CHAPTER PRICING DECISIONS

7:

TOPICS
1. Pricing Policies – Nature and Objectives
2. Pricing Responsibility
3. Factors Influencing Pricing Decisions
4. Market Models Affecting Pricing Decisions
5. Sales Price Determination
6. Price Setting Methods
7. Other Pricing Techniques

LEARNING OUTCOMES
1. Understand the objective of pricing policies.
2. Determine the four basic market models and their effect on pricing
decisions.
3. Determine the other factors or variables affecting pricing decision.
4. Understand the different types of price setting methods and learn how to
apply it.

TOPIC 1: PRICING POLICIES – NATURE AND OBJECTIVES

Pricing refers to the determination of the appropriate selling price for a product
or service provided by a firm. All organizations or firms that a sell a product or render
services for a free must decide on the price to be charged to customers or clients for the
products sold or services rendered.

For profit-oriented organizations, the selling price, includes all the costs incurred
to produce and sell the product, or all the costs incurred to produce and sell the
product, or all the costs incurred in rendering the service, plus an acceptable mark-up or
profit. In case of not-for-profit organizations, the price should likewise ensure recovery
of costs, plus a satisfactory margin to help the organization survive or remain as a going
concern.

A firm’s pricing policy, therefore, which consists of the procedures involved in

setting sales prices, as well as the methods and systems needed for its implementation,
plays a vital role in the attainment of the organization’s objectives – profit maximization
and/or survival as an entity.

TOPIC 2: PRICING RESPONSIBILITY

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 Ideally, it is the top management’s responsibility to formulate, or at least
approve, the pricing policies for the firm. Once formulated or approved, these pricing
policies become part of the overall company’s plan which is designed to attain the
objectives of the firm. Some firms even create a pricing committee composed of key
personnel involved in production, sales and other related departments whose task is to
formulate pricing policies for the firm, subject to approval by the board of directors, or
in some cases, the chief executive officer of the firm.

Pricing responsibility does not stop once a selling price has been set for a
product or service. Prices must be continuously studied or evaluated to see to it that
they still serve the purpose for which they are set, considering current costs, market
conditions, and other factors affecting the selling price.

TOPIC 3: FACTORS INFLUENCING PRICING DECISIONS

Establishing a selling price for the firm’s products and services is not as simple as
using a formula to add costs and desired profit. A figure obtained with the use of some
quantitative calculations may not necessarily be the final selling price, for pricing
decisions are influenced not only by the quantitative factors like cost data and profit
objective but by qualitative considerations as well.

These qualitative considerations may include internal factors such as type

product or service that the company sells, the company’s overall objective and the
image that it wants to portray to the public, management style, among others. The
external factors, on the other hand, consist of competitors’ actions, type of industry to
which the company belongs, type of market where the products and services are sold,
economic trends political situation and governmental influence.

TOPIC 4: MARKET MODELS AFFECTING PRICING DECISIONS

The types of market in which the company’s goods are traded greatly influence
the formulation of the firm’s pricing policies. These market types include the following:

Perfectly Competitive Market

Economist characterize a perfectly competitive market as a market where the

goods traded are homogeneous, i.e., purchasers, look at the products of one seller as
identical with those of other sellers. In a perfectly competitive market, neither the
buyers nor the sellers can individually influence the market price by their actions.
Instead, the products’ selling prices are determined through the interaction of demand
and supply. The mechanics involved in the determination of prices considering the
demand for and supply of the products concerned are extensively discussed in
economics textbooks and are beyond the scope of our subject matter.

Business firms which sell their products in a perfectly competitive market do not
necessarily have to formulate pricing policies, since, as already stated, the market forces
determine the selling price for their products. Examples of these firms are those
engaged in producing and selling agricultural products like onion, garlic, cabbage, etc.;
and those engaged in fishing and aquaculture, selling products like prawns,
‘galunggong’, milkfish, etc. these firms cannot establish a selling price on their own.

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 What they can do is merely to study the market forces and decide on the
quantity of the products that they want to produce and sell.

