PRICING & COSTING MODULE 3 relative terms.

Where ‘costs’ includes the cost of material and

COST CONCEPTS labor in addition to expenses, the term expenses is widely applied
in financial accounts for various types of historical cost.
3.0 Introduction In cost accounting, it is used for costs other than cost of raw
Element is an important area of a product. To estimate material and wages. To understand the meaning of cost, it is
correct cost accounting, cost classification and analysis is being necessary to define the meaning of expenses. Expenses: Generally,
done. This is also necessary to control the cost. In other words expenses are called expired costs means those costs which have
elements of cost means expenditure or cost incurred on resources been used up totally in generating revenue. They are not
which are helpful in producing an item, for example material, capitalized but only shown as expenses in the income statement.
labour and expenses. To understand the cost one should know There are so many examples of expenses such as costs of goods
what expenses and losses are. sold expenses, selling expenses and administrative expenses. For
expenses, there is no need to be paid in cash immediately; even a
3.1 Cost: How Should They Affect Pricing Decisions? promise to pay could be made for the profits received. The
manufacturing costs are capitalized in the form of finished goods
1. What is Cost? How does it affects Pricing Decision? inventory and when a sale is incurred, they expire becoming
Cost is the fundamental element in setting prices for a expenses. The cost of unsold stock which was an asset prior, now
product or service. The simple rule is that the business charges
converts expenses of cost of goods sold as it has contributed to the
such a price that should not only cover all of the costs incurred in
generation of revenue.
manufacturing, distribution and promotion of the product or
service, but also provide a fair return on the invested money. If a 10 Manufacturing expenses may be expressed as cost
business has low costs, then it can increase its sales and profit by because this is included in the cost of finished goods stock which is
lowering the price of its product or service. an asset unless sale is made. For example, depreciation of a factory
In some companies, there is an ongoing conflict between machine increases the utility of goods manufactured which are
managers in charge of covering costs (finance & accounting) and therefore included in work-in-progress and finished goods
managers in satisfying customers (in marketing & sales). The inventory.
conflict between these views wastes company resources and leads Selling and administrative expenses, when not included in
to pricing decisions that are imperfect compromises. Profitable the cost of finished goods stock, are deemed only as expenses, not
pricing involves an integration of costs and customer value. To cost (asset) and are deducted from revenues whenever obtained.
achieve that integration may require letting go of misleading ideas Similarly, depreciation of a factory building is a cost but
and forming a common vision of what drives profitability. depreciation of an office building is an expense. The term cost
Generally, cost may be explained as the amount of itself is without any significant meaning and therefore, it is always
expenditure, actual or notional, related to a specific thing or advisable to use it with an adjective or phrase that will convey the
activity such as product, job, service, process etc. It may also be meaning intended such as prime, direct, indirect, fixed, variable,
expressed as a sacrifice which may be defined in the terms of controllable, opportunity, imputed, sunk, differential, marginal,
money as it is the amount of resources given up in exchange for replacement and the like. Future costs are also considered in cost
some goods and services. Cost and expenses are different but accounting but not in financial accounting. Loss: To understand
the concept of cost, the term 'losses' should be defined. Loss is lost price alone in consumer behaviour. Price is set by the negotiation
cost. It is applied to define two accounting events. In financial between customers and the sellers.
accounting, it is used to describe a circumstance where expenses
exceed revenues for an accounting period, that is, the reverse of There are two main types of pricing which are as follows.
net income (earnings) for the accounting period. 1) Fixed Price, in which single price is set for all customers
On the other hand, a loss arises due to the cost of an asset 2) Dynamic Price that contains different prices for different
customers on the basis of the situation.
being more than the sale proceeds when the asset is sold. This
There are number of factors affecting the pricing
unfavorable event does not arise from a normal business activity
decisions and cost is not determined simply, there are many
but from non-operating transactions or events. This meaning of factors affecting pricing decisions. The reason is that the price is a
loss is used to recognize the reverse of gain. That is, if no gain is very sensitive issue for the customers in their purchasing
achieved from the cost incurred or it becomes definite that no behaviour.
benefits accrue, the cost becomes a lost cost, i.e., loss on sale of
fixed asset, loss of stock due to fire etc. B. Factors affecting Pricing Decisions
Before going into the details of why COST affects pricing Following are the two main factors affecting pricing decisions.
decisions, let’s discuss some of the basic concepts of pricing, which
are also important to know. 1. Internal Factors:
Internal factors are those factors that are related to the
A. Price internal environment of the business. This means that the
The money claimed against the offered product or service in issues that prevail within the business organization and upon
