Lecture 12 Week 6 Pricing Decisions Profitability Analysis

Warwick Business School

IB1160 Foundations of Management Accounting

Pricing Decisions and Profitability Analysis

Lectures 12 (week 6)

Ellertone Ndalama

MBA, FCCA, ACMA, Bcom (Acc), Dip. Bus.


This lecture, the subsequent case study and the readings should enable you to: Understand Strategies of pricing: Market skimming. Penetration Pricing. Predatory pricing. Price discrimination. Complementary pricing Product line pricing Product Life Cycle and pricing. Total Life Cycle Costing and pricing Customer Profitability analysis (CPA). Understand Pricing in Practice.

Learning Objectives


Strategic pricing Forms part of product and / or business

marketing strategy. Incorporates an allowance for how the

business plans to develop the product over time.

Price is uncoupled from cost and demand in the short term.


Market skimming Charging a high price (premium pricing) initially to new

products and reducing price later. Allows business to ‘cash in’ or ‘get high returns’ from

customers willing to pay extra to get the product first. Commonly used in the new high tech products, fashion,

publishing and IT sectors. Business takes advantage of novelty factor (inelastic

demand) or a short term monopoly business enjoys before competitors emerge.

Do not use when close substitutes are available. Use where there are barriers to entry.


Low Pricing Strategy Penetration Pricing Low (discount) pricing to gain rapid market acceptance

of new product or gain a large market share. Use when close substitutes are available. Use when the market is easy to enter.

Predatory pricing Involves establishing prices so low that competitors are

driven out of the market. Business can subsequently raise prices once there is no

significant competition.


Price discrimination (differentiation) Market segmentation - split customers up into

different groups (based on age, income, region, gender, employment status, etc.) for marketing management purposes.

Each customer group is charged a different price for the same good or service i.e. some pay premium prices; others pay low prices (may considerably enhance revenue).

It relies on barriers preventing transfer between markets.


Examples - price discrimination

Drinks price: £1.50 each (for keen buyers) or £3.90 for three (effectively £1.30 each, for less

keen buyer). Train fares - age proxy for willingness to pay. Standard train fare for adults. Reduced fare for children and senior citizens.


Example - price discrimination

Customer Group Prices per Case Cases Sold

Large drug store chain £200 125,000

Small local pharmacies £232 100,000

Individual health clubs £250 25,000

The company is practicing price discrimination!

Attempt question in appendix 1


In Practice

Products/Services Price

DVD, Music CD

Chocolate Bar

Digital Camcorder

Holidays

Skimming

Penetrating

Depends!

Skimming

Skimming/

Penetrating


Complementary pricing Applies to products that tend to be used

together e.g. an oil filter (£100) and oil (5 litres for £30) when servicing a car.

Company could link the sales of an oil filter (£100) with a complementary price on oil (5 litres at a discounted price of £20).

This will be worthwhile so long as that allows the company an overall positive contribution to be made.


Product line pricing Applies to products that tend to be related to

each other. Some sales will involve all products. e.g. if a customer wants to upgrade a utility

room, kitchen for example, might need a tumble dryer (£700), fridge (£600) and cooker (£500).

A package (for the 3 items) price of £1,500 could be offered.

This will be worthwhile as long as the company can make a contribution on the overall deal.


Cost

Sales

High

Low

Depends

High

Stable

High

Depends

Low

Product Life CycleIntroduction Growth Maturity Decline

PositiveProfit

NegativeProfit

R&D CustomerServices

Marketing&

Distribution

ManufactureDesign Supply

Cost Life Cycle

Sales

Time


Product life cycle and pricing An infant product may not be capable of yielding

a profit given that it requires high proportion of costs and may enjoy only a limited market acceptance.

An infant product may have to be priced low to a point which is actually below cost.

As a product reaches growth and maturity stages, the price may be raised relative to cost and profit may be ‘harvested’.

At decline stage product may be priced low – reduced customer taste, etc.


Total Lifecycle Costing Traces all costs to a product over its

complete lifecycle, from design through to cessation.

For many products significant costs are incurred in the early stages of their lifecycle.

The pricing and profitability of a product can then be assessed taking all costs into consideration.


Total-Life-Cycle-Costing


Illustration – Total Life Cycle (3 years) Costing and Pricing Total

£ £ R & D and design costs (pre-year 1) 250,000 Marketing costs Year 1 10,000 Year 2 5,000 Year 3 5,000 20,000 Fixed & variable production costs

Year 2 10,000 Year 3 15,000 25,000 Fixed and variable distribution costs

Year 2 5,000 Year 3 5,000 10,000 Fixed & variable selling costs

Year 2 10,000 Year 3 5,000 15,000 Administration costs

Year 2 2,000 Year 3 3,000 5,000 Total product life cycle costs 325,000 Say units produced and sold:

Year 1 8,000 Year 2 15,000 Year 3 2,000 25,000

Cost per unit = £325,000 / 25,000 £13 Selling price per unit (say 20% mark-up) = 120% x £13= £15.60


Advantages of total life cycle costing The visibility of ALL costs (over life cycle) is increased, so Facilitates better decision-making and cost control. R & D and design (RDD) costs would have to be seen in the context

of the expected trading results, therefore Preventing a serious over spend at this stage or under pricing at the

launch point. Individual costs and profitability for products is more accurate, this Facilitates performance appraisal and decision-making, and Means that prices can be determined with better knowledge of the

true costs. More accurate feedback can take place when assessing whether

new products are a success or a failure, since RDD costs are also taken into account.


