Cost and Pricing MGT For Competitive Advantage

Chapter 6
Cost and pricing management

for competitive advantage
Cost and Management Accounting: Operations and Management – A southern African approach (3rd edition)
© Juta and Company Ltd 2021
ISBN 9781485131229
Learning objectives
After studying this chapter, you should be able to:
• Discuss issues arising in pricing decisions.
• Explain how pricing strategies are used to maximise profit.
• Discuss market-based approaches to pricing, such as the
target costing approach.
• Discuss the different methods of cost-plus pricing.
• Establish target mark-up percentages.
• Explain the advantages and disadvantages of various pricing
strategies.
• Discuss alternative pricing strategies and their consequences.
ISBN 9781485131229
Factors influencing pricing
• Selling prices are influenced by three major factors:
customers, competitors and costs.
• For businesses which are not price leaders in their markets,
selling prices are determined by the market, i.e. customers
and competitors.
• Where there is a relatively small number of dominant
customers in a market, these customers will be the major
influence on suppliers’ selling prices, for example
supermarket chains in SA.
• If there are a few dominant competitors, they will tend to
be price leaders and a smaller supplier will set its prices
following their lead.
ISBN 9781485131229
Factors influencing pricing
• Cost control is the efforts of the business to maintain its
costs at the lowest levels possible while achieving its
volume goals.
• Cost management is a broader concept which includes not
only control, but also aspects such as product design,
process engineering, systems design and value analysis.
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Other common factors that
influence pricing
• Price sensitivity
• Compatibility with other products
• Competitors
• Price perception
• Quality
• Incomes
• Suppliers
• Inflation
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Review of economic principles
of pricing and demand
• Profit = (Q x P) – (Q x C) = Q x (P – C)
• If any or all of P, C and Q change, profit will also change.
• Price, cost and volume also influence each other.
• If volume increases, cost per unit will decrease within
the relevant range because fixed costs are spread over
more units.
• As soon as the volume increases to outside the relevant
range, additional capacity has to be obtained. If
volumes decrease, cost per unit increases and the
business must increase price to maintain profit.
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• According to economic theory, the law of demand indicates
that when prices increase, demand volumes will decrease
and vice versa. This is called a demand curve and is
illustrated graphically in Figure 6.1 on the next slide.
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Figure 6.1: A demand curve
Price
P1 A
P2 B
Q1 Q2 Demand
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• Price elasticity of demand = %  in quantity / %  in price
• Elasticity > 1, demand is price elastic
• Elasticity < 1, demand is price inelastic
• Factors affecting price elasticity:
• High disposable income: inelastic demand for luxury
items
• Necessities (food and clothing): less elastic than luxuries
• Highly differentiated products: less elastic than generic
• Advertising and consumer habits may influence elasticity
• The closer the market is to being perfectly competitive, the
less control a business has over its prices.
ISBN 9781485131229
• Imperfect markets:
• In monopolistic markets, a business has no competitors
and can set prices to maximise profits.
• In oligopolies there are only a few large suppliers,
between whom competition is fierce in price-setting and
other areas
• Most markets have some form of monopolistic competition,
in which there are many competitors, with no one dominant
one.
• Pricing is often a key strategy in imperfect markets in
gaining short-term benefits, although in the longer term
prices will tend to be determined by the market as a whole.
ISBN 9781485131229
The profit maximisation price model
• Profit is maximised at the sales volume where:
Marginal cost = Marginal revenue
• Price/demand equation(price required for a specific quantity
of demand): p = a – bx
Where: p = price
x = quantity of demand
a = a constant specific to the particular product
b = the slope of the demand curve
( price /  quantity)
ISBN 9781485131229
The profit maximisation price model
• The constants ‘a’ and ‘b’ are determined from data
obtained for the product being analysed.
• Marginal revenue, MR = a – 2bx, shows the additional
received for an extra unit of sales at any point on the
demand curve.
ISBN 9781485131229
Illustrative example 6.1
• Smart Security estimates that if it reduced the selling price of
its floodlights to zero, it could not sell more than 100 000
units, which may therefore be considered its maximum
demand.
• For every R0.50 by which it increases price, it estimates that
sales will fall by 10 units.
• Based on its cost structure, the company has determined that
it will achieve maximum profits when sales are 75 000 units.
Required:
At this volume, at what price should it sell each floodlight to
maximise profits?
ISBN 9781485131229
Solution
• Substituting known values in the price/demand equation p = a – bx enables
us to calculate the other values.
At p = 0. x = 100 000 units; so 0 = a – 100 000b (equation 1)
At p = 0.50 x = (100 000 – 10) = 99 990 units; so 0.50 = a – 99 990b (equation 2)
Subtract equation 1 from equation 2:
0.50 – 0 = (a – 99 990b) – (a – 100 000b) = a – 99 990b – a + 100 000b = 10b
0.50 = 10b
b = 0.5 / 10 = 0.05
Substitute b = 0.05 in equation 1
0 = a – 100 000 x 0.05
a = 5 000
• The demand equation for floodlights is therefore p = 5 000 - 0.05x