Monopolistic Competition

In a monopolistic competition, several sellers of similar, but not identical,

products exist in the market. In this case, no seller can directly influence the market
price of similar products. Examples of firms in this type of market are manufacturers of
some food products like sandwich spread, instant soup, instant coffee, vinegar etc.
selling prices in a monopolistic competition are set without giving much regard to the
competitors’ prices. Instead pricing policies are formulated considering the product’s
market acceptability at the established selling price.

Monopoly

When a product is sold by a lone supplier, monopoly occurs in this case, no

competing products exist in the market, and the sole supplier can dictate the selling
price that it wants to charge for its product. Examples are electric utilities (Meralco),
telephone companies (PLDT) and domestic airs transport (PAL).

In some cases, the government imposes some regulatory measures to control

sales prices when monopoly exists to protect the consuming public from the ill effects of
a monopolistic market.

Oligopoly

An oligopoly exists when several large sellers dominate the market and basically
compete with one another. In this case, a supplier is large enough such that any change
in its pricing policy may directly affect the market. This is why when business firms that
sell their goods in an oligopolistic market formulate their pricing policies, they give much
consideration to their competitors’ actions or possible reaction.

Examples of firms in an oligopolistic market are shipping lines, laundry and toilet
soap manufacturers and tourist bus operators. Observe that their selling prices are
basically the same, for if a firm decides to charge a relatively much higher price for it
product than its competitors’, a loss in sales volume will definitely result, since
customers will shift to other companies charging lower prices. On the other hand, if a
firm decides to charge a relatively much lower price than its competitors, it will affect
not only its profit position but the whole industry as well.

In some cases, price leaders are price followers exist in an oligopolistic market.
Here, a large supplier, or a price leader sets the selling price, and the price followers
merely adopt the selling price established by the leader. The idea is that if other
suppliers can afford to sell the product at that price, we can also afford to do the same.
Formulation of pricing policies of price followers is therefore much simpler than that of
the price leader, for the latter has to see to it that the selling price it establishes will
ensure maximization of profit, for the former will definitely sell all it can at the same
price.

TOPIC 5: SALES PRICE DETERMINATION

As earlier mentioned in a previous section of this chapter, the selling price must
be set such that it will ensure recovery of costs and generation of satisfactory or

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acceptable amount of mark-up or profit. Based on this statement, we can come up with
the following basic formula to compute selling prices.

Where
SP = Selling Price
SP = C + MU
C = Cost
MU = Mark – up

The above basic formula has two major components – cost and mark – up. How
much cost should be included in the computation and how much is ‘satisfactory’ or
‘acceptable’ amount of profit that must be added to cost to come up with the selling
price?

Cost Data

The selling price must include all the costs incurred in the production and sale of
the product, to wit, manufacturing cost, selling and administrative expenses. Once any
of these cost items is unintentionally excluded in the computation, the selling price will
be understated and the company’s profitability will be negatively affected.

If the cost data are expected to remain stable during the period in which the
selling price will be in effect, the actual costs may be used in the calculation. However, if
there are expected changes in the cost data, the expected new figures should be used.

For companies using the standard cost accounting system, it is advisable for
them to use the standard costs in computing the selling price. They should see to it,
however, that the standard costs they are using are realistic and reflective of the current
costs and operating conditions.

The reason for the use of standard costs is to avoid inclusion of operational
efficiencies or inefficiencies (variances) in the selling price. For instance, assume that the
standard unit cost to produce a product is P10, actual cost incurred during the previous
period amounted to P12. Based on the variance analysis made, the unfavorable variance
of P2 was due to inefficient usage of materials and labor hours. Basing the selling price,
therefore, on the actual cost figure, the result will be unrealistic, since it does not reflect
cost data based on normal operating conditions.

Target Profit

The amount of satisfactory profit mentioned earlier in the previous sections may
refer to the maximum profit level that the firm can possibly earn in the given business
environment. This profit level may use as a guide in computing the selling price. It may
be expressed as a total amount in pesos, a per unit figure, or as a certain percentage
based on some other data such as costs, sales or capital employed in the business.

TOPIC 6: PRICE SETTING METHODS

The following sectors illustrate the various methods of establishing selling prices.
These methods may serve as a guide for price setters in computing the appropriate
selling price for their product. Applications of the methods presented here depend on
the type of business, nature of the products, the manufacturing elements and processes
involved and the company’s objectives.

