Learning Objectives

1 Able to explain different pricing methods

2 Able to explain concept of target costing

3 Able to determine target cost, target profit & cost gap

4 Able to explain pricing strategies to achieve competitive advantage

 Chapter Overview & Summary

Pricing Decision

Pricing Methods Pricing Strategies

Traditional method: Target Costing Common strategies: Factors influencing

pricing decision
• Full costs • Premium pricing
• Marginal costs • Penetration pricing
• Minimum pricing • Market skimming
• Differential pricing
• Lost leader
• Predatory pricing
• Psychological pricing
 ▪ Pricing decision is the process of deciding the
price to be charged for each product or service to
ensure that products can be sold in the market
and the business remains competitive

▪ If the price is set high;

PRICING ▪ the business will get high profit in the short
run and be able to compete with other
businesses that offer a lower price
DECISION ▪ But it might out your customer, thus affecting
sales quantity

▪ If the price is set low;

▪ the business will not be able to cover costs
▪ may result in a loss

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 Objectives of Pricing
Maximize profit

Maintaining or increasing market share

Survival

Market stabilization

Reaction to competitors’ moves

 Factor affects Pricing Decisions
a) Firms' policy and objective

b) Economic conditions either growth, downturn or inflation

c) Government regulations-economic liberalization

d) Cost structure of the organization (long run or short run)

e)Competitors’ price

f) Business environment – competition/ innovation

 Factor affects Pricing Decisions
❑ FIRM’S POLICY & OBJECTIVES
❑ It is important to consider the company’s policy & objectives before deciding on what
price to set for the product
❑ If one of the firm's objectives is “to offer affordable prices ta o wide range of
customers”, thus the company should consider setting low prices for its products and
services.

❑ COST STRUCTURE & PRODUCTION COSTS

❑ Set price by estimating unit production cost plus some mark-up
❑ Useful to ensure production costs are covered by the price set
❑ Firms may set a lower price if they manage to produce their products at lower costs

❑ COMPETITORS’ PRICES
❑ It is common to refer to competitors’ prices in the setting selling price
❑ This is to ensure the product’s competitiveness in terms of price
❑ Various pricing strategies: skimming, penetration, defensive, predatory & prestige
pricing
 Factor affects Pricing Decisions
▪ Economic Conditions >
▪ during inflation, setting high prices will not help firms attain
more profits
▪ Government Regulations >
▪ ceiling price set by the government needs to be observed
▪ Business Ethics >
▪ taking too much profit by setting too high price is unethical
as it oppresses the Customers
▪ Business environment – changes in innovation - many product
differentiation
 Traditional
Pricing Method
 Traditional Pricing Method

FULL COST PLUS MARGINAL COST PLUS

Allocate all costs to products to ensure To get the selling price, profit will be
that all costs are covered in the cost added to the cost base. The cost base
base will only consist of variable costs.

MINIMUM PRICING
The price will only cover the variable
cost of the product plus additional FC
and opportunity cost (if any)
 Full Cost-Plus Pricing
▪ A percentage of profit is added to the production cost or total costs to get the
selling price. It is consistent with the absorption costing technique.
▪ The application of full-cost pricing is suitable where:
a) Products are made based on specifications by the customers
b) The estimations are difficult to be made
c) Ensure profit is made after fixed costs• are covered

d) Demand patterns are difficult to forecast.

• This method is commonly used in industries such as retailers, construction and
services.
• Advantages:-
▪ It is easy and simple to understand
▪ Pricing decisions become standardized
▪ Ensures all costs are covered and a reasonable rate of return is achieved
▪ The difficulty of estimating demand can be avoided.
 Full Cost-Plus Pricing
Disadvantages:
▪ It ignores competition and price elasticity of demand
▪ There is a tendency to set prices based on inaccurate cost estimates when
overheads need to be absorbed.
▪ Apportioning fixed costs between products may lead to some products
being unfairly under-priced and some
• over-priced
▪ Not suitable for short-term decisions since it ignores the distinction
between relevant and irrelevant costs.

For example, the selling price is set at 10% of the full cost
Total cost = RM1,000
Variable cost = RM600
Selling price = Total Cost + 10% x (variable cost + fixed cost)
= 1,000 + (10% x 1,000)
= RM1,100
 • The selling price is determined by adding a markup
or margin on the total variable costs (marginal
costs).
• It is based on the idea that any price above the
variable cost produces some contribution and
would be justifiable.
• Companies must however be still conscious so as to
Marginal ensure that it is sufficient to cover all fixed costs
and leave sufficient for a reasonable level of profit
Cost • Advantages:-
• It highlights the importance of the contribution
Pricing • It is more useful when tendering for the contract
because the selling price is lower as compared
to full-cost pricing.
• The difficulty to absorbed fixed costs to the
product can be avoided.
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 Disadvantages:
The selling price might not be sufficient to cover all costs
incurred It might not be suitable for a modern
manufacturing environment where the cost structure is
largely comprised of fixed costs.