• Demand for maximum profit has been determined as 75 000 units.
• Therefore, price for maximum profit is 5 000 - (0.05 x 75 000) = R1 250
ISBN 9781485131229
• Cool Air’s Sales Manager has estimated that the following quantities of air
conditioning units could be sold across a range of different prices.
Price R5 000 R6 250 R8 000 R9 750 R11 500

Units 200 170 150 120 80
• The quantity of 200 units per annum is the maximum that the existing
plant can produce without incurring substantial extra investment and fixed
cost.
• The variable cost of each unit is R3 500.
• Fixed costs directly attributable to air-conditioning units are R500 000 per
annum.
Required:
Prepare a table to show the price at which profits would be maximised.
ISBN 9781485131229
Solution
R R R R R
Price per unit 5 000 6 250 8 000 9 750 11 500
Variable cost per unit 3 500 3 500 3 500 3 500 3 500
Contribution per unit 1 500 2 750 4 500 6 250 8 000
Demand (units) 200 170 150 120 80
Total contribution 300 000 467 500 675 000 750 000 640 000
• Air conditioning units should be sold at a price of R9 750 to

achieve the maximum profit of R750 000.
ISBN 9781485131229
Product life-cycle pricing
• Product life cycles: Introductory, growth, maturity

and decline.
• Appropriate pricing strategies should be adopted for
each cycle.
• The pattern of sales and profit for a product during
its life is represented diagrammatically in Figure 6.2.
• Life cycle curves may differ, but generally similar to
those shown in Figure 6.2.
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Sales and profit over a product life cycle
Rands
Sales
Profit
Time
Introduction Growth Maturity Decline
Figure 6.2 Sales and profit trends of a product life cycle
• Introductory and growth: Rapid sales growth.

• Maturity: Sales flatten out during maturity.
• Decline: Sales fall.
• Profits will also follow a somewhat similar pattern.
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Introductory phase
• In competitive markets, a price penetration policy is often
adopted on introduction. The price is kept lower than that of
competitive products.
• Products that appeal to the fashion conscious or those that
are highly innovative may be introduced at high prices on
introduction, to take advantage of their novelty value.
• During the introductory phase, many costs such as
advertising, promotion and development will be higher than
later on, to establish the product in the market. This will also
reduce profits during this phase.
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Growth phase
• Increased sales volumes lead to decreased unit costs, and less
cost pressure on profits.
• An established market share may enable a firm to increase its
prices without reducing volumes, but often there is still keen
price competition to maintain and increase market share.
• Profits increase as volumes increase, unit costs fall and there
is less price pressure.
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Maturity phase
• Although demand now levels off, volumes are still high
enough to maintain profits, which may begin to fall
towards the end of this phase.
• Pricing is often not a key factor in maintaining volumes
during this phase, as businesses may use other strategies
such as product differentiation.
ISBN 9781485131229
Decline phase
• As the product nears the end of its life, sales decline more and
more rapidly.
• To reduce decline, a business may use aggressive price cutting
and advertising strategies.
• Together with reduced volume, this leads to lower profits and
eventually losses.
• It is important for a business to recognise when this stage has
been reached, so that the product can be discontinued before
losses become too great.
ISBN 9781485131229
Market-based pricing strategies
• This approach to pricing starts by considering what customers
want and also what the competitors’ reaction would be to
what the business does.
• In a very competitive market such as the petroleum industry,
the market-based approach is suitable. The products or
services produced by one organisation are very similar to
those produced by others, therefore businesses have no
influence over the price to charge.
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Target cost and
target price approach
• Target price is the estimated price that potential customers
are willing to pay for the product or service.
• After a target price has been established, a target cost is set
by deducting a suitable margin.
• This may initially result in lower than desired profits being
reached, but through improvements the firm aims to reach its
target cost and profit.
ISBN 9781485131229
Steps involved in
target pricing and costing
• Determine the target price based on customers’ perception of
the product and competitors’ prices.
• Determine the gross profit per unit that the business wants to
earn.
• Calculate the target cost per unit (Target price – Target gross
profit per unit)
• Estimate the actual cost of the product or service.
• If actual cost > target cost, find ways of reducing the actual
cost (value engineering or Kaizen costing).
ISBN 9781485131229
Yello Ltd is launching an addition to its product range which will

