PRICING DECISIONS

Setting the price for an organization’s product is one of the most important decisions a
manager faces. It is also one of the most difficult, due to number of factors. Manufacturers set
prices for the products they manufacture, merchandising company set prices for their goods
and the optimal pricing often depends on the situation. Four major influences on pricing
decisions are:

1. Customer demand- Product design and pricing considerations are interrelated, hence the
management must be careful not to price its products out of the market.
2. Actions of Competitors- In considering the reaction of customers and competitiors,
management must be careful to properly define its product. If a competitor’s price is
significantly below the market price, demand for the competitor’s products will increase
and demand for the output of other companies in the same market will decrease, forcing
the other companies to lower their prices.
3. Costs- Lower costs bring higher profits, and the higher the profits, the more units the
company will be willing to supply. A company needs to reduce or eliminate all costs that
do not add value to its product.
4. Other issues (Political, legal, etc)- Laws may prohibit companies from discriminating
among their customers in setting prices.
 Law of Demand
The law of demand states that the price of a product is inversely (negatively) related to the
quantity demanded of that same product.
Therefore, as the price of the product is reduced, the quantity demanded for that same product will increase,
and vice versa.
 Law of Supply
States that in the short run, there is a positive relationship between the price of a good or
service and the quantity supplied.
• As the price of a good increases, producers are willing to supply more of the good
to the market, causing an increase in the total quantity supplied.
• As the price of the good decreases, producers are willing to supply less of it to the
market because of the lower selling price. This relationship causes a decrease in
the total quantity supplied to the market as prices fall.
 Profit Maximization
Profit maximization refers to a tendency of business firms to maximize profits in the
short or long run by using the most efficient methods and equalizing the marginal
cost and revenues. Its main purpose is to increase the level of production of a firm or
business that will grant it the maximum profit on selling goods and services.

The profit maximization formula depends on profit = Total revenue – Total cost.
Therefore, a firm maximizes profit when MR = MC
If MR exceeds MC, then the producer will continue producing as it will add to his
profits.

Profit maximization is a strategy of maximizing profits with lower expenditure,

whereby a firm tries to equalize the marginal cost with the marginal revenue derived
from producing goods and services. Companies can maximize profits by increasing
the price or reducing the production cost of the goods.
 Price Elasticity
The impact of price changes on sales volume is called price elasticity. Elasticity of demand is
calculated in general as the percentage change in quantity demanded divided by the
percentage change in price.
Demand is “elastic” (“responsive”) if a 1% change in the price of the good causes more than a
1% change in the quantity demanded.

Demand is “inelastic” (“unresponsive”) if a 1% change in the price of the good causes less than
a 1% change in the quantity demanded.
• the demand for a product or service is price inelastic if the quantity demanded changes by a
smaller percentage than the associated change in the price.
• A price increase for a product with price inelastic demand will result in increased total
revenue because any decrease in the quantity demanded and sold that results from the
increased price will be small enough that it will not completely offset the increase in revenue
caused by the price increase.
• A price decrease will result in decreased total revenue because the resulting increase in
sales will not be enough to offset the lower price received for each unit sold.
Limitation of Profit- Maximization model
Despite the various advantages mentioned above, there are a few factors that create
uncertainty and confusion around using a profit maximization model:

• The “profit” aspect of this concept is unclear to a large extent. The firms demand
and marginal revenue curves are difficult to discern.
• In an oligopolistic market, ehre a small number of sellers compete among
themselves, the simple economic pricing model is no longer appropriate.
• The quality of products, services, and other such intangible factors in the business
are not considered.
• Cost accounting systems are not designed to measure the marginal changes in cost
incurred as production and sales increase unit by unit.
 Product pricing
Product pricing strategies are tactics used in business to determine the optimal pricing
for new products and to optimize the pricing of existing products. Some product
pricing strategies are based on value and costs, while others focus on the competitive
landscape or specific business circumstances.