the market is called price. In other words the value exchanged for which the organization has control are included in this
category. Internal factors further include the following.
use of the benefits of a certain product or service by the customers
is called the price of that product or service. Price may take the
A. Price Adjustment Strategies For Small Business
following forms. 1) Marketing Objectives & Marketing Mix Strategies
● Interest 2) Organizational Consideration
● Rent Each of these is discussed one by one.
1) Marketing Objectives & Marketing Mix Strategies
● Fee The objectives of the business serve as a basis for
● Tool the development of proper marketing mix strategy that
also includes in the price determination process. Those
● Premium businesses that have kept clear objectives feel convenience
● Fare etc in setting an effective price for their products or services,
Price was an important element that served as the basis for the because their prices are built on the ground of stated
choice of the customers in the purchase in the old days. But now objectives. Following are some of the important objectives
many other elements are considered as the more determining than that are covered by most businesses.
a.) Survival:
 In this objective the main purpose of the business is This factor includes the fact that who should be given the
survival in the market. The profit maximization purpose becomes responsibility to set the price within the organization. There are
secondary importance for such business, because its survival is at many ways to deal with such an issue. In smaller businesses, top
stake due to unfavourable market conditions like tough management is responsible for setting the price of the product. On
competition, changes in tastes of customers etc. In this case the the other hand, in large organizations product line managers or
business tries to keep its price low, so that a sufficient proportion divisional managers have the authority to set price for the product
of its product or service should be sold.
or service. In the case of industrial markets, salespersons handle
b.) Profit Maximization:
the pricing of products by negotiating with the customers within
Another important objective is the profit maximization that
is employed by many businesses. Such businesses count the costs the pre-specified range of prices. In certain price sensitive
and demand of their products or services and set different prices. industries (Oil Companies, Aerospace etc) have a separate pricing
From these price combinations, a business chooses the price that department that can either directly determine the best price or
can give maximum profit, return on investment or cash flow. This facilitates the pricing process of the business. In some firms, top
objective is beneficial for the short run and it neglects the long management likes the proposed prices of the lower level
term future of the business. Some businesses try to increase their employees like salespersons etc.
market share for the purpose of getting the highest profit, because
their management believes that higher market share leads to 2. External Factors
lower cost and hence higher profits. Businesses adopting such External Factors include factors that are related to the
strategies also keep their prices low. external environment of the business. The business has less
c.) Product Quality Leadership: control over these variables of the external environment. The
A business can set its basic objective as the product quality following are included in this category.
leadership in the market. For this purpose, such a business keeps
its price higher in order to cover the higher performance of its
1) The Market and Demand
product along with the costs incurred on research and
We have already discussed that the lower limits of
development.
Price can be used to accomplish other objectives for a price are determined by the costs incurred. On the other
business. Example include lowering of price to avoid increasing hand the upper limits are determined by the demand and
competition, keep prices competitive to make market stable and market elements. Price is balanced by the benefits of
avoid government intervention, to increase demand by lowering owning the relative product or service by consumer and
prices etc. In short the decisions taken in respect of price affect industrial customers. For this purpose the price and
other marketing mix variable decisions and so all of these demand relationship for a product is essential to be
decisions should be consistent with one another to make a understood before setting its price.
marketing program effective. The business should also keep its 2) Pricing in different Markets:
product as differentiated and set relatively high price for the Different market conditions require different sets of pricing
uniqueness of its product. In this way price is based on many non- strategies. Generally there are following four types of market
pricing factors. a. Pure Competition
In case of pure competition in the market, there are many
2) Organizational Considerations: buyers and sellers in the markets dealing with uniform
commodities like wheat etc. There is one ongoing price in the Another market condition is monopoly in which there is
whole market and no single buyer or seller can affect this price. only a single seller who can offer its products or services at
Because the customers can easily obtain their required quantity at different rates. As the seller is single and the buyers are much
the ongoing price of the market, so no seller can charge higher more, therefore the seller charges a relatively higher price because
prices. Similarly, no seller can charge a lower price because he can there is no fear of competition. In case of regulated monopoly, the
sell all his offered quantity to a lot of customers on the market. In seller can charge only a fair price, but in case of unregulated
case of the rise of the price or profit in the market, new sellers are monopoly the seller has freedom to charge extra for its offering.
