LESSON 5

PRICING DECISION
Pricing Decision – An overview
This chapter is related to how companies determine the
appropriate selling price for the products and services
that will help to achieve the overall company’s objectives
taking into consideration multiple factors will influence the
companies pricing policies.

We will be looking into the following:

Factors that will influence a firm’s pricing policies
Demand and pricing decisions
Various pricing models
Possible companies’ pricing policies
Demand and product life cycle

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Factors influencing pricing
Factors that will influence the firm’s pricing policies
 Costs – costs are the major determinants of pricing as a
companies’ major reason for existence is to make money
hence selling price set must be above the costs.
 Customers – customers bargaining power, the price elasticity
of demand, quantity ordered etc.
 Competitions – the degree of rivalry between existing
competitors, products, barriers to entry etc.
 Corporate objectives, strategies or policies – concentrates on
what the companies want to achieve and the time under
considerations eg. To maximize market share, product growth,
profit maximization etc
 Product life cycle – prices set may be influence by the stage in
which the product is in.
 Product mix – prices set which must consider the relationship
between the products and its mix

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Demand and pricing
Demand and pricing decisions
Demand is not only influenced by price as there are other
factors affecting demand which is basically subdivided
into internal and external variables/factors.

Examples of internal variables:

Advertising and promotion
Quality of product/service
After sales service satisfaction level
Distribution method
Credit terms and discounts

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Demand and pricing

Examples of external variables:

 Level of competition
 Competitors’ prices
 Consumers’ taste and preferences
 Purchasing power of consumers
 Stage in product life cycle
 Government policies

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Pricing Models
Pricing models
Pricing decision is one of the most important decision
make by a firm. If the price is set too high, the
demand would be badly affected and if the price
is set too low then it may not be economical to
provide the goods or services.
Basically, the pricing models can be divided into 3
major categories:
1. Profit maximization model
2. Cost-based model
3. Target costing

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Pricing Model – Profit Maximization

Profit maximization/demand based model

For imperfect competition where the firm may have an
advantage in determining the selling price, the company
will be able to lower selling price in order to increase
demand.
Profit maximization objective
This model is based on the economic theory that profit is
maximized at the sales level where marginal cost equal
to marginal revenue ie the optimal price/demand will be
at the point where:
Marginal cost (MC) = Marginal revenue (MR)
where MC is the increase in total cost from making an extra one unit
where MR is the increase in total revenue from making an extra one unit

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Revenue Maximization
Revenue maximization objective
 This objective is pursued when the
incremental profit is more than zero at any
output level ie when the MC is almost non
existence. For example, a scheduled flight.
The marginal cost of flying the route is almost
negligible and hence the airline will make more
profit if the seats are all filled. Hence the
optimal price/output level that will result in
revenue maximization will be the point where:
MR = 0

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Pricing Model – Profit Maximization

Example:
RAC Sdn Bhd manufactures LL and has determined that the
demand/price relationship for the product is linear and the following
data are available for the coming period:
Selling price
RM90 RM60
Demand (in units)
400 1000
It is estimated that the variable cost per unit of LL will be RM40 with
fixed costs of RM5,000 per period. All fixed costs are apportionment
of unavoidable fixed costs.
Required:
a)Determined the profit maximizing output and price level for LL and
the resultant profit.
b)Determine the revenue maximizing output and price levels for
product LL and the resultant profit.
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Pricing Model – Profit Maximization

Solution

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Pricing Model – Profit Maximization

Advantages of profit maximization model

The profit maximization output can be determined easily
if the price/demand relationship is known.
Focuses management’s attention on the importance of
accurate cost measurement especially when demand is
elastic.
Disadvantages of profit maximization model
Difficulty in determining with reasonable accuracy the
estimates for demand since it is influence by many other
variables beside price such as quality, promotional
activities, advertising, consumer taste and preferences
etc.

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Pricing Model – Profit Maximization

 Difficulty in estimating the cost function since marginal

cost is different at different output level.
 Pricing decision based on profit maximization may not
be appropriate if firms may pursue other objectives
such as market share, targeted growth rate, profit
growth etc.
 The assumptions that demand is a linear function to
price may not be realistic.

