Week 9 Everything Flashcards
Pricing decisions
How companies price a product or service ultimately depends on the demand and supply for it.
Three influences on demand and supply:
Customers – influence price through their effect on the demand for a product or service, based on factors such as quality and product features
Competitors – influence price through their pricing schemes, product features, and production volume
Costs – influence prices, because they affect supply (the lower the cost, the greater the quantity a firm is willing to supply).
Balancing customers, competitors and costs:
The three different markets
Competitive markets
Less-competitive markets
Non-competitive markets
Competitive markets
Companies have no control over setting prices and must accept the price determined by a market
Less-competitive markets
Can use either the market-based or cost-based approach
Non-competitive markets
Use cost-based approaches
Various objectives that a company may pursue through its pricing policy:
1/2
Profit maximisation
Revenue maximisation
To maximise unit sales [to keep their production facilities
operating near capacity]
To utilise spare capacity
To gain the largest market share
Various objectives that a company may pursue through its pricing policy:
2/2
To discourage market entry by competitors [Prices that produce only modest profits will often discourage competitors]
Survival
To create a perception of brand quality or exclusiveness
To create store traffic by slashing the price of a staple item [“loss leader” strategy brings people through the door]
To encourage trial purchases [to boost newly introduced products and services]
Price elasticity of demand
When a business proposes to change the price of a product or service, the key question is “To what extent will demand be affected?” Price elasticity of demand measures the change in demand (of a product or service) as a result of a change in its price. Since the demand goes up when the price falls, and demand goes down when the price rises, the elasticity has a negative value. However, it is usual to ignore the minus sign.
Price elasticity of demand (PED) =
Change in quantity demanded (as a percentage of demand)
Divided by Change in price (as a percentage of price)
Interpretation of PED
Elastic
If the percentage change in demand exceeds the percentage change in price, then demand is ‘elastic’ (i.e., very responsive to changes in price). Total revenue increases when price is reduced and vice versa.
Interpretation of PED
Inelastic
If the percentage change in demand is less than the percentage change in price then demand is ‘inelastic’ (not very responsive to changes in price). Total revenue decreases when price is reduced and vice versa.
Factors affecting price elasticity
Product or service pricing policies depend primarily on the circumstances of the firms and the markets in which they operate.
In particular, the following factors influence prices:
In particular, the following factors influence prices:
Scope of the market
Availability of substitutes
Complementary products
Disposable income
Habitual items
Scope of the market
larger the defined market, the more inelastic is the demand for the product
Availability of substitutes
the less the differentiation between competing products, the greater the price elasticity of those products
Complementary products
the inter-dependency of products results in price inelasticity, because the sales of the dependent goods rely on the sales of the primary goods.
Disposable income
The relative wealth of the consumers over time affects the total demand in the economy. Luxury goods tend to have a high price elasticity. Necessities (such as milk, bread, toilet rolls, etc.) are usually relatively price inelastic.
Habitual items
Items consumers buy out of habit such as cigarettes are usually relatively price inelastic.
Pricing approaches
Market-based
Cost-based
Market-based
price charged is based on what customers want and how competitors react.
Cost-based
also called cost-plus) – price charged is based on what it cost to produce, coupled with the ability to recoup the costs and still achieve a required rate of return.
Target pricing
target price – estimated price for a product or service that potential customers will pay
estimated on customers’ perceived value for a product or service, and how competitors will price competing products or services.
Understanding customers’ perceived value
understanding customers and competitors is important because
competition from lower cost producers has meant that prices cannot be increased
products are on the market for shorter periods of time, leaving less time and opportunity to recover from pricing mistakes
customers have become more knowledgeable and demand quality products at reasonable prices.
Competitor analysis:
Understanding competitors’ technologies, products or services, costs and financial conditions helps a company to evaluate how distinctive its own products or services will be in the market, and determine the prices it might be able to charge as a result of being distinctive.
Market segmentation:
price differentiation – the practice of charging different customers different prices for the same product or service
peak-load pricing – the practice of charging a higher price for the same product or service when the demand for it approaches the physical limit of the capacity to produce that product or service.
Cost-based (cost-plus) pricing
The general formula adds a markup component to the cost base to determine a prospective selling price. This is usually only a starting point in the price-setting process. Markup is somewhat flexible, based partially on customers and competitors.
Cost-plus target rate of return on investment
Target rate of return on investment ‒ the target annual operating return that an organisation aims to achieve, divided by invested capital.
