Pricing - Theory

Question 1

What is the pricing objective for profit maximization?

Answer 1

Profit maximization is assumed in classical economic theory to be the overriding goal of all firms

Question 2

What is the pricing objective for target margin maximization?

Answer 2

Target margin maximization is the process of setting prices to reach a specified percentage ratio of profits to sales

Question 3

What are volume-oriented pricing objectives?

Answer 3

Volume-oriented objectives set prices to meet target sales volumes or market shares

Question 4

What are image-oriented pricing objectives?

Answer 4

Image-oriented objectives set prices to enhance the consumer’s perception of the firm’s merchandise mix

Question 5

What are stabilization pricing objectives?

Answer 5

Stabilization objectives set prices to maintain a stable relationship between the firm’s prices and the industry leader’s prices

Question 6

What are internal price setting factors?

Answer 6

Internal factors are as follows:

1. Marketing objectives may include survival, current profit maximization, market-share leadership or product-quality leadership
2. Marketing-mix strategy
3. All relevant costs (variable, fixed and total costs) in the value chain from R&D to customer service affect the amount of a product that the company is willing to supply. Thus, the lower costs are in relation to a given price, the greater the amount supplied
4. Organizational locus of pricing decisions
5. Capacity - for example, under peak-load pricing, prices vary directly with capacity usage. Thus, when idle capacity is available, that is when demand falls, the price of a product or service tends to be lower given a peak-load pricing approach. When demand is high, the price charged will be higher. Peak-load pricing is often used by public utilities

Question 7

What are external price setting factors?

Answer 7

External factors are as follows:

1. The type of market (pure competition, monopolistic competition, oligopolistic competition or monopoly) affects the price. For example, a monopolist is usually able to charge a higher price because it has no competitors. However, a company selling a relatively undifferentiated product in a highly competitive market may have no control over price
2. Customer perceptions of price and value
3. The price-demand relationship
4. Competitors’ products, costs, prices and amounts supplied

Question 8

What external factors of price setting affect the price-demand relationship?

Answer 8

The demand curve for normal goods is ordinarily downward sloping to the right (quantity demanded increases as the price decreases)

However, over some intermediate range of prices, the reaction to a price increase for prestige goods is an increase (not a decrease) in the quantity demanded. Within this range, the demand curve is upward sloping. The reason is that consumers interpret the higher price to indicate a better or more desirable product. Above some price level, the relation between price and quantity demanded will again become negatively sloped

If demand is price elastic (inelastic), the ratio of the percentage change is quantity demanded to the percentage change in price is greater (less) than 1.0 (i.e. if customer demand is price elastic, a price increase will result in the reduction of the seller’s total revenue

Question 9

Why is the time dimension for price setting important?

Answer 9

The time dimension for price setting is important. Whether the decision is for the short-term (generally, less than 1 year) or the long-term determines which costs are relevant and whether prices are set to achieve tactical goals or to earn a targeted return on investment [i.e. short-term fixed costs may be variable in the long-term and short-term prices may be raised (lowered) when customer demand is strong (weak)]

From the long-term perspective, maintaining price stability may be preferable to responding to short-term fluctuations in demand. A policy of predictable prices is desirable when the company wishes to cultivate long-term customer relationships. This policy is only feasible, however, when the company can predict its long-term costs

Question 10

What is a Cartel?

Answer 10

A cartel arises when a group of firms joins together for price-fixing purposes. This practice is illegal except in international markets

For example: The international diamond cartel DeBeers has successfully maintained the market price of diamonds for many years by incorporating into the cartel almost all major diamond-producing sources

Question 11

How is a cartel characterized as a collusive oligopoly?

Answer 11

A cartel is a collusive oligopoly. Its effects are similar to those of a monopoly. Each firm will restrict output, charge a higher (collusive or agreed-to) price and earn the maximum profit

Thus, each firm in effect becomes a monopolist, but only because it is colluding with other members of the cartel

Question 12

What is Market-Based pricing?

Answer 12

The Market-Based pricing approach involves basing prices on the product’s perceived value and competitors’ actions rather than on the seller’s cost. Non-price variables in the marketing mix augment the perceived value. Market comparables (which are assets with similar characteristics) are used to estimate the price of a product

Example: A cup of coffee may have a higher price at an expensive restaurant than at a fast-food outlet

Market-based pricing is typical when there are many competitors and the product is undifferentiated (as in many commodities market i.e. agricultural products or natural gas)

Question 13

What is Competition-Based pricing?