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Cost Based Pricing Models
Cost based pricing models
 A profit oriented firm main existence is to
make profit and hence it should sell its
product in excess of the products or service’s
cost.
Selling price = Cost Base + Profit Margin
Cost can be determined as:
1. Marginal cost
2. Absorption cost (Traditional Absorption Cost)
3. Absorption cost (ABC Approach)

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Cost Based Pricing Models
Profit margin percentage takes into
consideration of a number of factors such as:
The stage in product life cycle
The type of customer (differentiation of
customers in terms of location, product
requirements, terms offered etc)
The possible reduction in profit mark up due to
bulk discount
Current state of capacity utilization
The required return of the company

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Cost Based Pricing Models –
Marginal Costing
Marginal cost based pricing
Marginal cost or incremental cost refers to the additional
cost incurred in making one more unit of output.
Advantages:
Simple to operate
It helps to focus management’s attention to short term
operational variables
Disadvantages:
Ignores market demand
It ignores general fixed costs which would need to be
recovered in the long run to ensure long term profitability

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Cost Based Pricing Models – Full
Costing (Traditional OA)
Full Cost Based Pricing (Traditional Absorption
Costing)
Advantages:
Simple, cheap and easy to operate
Considers all costs hence price set will be sufficient to
enable profit to be earned if the projected activity level is
achieved
Disadvantages:
Like marginal cost basis, it ignores the market price of
the products hence price set may not be competitive
Inappropriate when setting prices in the short run
Full cost may vary depending on the projected activity
level

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Cost Based Pricing Models – Full
Costing (Traditional OA)
 If volume decreases, the fixed cost per unit increases
hence selling price per unit increases – leads to a
vicious cycle
 It does not gives incentives to managers to control
cost due to the perception that cost will be passed on
to the customers

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Cost Based Pricing Models – Full
Costing (ABC)
Absorption costing (Activity Based Costing)
 Compared with traditional absorption method which
arbitrarily allocate fixed overhead costs to products
with what is being fair, ABC method traces cost to
products based on the products consumption on
activities, hence are more accurate. ABC establishes
the relationship between resources consumed with
products produced.
ABC is suitable for companies having the following
characteristics:-
 It produces a wide range of products
 Its products cost structure tilt more towards fixed
overhead costs

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Cost Based Pricing Models – Full
Costing (ABC)
 Advancement in information technology and the
lowering of hardware cost brought about by cheaper
adoption and deployment of such system
 Where the company faces intense rivalry with other
companies offering similar products
Advantages
 Simple, cheap and easy to operate
 Considers all costs hence price set will be sufficient to
enable profit to be earned if the projected activity level
is achieved

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Cost Based Pricing Models – Full
Costing (ABC)
Disadvantages:
 Like marginal cost basis, it ignores the market price of
the products hence price set may not be competitive
 Inappropriate when setting prices in the short run
 Full cost may vary depending on the projected activity
level
 If volume decreases, the fixed cost per unit increases
hence selling price per unit increases – leads to a
vicious cycle
 It does not gives incentives to managers to control
cost due to the perception that cost will be passed on
to the customers

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Pricing Policy for New Products

Pricing Policy for New Products

When a brand new product is introduced into the market,
the company may opt for the following pricing policy:
Market penetration policy
This method is applied when the company wishes to
obtain high penetration/market share in order to gain
rapid acceptance of the product.
Reasons:
The company wishes to discourage new entrants into
the market

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Pricing Policy for New Products
 The company wishes to shorten the initial period of the
product’s life cycle in order to enter the growth and
maturity stages quickly
 The company wishes to attain significant economies of
scale achieved from high volume output, and hence
able to gain significant reduction in unit costs.
 For penetration pricing to be effective, the total market
size in which the firm is operating must be substantial
and the anticipated market share is significant.

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Pricing Policy for New Products

Market skimming
This method involves setting a high price for the new
product to take advantage of its competitive advantage.
Market skimming is to exploit those sections of the
market that is price insensitive. Charging high initial price
when demand will be inelastic due to the novelty appeal
of the new product will maximize the company’s short run
profit.

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Pricing Policy for New Products
 A market skimming pricing policy offers safeguard
against future unexpected price increases, or a large
fall in demand after the novelty appeal has declined.
Once the market becomes saturated the price can be
reduced to tap that part of the market that has not
been exploited.