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COST-BASED PRICING

Most formulas used in determining selling price use the cost data as the base for
the desired mark-up. The cost data may be full cost, materials cost, variable cost,
conversion cost, and differential cost.

Full Cost Pricing

Under the full cost pricing method, selling price is computed by adding the total
production and operating costs to a mark-up based on such total cost. The formula may
be expressed as follows:

SP = TC + MU or SP = TC + (MU% x TC)

To illustrate, let us assume the following data:

Where:
Manufacturing Costs: SP = Selling Price
Materials P 10
Labor P4 TC = Total cost consisting of
materials, labor, factory overhead,
Factory overhead P8 P 22 selling and administrative expenses
Selling and administrative cost P8
Total cost or full cost per unit P 30 MU = Mark – up or target profit
which is usually expressed as a
percentage based on total cost
Target profit: 30% of full cost

Using the above data, selling price may be computed as follows:

SP = TC + MU
= P 30 + (30% x P 30)
= P 30 + P 9
= P 39

Materials Cost Pricing

Some products are manufactured using a production process where the most
significant element is the cost of materials, requiring a minimal amount of labor,
overhead and operating costs. To facilitate computation of selling price, mark-up may
just be based on material cost. The formula for this price setting method may be
presented as follows:

SP = M + (MU% x M) + CC + OE

Where:

M = Materials Cost
MU% = Mark –up percentage
CC = Conversion cost composed of labor and overhead
costs
OE = Operating expenses composed of selling and
administrative expenses

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Let us use the following data to illustrate application of the formula:

Manufacturing Costs:
Materials P50
Labor P5
Factory overhead P 10 P 65
Selling and administrative cost P5

Total unit cost P70

Desired mark-up = 40% of material cost

Using the materials cost pricing method, the selling price may be determined as follows:

SP = M + (MU% x M) + CC + OE
= P 50 + (40% x P 50) + (P 5 + P 10) + P 5
= P 50 + P 20 + P 15 + P 5
= P 90

A much simpler approach of determining selling price using the materials cost
pricing method involves setting a mark-up (based on materials cost) that is high enough
to cover even the conversion and operating costs.

For instance, assume that the desired mark-up in our first example is 80% of
materials cost, and this already covers the target profit, conversion and operating costs.
The sales price computation appears as follows.

SP = M + (MU% + M)
= P 50 + (80% x P 50)
= P 50 + P 40
= P 90

Note that we no longer showed the cost of labor, overhead and selling and
administrative costs, since these figures are already included in the designed mark-up.

The materials cost pricing method is particularly useful in cases where spot
quotations are required. In the printing business, for instance, some clients request
immediate or on the spot quotations for a printing job. Here, the printer can
immediately set the price for the project by estimating the cost of materials (or stocks)
needed for the project and adding the desired mark – up based on the cost of stock.

Conversion Cost Pricing

In cases where multiple products are manufactured by a firm, and the

conversion cost requirements vary from one product to another, some price setters
contend that the mark – up must be based on conversion cost alone. This is based on
the idea that products requiring more conversion costs should be assigned a higher
selling price. The following formula may be used for this method:

SP = CC + (MU% x CC) + M + OE

Where:
CC = Conversion cost composed of labor
and overhead
MU% = Mark- up percentage
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M = Materials cost
OE = Operating expenses composed of
selling and administrative costs
 Let us assume, for example that Product A is one of the product lines
manufactured by a company, and this product’s cost data are as follows:

Manufacturing Costs:
Materials P5
Labor P 25
Factory overhead P 20 P 50
Selling and administrative cost P 10

Total unit cost P 60

Mark – up = 40% of conversion cost

Computation of selling price using the conversion cost pricing methods:

SP = CC + (MU% x CC) + M + OE
= P 45 + (40% x P 45) + P 5 + P 10
= P 45 + P 18 + P 5 + P 10
= P 78

As in the case of materials cost pricing, this method may be made much easier
by setting a mark – up that includes allowance for materials and operating costs.

Valuable Cost Pricing

The variable cost pricing method is also called contribution approach pricing.
Under this method, all costs that vary with the product are determined and used as the
basis in computing the mark-up. Fixed costs are not allocated to the products or
services.