Cost-plus methods
Selecting different cost bases for the ‘cost-plus’ calculation:
variable manufacturing cost
variable cost
manufacturing cost
full cost.
These cost bases give four prospective selling prices that are close to each other.
Most firms use full cost for their cost-based pricing decisions because it:
allows for full recovery of all costs of the product
allows for price stability
is a simple approach.
Comparison of cost-plus pricing and target pricing:
Cost-plus selling prices are prospective prices and are set after balancing the trade-offs among costs, mark-up and customer reactions. The target-pricing approach sets the target price after assessing customer preferences, expected competitor responses, and the target cost.
Costing and pricing for the long run
Long-run pricing decisions have a time horizon of one year or longer, and include decisions such as: Pricing a product in a major market wherethere is some leeway in setting price. Costs that are often irrelevant for short-run policy decisions, such as fixed costs that cannot be changed, are generally relevant in the long run, because costs can be altered in the long run. Profit margins in long-run pricing decisions are often set to earn a reasonable return on investment – prices are decreased when demand is weak and increased when demand is strong.
Costing and pricing for the short run
Short-run pricing decisions have a time horizon of less than one year and include decisions such as pricing a one-time-only special order with no long-run implications and pricing a one-time-only special order with no long-run implications.
Relevant costs for short-run pricing decisions
direct materials
direct manufacturing labour
fixed costs of any additional capacity required
Firms may use different pricing policies, including the following 4:
Price-skimming pricing policy
Penetration pricing policy
Bait and Hook pricing
Product life cycle pricing policy
Price skimming 1/2
Firms use the price skimming policy to take advantages of price insensitive sections of the market. When demand is high for new products, initial prices may include high mark-ups. High initial prices safeguard against unexpected future increases in costs It also helps to recover high research and development costs.
Price skimming 2/2
At the later stages of product growth cycle, progressively lower prices may be charged (to attract other segments of the market). Apple has added a twist to the skimming strategy. Apple stakes out a price and then maintains and defends that price by significantly increasing the value of their products in future iterations. On occasions, this approach is used to prolong the life of the old products.
Penetration pricing
Under the penetration pricing policy firms initially charge low prices in order to introduce the product to the market and to build a customer base. Helps to compete with other producers or with close substitutes of the product. Low prices are also used to discourage potential competitors from entering the market. Low prices also enable a company to establish a large market share.
Bait and Hook pricing
A bait and hook pricing strategy sets the initial purchase price low but charges aggressively for replacement parts or other materials con- sumed in the course of using the product.
Gillette has done well for its owners for more than a century, in part because of its success in selling replacement blades for its shaving devices. Makers of ink-jet printers appear to have adopted the same pricing strategy: sell the printer cheaply, but make up for it on ink cartridges.
Product’s life cycle
Pricing policies may vary depending on the different stages of a product’s life cycle
A product life cycle consists of four stages:
Introductory
Growth
Maturity
Decline
Advantages of life cycle costing
A large proportion of a product ’s costs can be committed or “locked in” during the planning and design stage. Pricing can be most effectively set taking into consideration costs incurred during planning and design stages. Life cycle costing focuses on costs over the product’s entire life cycle. It determines whether profits earned during the manufacturing phase will cover the costs incurred during the pre-and post-manufacturing stages.
Customer profitability analysis
Customer-profitability analysis is the reporting and analysis of revenues earned from customers and costs incurred to earn those revenues. An analysis of customer differences in revenues and costs can provide insight into why differences exist in the operating income earned from different customers.
Customer-revenue analysis
A price discount is the reduction of selling prices to encourage increases in customer purchases. Lower sales price is a tradeoff for larger sales volumes. Discounts should be tracked by customer and salesperson to help improve profitability.
Customer-cost analysis
Customer-cost hierarchy categorises costs related to customers into different cost pools on the basis of different:
types of drivers
cost-allocation bases
degrees of difficulty in determining cause-and-effect or benefits-received relationships.
Categories of indirect costs in a customer-cost hierarchy:
customer output unit-level costs
customer batch-level costs
customer-sustaining costs
distribution-channel costs
organisation-sustaining costs.
Factors to be considered in allocating resources among customers include:
likelihood of customer retention
potential for sales growth
long-run customer-profitability
increases in overall demand from having well-known customers
ability to learn from customers.
