contracts are also used in research and development (R&D) activities, where a larger
company may outsource R&D activities to a smaller firm, such as large pharmaceutical company
contracting to the lab of a small biotech company. Governments generally prefer cost-plus
contracts because they can choose the most qualified contractors instead of the lowest bidder.

Types of Cost-Plus Contracts

Cost-plus contracts can be structured in different ways to provide profit beyond the cost of
materials. These include:

 A cost plus fixed fee contract in which the contractor receives a designated amount over
the cost of materials. This can be a completion contract in which the end project and cost
report must be delivered for the fee to be received, or a term contract in which the

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 contractor must put a certain amount of effort toward the project for a definitive time
period before the fee is received. After this period, the term contract can be renewed.
 A cost plus incentive contract provides a higher fee when the contractor keeps costs down
or meets the project deadline without delay. This type of contract is used to motivate an
effective performance of the project and includes a target cost and fee, minimum and
maximum fee, and a formula by which the fee is to be adjusted.
 A cost plus award contract provides a higher fee when certain project metrics are reached
and is usually based on subjective analysis by the buyer. This type of contract is usually
used when objective measures are not appropriate for that specific contract.
 Cost plus percentage contract means that as the project costs increase, the fee also
increases. This is not typically used because the contractor has no incentive to control
costs. In fact, federal government agencies are prohibited from using this type of contract.
 Cost-sharing contracts reimburse the contractor only for a portion of project costs, with
no added fee. These are typically used when contracting with a private company for
research and development and the company in question will benefit from the contract in
other ways.

Advantages and Disadvantages of Using Cost-Plus Contracts

Pros
 They eliminate some risk for the contractor.
 They allow the focus to shift from the overall cost to the quality of work being done.
 They cover all the expenses related to the project, so there are no surprises.

Cons
 They may leave the final cost up in the air since they can't be predetermined.
 They may lead to a longer timeline for the project.
 Might lead to disputes when trying to recover construction-related expenses
 Requires additional resources to reproduce and justify all related costs

 Fixed-price contract 

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A fixed-price contract is a type of contract where the payment amount does not depend on
resources used or time expended. This is opposed to a cost-plus contract, which is intended to
cover the costs with additional profit made. Fixed prices can require more time, in advance, for
sellers to determine the price of each item. However, the fixed-price items can each be purchased
faster, but bargaining could set the price for an entire set of items being purchased, reducing the
time for such bulk purchases treated as a whole batch. Also, fixed-price items can help in pre-
determining the value of the entire inventory, such as for insurance estimates.

However, such contracts continue to be popular despite a history of failed or troubled projects,
although they tend to work when costs are well known in advance. Some laws have been written
which mandate a preference for fixed-price contracts, however, many maintain that such
contracts are actually the most expensive, especially when the risks or costs are unknown.

Fixed Pricing Advantages

Fixed pricing is intended to attract more customers and clients because it offers them assurances. On project
work, for instance, a fixed price for the entirety of the job allows the prospective client to know how much
he will pay prior to agreement. Fixed pricing is also consistent, so customers get used to your pricing and
you have less risk of offending them by fluctuating prices over time. Sales forecasting and profit estimates
are also simpler when you know your price point.

Fixed Pricing Disadvantages

The risk with fixed pricing is that it doesn't allow for adjustments if you get into product or service delivery
and realize your cost basis is higher than expected. The customer pays the established price regardless of
changes in your time or costs. This may mean you undercharge a customer due to a lot of additional work
hours beyond those estimated in the price quote. Fixed pricing also doesn't allow for adjustments over time
to sell off extra inventory or available seats for entertainment and other types of events.

 Cost Reimbursement Contracts?

Cost reimbursement contracts, also called cost-plus contracts, are often used for research
projects, construction, and other undertakings that will require the purchase of materials.

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Because the cost of these materials is unknown when the contract is written, the contracting party
agrees to reimburse the contractor for the full cost of materials.

Usually, the contractor will also be paid a fee on top of the materials cost. These contracts
sometimes include clauses that offer financial incentives when the contractor exceeds
performance targets or schedules or decreases costs.

Unlike a cost-plus contract, a fixed price contract specifies an exact fee for the work to be done,
which means the contractor may earn less profit if the materials cost more than anticipated. An
unscrupulous contractor may cut costs on materials to increase his or her profit.

