Session 9
Pricing Policies and Practices &
Capital Budgeting
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PRICING
• Pricing denotes revenue to seller
• Perceived Value to buyer
• Pricing strategy Important for new product,
modified product, new market, new market
segment, objective of firm
• Basic determinants are supply and
demand
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PRICING PRACTICES
General Considerations To Be Kept In Mind
While Formulating A Pricing Policy:
• Objectives of business- Notwithout considering
its impact on all objectives
• Market structure
• Competitor’s strategy
• Price Sensitivity/ elasticity(even for
monopolist)
• Conflicting Interests of Manufacturers and
Middlemen, consumers
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General Considerations
• Routinisation of Pricing- Speed required
in decision-making, quality of data
available, competitive market
• Role of Non Business Groups in pricing
Decisions- Government, political
considerations , farmers and business
lobbies, Trade Unions etc
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Types of Pricing
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COST BASED PRICING
BASED ON FIRM’S OBJECTIVE
COMPETITION BASED PRICING
PRODUCT LIFE CYCLE PRICING
CYCLICAL PRICING
MULTIPRODUCT PRICING
ADMINISTERED PRICING
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I. COST BASED PRICING
• Cost Based Pricing
– Cost Plus or Mark Up
– Marginal Cost pricing
– Target Return pricing
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Cost Based Pricing
i. Cost Plus / Full Cost/Average Cost/
Mark-up Pricing
Price set to cover cost plus a percentage
for predetermined profits.
P= AC+ m
where, m =mark-up percentage
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• Mark up depends on target rate of return,
degree of competition, price elastiicty,
substitutes etc
- Most common
• Simple to fix the price
• More defensible on moral grounds
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Cost Based Pricing
Drawbacks:
-Historical cost rather than current cost data is
used, which may lead to over/under pricing
-Inappropriate if variable cost fluctuates frequently
-Some critics say it ignores demand side (But firm
determines mark up on the basis of ‘what the
market can bear’)
- Ignores marginal cost as it uses average cost
- Not suitable if competition is tough or when
entering new market
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Marginal Cost Pricing
ii. Marginal Cost Pricing/ Incremental cot
pricing:
Price of product = Variable cost plus a profit
margin.
Only those costs which are directly attributable to
the output of a specified product
Here price will be lower than the full cost pricing.
:WHY?
•
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Marginal Cost Pricing
• All past outlays are historical and a firm should
deal solely with anticipated revenues and
outlays
• Firm is more interested in future changes in cost
due to changing decisions
• Unlike fixed costs , MCs are controllable in the
short run
• Total costs can not be of use in case of multiproduct/ markets/ process situations
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Marginal Cost Pricing
Useful to beat competition
Also, to enter the market
Used for pricing public utility where profit is
not the motive
Weaknesses:
• Can only be a short term strategy (as it
omits fixed costs)
• Can be only restricted to pricing of specific
orders
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Cost Based Pricing
Iii) Target Return Pricing
• Producer rationally decides the minimum
rate of return which must be earned by the
product
• Methodology similar to the above, but
margin is decided on the basis of target
rate of return, on the basis of experience,
consumer’s paying capacity, risk involved
etc
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II. Based on Firm’s Objective
• Pricing Based on Firm’s objective
-Profit Maximisation- considers total cost
-Sales Maximisation- should adopt
competitive pricing, say marginal pricing
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III. COMPETITION BASED
PRICING
i. Penetration Pricing : Low price when
entering new market dominated by
existing players (Nirma, Deccan Air)
ii. Entry Deterring- Price kept low to make
market unattractive for competitors
(Common in oligopoly)
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Competition Based Pricing
iii. Going Rate Price:
Why?
Firms do not want price wars
Small/ new firms may not be sure of the
effect of charging a different price
Products are close substitutes with high
cross elasticity
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Competition Based Pricing
Popular in monopolistic and oligopoly
markets because
a) of low product differentiation and
b) for consumer the cost of switching is
minimal
• Uniform price of packaged water or fruit
juice
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IV. PRICE DISCRIMINATION
First degree Price Discrimination
-Each unit of output
is sold at a different price
or each consumer is charged
a different price .