attracted to enter in the market. In pure competition, pricing, sales But mostly the monopoly firm keeps its price low for a number of
promotion, new product development and marketing research are reasons like quick penetration in the market, government
not supported. In other words the sellers on the market do involve intervention etc.
in preparation of marketing strategies.
b. Monopolistic Competition: Consumer Perception about Value & Price
In case of monopolistic competition there are many sellers and The bottom reality in the pricing decision is that the
buyers who offer their products not at a single price but at a range customers are the final authority who determines the price of a
of prices. The difference in the price range is due to the product or service. It is obvious that the consumers pay the price
differentiated product or service offering by the sellers. Customers for the exchange of the benefits that they avail by using the
can feel the difference between the products and hence pay relative product or service. So businesses should focus on the
different prices for them. These differences can be in shape of pricing that is consumer oriented in which they try to determine
features, quality or style etc. So in this kind of market businesses how much would be the consumer willing to pay for how much
spend more time and money on differentiating their product or benefit of a certain product or service.
services in the shape of sales promotion, advertising etc. A single
business is not affected by the marketing strategies of its Price Demand Relationship
competitors because there are many competitors in the market. Businesses should also consider the important relationship
c. Oligopolistic Competition between the price of a product or service and its demand.
Another factor affecting pricing decisions is oligopolistic. In Generally price and demand is inversely related which means that
oligopolistic markets, there are few sellers and buyers which are the increase in the price would lead to the decrease in the demand
conscious about the pricing and other marketing strategies of for that product and vice versa. The reason behind this inverse
competitors. The offered products are either uniform or relationship is that the customers have limited resources for the
differentiated. It is difficult for new sellers to enter the market. A fulfilment of their demands.
certain change in the price of a single firm affects its own soil in a In some case the price and demand show the direct
negative way even if a seller lowers its price; its competitors also relationship which means that the increase in the price would lead
decrease their price. This means that the benefits are only for a to the increase in the demand of that product in the market. But
short while. this only happens with prestigious products where increased price
d. Monopoly means increased quality.
 The business management should also consider the Material means those items which are applied for
elasticity of the demand of their offering product while setting its manufacturing of a product and direct material is directly related
price. to production. For example, raw cotton in textiles, crude oil to
Costs, Prices & Offering of Competitors make diesel etc. There are so many names of direct materials such
One of external factors affecting pricing decisions of the as process material, prime cost material, stores material and
business is the costs, price and offering of the competitors as construction materials. Main points for direct material can be
compared to its own cost, price & offering. This means that the summarized as follows:
management of the business should take into account the change
in the price and offering of the competitors and take steps (1) Direct material specially acquired for a particular Job,
accordingly. order, process or product.
(2) It is an integrated part of manufacturing unit.
3.2 COST CLASSIFICATION (3) Value of direct material is comparatively higher than
that of other materials.
2. What are the classification of Costs (4) Material passing from one process to another process.
A. Two major types of costs which are as follows. (5) Primary packing materials e.g. wrapping, cardboard
1) Fixed Cost boxes, the glass bottle in production of syrup, etc.
The fixed cost is such cost that remains fixed and does not (6) It Increases in the same ratio as the increase in
change with the changing level of production or sales. The total
production
fixed cost remains the same but fixed cost per unit may change.
The example includes rent paid for the building, interest paid on
loan, salaries to employee staff etc. B) Indirect Material Cost:
1) Variable Cost: Indirect material cost is the material cost which cannot be
The variable cost is that kind of cost which changes with allocated but which can be apportioned to or absorbed by cost
the change in the level of production and sales. Although the total centers or cost units’’.
variable cost changes, the unit variable cost remains the same. For Thus, it may be said that indirect cost is the cost which
example, each car produced includes the variable cost of tires, cannot be directly identified to the unit of output or to the segment
metal sheets, Misc items etc that change with the increase or of a business activity e.g. oil, grease, consumable stores etc.
decrease in the quantity of production and sales. C) Direct Labour Cost:
The management of the business should ascertain different Direct labor is known as the wage of those workers who are
levels of costs with respect to different levels of production and involved in the production process whose time can be efficiently
sales so that the lowest cost can be obtained for the determination and economically traceable to units of products e.g. wages paid to
of effective prices for the manufactured products or services. compositors in a printing press, labor of machine operators and