For example 1, Sweet Scent Bhd. makes aromatherapy candle for

the Malaysian domestic market. Given below is the profit statement of the

Marginal company for the month of August 2018.

Cost RM
Sales (18,000 units)
Less: Total Variable Costs
186,840
150,000
Pricing Contribution Margin 36,800

Assuming the company uses the marginal cost-plus approach, calculate

the new selling price if the mark-up is 25%.

Total VC 150,000
Add: M-U (RM150,000 x 25%) 37,500
New Selling Price 187,500
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 For example 2, Sweet Scent Bhd. makes aromatherapy candle for
the Malaysian domestic market. Given below is the profit statement of the
company for the month of August 2018.

RM
Sales (18,000 units) 186,840
Less: Total Variable Costs 150,000
Contribution Margin 36,800

Marginal Assuming the company uses the marginal cost-plus 25% margin
approach, calculate the new selling.

Cost Total VC 150,000

Pricing Add: M-U (RM150,000 x 25/75)

New Selling Price
50,000
200,000

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 Minimum Pricing
It is the price at which a business should not sell or manufacture a product. A minimum price is a
price which is just enough to cover:
❑ the extra cost of an item and
❑ the opportunity of the resources used

▪ Where a business has spare capacity and its production is not restricted by scarce resources, the
minimum price will be the price which equals the
• incremental cost of manufacturing the product.

▪ When a business makes many products and the resources are scarce, the minimum price must
include the opportunity costs of consuming the scarce resources.

Why did a company sell at a minimum selling price?

❑ To clear old stocks
❑ to entertain special order
❑ to compete with competitors
❑ to utilize excess capacity

Minimum pricing = Incremental costs of manufacturing + opportunity costs (if any)

 Minimum Pricing
Illustration:
Minimum SP MM Enterprise has been asked to prepare a tender for a special order. Cost
= VC of the estimates for the special order are as follows:
product RM
Materials 20,000 (10000kg @ 2.00)
+ specific FC Labour 6,000 (4000hrs@ 1.50)
+ any opportunity cost Variable overhead 5,500
Fixed Overhead 1,000
The company is facing a shortage of skilled labour. If they accept the job, the
skilled labour is not able to work on another job that earns a contribution of
RM 2,500. Determine the minimum selling price of the special order.

Suggested solution:
A minimum price is equal to:
RM
Materials 20,000 (10000kg @ 2.00)
Labour 6,000 (4000hrs@ 1.50)
Variable overhead 5,500
Marginal costs 31,500
Plus: Opportunity costs 2,500
Minimum selling price 34,000
Target Costing
 • A system of profit planning and cost
management that determines the life cycle
cost at which a proposed product must be
produced, to generate the firm’s desired
level of profit, given the products’
anticipated selling price.
• Originating in Japan, Target Costing is not
Target Costing a method for product costing, but rather a
technique for cost management.

• It is widely used in automobile, electrical

and equipment manufacturing industries.
 Why Target Costing?
❑In industries such as manufacturing, construction, healthcare, and energy,
competition is so intense that prices are determined by supply and demand
in the market.

❑Producers can’t effectively control selling prices. They can only control, to
some extent, their costs, so management focuses on influencing every
component of product, service, or operational costs.

❑The key objective of target costing is to enable management to use

proactive cost planning, cost management, and cost reduction practices
where costs are planned and calculated early in the design and
development cycle, rather than during the later stages of product
development and production.
 The characteristic of Target Costing
❑The costing that focuses on customers

❑Emphasis on cost reduction at the early stage of product

development

❑Considers the whole product life cycle

❑Involves the whole value of the supply chain

 How Target Costing Work?

1. Target costing begins with 2. Working backwards from

identifying customer needs the sales price, companies
and calculating an acceptable establish an acceptable
target sales price for the target profit and calculate
product. the target cost as follows:
Key Features of Target Costing
The price of the product is determined
by market conditions. The company is a
price taker rather than a price maker.
The minimum required profit margin
is already included in the target selling
price.
It is part of management strategy to
focus on cost reduction and effective
cost management.
The difference between the current
cost and the target cost is the
“cost reduction,” which management
wants to achieve.
A team is formed to integrate
activities such as designing,
purchasing, manufacturing,
marketing, etc. to find
and achieve the target cost.