A pricing strategy is a model or method used to establish the best price for a product
or service. It helps you choose prices to maximize profits and shareholder value while
considering consumer and market demand.
The price must be:
• It must be high enough to produce a profit, and
• It must be low enough to encourage demand.
The price floor is product cost. The ceiling is customer perception of the product’s
value. The best price is between these extremes and is determined by competitors’
prices as well as the internal and external factors.
 Product approaches
Few pricing approaches are:

1. Cost-based
• Absorption Cost pricing
• Variable Cost pricing
2. Strategic pricing of new products
3. Value-based pricing / Target costing
4. Competition-based
 Cost-based Pricing
Cost-based pricing is based off of the cost of producing the product.
• Cost-plus pricing The company determines its costs and adds a standard
markup to the cost to arrive at the price.
• Break-even pricing
• Target profit pricing
In break-even pricing and target profit pricing, the firm determines a price at
which it will break even or make a target profit. Target pricing is based on forecasts
of total cost and total revenue at various sales volume levels.
• Markup pricing: Markup pricing refers to either markup on cost or markup on
selling price.
 Markup on Cost or sales
• The company determines its costs and then adds a standard markup percentage of
the cost to arrive at a price.
For example, retailers who purchase products from suppliers for resale frequently
use “markup-on-cost” pricing. The formula for calculating the price for “markup on
cost” is:
• Price = Item Cost + (Item Cost × Markup %)
• Price = Item Cost × (1 + Markup %)

• A variation of markup pricing. Many retailers think of markup not as a markup on

cost but rather as a percentage of the selling price.

Price = Item Cost

1 – Markup Percentage
 The Cost of Production
The company may use whatever it wants as the cost of production, but The most
common costs of production to use are:
• Total cost
• Absorption manufacturing costs
• Variable manufacturing costs
• Total Variable costs.

Most companies that use cost-plus pricing use either absorption cost or total cost as
the basis for pricing products mainly because:
• In the long rung the price must cover all cost and a normal profit.
• Absorption cost or total cost pricing provides a justifiable price.
• When a companies competitors have similar operations, cost plus pricing gives
management a better idea to set prices
 The Cost of Production
Some managers use variable cost plus pricing, as variable cost do not obscure the
cost pattern by unitizing fixed cost as variable.

Regardless of the cost method the firms markup should be sufficient to cover the
profit
 Cost-based Pricing Drawback
The main drawback to cost-plus pricing is that it ignores customer demand and
competitor prices. But it persists for several reasons:
• Sellers are more confident about their costs than about demand. Since the
price is tied to cost, they do not have to adjust pricing to reflect demand
changes.
• If all companies in an industry use the same pricing method, prices are
similar and price competition is minimized.
Cost-based Pricing benefits
• Sellers may be more confident about their costs than about demand for their
product.
• Markup pricing is simple. The retailer chooses a set percentage as the
amount of markup for each product category, and that percentage is
consistent for all products in that category.
 Pricing Strategies for New Products
Two pricing strategies that may be followed when a new product is introduced are:
1. Market penetration pricing
When a company wants to penetrate a market quickly and maximize its market
share with a new product, it may set a low initial price.
• It may set a low initial price with the expectation of high sales volume, lower per-
unit costs, and higher long-term profit.
• The goal is to win market share, stimulate market growth and discourage
competition.
2. Market skimming
A company unveiling a new technology may set an initial high price to “skim” the
market and then quickly reduce the price to attract new customers after those who
could afford to pay the highest price have purchased. This is often followed by
subsequent lowering of prices, thereby skimming maximum revenues from the
different market segments.
 Competition-based Pricing
Customers’ use competitors’ prices to form their perceived value of a product.
Going-rate pricing is based almost entirely on competitors’ prices.
This does not mean that the company charges the same price as its competitors
charge. Actual prices may be more or less. If a company is a market leader faced
with lower-priced competitors, it can elect to maintain its price while raising the
perceived value or quality of its product, or perhaps it might launch a lower-priced
“fighter” line.
Going-rate pricing is used frequently. Companies accept the going price as
representative of the price that will yield a fair return.
The firm’s strategy may be determined whether its products are homogeneous with
(identical to) or nonhomogeneous with (different from) its competitors’ products.
• If the industry involves a commodity, i.e., a homogeneous good with little
differentiation among producers, competing firms normally all charge the
same price.
 Value-based Pricing
Value-based pricing (also called buyer-based pricing) bases prices on buyers’
perceptions of the value of the product instead of on the seller’s cost.
Value-based pricing is the reverse of cost-based pricing. The target price is based on
customer perceptions of the value of the product.
The pricing process begins with consumer needs and value perceptions. The price is
set to match that.
More companies are adopting value pricing strategies, and this has led to
introduction of less expensive versions of brand-name products.

