Chapter 15

Chapter 15
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Pricing decisions
• Learning objectives
– Discuss particular issues that arise in pricing
decisions
– Understand demand and product life cycle
– Apply and evaluate profit maximization
– Identify and discuss different methods of cost plus
pricing
– Identify and discuss market based pricing strategies
– Explain the limitations of various pricing strategies
© Juta & Company 2015 ISBN: 978 1 48511 190 0 2

Pricing
• The price is what customers pay for an
organisation’s products or services.
• It is considered to be one of the most important
decisions made by the managers.
• Pricing decisions are depended on factors such
as customers, competition, cost and suppliers.
• All organisations are not free to decide their
own selling price.

Price elasticity of demand
• A product’s price elasticity of demand measures the degree
to which the unit sales of a product are affected by a
change in price.
• Price elasticity should be a key element in setting the price.
• Demand for a product is said to be inelastic if a change in
price has little effect on the number of units sold.
– Example: designer perfumes.
• Demand for a product is said to be elastic if a change in
price has a considerable effect on the sales volume.
– Example: diesel fuel

Elastic and Inelastic Demand
Figure 15.1 Graph of elastic demand and inelastic demand
(a) Elastic Demand (b) Inelastic Demand
Price Price
P1 P1
P2 P2
0 Q1 Q2 Demand 0 Q1 Q2 Demand

Price elasticity of demand
• The price elasticity of demand measures the
change in demand as a result of a change in its
price.
– Price elasticity of demand = Percentage change in

quantity demanded /Percentage change in price.

Illustrative example 15.1
• Micro Ltd estimated that the sales fall from 50 units per
day to 30 units per day when the price of Product A goes
up from R40/unit to R60/unit. Calculate the price elasticity.
• Original demand = 50 units
• Decrease in demand = 20 units (50 - 30)
• % change in demand = (20/50) x 100 = 40%
• Original price = R40/unit
• Increase in price = R20 (60 - 40)
• % change in price = (20/40) x 100 = 50%
• Price elasticity of demand = 40 / 50 = 0.8

Factors affecting price elasticity
• The following factors can affect price elasticity.
• Definition of products:
– If a product is broadly defined, the demand is often inelastic. For example, milk. But specific brands of milk
are more likely to be elastic following a change in price.
• Availability of substitutes:
– If there are many substitutes available for a product, the demand will be more elastic. For highly
differentiated products, demand tends to be more inelastic.
• Disposable income
– The wealth of the consumers and the proportion of income spent on the purchase will affect the demand.
• Complementary products
– The sales volume of the complementary products depends on sales of primary products. This
interdependency results in price elasticity. For example, purchase of a clock or a torch requires the
purchase of batteries which is a complementary product.
• Habit forming goods
– The demand is inelastic for habit forming goods such as cigarettes. Consumers are less responsive to the
price changes since they become addicted to the product.

Product life cycle
• A product’s life cycle consists of four stages,
namely introductory, growth, maturity and
decline.
• Each stage has different objectives and
prospects.
• Any business should adopt appropriate pricing
strategies for different stages in the life cycle.
• This method is called product life cycle pricing.

Product life cycle
Fig 15.2 Product life cycle graph.
Sales revenue
Profit
0 Time
Introduction Growth Maturity Decline

Product life cycle
• The sales revenue picks up in the introductory phase and increases
rapidly during the growth phase.
• The revenue reaches its peak during maturity phase, then the revenue
starting to drop in the decline phase.
• Profit follows the same pattern, but normally make losses in the
introductory phase.
• In the growth phase profit will be realised and reaches its maximum
during later growth phase and maturity phase.
• In the decline phase, profit drops rapidly and even record losses.
• Length of each phase differ significantly depending on the type of
product and the market conditions.
• There must be strategies in place to extend the maturity phase where
maximum profits are realised.