Product design, specifications, and

customer expectations are already
built in while formulating the total
selling
price.
Process of Target Costing
 Process of Target Costing
Market-driven costing Product-level target costing Component-level target costing

The target cost in an ideal world’ •
• Determine target selling
prices
• Determine target profit
margin • Need to estimate the current
• Calculate allowable cost
• The target cost at which a
product must be produced if
it is to be sold at the target
selling price and generate the •
required rate of return
Cost reduction objective is
the degree of cost reduction
needed to achieve the
allowable cost
cost—the cost that the
product could be
manufactured for, prior to any
cost reduction objectives
Product-level target cost is
the difference between the
current cost and the target
cost reduction objective
• Breaking down the product-
level target cost into target
costs for components
• Value engineering (VE)
• Reviewing the product or
process design to make
changes to reduce cost while
still maintaining the
functionality of the product
• Pursue continuous
improvement once production
begins
Closing the cost of the gap to achieve target cost

▪ One way to close a target

cost gap is to reduce the
product’s direct costs (i.e.,
direct materials or direct
labour).
▪ This can best be achieved
by eliminating non-value-
adding raw materials (such
as packaging) or improving
labour productivity (e.g., by
investing in training to
accelerate learning effects).
 Closing the cost of the gap to achieve target cost
❑ Target cost gap = Estimated product cost – Target cost.
❑ It is the difference between what an organisation thinks it can currently make a product and
what it needs to make the required profit.

❑ Management can set benchmarks for improvement towards the target costs by improving
technologies and processes.

❑ The cost is reduced by getting rid of the activities and operations that caused costs and do
not add value to the product. Cost can be reduced by substituting the machine instead of the
employee or substituting the current raw materials with other low-cost materials without
affecting the products.

❑ Review the product's features. Remove features that add to cost but do not significantly add
value to the product when viewed by the customer (non-value-added activities). This should
reduce cost but not the achievable selling price (value engineering/value analysis).
Methods to Close the Gap

✓ Reducing the number of components

✓ Using standard components wherever
possible
✓ Training staff in more efficient techniques
✓ Using different materials
✓ Using cheaper staff
✓ Acquiring new, more efficient technology
✓ Value Engineering (Cutting out nonvalue-
added activities)
 Example 1
ABC Ent operates in a very competitive market. It sells
packaged food to end customers. ABC Ent can only charge RM
20 per unit. If the company’s intended profit margin is 10% on
the selling price, calculate the target cost per unit.

Solution:
Target Profit Margin = 10% of 20 = RM2 per unit
Target Cost = Selling Price – Profit Margin
= RM20 – RM2
Target Cost = RM18 per unit
 Example 2 - Q
Fossa Auto Berhad (FAB) is considering the production of the compact hybrid car
, which will be known as the Fabelez. All key competitors produce a small model
aimed at the same market segment.

The average price of these cars in the market is RM50,000. The total cost of
producing a unit of Fabelez has been estimated at RM45,750. FAB’s
shareholders require a markup of 25% on all retail car sales.

Required: Calculate the expected selling price of Fabelez using:

1. Traditional mark-up pricing; explain what will happen if production goes

ahead at this point.
2. Target costing; determine the target profit and cost.
 Example 2 - A
The expected selling price of Fabelez using:
1. traditional mark-up pricing: mark-up 25%
SP = RM45,750 x 125% = RM57,187.50
If production goes ahead at this point, selling at this price, FAB is losing its
competitiveness in the market.

2. Using target costing, SP should be set at RM50,000 or lower.

Mark-up = 25% on TC; thus, profit margin = 25%/125% = 20% on SP
Target profit margin = 20% x RM50,000 = RM10,000
Target cost = 80% x RM50,000 = RM40,000
Cost reduction required: RM45,750 – RM40,000 = RM5,750
 Advantages of Target Costing
It shows management’s
commitment to process
improvements and
product innovation to gain
competitive advantages.
The product is created
from the expectation of
the customer and hence
cost is also based on
similar lines. Thus, the
customer feels more
value is delivered.
With the passage of time, the company’s
operations improve drastically,
creating economies of scale.
The company’s approach to
designing and
manufacturing products
becomes market-driven.
New market opportunities
can be converted into real
savings to achieve the
best value for money
rather than to simply
realize the lowest cost.
 Target Costing VS Traditional Costing
Target Costing Traditional Costing

