COST AND MANAGEMENT

UNIT 2 SECTION 2 PRODUCT PRICING AND TIME HORIZON

ACCOUNTING Unit 2, section 2: Product pricing and time horizon

Dear Student, you are warmly welcome to the first section of the first unit of
the module. In this section we shall introduce ourselves to the discipline of

One of the most difficult decisions faced by a company is pricing. Pricing

decisions are concerned with what to charge for the products and services
delivered by organisations. These decisions impact upon the revenues a
company earns, which must exceed total costs if profit are to be achieved.
Consequently, determining product costs is important for pricing decisions.

This section will examine the impact of cost on price, major influences on
pricing and short-run and long-run pricing decisions.

By the end of the section, you should be able to:

 discuss the three major influences on pricing decisions
 explain two product pricing approaches
 distinguish between short-run and long-run pricing decisions

Major Influences on pricing

There are three major influences on pricing decisions: customers,
competitors and costs.

Customers
Managers must always examine pricing problems through the perspectives
of their customers. A price increase may cause customers to reject a
company’s product and choose a competing or substitute product.
Understanding customers’ price and product characteristic preferences is a
core competitive strength for businesses today. Currently, organisations are
embracing dynamic pricing which is technology-driven. The idea of
continuous variable pricing which prevailed in the pre-industrial world is
proving a reality for today’s web-enabled businesses.

Firms can price dynamically to respond to demand, to create demand, to

reduce waste and to turn over stock more rapidly. Many businesses use
customer profiling and targeted pricing to refine product offerings to match
individual customers’ price sensitivities. Although price comparison can
help customers identify the lowest prices for specific products, “one-to-one”
and private offers to customers cannot be tracked down in this way.
Customer knowledge becomes a core technological-driven strength which
helps render real prices.

Competitors
Competitors’ reactions influence pricing decisions. On one hand, a rival’s
prices and products may force a business to lower its prices to be
competitive. On the other hand, a business without a rival in a given
situation can set higher prices. A business with knowledge of its rivals’

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technology and operating policies is able to estimate its rivals’ costs, which
is valuable information in setting competitive prices.

Competitor analyses take different forms. Many companies in the world

have established departments to search out information on their competitors’
financial performance, technologies, revenue and cost structures and
strategic alliances. Competitors themselves and their customers, suppliers
and former employees are important sources of information. Another form
of obtaining information is through reverse engineering – a process of
analysing and tearing down competitors’ products – to incorporate the best
features, materials and technology in a company’s own designs.

Costs
Businesses generally price products to exceed the costs of making them.
The study of cost-behaviour patterns gives insight into the income that
results from different combinations of price and output quantities sold for a
particular product. Research on how executives make pricing decisions
reveal that companies weigh customers, competitors and costs differently.

Businesses selling commodity-type products in highly competitive markets

must accept the price determined by market forces. For example, sellers of
rice have many competitors, each offering the identical product at the same
price. The market sets the price, but cost data can help these sellers to
decide, say, on the output level that best meets a company’s particular
objective.

In less competitive markets, such as for mobile phones, products are

differentiated and all three factors affect price. The pricing decision depends
on how much customers value the product, the pricing strategies of
competitors, and the costs of the product. As competition reduces further,
the key factors affecting pricing decisions is the customer’s willingness to
pay; costs and competitors become less important in the pricing decisions.

Time Horizons and Pricing

When reducing costs, a company must consider costs across all its value-
chain business functions, from research and development to customer
service. In computing the costs within these functions that are relevant in a
pricing decision, the time horizon of the decision is critical.

Most pricing decisions are either short run or long run. Short-run decisions
include pricing for a one-offer special order with no long-term implications,
and adjusting product mix and output volume in a competitive market. The
time horizon used to calculate those costs that differ among the alternatives
for short-run decisions is less than one year.

Long-run decisions include pricing a product in a major market where price

setting has considerable leeway. A time horizon of a year or longer is used

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when computing relevant costs for these long-run decisions. Many pricing
decisions have both short-run and long-run implications.