The amount of mark – up used in the calculation of selling price usually includes
the target profit and an allowance for the recovery of fixed costs. Hence, the problem of
allocating fixed costs is avoided since fixed cost is not directly included in the
computation. The formula to compute selling price under the contribution approach
pricing is:

SP = VC + (MU% x VC)

Where:
VC = Variable Cost
MU% = Mark-up Percentage

Presyo Company products three products, A, B and C, Cost data for the three
products are as follows:

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 A B C
Materials P5 P6 P8
Labor P3 P2 P7
Variable P2 P4 P5
Overhead
Variable P2 P2 P2
Selling and
Administrative
Cost
Total Variable P 12 P 14 P 22
Cost per Unit
Mark-up based 50% 60% 40%
on Variable
Cost
Fixed P 150, 000
Manufacturing
Cost
Fixed Selling P 200, 000
and
Administrative
Expenses

Solution:

Selling prices for each product may be computed using the variable costing
method as follows:

A B C
Variable cost per unit x P 12 P 14 P 22
Mark – up % 50% 60% 40%
Mark – up P6 P 8.40 P 8.80
Add variable cost per P 12 P 14.00 P 22.00
unit
Selling Price P 18 P 22.40 P 30.80

Note that the above computations do not require allocation of fixed cost among
the three products. It is assumed that the mark – up is high enough and that the firm
can sell enough number of units of each product to ensure recovery of all fixed costs
and generation of desired profit.

Differential Cost Pricing

Differential cost pricing method is usually applied in cases involving special

orders where a customer offers to buy a relatively high volume of the company’s goods
at a price much lower than the normal or regular selling price.

Examples of this case were presented in Chapter 8 under the topic accept or
reject a special order. However, the discussions there focused on making a decision
whether the special order should be accepted or rejected.

At this point, the illustration highlights determination of the appropriate selling

price for the special order. Let us consider the following examples:

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 Using Company manufactures a product called Tie-phun which it sells at a price
of P50. Production and selling costs for this product are as follows:

Manufacturing:
Materials P 10
Labor P8
Overhead (1/3 fixed) P 12 P 30
Selling and administrative (1/3 fixed) P6

Total cost per unit P 36

At present, the company utilizes 60% of the normal capacity of 20,000 units. To
be able to utilize the idle capacity, it is considering to accept a special order for 5,000
units of the product. However, the customer is asking for a special price, which naturally
should be much lower than the regular price of P 50.

The company does not expect to incur additional selling and administrative costs
for this special order.

What amount of selling price should be charged for this special order?

Solution:

In this particular case, the amount of selling and administrative cost of P6 and
the fixed overhead coast of P 4 (1/3 of P 12) are irrelevant because they are not
expected to change whether the special order is accepted or rejected.

The differential or relevant cost data that must be included in the computation
are composed of the variable manufacturing costs as follows:

Materials P10
Labor 8
Variable overhead (2/3 of 12) 8

Differential cost per unit P26

The total differential cost per unit is P26 which means that if the special order is
accepted, the additional cost to be incurred for each additional unit to be produced is P
26.

Therefore, the company should not charge a special price that is lower than P 26
for the special order because this will definitely result into a loss. If it charges a price of
exactly P 26, the company will just break-even from this order.

Therefore, the minimum selling price that must be charged for the special order
is P 26. Of course, the company would be better off if it could set a price higher than this
amount.

With the foregoing analysis, we were able to set a starting point, i.e., P26 for the
company to set the appropriate selling price for the special order. The only problem left
is to decide on the amount of mark – up that must be added to the differential cost that
will result into a selling price which is just appropriate to enable the company to win the
special order.
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MARK – UP BASED ON SALES

Some firms prefer to base their mark – up on sales rather than on cost or
amount of investment. In this case, the formula to compute selling price may be derived
as follows:

Basic formula: SP = C + MU

If mark-up is based on sales:

SP = C + (MU% x SP)

Transpose (MU% x SP) to the other side:

SP – (MU% x SP) = C
0r
SP (1 – MU%) = C

Therefore: SP = C/ 1- MU%

Where:
SP = Selling Price
C = Full or Total cost
MU% = Mark-up percentage

To illustrate, assume that Gana Company marks-up its merchandise at 40% of

sales price. Cost per unit or merchandise is P 60. The selling price, therefore, is equal to
P 100, computed as follows:

C
SP =
1−MU %

P 60
=
1−0.40

P 60
= 0.60

= P100

OTHER FACTORS CONSIDERED IN PRICE SETTING

The sales price figures computed in all the foregoing illustrations may be more
appropriately called tentative sales prices. This is because, as already mentioned at the
beginning of this chapter, some qualitative factors must be considered before a final
setting price is set. To reiterate, among these are price ceilings and other pricing
regulations imposed by some government agencies, competitors’ sales prices,
acceptability of the product at the sales price established, the type of market where the

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goods and services are sold, etc. aside from these qualitative considerations, there are
still other factors, such as trade discounts and sales taxes, which necessitate some
adjustments on sales price computations.

Trade Discount

When a firm wants to allow for a certain trade discount on sales, and the selling
price computed with the use of any of the methods discussed and illustrated in the
previous sections is still exclusive of the discount, (i.e., the selling price is regarded as
the next selling price), the adjusted or gross selling price (inclusive of trade discount)
may be computed as follows:

NSP
GSP =
1−Disc .%
Where:
GSP = Gross selling price
NSP = Net selling price
Disc. % = Rate of discount

For example, assume that Bargain Company has computed a selling price of P
29.10 using the full cost pricing method. If Bargain Company wants to allow for a 3%
discount on sales, and he wants to include this on the sales price determined, the gross
selling price can be computed as follows:

NSP
GSP =
1−Disc .%
P 29.10
=
1−0.03
P 29.10
=
0.97

Sales Tax

Some firms are required to pay sales taxes on goods and services sold. Gross and
net sales price computations in this case are presented below.

Sales Price Does Not Include Sales Tax:

The procedure involves simply adding the applicable sales tax to the net selling
price to arrive at the gross sales price figure:

Net selling price (NSP) Pxx

Add Sales tax (NSP x TxR) xx

Gross Selling Price Pxx

Where TxR = Sales Tax Rate

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 To illustrate, assume that the selling price established by a company for its
product is P 200, exclusive of sales tax of 10%. The gross selling price will be P 220,
computed as:

Net selling price P 200

Add sales tax (P200 x 10%) P 20

Gross selling price P 220

Gross Sales Price Includes Tax:

If the sales price given already includes sales tax, and the sales tax is based on
net sales as in the case of value added tax (VAT), the net selling price may be
determined with the use of the following formula:

GSP
NSP =
1+ 1 xR
Where:
NSP = Net Selling Price
GSP = Gross Selling Price
TxR = Sales Tax Rate

Assume, for example, that Lilito Company is a VAT – registered firm which sells
its products at P 330 each, inclusive of the value added tax of 10%. The net selling price
for Lilito’s products may be computed as follows:

GSP
NSP =
1+ TxR
P330
= 1+ 0 ,.10
P 330
= 1.10

= P330

TOPIC 7: OTHER PRICING TECHNIQUES

The following sections deal with two unusual pricing techniques applied by some
firms. These are the loss leader pricing and inferior goods technique.

Loss Leader Pricing

It is but natural for us to always think of a selling price that will ensure recovery
of all costs and generation of satisfactory amount of profit. We do not usually attempt
to sell our goods at a price lower than its cost, for this will result into a loss.

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 However, some companies do sell one or some of their multiple products at a
price lower than the cost, hoping that as the customers go to their place of business to
take advantage of the low-price offer, they will buy the company’s other regularly-
priced products. Earnings from the regularly-priced products are expected to more than
offset the loss incurred from selling the other products at a price below cost. This is
called loss leader pricing technique.

Inferior Goods

When we increase our selling price, it is but natural for the sales volume to
decrease, since our customers will tend to shift to other suppliers selling the same items
at a lower price.

But is there a possibility to break this general rule?

Some companies have tried this. They increased their selling price to a level that
is much higher than their competitor’s, and their sales volume dramatically increased to
an unexpected level. These firms applied the so-called inferior goods theory, which is
based on the saying that “you get what you paid for”. Some customers relate the quality
of a product to its price. Low-priced products are usually of inferior quality than those
with a high selling price.

These special pricing techniques should not be used in the general analysis of
pricing decisions. They should be used only on a case to case basis, considering strong
possibility of success.

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