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Introduction
The three major influences on pricing are:
Customers
Competitors
Costs
For an organisation to survive it needs to make a profit – i.e. selling price must exceed costs.
Costs are a major consideration – vital to obtain accurate product or service costs.
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Allocation of Costs
Direct costs easily traced to products.
Problems with manufacturing overheads
Inaccurate charging of overheads could lead to:
Incorrect pricing of goods/ services
Less profitable products pushed to gain market share
May lose market due to overpricing of products
Decision to buy in products rather than manufacture
Managers mis-focused
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We saw in previous lectures activity
based costing refined the process of
allocating production overheads to
obtain accurate product costs.
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Pricing Strategies
Profit maximisation model
Cost plus pricing
Premium pricing
Skimming the market
Penetration pricing
Price differentiation
Loss leader pricing
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The economist’s approach
to pricing
• Elasticity of demand: a measure of how the volume of sales is affected by a change in price.
• Demand is inelastic if unaffected by price (e.g. designer goods).
• Demand is elastic if affected by price (e.g. grocery prices are affected by supermarket pricing wars).
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The economist’s approach to
pricing (cont.)
• Price elasticity of demand can be used
to calculate the profit-maximising
price for a company.
• Profit-maximising price is affected by
how sensitive unit sales are to price.
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Determining the profit maximising price
• The price elasticity of demand is computed as follows:
d = In (1 + % change in quantity sold)
In (1 + % change in price)
• The profit maximising price can be set by using the following formula:
Profit maximising price on variable cost
= d x Variable cost
(1 + d )
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Example
• Nature’s Garden believe that every 100%
increase in the selling price of their apple-
almond shampoo would result in a 15%
decrease in the number of bottles of
shampoo sold. If the variable cost of a
bottle of shampoo is £2 determine the
profit maximising price.
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Problems with economists’
model • difficult to estimate demand
curve/elasticity
• non-price forms of competition
• difficult to estimate true marginal cost
curve for each product
• problems with time periods - long
versus short-run
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Problems with economists’ pricing
model (cont.)
• problems with product mix
• surveys - most managers prefer to mark
up some version of full, not variable, costs
• mark-up is based on desired profits rather
than on factors related to demand
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Cost-based pricing models
• cost-plus- used in regulated/monopoly
situations
• target costing- used on more
competitive situations
w.b.seal, 2005 14
Cost-plus pricing
• Mark up = difference between selling
price and cost
• Cost-plus pricing=
Selling price= Cost + (mark up % x Cost)
• What cost should be used?
• How should the mark up be
determined? 15
Absorption costing approach
• The first step in absorption costing is to compute the unit product cost.
• The mark up must be large enough to cover SG&A expenses and provide an adequate return on investment (ROI).
• The ROI will be attained only if the forecasted unit sales volume is attained.
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Problems with absorption costing
• Managers think approach is ‘safe’.
• But what if sales are only 7000 units?
• ROI becomes negative!
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The structure of target costing
Target cost (Allowable Cost) =
Expected Sales Price – Target Profit
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Target costing
Target costing is the process of
determining a new product’s maximum
cost and developing a prototype that can
be profitably made for that figure.
Target = Anticipated _ Desired Cost Selling Price profit
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Hitting the Target
• Target costing is not just a pricing model.
• It is also a cost management model.
• Target costing involves designing to cost and quality targets set by competitive conditions.
• It takes a longer term perspective by considering the life-cycle of a product.
• Examines all ideas for cost reduction:
- from product planning stage,
- to development stage.
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Some problems with
target costing • may reveal unpalatable view of internal
operations
• may be too time-consuming
• ok for car industry (Toyota)
• too slow for electronics- time to market must be minimised
• still need to estimate costs
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Using target costing
• Instead of starting with a product and
determining costs and prices, target
pricing starts with the price and then
determine allowable costs.
• The anticipated market price is taken as
a given.
• Most of the cost is determined at the
design stage of the product.
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Revenue and yield management
• Yield management is a practice of achieving high capacity utilization through varying prices according to market segments and time of booking. It is applicable in industries like hotels, airlines etc., which are characterized by high fixed costs and perishability.
• An empty room in a hotel or an empty seat in a plane will represent lost revenue. Managers always like to sell all rooms at the highest rate but they know that there is a trade-off between high occupancy and high room rates.
• At the time of planning sales, price and market segment the resolution lies with control over rates.
• The key performance metric in this model is the; Yield percentage = Actual revenue/Maximum potential revenue
• Yield percentage depend on the average price × the number of units sold (hotel rooms, airline seats etc.). The maximum potential revenue is a full hotel or plane charging the maximum price.
• Yield management may be used to segment the market and offer different prices to different segments at different booking times
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Summary
• Pricing is a delicate balancing act.
• Managers often reply on cost-plus formulas to set target prices.
• In absorption costing approach, the cost base is absorption costing unit product cost and mark up.
• Companies using target costing set prices, then design products at an allowable cost.
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