Price
Entire consumer’s surplus wiped out
Quantity
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Second Degree Price
Discrimination
Seller gets part of
consumer’s surplus.
D
A
P1
Price
Highest price of OP1
for OQ1 units.
P2
Price is OP2 for Q1Q2
units
B
C
P3
D
O
Q1
Q2
Demand
Q3
Lowest price of OP3 for
the next Q2Q3 units.
Monopolist maximises
revenue at
TR= (OQ1*AQ1)+
(Q1Q2*BQ2)+
(Q2Q3*CQ3)
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Third Degree Price Discrimination
Cost & Revenue
MC
B
A
T
MRa
Da
Db
O
Qa
MR
MRb
o
Qb
Quantity Demanded
AR=D
O
Q
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Third Degree Price Discrimination
• Monopolist has 2 markets, A and B.
• For market A, Da is the average revenue
(demand) curve and MRa is the marginal
revenue curve.
• For market B, Db is the average revenue
(demand) curve and MRb is the marginal
revenue curve.
• Horizontal summation of the two markets give
the aggregate AR=D and MR curves for the
monopolist.
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Third Degree Price Discrimination
• Firm’s MC intersects MR curve at T.
• Drawing a perpendicular from T we get the
optimum level of the firm’s aggregate
output at OQ.
• At this level of output, MR=MC.
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Third Degree Price
Discrimination
• OQ is divided between the two markets in such
a way that the profit maximisation condition (i-e.,
MC (=TQ ) is equal to MR) is satisfied in both
the markets.
• This is achieved by drawing a line from point T
parallel to X axis , through MRa and MRb.
• Optimum share for market A is OQa (at price
AQa) and for market B the share is OQb (at
price BQb).
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V. PRODUCT LIFE CYCLE
PRICING
• Refers to different pricing strategies for a
product depending on the different stages
of its life cycle
• Each phase is unique- different demand
patterns and competition
• So setting same price will mean less than
optimum revenue
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V. PRODUCT LIFE CYCLE
PRICING
Sales revenue Curve
1.Introduction
2.Growth
3.Maturity
4.Saturation
5. Decline
1
2
3
4
5
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PRODUCT LIFE CYCLE PRICING
i) New Product:
a)Skimming Policy
: Charging very high initial price and super normal
profits-Lower price during maturity
• The first ball pens introduced in 1945 cost 80
cents to produce but were priced at $12.50.
• Initial high prices of computers
• 1st day movie tickets
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PRODUCT LIFE CYCLE PRICING
Why?
• Demand is likely to be less price-elastic in initial
stages
• If life of product is likely to be short, the producer
can get as much as possible as fast as possible
• The policy can lead to introduction of product for
lower segments later.
• High initial price may finance the heavy initial
costs of introducing a new product when other
sources of finance may not be available
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PRODUCT LIFE CYCLE PRICING
Benefits of lower cost due to growing
volumes and technological development
allows for lowering of prices at a later
stage.
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PRODUCT LIFE CYCLE PRICING
b) Low Penetration Price: Close to customary
price- only minor adjustments required
eventually.