Answer 13

Competition-Based pricing involves:

1. Going-rate pricing bases price largely on competitors’ prices
2. Sealed-bid pricing bases price on a company’s perception of its competitors’ prices

Question 14

What is Price skimming?

New Product pricing

Answer 14

Price skimming is the practice of setting an introductory price relatively high to attract buyers who are NOT concerned about price and to recover research and development costs

Question 15

What is Penetration pricing?

New Product pricing

Answer 15

Penetration pricing is the practice of setting an introductory price relatively low to gain deep market penetration quickly

Question 16

What is the pricing by intermediaries approach?

Answer 16

Pricing by intermediaries involves:

1. Using markups tied closely to the price paid for a product
2. Using markdowns - a reduction in the original price set on a product

Question 17

What is FOB-origin pricing?

Geographical pricing

Answer 17

FOB-origin pricing charges each customer it s actual freight costs

A seller that uses uniform delivered pricing charges the same price (inclusive of shipping) to all customers regardless of their location

This policy is easy to administer, permits the company to advertise one price nationwide and facilitates marketing to faraway customers

Question 18

What is Zone pricing?

Geographical pricing

Answer 18

Zone pricing sets differential freight charges for customers on the basis of their location

Customers are NOT charged actual average freight costs

Question 19

What is Basing-point pricing?

Geographical pricing

Answer 19

Basing-point pricing charges each customer the freight costs incurred from a specified city to the destination regardless of the actual point of origin of the shipment

Question 20

What is Freight-absorption pricing?

Geographical pricing

Answer 20

A seller that uses freight-absorption pricing absorbs all or part of the actual freight charges

Customers are NOT charged actual delivery costs

Question 21

What are Cash discounts?

Answer 21

Cash discounts encourage prompt payment, improve cash flows and avoid bad debts

Question 22

What are Quantity discounts?

Answer 22

Quantity discounts encourage large volume purchases

Question 23

What are Trade (functional) discounts?

Answer 23

Trade (functional) discounts are offered to other members of the marketing channel for performing certain services (i.e. selling)

Question 24

What are Seasonal discounts?

Answer 24

Seasonal discounts are offered for sales out of season

They help smooth production

Question 25

What are Allowances?

Answer 25

Allowances (i.e. trade-in and promotional allowances) reduce list prices

Question 26

What is Discriminatory pricing?

Answer 26

Discriminatory pricing adjusts for differences among customers, the forms of a product or locations

Question 27

What is Psychological pricing?

Answer 27

Psychological pricing is based on consumer psychology (i.e. consumers who cannot judge quality may assume higher prices correlate with higher quality)

Question 28

What is Promotional pricing?

Answer 28

Promotional pricing temporarily reduces prices below list or even cost to stimulate sales

Question 29

What is Value pricing?

Answer 29

Value pricing entails redesigning products to improve quality without raising prices or offering the same quality at lower prices

Question 30

What is International pricing?

Answer 30

International pricing adjusts prices to local conditions

Question 31

What is Product-line pricing?

Product-Mix pricing

Answer 31

Product-line pricing sets price steps among the products in the line based on costs, consumer perceptions and competitors’ prices

Question 32

What is Optional-product pricing?

Product-Mix pricing

Answer 32

Optional-product pricing requires the firm to choose which products to offer as accessories and which as standard features of a main product

Question 33

What is Captive-product pricing?

Product-Mix pricing

Answer 33

Captive-product pricing involves products that must be used with a main product (i.e. razor blades with a razor)

Often the main product is relatively cheap, but the captive products have high markups

Question 34

What is By-product pricing?

Product-Mix pricing

Answer 34

By-product pricing usually sets prices at any amount in excess of storing and delivering by-products. Such prices allow the seller to reduce the costs and therefore the prices of the main products

Question 35

What is Product-bundle pricing?

Product-Mix pricing

Answer 35

Product-bundle pricing entails selling combinations of products at a price lower than the combined prices of the individual items

This strategy promotes sales of items consumers might not otherwise buy if the price is low enough (i.e. season tickets for sport events)

Question 36

What is Predatory pricing?