E.g. Tata Nano is the best example of value pricing, despite several Tata cars, the
company designed a car with necessary features at a low price and lived up to its
quality.
 Target Costing
In target pricing, the selling price for a product is determined first. Based on the
insights from the marketing department and other market intelligence data, the most
competitive price that the customers would be willing to pay is fixed as a selling
price.

The desired profit margin is deducted from this selling price to arrive at a cost within
which the production department would have to produce the product or the
procurement department would have to procure the product.

Price and quality may be determined by customer needs. For instance, a piece of
equipment could be manufactured inexpensively and sold cheaply; but its ongoing
maintenance might be high. Customers might prefer equipment that they pay more
for but which will be maintenance-free.
 Target Costing
Working backward from the sales price, companies establish an acceptable target
profit and calculate the target cost as follows:

Target Cost = Expected selling price – Desired profit

 Target Costing- Key Principles
Price-Led Costing: Target costing sets the target cost by first determining the price
at which a product can be sold in the marketplace.

Focus on the Customer: To be successful at target costing, management must listen

to the company’s customers. What products do they want? What features are
important? How much are they willing to pay for a certain level of product quality?

Focus on Product Design: Design engineering is a key element in target costing.

Engineers must design a product from the ground up so that it can be produced at its
target cost.

Focus on Process Design: Every aspect of the production process must be examined
to make sure that the product is produced as efficiently as possible.
 Target Costing- Key Principles
• Cross-Functional Teams: Manufacturing a product at or below its target cost
requires the involvement of people from many different functions in an
organization: market research, sales, design engineering, procurement etc.
Individuals from all these diverse areas of expertise can make key contributions
to the target costing process.

• Life-Cycle Costs: In specifying a product’s target cost, analysts must be careful

to incorporate all of the product’s life-cycle costs. These include the costs of
product planning and concept design, preliminary design, detailed design and
testing, production, distribution and customer service.

• Value-Chain Orientation: Sometimes the projected cost of a new product is

above the target cost. Then efforts are made to eliminate non-value-added costs
to bring the projected cost down
 Value Engineering and Target Costing
If a product meets the requirements of the users at the lowest price, then that
products considered valuable. “Functionality and cost thus define what value can
be placed on a product,”
 Activity based Costing and Target Costing
Activity-based costing provides a more accurate method of product/service costing,
leading to more accurate pricing decisions. It increases understanding of overheads
and cost drivers; and makes costly and non-value adding activities more visible,
allowing managers to reduce or eliminate them.

This costing system is used in target costing, product costing, product line
profitability analysis, customer profitability analysis, and service pricing. Activity-
based costing is used to get a better grasp on costs, allowing companies to form a
more appropriate pricing strategy.

The formula for activity-based costing is the cost pool total divided by cost driver,
which yields the cost driver rate. The cost driver rate is used in activity-based
costing to calculate the amount of overhead and indirect costs related to a particular
activity
 Customer Profitability Analysis
Customer Profitability analysis focuses on how individual customer or customer
groups contribute to profit. The focus is to ensure that most profitable customer or
customer groups receive comparable attention from the organization.