B. Classification of Costs under Manufacturing assemblers.
Company It may also be defined as prime labor cost, process labor
cost, operating labor cost, manufacturing wages, direct wages and
1. Direct Material cost: productive labor cost.
 Direct wages is that wages which can be allocated to cost calculated by analyzing the additional expenses involved in the
centers or cost units.” production process, such as raw materials, for one additional unit
D) Indirect Labor Cost: of production. Understanding incremental costs can help
Some workers do not engage directly in conversion of companies boost production efficiency and profitability.
output but contribute indirectly. Labor is paid for the objective of
carrying tasks incidental to goods or service provided. It cannot be KEY TAKEAWAYS
practically traced to particular units of output e.g. wages of store- ● Incremental cost is the amount of money it would cost a
keepers, foremen, time-keepers, supervisors, Inspectors etc. company to make an additional unit of product.
“Wages which cannot be allocated but which can be ● Companies can use incremental cost analysis to help
apportioned or absorbed by cost centers or cost units is indirect determine the profitability of their business segments.
wages.’’ ● A company can lose money if incremental cost exceeds
E) Direct Expenses Cost:
incremental revenue.
It is also defined as chargeable expenses. These direct
expenses are incurred directly on a particular product, Job or cost Understanding Incremental Cost
units and recognizable with the cost units. Since incremental costs are the costs of manufacturing one
“Direct expenses means expenses which can be allocated to more unit, the costs would not be incurred if production didn’t
cost centers or cost units.” For example, - increase. Incremental costs are usually lower than a unit average
(1) Hiring a particular tool plant or equipment for job. cost to produce incremental costs. Incremental costs are always
(2) Cost of special molds, designs and patterns. comprised of variable costs, which are the costs that fluctuate with
(3) Fees paid to architects, surveyors and consultants. production volumes. Incremental costs might include the
(4) Insurance charges on special materials chargeable to a following:
job. ● Raw materials such as inventory
F) Indirect Expenses Cost:
● Utilities, such as the additional electricity needed to
Those expenses which cannot be directly, conveniently and
power the equipment
fully charged to cost units are known as indirect expenses
“Indirect expenses are expenses which cannot be allocated ● Wages or direct labour that’s only involved in
but which can be apportioned to or absorbed by cost centers or production
cost unit” For example, insurance, power, lighting and heating, ● Shipping and packaging
rent, rates and taxes. In other words, incremental costs are solely dependent on
production volume. Conversely, fixed costs, such as rent and
3.3 Incremental Cost overhead, are omitted from incremental cost analysis because
3. Why Incremental Cost? these costs typically don’t change with production volumes. Also,
fixed costs can be difficult to attribute to any one business
Incremental cost is the total cost incurred due to an segment. Incremental costs are often referred to as marginal costs.
additional unit of product being produced. Incremental cost is
Benefits to Incremental Cost Analysis units of production and comparing it to the selling price of these
Understanding incremental costs can help a company goods assists in meeting profit goals.
improve its efficiency and save money. Incremental costs are also Example of Incremental Cost
useful for deciding whether to manufacture a good or purchase it Let’s say, as an example, a company is considering
elsewhere. Understanding the additional costs of increasing increasing their production of goods but needs to understand the
production of a good is helpful when determining the retail price incremental costs involved. Below are the current production
of the product. Companies look to analyze the incremental costs of levels as well as the added costs of the additional units.
production to maximize production levels and profitability. Only ● 10,000 units has a total cost of P300,000 or P30 per unit
the relevant incremental costs that can be directly tied to the
(P300,000 / P10,000)
business segment are considered when evaluating the profitability
of a business segment. ● 12,000 units has a total cost of P330,000 or P27.50 per unit
Analyzing production volumes and the incremental costs (P330,000 / P12,000)
can help companies achieve economies of scale to optimize As a result, the total incremental cost to produce the additional
production. Economies of scale occur when increasing production 2,000 units is P30, 000 or (P330, 000 – P300, 000).
leads to lower costs since the costs are spread out over a larger ● The incremental cost per unit equals P15 (P30, 000 / 2,000
number of goods being produced. In other words, the average cost units).
per unit declines as production increases. The fixed costs don’t The reason there’s a lower incremental cost per unit is due to certain
usually change when incremental costs are added; meaning the costs, such as fixed costs remaining constant. Although a portion of fixed
cost of the equipment doesn’t fluctuate with production volumes. costs can increase as production increases, usually, the cost per unit
Incremental costs are relevant in making short-term declines since the company isn’t buying additional equipment or fixed
decisions or choosing between two alternatives, such as whether costs to produce the added volume.
to accept a special order. If a reduced price is established for a
special order, then it’s critical that the revenue received from the 3.3 Avoidable Cost
special order at least covers the incremental costs. Otherwise, the
special order results in a net loss. 4. Why Avoidable Cost?