Introductory phase
• When a product is first introduced into the market, usually demand will be low.
• Heavy investment in advertising and promotion is necessary to create awareness and
attract customers to buy the product.
• The objective at this stage is to establish the product in the market with sustainable
sales volume.
• Price penetration strategy is often used at this stage depending on the nature of the
product.
• For innovative and high tech products market skimming may be used.
• This means that the new products are introduced at high prices to take advantage of
the customers who are keen to have the latest product.
• Later, the price may be reduced to keep a constant demand.
• Costs incurred during this phase is relatively high due to heavy investment in product
development, advertising and promotion in order to establish the product in the
market.
• Usually profit will be low during this phase.

Growth phase
• Second phase in the product life cycle

• The distinguishing feature of this phase is a steady and
often rapid increase in demand.
• The cost per unit decreases as a result of increased
production.
• The aim at this stage is to increase the market share or
even to become a market leader.
• During this stage competitors will enter the market.
• Although pricing is vital to gain market share, it is
considered as the most profitable stage.
Maturity phase
• At this stage the product reaches the mass market

and the growth in demand starts declining.
• Sales volumes are still high to make good profit,
but towards the end of the phase profit begin to
fall.
• Product differentiation is key to maintain the
market share at this phase.
• Usually profit will be lower than the growth phase
towards the end of this phase.
Decline phase
• This is the last phase in the product life cycle.

• The sales volume as well as profit declines at a
rapid rate.
• Aggressive price cuts and advertising are used
to avoid losses.
• Before the product reaches the end of its life,
the product should be discontinued or a
modified or new product should be introduced.

The profit maximization model
• It is a mathematical model which is used to determine an optimum selling price that

will generate maximum profit.
• The economic theory behind this model imply that the profit is maximized at the sales
volume where marginal cost equals marginal revenue.
• The equation to calculate price is p = a - bx
• Where
• p = price
• x = quantity in demand
• a and b are constants, where b is the slope of the demand curve, which is equal to
change in price divided by change in quantity ( change in price / change in quantity)
• Marginal cost is the cost of making one extra unit, which is usually equal to the
variable cost.
• The marginal revenue can be found by doubling the value of b.
• MR = a - 2bx

Limitations of the profit maximizing model
• Organisations are unable to determine accurate demand for

their products and services.
• The aim of majority of the organisations’ are to achieve a
target profit, not maximum profit.
• It is difficult to determine accurate figures for marginal or
variable costs.
• Variable cost per unit vary depending on the quantity sold.
– For example supplier discounts may reduce unit cost for higher
sales volumes.
• The level of advertising and change in income of consumers
will affect the demand.

• A company estimates that the maximum demand for its product X is 50 000 units at price zero. The demand will be reduced by 20
units for increase of R1 in the selling price. The company has determined that the profit is maximized at the sale of 21 000 units.
• Calculate at what price the company should sell product X to maximize profit.
• At maximum demand the price is zero.
• When p = 0, quantity demanded x = 50 000 units
• 0 = a – 50 000b ………….(1)
• When p = 1, quantity demanded x = 49 980 units
• 1 = a – 49 980b …………..(2)
• Subtract equation (1) – (2)
• 1 = 20b
• b = 0.05
• Substitute b = 0.05 in equation (1)
• 0 = a- 50 000 x 0.05
• a = 2 500
• The equation for product X is
• p = 2 500 - 0.05 x
• When x = 21 000 units
• p = 2 500 – 0.05 x 21 000
• p = 1450
• Therefore profit maximizing selling price is R1450 per unit.

Pricing strategies based on cost
• Cost based pricing involves setting the selling

price based on costs.
• The general formula for setting a cost based
price is to add a markup to the cost base.
• Mark-up is usually expressed as a fixed
amount or as a percentage of the cost or
selling price.