The traditional approach focusses on what profit one made from products or services.

CPA involves expressing results in terms of what profit (revenue streams less service costs) or profit margins is associated with particular customers or groups of customers.

Customer specific costs are attributed through a process of ABC. CPA aids customer relationship management e.g. Dropping more costly and less profitable customers. Re-engineering customer profitability by reducing associated

customer costs or increasing customer associated revenues (i.e. price discrimination?).

Understanding customer profitability is key to creating a competitive advantage for a business in the new economy.

Customer Profitability Analysis (CPA)


The adaptation of a mathematical model for business management purposes.

The substance of the model is that 20% of events account for 80% of outcomes.

In the context of CPA, this model suggests that most of the profits earned by a business will come from a small proportion of customers. The rest of the customer relationships may make little contribution.

The problem is to identify who the profitable customers are and take appropriate actions based on this knowledge.

Pareto analysis


Summary Strategies of pricing Product Life Cycle and pricing. Total Life - Cycle Costing and pricing. Customer Profitability analysis (CPA). Understand Pricing in Practice


References Atkinson, A.A., R.D.Banker, R.S.Kaplan, and S.M.Young (2001), 'Management

Accounting', Prentice Hall Inc, NJ. Atrill, P., and E. McLaney (2004), ‘Accounting and Finance for Non-Specialists’,

FT Prentice Hall, London Drury, C., (2004), ‘Management and Cost Accounting’, International Thomson,

London. Garrison, R.H. and Noreen, E.W., (2005), ‘Managerial Accounting’, McGraw

Hill, Boston Hansen, D.R., and M.M.Mowen (2000), ‘Management Accounting’, South-

Western College Publishing, Ohio. Hilton, C (2005). Managerial Accounting. McGraw Hill, Boston. Horngren, C.T., G.Foster, and S.M.Datar (2000), ‘Cost Accounting’, Prentice Hall

International, Inc., NJ.Articles: Guilding, C., Drury, C, and Tayles, M. (2005) ‘An empirical investigation of the

importance of cost-plus pricing’, Managerial Auditing Journal, 20 (2): 125-137. Lucas, M. (2003) ‘Pricing decisions and the neoclassical theory of the firm’,

Management Accounting Research, 14: 201-217. [An easier version is available at Management Accounting, June 1999:77 (6)].


Annual production of Accue check machine averages 200,000 units. A large chain store (Boots) purchases about 40% of its production. Several thousand independent retail drugstores and medical supply stores (Lloyds etc) purchase the other 60%.

Bernse ltd. incurs the following costs of production per box.

Direct material £2.2Direct Labour 1.05Overhead 0.75Total £4.00

It has one sales person assigned to the chain store account at a cost of £65,600 per year. Delivery is made in 1000 unit batches about three times a month at a delivery cost of £600 per batch. Four sales people service the remaining accounts. They call one of the stores and incur salary and mileage expenses of appx. £39900 each. Delivery costs vary from store to store, averaging £0.45 per unit. Bernse ltd charges the chain store £6.25 per box and the independent stores £6.5 per box.

Required: Is Bernse Ltd’s Pricing policy supported by cost differences in serving the two different classes of customer? Support your answer with relevant calculations.

Appendix 1: Discriminatory Pricing


Appendix 1:Discriminatory Pricing

Independent Store Costs

Sales support ...... ...£ 159,600Delivery cost ....…… 54,000**Total .................……£ 213,600Number of cases … ÷ 120,000Cost per case ......... £ 1.78

Chain Store Costs

Salesperson salary.......... £ 65,600 Delivery cost................... 48,000* Total ............................ £ 113,600 Number of cases............... ÷ 80,000Cost per case ............. £ 1.42

(0.4 x 200,000 = 80,000 units)(80,000/1000 = 80 batches@£600) = £48,000*

(0.6 x 200,000 = 120,000 units)(120,000 unit @ £0.45) = £54,000**

Yes, the cost differential of £0.36 (£1.78 – £1.42) per case more than justifies the price differential of £0.25 per box.

39,900 x 4


Seminar week 7: Mike and John Summers Pricing approaches. Pricing strategies. Product life cycle – monitoring and reviewing

prices during cycle. Factors affecting pricing. Actual pricing in practice: Price taker – target pricing. Price setter – cost plus pricing

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Lecture 12 Week 6 Pricing Decisions Profitability Analysis

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