Incremental cost is also known as marginal cost. An avoidable cost is an expense that will not be incurred if a
Incremental Cost vs. Incremental Revenue particular activity is not performed. Avoidable costs refer
Incremental costs help to determine the profit primarily to variable costs that can be removed from a business
maximization point for a company or when marginal costs equal operation, unlike most fixed costs, which must be paid regardless
marginal revenues. If a business is earning more incremental of the activity level of a company. There are instances in which
revenue (or marginal revenue) per product than the incremental fixed costs can be avoidable costs.
cost of manufacturing or buying that product, the business earns a KEY TAKEAWAYS
profit. ● An avoidable cost is a business expense that can be
Alternatively, once incremental costs exceed incremental
revenue for a unit, the company takes a loss for each item eliminated by no longer undertaking the specific business
produced. Therefore, knowing the incremental cost of additional activity.
 ● In most cases, but not all, avoidable costs apply to variable The benefit is that in times of financial distress or during
economic downturns, a business can adapt and maneuver quickly
costs rather than fixed costs.
by shedding avoidable costs. This might require streamlining
● A company with multiple product lines can exit product groups, improving efficiency, negotiating shorter-term
underperforming ones, thereby removing the costs leases on buildings, or shorter term-leases with suppliers.
associated with them. Real World Examples
● Businesses should strive to move as many costs as they can In 2016, Procter & Gamble (PG) undertook a serious effort
to become avoidable costs, which allow them more to rationalize many of its products, eliminating dozens of
flexibility in times of financial distress. unprofitable or low-margin brands from its consumer
staples portfolio.
Understanding an Avoidable Cost Even though fixed cost items, like building rent, utilities, insurance,
and certain administrative salaries still had to be paid despite a
Avoidable costs are expenses that can be eliminated if a
reduction in the product count, there were significant avoidable
decision is made to alter the course of a project or business. For
costs associated with those products, such as marketing and sales
example, a manufacturer with many product lines can drop one of
expenses
the lines, thereby taking away associated expenses such as labor
General Electric (GE) and research and development (R&D)
and materials.
expenses, that P&G was able to remove from its operations, is
Corporations looking for methods to reduce or eliminate
another company that revaluated its product offerings. GE is one of
expenses often analyze avoidable costs associated with
the largest companies in the world and has multiple product lines.
underperforming or non-profitable product lines. Fixed costs, such
It is known for its airplane engine business, lighting products,
as overhead, are generally not preventable because they must be
kitchen appliances, and more. During the economic downturn in
incurred whether a company sells one unit or a thousand units.
early 2020, which impacted travel, GE’s most profitable business,
However, if a specific business line utilizes a factory to make goods
its airplane engine business was hit hard.
and that business line is discontinued, the factory can then stop
Airline manufacturers, such as Boeing, experienced a drop
being rented or can be sold.
in demand for new airplanes as airplane companies saw a
In reality, variable costs are not entirely avoidable in a
dramatic drop in travel demand. As such, Boeing (BA) did not need
short timeframe. This is because the company may still be under
airplane engines, which impacted GE. In 2019, 33% of GE’s
contract with workers for direct labor or with a supplier for direct
revenues came from aviation, 20% from healthcare, 18.6% from
materials. When these agreements expire, the company will be
power, and 15% from renewable energy.
free to drop the costs.
As GE was struggling it decided to sell its 130-year-old
consumer lighting business to Savant Systems. It previously sold
Avoidable Cost Strategy
its commercial lighting business in 2018. This allowed GE to focus
It is in the best interest of all companies to have a cost
on its most profitable divisions while shedding underperforming
strategy whereby the majority of the costs are avoidable.
ones to free up capital by cutting costs and reducing debt. While
Businesses should often conduct a cost analysis of the company
deciding to sell this business, GE turned all of the costs associated
and determine how to transfer unavoidable costs to avoidable
with the division to avoidable costs.
costs.
In any industry where price competition drives down profit
margins, companies attempt to identify as many avoidable costs as
possible to improve their bottom line, streamlining their business apportioned. Costs are affected by volume and volume is affected
to focus on its core goods and services. by price. The management has to assume some desired price and
volume relationship for determining costs.
3.5 Role of Cost in Pricing The above discussion does not purport to indicate that
costs should be ignored altogether while setting prices. Costs have
What is the Role of Cost in Pricing? to be taken into consideration like many other factors. In the long
In the price setting process, cost data are most important run if costs are not covered manufacturers will withdraw
element. Hence, cost must be relevant to the pricing decision and themselves from the market and the supply will be curtailed and
under-estimation and exaggeration must be avoided. Besides prices will be raised. All this goes to show that cost is not the only
costs, there are also other factors that require consideration. An factor in setting prices.
increase in the demand may make an increase in prices possible 3. Relevant Costs:
even without an increase in costs. Pricing is like a tripod having For managerial decisions in the short run, direct costs are
three legs. more relevant. In a single product firm all costs are direct. The
In addition to costs there are other two legs of market management would try to cover all the costs. But problems are
demand and competition. As we cannot say definitely which of the more complex in a multi-product firm. Relevant costs are those
legs supports the tripod, similarly, we cannot assert which of the costs that are directly traceable to an individual product. Selling
above three factors determines the price. Demand is at times more price must cover all direct costs variable and fixed that are
important than even cost. If cost is increased, the price is to attributable to the product.
increase even if the demand does not permit it. In addition, it must include some profit. But in a short
period of time, it is tolerable if the price of a product has to do no
more than cover its direct costs only (only the direct variable
costs).