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Pricing Policy for New Products
Conditions where market skimming policy is suitable:
When the product is new and different and customers
are willing to pay high prices to be the first in line to own
the product.
When the strength of demand and the sensitivity of
demand to price are unknown. From a psychological
point of view, it is better for the company to start off with
a high selling price and reducing it if the demand for the
product appears more price sensitive than initially
estimated.

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Pricing Policy for New Products
 When the company faces liquidity problem hence
would want to set high prices initially to overcome
cash flow problem.
 When the product have short product life cycle hence
would need to recover their development costs and
make profit quickly.
 When the product introduced is within the company’s
umbrella product/brand.

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Product Mix Pricing Policy

Product mix pricing policy

Loss leader pricing
When a product range consists of one or more main products
and a series of related optional extras, where the customer
‘add on’ to the main product, the supplier can set a relatively
low price for the main product and a high price for the ‘extras’.
Product bundling
Bundling refers to a package of products together to be sold
at a temptingly low price. The aim is to create value for
customers and increase company profits.

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Pricing Strategies and Product
Life Cycle
Pricing strategies and product life cycle
A product even if an animated object has a ‘life’ that
goes through four phases ie introduction, growth,
maturity and decline.
The price at which a product should be sold is not fixed

throughout its life and should be modified based on the

phase the product is in.

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Pricing Strategies and Product
Life Cycle

Demand

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Pricing Strategies and Product
Life Cycle
Development/Pre production stage
At this stage, the company is involved with gathering
information on factors that affects the pricing of product,
market size, legal constraints, production constraints and
environmental constraint.
Introduction stage
he company is to choose between alternative pricing
policies ie
Market skimming
Sell at high price in order to generate high net cash
inflow initially to recover the development cost quickly

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Pricing Strategies and Product
Life Cycle
 Effective if product is brand new and different and
demand is inelastic.
 Major problem – may attract entrants into the market
Market penetration
 Promotes high growth, discourage competition and to
achieve economies of scale
 But there is a danger that the company may not be
able to recover the initial development cost and hence
making a profit for the product in the long run.

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Pricing Strategies and Product
Life Cycle
Growth stage
Rapid sales growth due to market acceptance but the
attractiveness brings about new entrants into the market
resulting in company lowering the initial market skimming
price in order to maintain market share, dominance and
achieve economies of scale.

Maturity stage
Sales growth almost stagnant
Emergence of an established competitive market price

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Pricing Strategies and Product
Life Cycle
 An average on going rate may be charged
 Alternatively, company may charge a premium price if
the company has developed a strong and reputable
brand
 Profits earned is the highest at this stage at the
product would have achieved the lowest possible cost
unit
 Company may try to extend the maturity stage by
launching upgrades or adopt a market development
strategy

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Pricing Strategies and Product
Life Cycle
Decline stage
The initial innovation would have been superseded by a
superior product
Price reasonably to retain a small but profitable niche
market
Alternatively use product bundling strategy

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Pricing Strategies and Product
Life Cycle
ACCA f7-2015 June
ALG Co is launching a new, innovative product onto the
market and is trying to decide on the right launch price for the
product. The product’s expected life is three years. Given the
high level of costs which have been incurred in developing the
product, ALG Co wants to ensure that it sets its price at the
right level and has therefore consulted a market research
company to help it do this. The research, which relates to
similar but not identical products launched by other
companies, has revealed that at a price of $60, annual
demand would be expected to be 250,000 units. However, for
every $2 increase in selling price, demand would be expected
to fall by 2,000 units and for every $2 decrease in selling
price, demand would be expected to increase by 2,000 units.
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Pricing Strategies and Product
Life Cycle
A forecast of the annual production costs which would be
incurred by ALG Co in relation to the new product are as
follows:
Annual production
(units) 200,000 250,000 300,000 350,000
  $ $ $ $
Direct material 2,400,000 3,000,000 3,600,000 4,200,000
Direct labour 1,200,000 1,500,000 1,800,000 2,100,000
Overheads 1,400,000 1,550,000 1,700,000 1,850,000

Required:        
(a) Calculate the total variable cost per unit and
total fixed overheads.