• Objective of low penetration pricing is to keep off
competition
Appropriate where:
• Sales respond strongly to lower prices
• High volumes lead to lower costs
• Product acceptable for mass consumption
• To capture a large share of market quickly
where there is a threat of potential competition
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PRODUCT LIFE CYCLE PRICING
High Skimming price
Low penetration Price
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PRODUCT LIFE CYCLE PRICING
ii) Rapid Growth- Stable price policy for
sustained growth
iii) Maturity: Growth occurs at diminishing
rate- firm may introduce minor quality
changes with higher prices
iv) Saturation- Lower prices and discounts to
clear stocks
v) Decline- Wind up
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PRODUCT LIFE CYCLE
PRICING
Product Bundling- Two or more products
bundled together for a single price
Strategy for both new and mature/
declining product
Saves cost of spreading awareness
Captures part of consumer surplus
Regain customers during decline phase
TOI and ET
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PRODUCT LIFE CYCLE
PRICING
Perceived Value pricing: Psychological
pricing depending on consumer’s
perception of utility- Tanishq jewelry,
Parker pens etc-by creating a hype about
high quality
Value pricing- variant of iv. Try to create
high value and charge a low price ie., price
charged is lower than perceived value
e.g., heavy discounts
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Product Life Cycle Pricing
Loss Leader Pricing: Here, multi product
firms sell one product at a low price and
compensate the loss by another product
Charge lower price for a good that is durable
and has a high value but high price for the
complementary, low value consumable
(HP printers and cartridges)
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VI.CYCLICAL PRICING
Rigid or flexible?
• Rigid price means Firms selling a stable
price irrespective of the business cycle
phase (Flexible pricing is meaningless for
eatables etc where demand does not
change with cycles; dangerous in case of
durables as consumers will wait for the
next recession to buy durables)
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VII. MULTIPRODUCT PRICING
• Tata Sons produces steel as well as trucks and
cars where steel is used as input
• Demand Interdependence: A firm can produce
goods which are substitutes(Zen and wagon R)
or complements.
• If substitutes, either price them the same(coke
and Thums Up) or resort to perceived value
pricing; or even, going price strategy
• One firm’s output may be another’s input
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MULTIPRODUCT PRICING
Ramsay pricing
• A firm should fix the price close to the
marginal cost for product which has high
elasticity and charge substantial margins
for products which have low elasticity.
Price deviations from marginal cost should
be inversely proportional to the price
elasticity of the product,
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TRANSFER PRICING
Transfer Prices are the charges made when a
company supplies goods, services, or financial
services to its subsidiary or sister concern.
Globally, 60% of transactions are between
associated companies. MNCs are required to set
Transfer Prices for supply of goods, technical
know-how, marketing rights etc from parent to
subsidiary or one subsidiary to another.
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TRANSFER PRICING
Govts keep strict watch on this in order to check
tax evasion as companies try to reduce tax
incidence globally by transferring higher income
to low tax jurisdiction and higher expenditure to
high tax countries
• In general regulatory authorities agree on “arms
length price”- i.e., same price should be charged
whether the transaction is between related or
unrelated parties
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VIII. PEAK LOAD PRICING
Peak Load Pricing
• Higher price at peak level of use and lower
at slack time
ExamplesElectricity, telephone charges, air fares
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IX. Administered Price
Administered Price
Originally associated with monopoly
- Now understood as Fixed by authorities
- Specific social objectives- social justice,
correcting imbalances, price stability
-Conflict between ‘public utility approach’
and ‘rate of return’ approach
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Guidelines for Price Fixing
Bates and Parkinson’s Guidelines for Price
Fixing:
• Find out how your costs compare with your
competitors’.
• Keep an eye on the market-if orders are difficult
to come by, drop prices; if easy, raise.
• Goodwill of customers is probably gained more
through advertising than keeping price low
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• If you can sell all your output at prices that give
you substantial profit, consider expanding
production.
• If you find that your sales vary over seasons,
adjust prices
• If your prices seem to be higher than those of
your competitors although they scarcely cover
costs, you may need to take a re-look at your
production methods and organisational process
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• If you are one of very few producers in the
industry, what your competitors are likely
to do may be a more important
consideration in fixing prices rather than
your costs.
• If you are a monopolist and follow a pricing
policy that is seen as being against public
interest, beware of government action and
potential competition…
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Capital Budgeting
Process of conceiving, analysing,
evaluating, and selecting the most
profitable project for investment.
Significant because
i) capital expenditure is generally irreversible
ii) survival of firm depends on how well
planned the capital expenditure is.
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Prerequisites/Steps in Capital
Budgeting
1. Defining Capital Expenditure
Expenditure on acquiring assets which yield
returns over a number of years
-Only long term expenditure involving a
commitment of at least one year is taken
into consideration.