face fierce competition from existing products in the market. The
maximum price at which it is expected that it can be sold, is
R495 per unit. The company requires that its products make at
least 30% profit on sales. At expected volumes, the actual
product cost is estimated to be R400 per unit.
Required:
1. Calculate the target cost of the product.
2. Suggest ways in which this target cost can be achieved.
ISBN 9781485131229
Solution
1. Target cost = R495 x (1– 30%) = R346.50

The actual cost is R53.50 higher than the target cost.
2. The company should undertake a value analysis of its

product compared to the competition to identify
possible savings as a result of changes in its quality or
specification levels.
A marketing campaign might lead to increased
volumes and therefore decreased fixed costs per unit.
ISBN 9781485131229
Cost-based pricing strategies
• Many businesses base their selling prices on product cost.
• If prices > cost, businesses will always make a profit.
• The problem is determining the correct cost on which the
price is to be based (variable, absorption, activity-based)
• Different types of cost: historical, current (actual),
standard, budget
• Even if one basis and type is used, it may still be possible
to calculate different costs for the same product, e.g. the
standard absorption cost of a product will depend on the
volume used in determining overhead absorption rates.
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Determining the mark-up
to be added to cost
• How should mark-up be determined? Different methods could
be:
• percentage added to cost
• an amount per unit of product
• an amount per labour or machine hour
• How much should mark-up be?
• depends partly on the cost basis
• depends partly on profit objective
• Regardless of how the mark-up is determined, consideration
should be given to capacity utilisation, i.e., the volume on
which overhead allocation and return on investment is based.
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A company makes a single product with the following data:
• Fixed overheads are calculated by dividing the relevant cost by the number of units.
• Unit costs will be as follows:
Historical Current Budget Standard

Variable cost per unit R37 R40 R45 R43
Fixed manufacturing cost R126 000 R130 000 R150 000 R150 000
Fixed administrative cost R64 000 R70 000 R75 000 R75 000
Capital employed R1 050 000 R1 100 000 R1 200 000 R1 200 000
Units produced and sold 10 500 10 000 12 000 11 000
ISBN 9781485131229
Fixed overheads are calculated by dividing the relevant cost
by the number of units.
Unit costs will be as follows:

Historical Current Budget Standard
(R) (R) (R) (R)
Variable cost per unit 37.00 40.00 45.00 43.00

Fixed manufacturing cost/init 12.00 13.00 12.50 13.64
Fixed administrative cost/unit 49.00 53.00 57.50 56.64
Fixed admin cost/unit 6.10 7.00 6.25 6.82