Cost reimbursement contracts are best when project flexibility is needed, such as when the
project is high-risk or the scope of work is unclear at the outset.

Federal agencies, particularly defense agencies, commonly use this type of contract, including
the National Weather Service, Federal Transit Administration, and Department of Defense.

Advantages

 Higher quality since the contractor has incentive to use the best labor and materials
 Less chance of having the project overbid
 Often less expensive than a fixed-price contract since contractors don't need to charge a
higher price to cover the risk of a higher materials cost than expected

 The ability to take on a project in which the design or scope of work is not fully defined
 The chance for additional profit with performance incentives

Disadvantages

For the buyer, the major disadvantage of this type of contract is the risk for paying much more
than expected on materials. The contractor also has less incentive to be efficient since they will
profit either way. Additional administration and oversight are needed to ensure that the
contractor adheres to cost controls and other austerity measures.

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When using this type of contract, it is prudent to establish a maximum limit for materials costs,
provisions on how reimbursements will be made and costs documented, and what costs can be
reimbursed.

 Lump sum contracts

A lump sum contract in construction is one type of construction contract, sometimes referred to
as stipulated-sum, where a single price is quoted for an entire project based on plans and
specifications and covers the entire project and the owner knows exactly how much the work
will cost in advance. This type of contract requires a full and complete set of plans and
specifications and includes all the indirect costs plus the profit and the contractor will receive
progress payments each month minus retention. The flexibility of this contract is very minimal
and changes in design or deviation from the original plans would require a change order paid by
the owner.  In this contract the payment is made according to the percentage of work
completed.  The lump sum contract is different from guaranteed maximum price in a sense that
the contractor is responsible for additional costs beyond the agreed price, however, if the final
price is less that the agreed price then the contractor will gain and benefit from the savings.

There are some factors that make for a successful execution of a lump sum contract on a project
such as experience and confidence, management skills, communication skills, having a clear
work plan, proper list of deliverables, contingency, and dividing the responsibility among the
project team. 

In lump sum Contracts or fixed-price contracts, the contractor is evaluating the value of work
as per the documents available. Mainly these documents can be specifications and the drawings.
In pre-tender stage Contractor evaluates the cost to execute the project (based on the above
documents such as drawings, specifications, schedules, tender instruction and the clarification
received for the raised queries). And the contrast to these documents Contractor is evaluating and
agreeing with the owner (or employer) to complete the works without exceeding the agreed lump
sum amount.

Advantages

 The owner's risk is reduced due to the price of the contract being fixed and variations are not
as much like other contracts. 

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 There are fewer change orders and they are reduced.
 The bidding and contractor selection is less complicated.
 Obtaining construction loans are easier with this type of contract
 The profit margins and percentages are greater for engineers and contractors.
 Payments and installments are made on regular basis which provides the contractor with a
reliable cash flow.
 Management of the contract is a lot easier for the owner
 It creates an improved communication and relationship between the design team, contractor,
and the owner.

Disadvantages

 There is a higher risk for the contractor.

 Proper change order documentation is required which could be time-consuming.
 Higher fixed price due to unforeseen conditions.
 The contractor selection usually takes longer.
 The design has to be completed before the start of activities.
 Change orders could be rejected by the owner.
 It increases the adversarial relationship among the stakeholders of the project
 The contractor has a freedom to choose its own methods.
 Potential for disputes between the client and the contractor, due for example to unbalanced
bids, change orders, design changes, and compensation for early completion.

Variations to lump sum contracts

Variations occur due to fluctuation in prices and inflation, provisional items, statutory fees,
relevant events such as failure of the owner to deliver goods, etc.

Where the cost of a specific activity is identified as a "provisional sum", a variation in actual
cost may be accepted by the employer.

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 Unit 5: Assignment

Question one

(a). Pricing is the process of determining what a company will receive in exchange
for its products.

List FIVE (5) factors that determine pricing. 5marks

(b). Differentiate between price and cost. 5 marks

(c). Explain the following types of pricing agreements for contracts.

i. Incentive pricing 5marks

ii. Cost plus contracts 5marks

iii.Cost plus incentive 5marks

iv. Cost reimbursement 5marks

v. Lump sum 5marks

Vi. Cost plus Fixed fee 5marks

vii. Target pricing 5marks

(c). Explain what is meant by margin? 5marks

Total 50 marks

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 Due date:

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