Illegal Pricing

Answer 36

Predatory pricing is pricing products below cost to destroy competitors is illegal

The U.S. Supreme Court has held that a price is predatory if it is below an appropriate measure of costs and the seller has a reasonable prospect of recovering its losses in the future through higher prices or greater market share

Question 37

What is the Robinson-Patman Act of 1936?

Illegal Pricing

Answer 37

The Robinson-Patman Act of 1936 makes price discrimination among customers illegal if it has the effect of lessening competition (although price discrimination may be permissible if the competitive situation requires it and if costs of serving some customers are lower)

The Robinson-Patman Act applies to manufactures (not service entities)

Question 38

What is Collusive pricing?

Illegal Pricing

Answer 38

Collusive pricing is an improper form of pricing (its illegal). Companies may NOT conspire to restrict output and set artificially high prices. Such behavior violates antitrust laws

Question 39

What is dumping?

Illegal Pricing

Answer 39

Another inappropriate pricing tactic is selling below cost in other countries (dumping), which may trigger retaliatory tariffs and other sanctions

Question 40

What is Cost-Based pricing?

Answer 40

Cost-Based pricing process begins with a cost determination followed by setting a price that will recover the value chain costs and provide the desired return on investment

When an industry is characterized by significant product differentiation (i.e. the automobile industry) cost-based and market-based pricing approaches are combined

Basing prices on cost assumes that costs can be correctly determined. Thus, cost-behavior patterns, cost traceability and cost drivers become important determinants of profitability

Question 41

What is a Cost-plus price?

Answer 41

Cost-plus price = Cost plus + Markup

Cost may be defined in many ways. Most companies use either absorption manufacturing cost or total cost when calculating the price. Variable costs may be used as the basis for cost, but then fixed costs must be covered by the markup

Question 42

What is one of the four common Cost-Plus pricing formulas?

Answer 42

Price = Total cost + (Total cost x Markup %)

Question 43

What is one of the four common Cost-Plus pricing formulas?

Answer 43

Price = Absorption manufacturing cost + (Absorption manufacturing cost x Markup %)

Question 44

What is one of the four common Cost-Plus pricing formulas?

Answer 44

Price = Variable manufacturing cost + (Variable manufacturing cost x Markup %)

Question 45

What is one of the four common Cost-Plus pricing formulas?

Answer 45

Price = Total variable cost + (Total variable cost x Markup %)

Question 46

Should costs of unused capacity be included in cost-based pricing?

Answer 46

The costs of unused capacity in production facilities, distribution channels, marketing organizations, etc. are ordinarily not assignable to products or services on a cause-and-effect basis so their inclusion in overhead rates may distort pricing decisions

Question 47

What is the Downward (black hole) demand spiral?

Cost-Based Pricing

Answer 47

Including the fixed costs of unused capacity in a cost-based price results in higher prices and in what is known as the downward (black hole) demand spiral

As higher prices depress demand, unused capacity costs and the fixed costs included in prices will increase. As a result of still higher prices, demand will continue to spiral downward

Note: One way to avoid this problem is NOT to assign unused capacity costs to products or services. The result should be better operating decisions and better evaluation of managerial performance

Question 48

What is a Target price?

Answer 48

A target price is the expected market price for a product or service given the company’s knowledge of its consumers’ perceptions of value and competitors’ responses

The company’s contacts with its customers and its market research studies provide information about consumers’ perceptions of value

The company must also gain information about competitors’ potential responses by learning about their technological expertise, products, costs and financial positions. This information may be obtained from competitors’ customers, suppliers, employees and financial reports. Reverse engineering of their products is also possible

Question 49

What are other attributes of Target pricing?

Answer 49

Subtracting the unit target operating income determines the long-term unit target cost

Relevant costs are all future value-chain costs whether variable or fixed

Since it may be lower than the full cost of the product, the target cost may not be achievable unless the company adopts comprehensive cost-reduction measures

Question 50

How is the concept of kaizen relevant to target costing?

Answer 50

The Japanese concept of kaizen is relevant to target costing. A policy of seeking continuous improvement in all phases of company activities facilitates cost reduction, often through numerous minor changes

Question 51

What is Value engineering?