Full cost/unit 55.10 R60.00 63.75 63.46
ISBN 9781485131229
(cont)
• Assume that the company aims to make 10% return on
capital employed or investment and to apply the mark-up
as a percentage of cost.
• Use budget to illustrate the calculation.
• 10% of budget capital employed = 0.10 x R1 200 000 =
R120 000 profit.
• Total budget VC = 12 000 units x R45 = R540 000.
• Add fixed manufacturing cost R150 000 to get total
manufactured cost of R690 000.
• To this, add total administrative cost R75 000 to get total
full cost of R765 000.
ISBN 9781485131229
(cont)
• In calculating mark-up based on anything other than full
cost, we must add the costs not included to the profit
target.
• Mark-up based on variable cost
= (120 000 + 75 000 + 150 000) / 540 000 x 100%
= 63.9%
• Mark-up based on manufactured cost
= (120 000 + 75 000) / 690 000 x 100%
= 28.2%
• Mark-up based on full cost
= 120 000 / 765 000 x 100%
= 15.7%
ISBN 9781485131229
(cont)
• These mark-ups are then applied to the relevant costs per
unit to calculate the required selling price.
• Mark-up based on variable cost:
• Selling price = 45.00 + 63.9% x 45.00 = R73.76
• Mark-up based on manufactured cost:
• Selling price = 57.50 + 28.3% x 57.50 = R73.77
• Mark-up based on full cost:
• Selling price = 63.75 + 15.7% x 63.75 = R73.76
• When we use different cost bases, the prices calculated for
each cost method will be the same within a cost basis, but
differ between cost bases because different data is used.
ISBN 9781485131229
Disadvantages of cost-based pricing
• No guarantee that the prices will be accepted by the market.
• Cost-based prices may be affected by the volumes which have been used
in the calculations.
• Base for overhead absorption may lead to different prices being charged
by different businesses for similar products in the same market, possibly
making a firm either uncompetitive unprofitable.
• Stage in product’s life cycle might be ignored.
• Cost-plus price may become accepted and no longer scrutinised.
• No motivation to minimise costs, since costs are passed on to customers.
• Reduced costs may lead to reduced selling prices. If mark-up is % of cost,
profit will reduce.
• New competitors in the market may offer a better price through new
technology and improved processes.
ISBN 9781485131229
Advantages of cost-based
pricing
• It is simple to calculate a selling price once basis and
capacity utilisation has been decided.
• Price increases can be justified to customers.
• Costly market research is not required.
• If the expected volumes and costs are reached, required
profit will be achieved.
• Cost-based pricing may help a firm to predict the prices of
competitors where the average mark-up for the industry is
known.
ISBN 9781485131229
Alternative pricing strategies
• Penetration pricing
• Price skimming
• Premium pricing
• Price differentiation
• Loss leader pricing
• Product bundling
• Price discounting
• Controlled prices
ISBN 9781485131229
Penetration pricing
• New product introduced: wants to gain acceptable market
share quickly
• Attract new customers not aware of product attributes,
thus set price lower than target price (hope customers
switch based on price)
• When the target market share reached -> increase price
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Price skimming
• New product is launched: set high price to take advantage
of customers who are attracted by novelty and fashion
• Launch usually preceded by extensive advertising and
publicity campaigns to generate demand
• Once the initial excitement is over -> lower price to attract
more conservative and price-conscious customers
ISBN 9781485131229
Premium pricing
• Aim to maintain higher than normal prices over long period
• Establishing popular brand name for a product resulting in
customer loyalty and low price elasticity of demand
• Brand name may be established on the basis of the attributes
of the product, e.g. quality, durability and style
• Requires heavy spending on advertising and promotion
• Reduced advertising -> product quickly loses market share
and premium position
• Continually assess whether premium price justifies higher
costs
ISBN 9781485131229
Price differentiation
• Split market for product into segments where customers

operate separately from the other segments
• Price product differently in the different segments.
• Segmentation may be accompanied by different costs, e.g.
transport costs to different regions (with similar profits)
• Price differentiation may lead to higher profits through
increased volumes
• Price differentiation usually a longer-lasting strategy than
price penetration and skimming
ISBN 9781485131229
Loss leader pricing
• Sell one product at a low price (or at a loss), in the hope of
attracting customers to buy the other products, which are
priced much higher
• Works well when the other products are required for use in or
with the ‘loss leader’ product (e.g. printer and cartridges)
• Makes it difficult for customers to use products other than
those specified
ISBN 9781485131229
Product bundling
• Similar to loss leader pricing: aim to get the customer to

buy range of the firm’s products, increasing overall
volumes and profitability
• Difference: all prices in range are reduced if bought
together
• To be successful, the reduced prices must be at least
compensated for by increased volumes and potential cost
saving resulting from the bundling (e.g. reduced packaging
and transport costs)
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Price discounting
Permanent or temporary discounts:

• Trade discounts are permanent and used to differentiate
prices between types of customers, e.g. wholesale, retail and
supermarkets.
• Clearance sales discounts are temporary, for example when
the firm is overstocked.
ISBN 9781485131229
Controlled prices
• controlled or regulated by legislation or some other

mechanism external to the business.
• This price control should force the businesses concerned to
generate profit through cost management, but its
effectiveness is often doubtful.
ISBN 9781485131229

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Chapter 6

Cost and pricing management

• The demand equation for floodlights is therefore p = 5 000 - 0.05x

Price R5 000 R6 250 R8 000 R9 750 R11 500

• Air conditioning units should be sold at a price of R9 750 to

• Product life cycles: Introductory, growth, maturity

Introduction Growth Maturity Decline

Figure 6.2 Sales and profit trends of a product life cycle

• Introductory and growth: Rapid sales growth.

Yello Ltd is launching an addition to its product range which will

1. Target cost = R495 x (1– 30%) = R346.50

2. The company should undertake a value analysis of its

Historical Current Budget Standard

Unit costs will be as follows:

Variable cost per unit 37.00 40.00 45.00 43.00

Fixed admin cost/unit 6.10 7.00 6.25 6.82

• Split market for product into segments where customers

• Similar to loss leader pricing: aim to get the customer to

Permanent or temporary discounts:

• controlled or regulated by legislation or some other

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