Establishing percentage mark-ups
• Markups are affected by various factors, including competition and

is likely to decrease when competition is intense.
• Markups also relate to the demand for a product.
• An organization that has a high demand for its product is able to
command a higher markup.
• The markup must be high enough to cover selling and administrative
costs and provide an adequate return on investment.
• The markup percentage can be calculated as:
• Markup % = Required ROI x Investment + Selling and admin
expenses
• Sales units x cost per unit

Cost-plus pricing
• Two approaches in cost plus pricing generally used are total cost plus pricing
and variable cost plus pricing.
• In total cost plus pricing both variable and fixed costs are considered in the
calculation of the selling price.
• In variable cost plus pricing only variable cost is considered in calculation of
selling price and a larger markup is added to cover fixed costs and profit.
• Selling price is determined by adding a percentage to the cost usually called
mark up.
• For example a product has R20 variable cost per unit and R30 fixed cost per
unit. Therefore the total cost is R50. The business requires a profit margin of
20%, so add R10 (20% of R50) as markup to come up with a selling price of
R60 per unit.
• This strategy is commonly used in make to order products and in retailing.
The markup used usually vary according to the market conditions.

Advantages of cost plus pricing
• It is a simple method to calculate price.

• Awareness of the cost structure and the routine
nature of the method saves management time.
• If the forecasted sales figures are achieved, then
the required profit can be realised.
• Price increase can be justified to customers, which
is often followed by an increase in cost.
• This method is useful to determine price in
contract costing industries.
Disadvantages of cost plus pricing
• Cost plus pricing does not consider competitors' actions regarding
pricing and also pays no attention to the stages of product life
cycle.
• It does not consider the willingness of the customer to pay the
price chosen.
• There will be problems with the basis on which fixed costs are
allocated to products.
• There will be lack of interest to minimize cost for organisations
using cost plus pricing because reducing cost will result in
reduction of profit.
• Competitors can offer similar products at lower prices and gain
market share.

Return on investment pricing
• The price is based on the targeted return on the capital invested in a product.
• The unit price is calculated as follows:
• Unit price = (Total cost (Variable + Fixed) + % return x Investment)/ Budgeted sales
volume
• Advantages.
– It is consistent with other performance measures such as return on investment.
– It is considered as an appropriate method for market leaders who sets a price which competitors
follow.
– It is a relevant pricing method for new products which requires substantial investment.
• Disadvantages.
– There is an element of uncertainty about reaching expected sales volume for new products which
is influenced by the set price.
– In cases where the investment may be common to a number of products, the apportionment of
the investment amongst product is often difficult.

• Following budgeted cost information is available for a company making a single product.
• Variable cost /unit R50
• Fixed manufacturing costs R100 000
• Fixed administration costs R50 000
• Capital invested R1 000 000
• Units produced and sold 10 000 units
• Assume that mark up to be 20% of projected investment.
• Then Profit = 20% of R1 000 000 = R200 000
• Total variable cost = R50 x 10 000 units = R500 000
• Total cost = total variable costs + fixed manufacturing costs +fixed administrative cost
• = R500 000 + R100 000 +R50 000 = R650 000
• Mark up based on variable cost = (200 000 +100 000 +50 000) x 100 = 70 %
• 500 000
• Selling price based on variable cost = 50 + 70 % x 50 = R85/unit
• Mark up based on total cost = 200 000 x 100 = 30.77 %
• 650 000
• Selling price based on total cost = 65 + 30.77% x 65 = R85/unit
• Selling price based on return on investment = total costs + % return x investment = 650 000 + (20 % x 1 000 000) =
R85/unit
• Budgeted sales volume 10 000

Market based pricing strategies
• The price is set based on the customer

expectation, demand for the product and
competitors’ price.
• It considers customers’ perceived value and how
much they are willing to pay for the product.
• If the product has more or less features than a
similar product of a competitor, the company
sets the price higher or lower than the
competitor’s price.
Target costing and pricing
• Target costing uses the price to determine the cost.
• In target costing, organisations use market information to determine the
price for a product (or service) that potential customers are willing to pay
as well as competitors’ price.
• An organization starts by determining how much it wants to charge for a
product and then subtracts its desired profit from that price to determine
the maximum amount it can afford to pay to manufacture the product.
• For example, if you manufacture computers and want to introduce a new
line, market research shows that you shouldn’t charge more than R9 100
per computer. If a markup of 30% is desired on the cost, then you must be
able to produce each unit for R7 000. The target cost can be calculated as:
– Target cost = Target price – Target profit