Price is determined based on the external Dominated by standard costing Product is

market analysis developed first, then expected standard cost is
being determined
Use proactive approach as price is determine Use a reactive approach where it considers all
first and then the total costs production costs & other operating costs to
determine the selling price
A desired profit margin is deducted from the Profit is allocated and added to the total costs
target selling price to arrive at the target cost to determine the selling price
Product may need to be redesigned to achieve It is difficult to change the product as they are
target cost already launched to the market
More efficient and focus in keeping costs low as Cost reduction is only done after product is
costs are determined during product planning already developed i.e. during manufacturing
& development process, therefore cost reduction is more
difficult to achieve
 ▪ Unrealistic target costs set can be
very difficult or
impossible to be achieved by
the management
Limitation of ▪ Workforce would be demotivated if
Target Costing unable to achieve the unrealistic
target
▪ This may lead to dysfunctional
behaviour among the
managers
Pricing Strategies
▪ The use of pricing policy to identify a
products or service’s optimum price in the
marketplace
▪ What is the pricing policy?
▪ The determination of what price a
business will charge for a product or
service

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 Common Pricing Strategies

Price Penetration Value based

discrimination pricing pricing

Price Product Differential

skimming bundling pricing

Premium Predatory
Loss leader
pricing pricing
 Common Pricing Strategies
PREMIUM PRICING
▪ Establishes a price higher than the competitors.
▪ There is something unique about the product or when the product is first to market and
the business has a distinct competitive advantage. A high price designed to reflect
quality, reputation and status.
▪ Example: Apple sold new iPhone 14 Pro at approx. RM5,000++.

PENETRATION PRICING
▪ Sets the initial product price low for a new product to attract market share.
▪ The management hopes to gain wide acceptance of the product and quickly attract a
large market share.

▪ Example: MAGGI uses this strategy to control its market. Consumers will choose MAGGI
because of it has homogeneous products and the company is also in a perfect
competition market. In the market, MAGGI has many competitors, therefore, MAGGI
lowers their price than others to attract more buyers to purchase their product so that
customers will feel it is more worth buying MAGGI instead of other brands.
 Common Pricing Strategies
MARKET SKIMMING
▪ a pricing strategy that sets new product prices high and subsequently lowers them as
competitors enter the market.

▪ Example: Apple is a strong example of a price-skimming brand. Historically, new Apple

products—like the iPod, iPhone, and iPad—launch with a premium price attached. In a few
months, that price drops, opening the door for other types of buyers.
DIFFERENTIAL PRICING
▪ involved charging different prices to different groups of customers (because the customers
value the products differently).
▪ Customers with high valuations are willing to pay more. Customers with lower valuations
may buy if the price is lower.

▪ Example: Umbrellas or raincoats may have a different price during rainy seasons in Malaysia.
 Common Pricing Strategies
PRODUCT BUNDLING
▪ Putting a package of products together to make a complete kit for customers. This is done
to create value for customers, maintain sales volume and increase company’s profit.

▪ Example: Bundle a word processor, a spreadsheet, and a database into a single office suite
software; value meals at restaurants
VALUE-BASED PRICING
▪ Sets prices based on the benefit and value of the product perceived or estimated by the
customer rather than on the cost of the product, the market price, competitors’ prices, or
historical prices.

▪ Example: A painting may be priced as much more than the price of canvas and paints: the
price in fact depends a lot on who the painter is. Painting prices also reflect factors such as
age, cultural significance, and, most importantly, how much benefit the buyer is deriving
from a such painting by Picasso.
 Common Pricing Strategies
PREDATORY PRICING
▪ The illegal act of setting prices below the cost in an attempt to eliminate the competition.
Predatory pricing violates antitrust law, as it makes markets more vulnerable to a monopoly.

▪ Example: Amazon has consistently engaged in predatory pricing — selling products and
services below cost to kill off competitors and expand its market share. During its first six
years, Amazon lost billions of dollars selling books below cost, a strategy that drove many
bookstores out of business.

LOSS LEADER
▪ a marketing strategy that prices products lower than the cost to produce them in order to
attract new customers or to sell additional products to customers. Companies typically use
loss leader pricing when they are entering new markets or attempting to increase market
share.

▪ Example: like bread or milk, below the cost, it takes to produce them in order to bring
buyers into the store and entice them to purchase other items, cereal, a candy bar, and
some laundry detergent.
 Common Pricing Strategies
PRICE DISCRIMINATION
▪ Price discrimination refers to a pricing strategy that charges consumers different prices for
identical goods or services.

▪ Example: Movie theatres and amusement parks use price discrimination when they charge a
different price for children than for adults.
▪ issuing coupons, applying specific discounts (e.g., age discounts), and creating loyalty
programs. One example of price discrimination can be seen in the airline industry
End of topic 4
Thank you
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