short term pricing Flashcards
what factors should we be aware of when charging prices?
- organisation’s objectives
- market within which organisation operates
- demand
- supply
- price elasticity of demand
- costs
- competition
- inflation
- legislation
- availability of substitutes
what is demand influenced by?
- price of the good
- price of other goods
- size and distribution of household income
- for most products and services the quantity demanded falls as price increases
- tastes and fashion
- expectations
- obsolescence
what is supply?
refers to the quantities of commodities or services actually offered for sale at particular prices per unit of time
what factors influences supply?
- the goals of the firm (assumed to be profit maximisation)
- the prices of commodity
- the price of other commodities
- the prices of factors of production
- the state of technology
- natural factors (e.g. weather)
generally the higher the price, the more profitable it is to supply, so the greater will be quantity supplied
how do companies establish their prices?
- many companies use variations of formula pricing
- that is they establish formulas to to guide salesmen and managers regarding the prices they should charge their customers
- the most widely used formulas are cost-plus pricing approaches
what types of pricing are there?
- full cost plus
- marginal cost plus/mark-up
- minimum pricing
- the contribution approach
what is the formula used for full-cost plus pricing?
sales price = full cost + %mark-up
- mark-up can be varied from product to product and to take account of prevailing market conditions
- costing system is geared up to provide costs for goods and services and is convenient for pricing
- varying the mark-up provides flexibility to adjust to market conditions
what are the advantages of full-cost plus pricing?
- covers all fixed costs and makes a profit (when a company is working at normal capacity)
- simple, quick and cheap method
- can justify prices
- flexible = can cope with differing mark up %s
- suitable if difficult to estimate expected demand
disadvantages of full-cost plus pricing
- must be large enough to cover non-production costs
- too simplistic to reflect demand and market conditions
- pricing problem looks deceptively simple = fails to recognise that since demand may be determined by price, there is a profit-maximising combination of price and demand
what is marginal cost-plus/mark-up pricing?
adding a profit margin onto marginal cost (either marginal cost of production or marginal cost of sales)
what are the advantages of marginal cost-plus pricing/mark-up pricing?
- draws managements attention to contribution and the effects of higher or lower sales volume on profit
- mark-up can be adjusted to reflect demand conditions
- convenient when readily identifiable variable costs
what are the disadvantages of marginal cost-plus pricing/mark-up pricing?
- although you can vary mark-up in accordance with demand conditions, it does not pay sufficient attention to demand conditions, competitors’ prices and profit maximisation
- it ignores FCs, so how can you be sure we’re covering them
what is rate of return pricing?
a variation on cost-plus pricing which is designed to ensure that the company achieves a particular target rate of return on capital employed
how is the mark-up % determined?
- a mark-up is chosen to earn a target rate of return on investment
- look at the capital investment needed for a company’s product and their target rate of return on investment
- calculate their target annual operating profit (= capital investment x target rate of return)
- look at how much they expect to sell and calculate the target operating profit per unit = target annual operating profit / units expecting to sell
what is minimum pricing?
the prices that would be charged so that it covers:
- incremental costs of producing and selling the product or service
- the opportunity cost of the resources consumed in making and selling the product or service
therefore based on relevant costs!!
what are incremental costs?
the cost added by producing one additional unit of a product or service
when is a minimum price charged?
unlikely that a minimum price wold be charges as there is not incremental profit but it does show:
- the absolute minimum price
- the incremental profit that will be earned from any price higher than the minimum
if there are no scarce resources and spare capacity what would the minimum price be?
the incremental cost of making it
if there are scarce resources what would the minimum price be?
must include allowance for the opportunity cost of using these scarce resources
what is the contribution approach to ‘optimal pricing’?
- cost analysis
- market analysis
- cost/volume/profit analysis
what is cost analysis?
identifies the base (variable or relevant costs) below which a price should not fall (or a negative contribution is earned)
what is market analysis?
estimates selling price/volume relationships
what is cost/volume/profit analysis?
combines cost and market analysis to identify the “optimal price”
how to calculate revised overhead absorption rate?
variable overhead absorption rate = sum of variable overheads (materials, labour, variable overhead) / expected units
what are the criticisms for formula pricing?
- market opportunities may be missed: it ignores customers’ response
- it ignores competitor offerings
- it frequently uses a concept of cost (full cost) which is inappropriate for decision making
- ignores interplay of: volume, unit fixed cost and selling price
what are price setters?
organisations that sell products/services that are highly customised or differentiated from another by special features, or who are market leaders, have some discretion in setting selling prices
- these organisations have the ability to set prices based on costs as they have some bargaining power
what are price takers?
organisations that have little influence over prices of products/services
- could be because there are a number of organisations within the market place with little distinguish between the offerings of each organisation
- DOMINANT market leader sets the price
- cost information is important for determining the relative profitability of products
consider..
- whether the organisation is a price setter or a price taker
- the long run and short run:
*short-run tends to be less than a year and include decisions such as pricing a one-time-only special order
*long-run is a year or more
short-run
- many costs are fixed
- for on-off jobs many costs are already fixed, so it’s best to take only relevant costs into account
- if company does not have spare capacity, it may also wish to take opportunity costs into account
- in the long-run, companies need to cover FCs, but it may still be inappropriate to use cost-plus as a basis for setting prices
long-run
- in the long-run the company needs to survive and therefore cover its long-run costs
- most, if not all, costs are variable and therefore relevant
- need a system in place that accurately reflects the costs of each product