Target costing
• Target costing is price led and customer focused.
• Product design is a key component in target costing.
• Products are designed in such a way that it can be produced at its
target cost.
• It also focuses on the efficiency of the production process.
• Target costing is value chain oriented.
• If the budgeted cost of a new product is more than the target cost,
efforts are made to eliminate non value adding costs so as to bring
the budgeted cost down.
• Target costing takes into account all life cycle costs of the product.
• The traditional cost accounting system often do not pay attention to
the product’s life cycle costs.

• Kitchen Appliances Ltd found that there is a market niche for a hand blender with
some new features. Marketing department performed a survey analysing the
features and prices of hand blenders already in the market and suggested that a
price of R300 would be right for the new blender. At that price, it was estimated
that 30 000 new blenders could be sold annually. An investment of R10 million
would be required to design, develop and produce these new blenders. The
required rate of return is 24%. Calculate the target cost for the new blender.
• Projected sales (30 000 blenders x R300) = R9 000 000
• Less desired profit (24% x R10 000 000) = R2 400 000
• Target cost for 30 000 blenders = R6 600 000
• Target cost per mixer (R6 600 000 ÷ 30 000 blenders) = R220
• The target cost of R220 would be broken down into target costs for different
functions such as manufacturing, marketing, distribution, after sales service and so
on. Each function would be responsible to keep the actual cost within the target.

Other pricing strategies
• Penetration pricing
– Penetration pricing is most commonly used to support the introduction
of a new product.
– The price is set very low initially, usually lower than the total cost, to
attract new customers.
– One of the key objectives of this strategy is to increase market share of
a product.
– Once this objective is achieved the price will be increased.
– This strategy leads to lower profit in the short term, however,
significant long term benefits will be achieved through a higher market
share.
– A classic sign of penetration pricing “special introductory offer” which
is often seen on the advertisements.

• Price skimming
– Skimming involves setting a high price for the product initially, which is the
opposite of penetration pricing.
– This strategy is often used for the launch of a new product which often
faces little or no competition.
– Such products are often bought by those who are prepared to pay a
higher price to have the latest or the best product in the market.
– The aim of this strategy is to maximise profit but the high price attracts
new entrants into the market, and the price drops due to increased
supply.
– Once the price is lowered the product is more accessible to the customers.
– The Apple iPad and Sony PlayStations are good examples of price
skimming.

• Premium pricing
– Premium pricing is the practice of setting a price higher than the
competitors’, with the hope that customers will purchase it due to
the perception that the product is superior to the competition.
– Usually a brand name needs to be established for these products
which are different in terms of quality, reliability, image, durability,
etc.
– In order to establish a brand heavy investment is required in
marketing and promotion.
– However, the benefit is higher selling price generating higher profit
and loyal customers.
– Branded products such as Levis and Porsche uses premium pricing.

• Price differentiation
– Price differentiation is a pricing strategy in which a company sells
the same product at different prices in different markets.
– This is possible because different segments in the market have its
own demands.
– For example, if the segmentation is on the basis of time, different
rates are charged for travel, hotel accommodation and telephone
calls during off peak.
– If the segmentation is based on quantity, bulk orders receive a
discount and small orders are purchased at a premium.
– The profit will be improved if the customers are willing to make
use of the service at the less popular time.