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Pricing Strategies and Product
Life Cycle
(b) Calculate the optimum (profit maximising) selling price for the
new product AND calculate the resulting profit for the period.
Note: If P = a – bx then MR = a – 2bx.
(c) The sales director is unconvinced that the sales price calculated
in (b) above is the right one to charge on the initial launch of the
product. He believes that a high price should be charged at
launch so that those customers prepared to pay a higher price
for the product can be ‘skimmed off’ first.
Required:
Discuss the conditions which would make market skimming a more
suitable pricing strategy for ALG, and recommend whether ALG
should adopt this approach instead.

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Pricing Strategies and Product
Life Cycle
ALG Co
Variable cost per unit
Material cost = $2,400,000/200,000 = $12 per unit.
Labour cost = $1,200,000/200,000 = $6 per unit.
Variable overhead cost using high-low method:
($1,850,000 – $1,400,000)/(350,000 – 200,000) = $3 per
unit. Therefore total variable cost per unit = $21.
Fixed costs = $1,400,000 – (200,000 x $3) = $800,000

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Pricing Strategies and Product
Life Cycle
Optimum price
Find the demand function
Demand function is P = a – bx, where P = price and x =
quantity, therefore find a value for a and b firstly. B =
∆P/∆Q = 2/2,000 = 0·001 (ignore the minus sign as it is
already reflected in the formula P = a – bx.) Therefore P
= a – 0·001x
Find value for ‘a’ by substituting in the known price and
demand relationship from the question, matching ‘p’ and
‘x’ accordingly.

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Pricing Strategies and Product
Life Cycle
60 = a – (0·001 x 250,000)
60 = a – 250
310 = a
Therefore P = 310 – 0·001x.
Identify MC
MC = $21 calculated in (a)
State MR
MR = 310 – 0·002x

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Pricing Strategies and Product
Life Cycle
Equate MC and MR to find x
21 = 310 – 0·002x 0·002x = 289
x = 144,500
Substitute x into demand function to find P
P = 310 – (0·001 x 144,500)
P = $165·50

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Pricing Strategies and Product
Life Cycle
Calculate profit
Sales revenue = 144,500 x $165·50 = $23,914,750
Variable overheads = 144,500 x $21 = $3,034,500
Fixed overheads = $800,000
Therefore profit = $20,080,250

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Pricing Strategies and Product
Life Cycle
Market skimming
As the sales director suggests, market skimming is a strategy
which initially charges high prices for the product in order to
take advantage of those buyers who want to buy it as soon as
possible, and are prepared to pay high prices in order to do so.
If certain conditions exist, the strategy could be a suitable one
for ALG Co. The conditions are as follows:
– Where a product is new and different, so that customers are
prepared to pay high prices in order to gain the perceived
status of owning the product early. All we know about ALG
Co’s product is that it is ‘innovative’, so it may well meet this
condition.

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Pricing Strategies and Product
Life Cycle
– Where products have a short life cycle this strategy is
more likely to be used, because of the need to recover
development costs and make a profit quickly. ALG Co’s
product does only have a three-year life cycle, which
does make it fairly short.
– Where high prices in the early stages of a product’s life
cycle are expected to generate high initial cash inflows. If
this is the case here, then skimming would be useful to
help ALG Co cover the high initial development costs
which it has incurred.

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Pricing Strategies and Product
Life Cycle
– Where barriers to entry exist, which deter other
competitors from entering the market; as otherwise, they will
be enticed by the high prices being charged. These might
include prohibitively high investment costs, patent protection
or unusually strong brand loyalty. According to the
information we have been given, high development costs
were involved in this case, which would be a barrier to entry.
– Where demand and sensitivity of demand to price are
unknown. In ALG Co’s case, market research has been
carried out to establish a price. However, this information is
based on the launch of similar but not identical products, so
it is not really known just how accurate it will be.

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Pricing Strategies and Product
Life Cycle
It is not possible to say for definite whether this pricing strategy
would be suitable for ALG Co, because of the limited information
available. However, it could always be launched at a higher price
initially to see what demand is. It is far easier to lower a price
after launch than to raise it. The optimum pricing approach in (b)
above is based on a set of assumptions which do not hold true in
the real world. Also, as the data is derived from similar but not
identical products, it may not hold true for this particular product.

 
 
 

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