Answer 51

Value engineering is a means of reaching targeted cost levels. It is a systematic approach to assessing all aspects of the value chain cost buildup for a product: R&D, design of products, design of processes, production, marketing, distribution and customer service

The purpose is to minimize costs without sacrificing customer satisfaction

Question 52

What are Value-added costs?

Answer 52

Value engineering requires identifying value-added and non-value added costs

Value-added costs are costs of activities that CANNOT be eliminated without reducing the quality, responsiveness or quantity of the output required by a customer or the organization

Question 53

What is the concept of Cost incurrence?

Answer 53

Value engineering also requires distinguishing between cost incurrence and locked-in costs

Cost incurrence is the actual use of resources

Question 54

What is the concept of Locked-in (designed-in) costs?

Answer 54

Value engineering also requires distinguishing between cost incurrence and locked-in costs

Locked-in (designed-in) costs results in the use of resources in the future as a result of past decisions

Traditional cost accounting focuses on budget comparisons, but value engineering emphasizes controlling costs at the design stage before they are locked in

Question 55

What is the Pre-commercialization (product development) strategy?

(Product life cycle & pricing decisions)

Answer 55

The strategy in the pre-commercialization (product development) stage is to innovate by conducting R&D, marketing research and production tests

During product development, the entity has no sales, but it has high investment costs

Question 56

What are characteristics of the introduction stage in the product life cycle process?

Answer 56

The introduction stage is characterized by slow sales growth and lack of profits because of the high expenses of promotion and selective distribution to generate awareness of the product and encourage customers to try it. .Thus, the per-customer cost is high

Competitors are few, basic versions of the product are produced and higher income customers (innovators) are usually target. Cost-plus prices are charged. They may initially be high to permit cost recovery when unit sales are low

The strategy is to infiltrate the market, plan for financing to cope with losses, build supplier relations, increase production & marketing efforts and plan for competition

Question 57

What are characteristics of the growth stage in the product life cycle process?

Answer 57

In the growth stage, sales and profits increase rapidly, cost per customer decreases, customers are early adopters, new competitors enter an expanding market, new product models and features are introduced and promotion spending declines or remains stable

The entity enters new market segments and distribution channels and attempts to build brand loyalty and achieve the maximum share of the market. Thus, prices are set to penetrate the market, distribution channels are extended and the mass market is targeted through advertising

The strategy is to advance by these means and by achieving economics of productive scale

Question 58

What are characteristics of the maturity stage in the product life cycle process?

Answer 58

In the maturity stage, sales peak but growth declines, competitors are most numerous but may begin to decline in number and per-customer cost is low

Profits are high for large market-share entities. For others, profits may fall because of competitive price-cutting and increased R&D spending to develop improved versions of the product

The strategy is to defend market share and maximize profits through diversification of brands and models to enter new market segments; still more intensive distribution, cost cutting, advertising and promotions to encourage brand switching and emphasizing customer service

Question 59

What are characteristics of the decline stage in the product life cycle process?

Answer 59

During the decline stage, sales and profits drop as prices are cut and some entities leave the market. Customers include late adopters (laggards) and per-customer cost is low

Weak products and unprofitable distribution media are eliminated and advertising budgets are pared to the level needed to retain the most loyal customers

The strategy is to withdraw by reducing production, promotion and inventory

Question 60

What is Life-Cycle costing?

Answer 60

The product life cycle begins with R&D, proceeds through the introduction and growth stages, continues into the product’s mature stage and finally ends with the harvest or decline stage and the final provision of customer support. Life-cycle costing is sometimes used as a basis for cost planning and product pricing

Life-cycle costing estimates a product’s revenues and expenses over its expected life cycle. The result is to highlight upstream and downstream costs in the cost planning process that often receive insufficient attention

Emphasis is on the need to price products to cover all costs (not just production costs)

Question 61

What is the concept of Whole-life cost?

Answer 61

A concept related to life-cycle cost that is relevant to pricing is whole-life cost, which equals life-cycle costs + after-purchase costs (operating, support, repair and disposal) incurred by customers

Reduction of whole-life costs is a strong competitive weapon. Customers may pay a premium for a product with low after-purchase costs