The Role of Cost in Pricing

1. It is the Price that Determines Cost that may be Example:
incurred: During the recession, a firm manufacturing a certain
The product ultimately goes to the public and their capacity component was operating at 50% of its capacity. A foreign
to pay is known. Given the price we arrive at the cost working importer offered to purchase 5,000 units of the component at Rs. 5
backwards from the price, consumer can afford to pay. If the per unit. The average cost of the product is Rs. 6. The question was
quality of the product is to be improved this may be possible only whether the order should be accepted.
when customers are willing to pay higher price because cost will
naturally go up. The cost data were as follows:
2. If Costs were to Determine Price:
Why do so many factories report losses? Different
producers have different costs of production. But in the market,
prices are close together for a somewhat similar product.
Therefore costs are not the determining factor for the pricing.
Again it is also difficult to measure costs accurately as they are
 4. Demand Elasticity and Price Policy:
The price policy of a firm will depend upon elasticity of demand
as well. If the demand is inelastic, it will not be profitable for the firm to
reduce its prices. But, if the demand of the product is less elastic then the
firm should take care not to fix the very high price. In that case a policy
of price rise would not pay.
If the demand is elastic, it is a policy of price reduction rather
than the policy of price increase. These price strategies are illustrated by
the following example relating to two products A and B, the former
having a very little elastic demand and the latter a highly elastic demand.
On analysis of the above data, we find the additional cost of producing
5,000 units would be only Rs. 10,000 (Rs. 5,000 for material and Rs. 5,000 for
labor). The incremental revenue would be Rs. 25,000 and the firm would gain
Rs. 15,000 by accepting this order.
In the same way, while making quotations for tenders in a highly
competitive situation the more important is that at least the direct costs must be
covered. But before accepting this order considerations have to be made. If
other customers learn that the component is being sold at a lower price they
may also demand a similar price cut or else threaten to cancel their orders.
What is essential for the firm is that the acceptance of this order should be kept
a guarded secret.
In the long run the aggregate revenues from all products must cover
not only the direct costs but also contribute towards common costs. Ideally,
each product should make a significant constitution to common cost but it is not
possible to state any general rule for determining satisfactory or unsatisfactory
contributions.
If a competitive price does cover direct cost and yields some From the above it is quite clear that price reduction for
contribution to common cost, the question arises how high must that expanding sale would be profitable for product B with highly elastic
contribution be to justify the long run continuance of a particular product in a demand and not for product A with little elastic demand.
company’s product line? If the product is discontinued, will any other product
be substituted for it? What effect will the discontinuance of the product have on
the demand for the other products in the line? Product pricing decisions should
be made with a view to maximize the company’s profits in the long run.
Another problem that has to be faced is “How can the common costs are PRICE STRUCTURE
covered, if individual prices are set in consideration of, direct cost only?” The
point is that covering direct costs is only a starting point in the pricing decision.
Factors of supply and demand and competition may allow prices that will give a  Pricing structure defines and organizes prices for your
very substantial contribution to common costs. company's products and services. Pricing structure prices
If the economic determinants of price are such that the combined price
for all of a company’s products is not sufficient to cover common costs in the products and services so that it makes sense to customers and
long run the conclusion is not that the individual prices are wrong but rather
gets them to buy. For instance, you might offer a discount
that the firm is economically inefficient. Such a firm must either improve its