By focusing on the most profitable customers and providing an improved service,

customer relation and customer retention improves. By having to know that why a
certain group of customers do not significantly contribute to profit, management can
assess and work on solutions.

The process require the use of an activity based costing system and involves
gathering cost and revenue information for each customer group.
 Customer Profitability Analysis
• Sales details- This includes price charged and any discount given
• Cost details- These involve focusing on the resource consumed by different
customers. These cost drivers needs to be separately identified and a cost driver
rate associated with the activity.
 Life Cycle Product Costing
The product life cycle is the time from the initial research and development of a product to
the point when the company no longer offers customer servicing and support for the
product.
• Life-cycle costing tracks and accumulates all the costs of each product all the
way through the value chain.
• A product’s life cycle usually spans several years.
The price that is set is the price that will maximize lifecycle operating income.

Life-cycle budgeted costs are used in pricing decisions because they incorporate costs that
might not otherwise be considered.

If costs for research and development and other nonproduction costs such as marketing,
distribution, and customer service are significant, it is essential to include them in the
product’s cost, along with the direct manufacturing costs, to determine the price.
 Stages in the Product Life Cycle
Brands, products and technologies all have life cycles. The stages in a “product” life cycle
are:
1. Product development stage – no sales and no revenues. The company’s investment
costs increase.
2. Introduction stage slow growth and minimal profits due to heavy upfront expenses to
introduce the new product.
3. Growth stage If the introduction is successful, the product will experience rapid sales
growth and increasing profits in the growth stage.
4. Maturity stage  Sales growth slows down and profits level off or decrease. The
company has to spend more for marketing to defend the product against the competition.
5. Decline stage  Sales drop and profits fall.

Some products remain in the maturity stage for a long time; some enter the decline stage but
then cycle back to the growth stage, perhaps because the company successfully repositions
the product.
1. Development Stage
The product is not for sale so there are no pricing issues yet.

2. Introduction Stage
The primary characteristics of an introduction stage product life cycle strategy are:
The introduction takes time and sales growth is slow. The marketing objective is to
create interest to try the product.
Promotion spending is high to motivate consumers to buy.
The company may produce only basic versions of the product and focus sales efforts
on buyers who are the most ready to buy, the so-called early-adopters.
Pricing may be high, assuming A skim pricing strategy for a high profit margin as
the early adopters buy the product and the firm recoups its development costs.
Sometimes Penetration pricing is used and introductory prices are set low to gain
market share rapidly.
3. Growth Stage
The primary characteristics of a growth stage product life cycle strategy are:
• Sales increase rapidly but sales efforts are less critical since consumer demand is
high.
• Prices usually remain steady or they fall slightly.
• Companies maintain high promotional spending, even increasing it slightly to
counter the competition’s efforts
• Profits increase because promotion costs and fixed manufacturing costs are
spread over a larger volume.
• The marketing objective is to maximize market share.
• Some advertising is moved from the goal to build product awareness to building
product conviction and purchase.
• Since cash flow from the product is low or negative during the growth stage,
working capital and cash management are very important at this stage.
4. Maturity Stage
The primary characteristics of a maturity stage product life cycle strategy are:
• Sales peak during this stage, but sales growth slows down.
• Although profits are still high, prices begin to decrease while at the same time promotion costs
increase, leading to lower profits.
• The marketing objective at this stage is to maximize profit while defending market share.

5. Decline Stage
The primary characteristics are:
• New technology and other factors cause sales to decline.
• More firms withdraw from the market. The remaining firms cut back their product offerings. They
may cut the promotion budget and reduce prices further.
• Management identifies products in the decline stage by monitoring sales, market share, costs and
profits to decide to maintain, harvest, or drop the declining products.
• The marketing objective at this stage is to reduce expenditures and “milk” (make the most of) the
brand.
• Prices will probably be cut. If sales hold up, this tactic will increase short-term profits.