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Defining Capital Expenditure
Examples:
– Expenditure on new capital equipment
– Expenditure on long term assets by a new
firm
– Expenditure on expansion or diversification of
assets and addition to stock by old firms
– Expenditure on replacement of depreciated
capital
– Expenditure on R&D and innovation
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Deciding the Project Period
2. Deciding the Project Period
Determining the span of the project
A clear vision is required fora) Effective planning, execution and control;
b) For possible dovetailing of old plan with the
new
c) Assessment of economies of scale and
determination of plant size
d) Timely arranging of finances
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Appraisal Criteria
3. Choice of Decision Rules/ Appraisal Criteria
-Criteria for accepting or rejecting a project
The first step is to clearly define the objective of
investment.
Objective may be profit maximization, asset
building, regular cash flow or maximization of
short term or long term gains etc.
Normally, criteria for accepting or rejecting is
chosen on the basis of the objective of the firm.
.
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Appraisal Criteria
The second step is to select the criterion for
evaluating the projects.
The important criteria for evaluation are:
i) Pay back period
ii) Discounted cash flow (Present value
criterion)
iii) IRR.
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Choice of Decision Rules
Once the evaluation criterion is decided, the
third step is to decide on the final selection
of the projects.
There are 2 approaches for this a) Accept-reject approach
b) Ranking approach
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Data
4. Relevant, Reliable and Adequate Data on• Alternative avenues of investment
• Cost of the projects
• Expected returns from the projects,
• Period of maturity and productive life of each
project
• Market rate of interest
• Availability of internal and external finances
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i)Pay-back or pay-out method
Pay-back Period :
Time required to recover the total investment
outlay from the cumulative net revenue.
In this period cumulative net revenue equals
original investment.
Projects are ranked in increasing order of their
pay-back period.
All other things being equal, a project with a
shorter pay-off period is preferred.
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Pay-back or pay-out method
Pay- back Period =
Total Investment Outlay/Return per period
If a project costs Rs. 40,000 and is expected to
yield an annual income of Rs. 8000, then,
Pay-off period = 40,000/ 8,000
= 5 years
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Pay-back or pay-out method
- In case inflows are not uniform, it is calculated
by taking cumulative total of annual returns until
the total equals the investment outlay.
- Simple and realistic method
- Crude ‘rule of thumb’ method
- But assumes that cash inflows are known with a
high degree of certainty
- Neglects the profits over the whole life of the
investment and after the pay off period.
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ii) NPV Criterion
Time lag between investment and its returns
-Time Value of Money: A Rupee received
today is worth more than a Rupee
received tomorrow , or present value of an
income expected at a future date is lower
than the same amount received today.
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ii) NPV Criterion
The formula for dn (discount rate in the nth year)
is given by,
Dn= 1/(1+r)n.
This means that the discount rate (d2) for an
income receivable after 2 years will be 1/(1+r)2
and the discount rate (d3) for an income
receivable after 3 years will be 1/(1+r)3. The
discount rate (dn) for an income receivable after
n years will be 1/(1+r)n,
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ii) NPV Criterion
• Formula for calculating PV of an amount
receivable in the nth year is,
• PV= Xn /(1+r)n.
• NPV is the difference between the present
value PV of an income stream and the
cost of investment, C.
NPV=PV-C
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ii) NPV Criterion
Present value (PV) of an income of Rs.200
expected after one year at interest rate of 8%
per annum (r=0.08) would be,
PV=200(1/1+0.08)= 185.19. It means, the
present value of Rs. 200 expected after one year
is Rs. 185.19 at 8% interest.
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iii) Internal Rate of Return (IRR)
Criterion
• Also called Marginal Efficiency of investment or
internal rate of project.
• If a one-year project costing Rs. 100 mn yields
Rs. 120 mn at the end of one year, then the IRR
is 20%
• IRR is the rate of return at which the discounted
present value of receipts and expenditures are
equal.
• As long as IRR >market rate of interest , it is
worthwhile to borrow and invest.
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