working efficiency or cease working and wind up. when customers buy more than one product.
  A pricing structure or strategy is a consistent, uniform, planned  Market Condition, Consumer Willingness to Pay, Competition,
approach to pricing of products and services to achieve business Trade Margins, Cost Incurred
and marketing goals. When customers experience consistency in
pricing and quality, they know what to expect from your  Pricing strategy is the overarching approach used to set pricing
business, as well as how to budget for a company’s products and services. It doesn’t define actual
price points, but the pricing structure is a consequence of the
Several pricing structures:
strategy, and it’s where you set the price customers see. You must
1. Flat rate - You choose one price for your offerings and you’re first set a pricing strategy before you can build a price structure
done. This works great when you have a single product or service, since the former dictates the latter.
or you charge an hourly rate that doesn’t change.
How to set up a pricing structure?
2. Tiered pricing - This is a popular option. You set different product
Step 1: Do your homework
prices based on value. The greater the value, the higher the price.
An e\ample is a software product. The basic version is one price, - Before you tackle pricing, do your homework. Research and understand
your target customers, the competition, and the marketplace.
and if you want more features, you upgrade and pay a higher price.
Depending on the industry you operate in, other factors may affect
3. Pay per use – This pricing structure charges based on how much price, such as local laws and industry regulations.
of your offering is used. A typical example is electricity. The more
Step 2: Define success metrics
electricity you consume, the more you pay.
- You’ve done the research and set a pricing strategy aligned with your
4. Razor-blade pricing – This approach is called "razor-and-blade" company’s positioning, which defines how your business is presented to
because razor blades are an example of how the model works. You customers. Now decide how to measure your sales.
sell a core product, the razor, then make money from selling
Price Metrics - The unit by which buyers acquire your offering. It also
complementary products: the razorblades.
represents the unit-of-measure that a buyer uses to estimate the
 Prices are dynamic. Your competition may change prices. Your benefits and value of your offering.
costs increase as suppliers charge more. The pricing structure
Criteria for Evaluating Price Metrics:
keeps you organized in this dynamic environment.
 Performance Metrics - are data used to track processes within a
Factors Affecting pricing strategy:
business. This is achieved using activities, employee behavior, and
productivity as key metrics
 Tie-Ins as Metrics - A very common challenge for a company that sells  Expectations drive buyer behavior and nowhere more so than
capital goods is that the value of owning them can vary widely across when responding to prices.
segments based upon how intensely they are used  The same dynamic plays out – only more so – when businesses
sell products or services to other business (hereafter referred to as B-to-
Step 3: Find a base price
B sales and purchases.
- Establish a base price to build your pricing structure. The base price is  Price fences - are rules and regulations constructed to prohibit
the foundation for pricing decisions, even if the amount isn’t applied to customers from leaping from one segment to another in an attempt to
all offerings. The base price gives you a starting point receive a lower rate

Step 4: Develop pricing models Types of Fences:

- This is the culmination of the other steps. Using your success metrics 1. Buyer Identification Fences - Occasionally pricing goods and services at
and base price, model how you see your business growing. This pricing different levels across segments is easy because customers have obvious
model helps you assess which pricing structure makes the most sense. characteristics that sellers can use to identify them.

Step 5: Experiment to Grow Market Share and Profit 2. Purchase Location Fences - When customers who perceive different
values buy at different locations, they can be segmented by purchase
- Despite your best efforts, you won’t know how customers will respond to
location. This is common practice for a wide range of products.
your pricing until you try them.