• Loss leader pricing
– Loss leader pricing is a method of setting relatively
low price for the main product and a high price for
its accessories.
– This is used to stimulate adequate demand for the
main product and to guarantee the target return
from the sales of its accessories.
– For example, home printers are sold at a very low
price compared to the ink cartridge which sells at a
high price.
• Product bundling
– Product bundling combine several products in the same
package, which can be sold at a low price.
– It creates value for customers and increases profit.
– This also helps to move old stock.
– For example Blu-ray and video games are often sold using
the bundle approach once they reach the end of their
product life cycle.
– In South Africa, for example, DSTV offers different bundled
packages to customers. Telecommunication companies sell
data and phone bundles.

• Discount pricing
– Discount pricing is a long term pricing strategy for
low cost, high volume products with low margins.
– Products are priced lower than the market rate by
keeping the sense of comparable quality.
– The aim is to attain a larger share of the market,
compensating for a reduction in the selling price.

• Controlled pricing
– The pricing of certain products is controlled or
regulated by the government.
– Cost management is key for these businesses to
generate profit.
– For example price of petrol in South Africa is
totally controlled by the government.

Chapter 15 - Pricing Decisions

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Book Cover Here

© Juta & Company 2015 ISBN: 978 1 48511 190 0 2

© Juta & Company 2015 ISBN: 978 1 48511 190 0 3

© Juta & Company 2015 ISBN: 978 1 48511 190 0 4

Figure 15.1 Graph of elastic demand and inelastic demand

(a) Elastic Demand (b) Inelastic Demand

© Juta & Company 2015 ISBN: 978 1 48511 190 0 5

– Price elasticity of demand = Percentage change in

© Juta & Company 2015 ISBN: 978 1 48511 190 0 6

© Juta & Company 2015 ISBN: 978 1 48511 190 0 7

© Juta & Company 2015 ISBN: 978 1 48511 190 0 8

© Juta & Company 2015 ISBN: 978 1 48511 190 0 9

Fig 15.2 Product life cycle graph.

Introduction Growth Maturity Decline

© Juta & Company 2015 ISBN: 978 1 48511 190 0 10

© Juta & Company 2015 ISBN: 978 1 48511 190 0 11

© Juta & Company 2015 ISBN: 978 1 48511 190 0 12

• Second phase in the product life cycle

• At this stage the product reaches the mass market

• This is the last phase in the product life cycle.

© Juta & Company 2015 ISBN: 978 1 48511 190 0 15

• It is a mathematical model which is used to determine an optimum selling price that

© Juta & Company 2015 ISBN: 978 1 48511 190 0 16

• Organisations are unable to determine accurate demand for

© Juta & Company 2015 ISBN: 978 1 48511 190 0 17

© Juta & Company 2015 ISBN: 978 1 48511 190 0 18

• Cost based pricing involves setting the selling

© Juta & Company 2015 ISBN: 978 1 48511 190 0 19

• Markups are affected by various factors, including competition and

© Juta & Company 2015 ISBN: 978 1 48511 190 0 20

© Juta & Company 2015 ISBN: 978 1 48511 190 0 21

• It is a simple method to calculate price.

© Juta & Company 2015 ISBN: 978 1 48511 190 0 23

© Juta & Company 2015 ISBN: 978 1 48511 190 0 24

© Juta & Company 2015 ISBN: 978 1 48511 190 0 25

• The price is set based on the customer

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© Juta & Company 2015 ISBN: 978 1 48511 190 0 28

© Juta & Company 2015 ISBN: 978 1 48511 190 0 29

© Juta & Company 2015 ISBN: 978 1 48511 190 0 30

© Juta & Company 2015 ISBN: 978 1 48511 190 0 31

© Juta & Company 2015 ISBN: 978 1 48511 190 0 32

© Juta & Company 2015 ISBN: 978 1 48511 190 0 33

© Juta & Company 2015 ISBN: 978 1 48511 190 0 35

© Juta & Company 2015 ISBN: 978 1 48511 190 0 36

© Juta & Company 2015 ISBN: 978 1 48511 190 0 37

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