Pricing for the Short-run

Short-run decision making consists of choosing among alternatives with an
immediate or limited end in view. Short-run pricing decisions have a time
horizon of less than one year and include decisions such as:
 Pricing a one-time-only special order with no long-run implications
 Adjusting product mix and output volume in a competitive market

Consider a one-off special order from a customer to supply products for the
next four months. Acceptance or rejection of the order will not affect the
revenues (units sold or the selling price per unit) from existing sales outlets.
The customer is unlikely to place any future sales orders.

In calculating the relevant costs for the price decisions, companies must
analyse the costs in each business function of the value chain. For example
in a manufacturing business, where only manufacturing costs are relevant,
all other costs in the value chain will be unaffected if a special order is
accepted, making them irrelevant.

Pricing for the long-run

Many pricing decisions are made for the long run. Buyers – whether a
person buying a bar of chocolate, a construction company, buying tractors
or bank buying audit services – prefer stable prices over an extended time
horizon. A stable price reduces the need for continuous monitoring of
suppliers’ prices. Greater price stability also improves planning and builds
long-run buyer-seller relationships.

Obtaining appropriate product-cost information is useful to a manager

making a pricing decision. In industries such as oil and gas and mining,
competitive forces set the price for a product, and knowledge of long-run
product costs can guide decisions about entering or remaining in the market.
In other industries such as specialised machines and appliances, managers
have some control over the price charged for a product, and long-run
product costs can be used as a base for setting that price.

Alternative long-run pricing approaches

1. Market-based approach: under this approach, price charged is based
on what customers want and how competitors react. The market-based
approach to pricing starts by asking: given what our customers want and
how our competitors will react to what we do, what price should we
charge?

2. Cost-based approach: under cost-base approach, price charged is based

on what it cost to produce, coupled with the ability to recoup the costs
and still achieve a required rate of return. The cost-based approach to

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pricing starts by asking: What does it cost us to make this product, and
hence what price should we charge that will recoup our costs and
produce a desired profit?

Both approaches consider customers, competitors and costs. It must be

noted that only their starting points differ. In very competitive markets, the
market-based approach is logical. The items produced or services provided
by one company are very similar to those produced or provided by others,
so companies have no influence over the prices to charge. In other
industries, where there is more product differentiation, firms have some
discretion over prices, products and services. Companies choose prices and
product and service features on the basis of anticipated customer and
competitor reactions. A final decision on price, product and service is made
after evaluating these external influences on pricing along with the costs to
produce and sell the product.

Under the cost-plus approach, price is first calculated on the basis of the
costs to produce and sell a product. Typically, a reasonable profit is added to
cost, in order to determine the price. Often, the price is then modified on the
basis of anticipated customer reaction to alternative price levels and the
prices charged by competitors for similar products.

The Legal Dimension of Price Setting

 Price Discrimination (the practice of charging different customers
different prices for the same product or service) is illegal if the intent is
to lessen or prevent competition for customers
 Predatory Pricing, that is deliberately lowering prices below costs in an
effort to drive competitors out of the market and restrict supply, and then
raising prices
 Dumping – a non-Ghanaian firm sells a product in Ghana at a price
below the market value in the country where it is produced, and this
lower price materially injures or threatens to materially injure an
industry in Ghana.
 Collusive Pricing – this occurs when companies in an industry conspire
in their pricing and production decisions to achieve a price above the
competitive price and so restrain trade

There are three major influences on pricing decisions: customers,

competitors and costs.

Pricing can be done for the short-run or long-run. Alternative long-run

pricing approaches are market-based approach and cost-based approaches.
Competitive markets use the market-based approach; non-competitive
markets use cost-based approaches while less-competitive markets can use
either the market-based or cost-based approach

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Exercises
1. List and explain the three major influences on pricing decisions?
2. Give two examples of pricing decisions with a short-run focus.
3. Explain two long-run pricing approaches.
4. With practical examples, distinguish between long-run and short-run
pricing approaches.

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