3. Time of Purchase Fences - When customers in different market

 Pricing policy - defines the rules and conditions for price segments purchase at different times, one can segment them for pricing by
discounts or surcharges that could be applied to a transaction time of purchase
with a segment. Pricing policies involving things like an upcharge
4. Purchase Quantity Fences - Segmenting by Purchase Quantity When
for rush orders or a discount for must-take orders to which the customers in different segments buy different quantities, one can sometimes
customer commits far in advance of shipment segment them for pricing with quantity Discounts

Pricing Policies and Price Expectations CONSIDERATIONS FOR PRICING POLICY:

 A customer’s willingness-to-pay an offered price is not determined solely  Competition : Your business likely understands who its competitors are

by whether that price is fair or reasonable when compared to economic and what they charge consumers. Pricing policies heavily consider

value. competition with other firms in the market.

 Profit Goals : You might choose a pricing policy to meet a specific profit Businesses typically weigh the competitive consequences of any price
goal for your company point against profit potential.
 Sales Totals : Pricing policies directly affect how many people buy your  Gaining market share: Your pricing policy might aim at maximizing
company's product and how much they purchase. market share. Earning a large portion of market share provides both
 Firm Health : The financial circumstances of your company may enable strategic and financial advantages.
it to prioritize market strategy over immediate profit, or you may need to  Consumer satisfaction: Consumers' expectations change depending
earn revenue as soon as possible to remain in business. on the price they pay for something. Your business might consider what
 Flexibility : Companies often react to market shifts by changing prices. expectations you want to meet and price accordingly
Your company might consider if your initial price enables you to respond
to the market without losing profitability TYPES OF PRICING POLICY:
 Government Regulation : To protect consumers, the government
Cost-based Pricing Policy - calculates the average cost of production for a
regulates the pricing of certain goods and services. Depending on your
good or service and then accounts for the profit margin your company
industry, this may be irrelevant or a central concern in pricing policy.
desires.
 Method of Price Adjustment : Increasingly, companies that sell vast
amounts of goods may automate pricing with specialized software. Value-based Pricing Policy - Some companies have to respond to what

Pricing policies consider how your company intends to change prices. consumers are willing to pay for a product. To determine what this price is,
your company would conduct market research on market expectations,
 Sales Venue : If your company sells the same product in wholesale,
consumer preferences and competitors' offerings. Value-based pricing
retail or other venues, pricing policies may differ for each one
tries to understand the select factors distinguishing your specific good.
Objectives for Pricing Policy:
Demand-based Pricing Policy - Consumer demand has different properties
As with many businesses, you may have objectives other than simply making money depending on the product. Demand-based pricing policies maximize profit by
in the short-term. Your pricing policies are key tools for achieving the various goals responding to the various consumer behaviors found in markets.
businesses commonly have, such as:
Competition-based Pricing Policy - can be useful because it's a simple
 Profit: The most basic business objective of making profit is still an
way to determine price. It also can be both accurate and low-risk, since you
important one. For some businesses, it might be critical to maximize
likely understand what your consumers already pay for what you're offering
profit in the immediate future.
 Firm survival: Sometimes the only available pricing policy is the one
that enables your firm to continue operations. How to create a pricing policy:
 Limiting competition: Your business may have structural advantages
1. Assess Business Needs - The first step to creating the right pricing policy
that enable it to produce a good at a price point no competitor can match.
arrangement for your business is to recognize the needs of your
company. Consider what you hope to achieve with the product you're
introducing to the market and the financial position of your firm. Your
company's needs are likely influenced by: Size of company, Profitability,
Number of offered products, Competition, Economic conditions, Market
supply and demand

2. Evaluate Product - Determine if your product lends itself to one type of

pricing policy instead of another. Unique products have much different
earning potentials than duplicate products from different brands, for instance.
Important product considerations include: Production costs, Market demand,
Market segment, Novelty

3. Research Competition - No matter which pricing policy you choose,

researching competition is an important business practice that helps you
understand your product's potential, market trends and competitors'
approach to pricing.

4. Set price - Once you have determined which pricing policy can help your
business earn necessary revenues, gain market share and strategize for
long-term success, set the price that your policy dictates. Your business
can use its research insights

 GOOD POLICIES LEAD CUSTOMERS TO THINK ABOUT THE PURCHASE OF

YOUR PRODUCT AS A PRICE-VALUE TRADE-OFF RATHER THAN AS A
GAME TO WIN AT YOUR EXPENSE.
 AS SUCH, THEY ARE AN ESSENTIAL PART OF ANY PRICING
STRATEGY DESIGNED TO CAPTURE VALUE AND MAINTAIN ONGOING
CUSTOMER RELATIONSHIP