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F5 - Pricing
Written by Seah Chooi Kheng
Text
Video
Recap
For every company, the price that the company offers for the goods or services is very
important as profits come from the sales and different prices set will have an impact
on the sales volumes and also the company’s profits.
What influence the price?
There are many factors that influence the pricing of product or service, the main one
could be 3Cs:
1. Customer – customer demand is a major influence. According to economic theory,
the higher the price of a good, the lower will be the quantity demanded.
2. Competitor – company cannot set prices without considering the products and
pricing strategies of competitors.
3. Costs – this is the primary factor which accountant will consider. In the long run,
company must cover its costs in order to survive and that’s why price may be set
using mark-up to ensure price covers costs.
There are other factors such as quality, suppliers, inflation, market conditions, product
life cycle and so on to consider.
Price elasticity of demand (PED)
PED measures the sensitivity of the changes in demand to the changes in
price. As according to economic theory, high price low demand, low price
high demand.
PED = % change in demand / % change in price.
For example, price of a good is $1.20 per unit and annual demand is
800000 units. An increase in price of $0.10 will result in a fall in annual
demand to 725000 units. Calculate PED and comment whether the demand
is elastic.
Solution: PED = [(800000 – 725000)/800000] x 100% / [(1.30 –
1.20)/1.20] x 100% = 1.125
The demand for this good is elastic because the price elasticity of demand
is greater than 1. Demand is elastic means that if there is an increase in
price, the demand will change much (sensitive demand).
Demand equation, marginal cost and marginal revenue
This is a skill that you must know in F5, the demand equation is P = a – bQ where P is
the price, Q is the quantity demanded, a is the price at which demand would be nil and
b is the change in price/change in quantity. The demand equation and the formula for
a and b are given in exam.
Now in the new syllabus, you are required to determine optimum selling price and
quantity for an organisation using economic profit-maximising model. According to
economy theory, profit is maximised when marginal cost (MC) = marginal revenue
(MR). Marginal cost is of course the variable cost, marginal revenue is the revenue
from selling one more unit and MR = a – 2bQ. MR equation will be given in exam as
well and it is similar to demand equation, the following example will help you to
understand how everything is applied.
A company is reviewing the price of one of its products. The product has a marginal
cost of $28 per unit and is currently sold for $65 per unit. At this price the demand for
the product is 800 units per week. A market research study shows that for each
reduction in the selling price by $5 per unit, the weekly demand would increase by 40
units, and that for each increase in the selling price by $5 per unit, the weekly demand
would decrease by 40 units. Calculate the optimal selling price.
Solution: A step-by-step approach can be useful to avoid any confusion:
1. We calculate b first, b = change in price/change in quantity = 5/40 = 0.125
2. In exam, formula for a is given, I have another approach, since we have the value
of b now, let us put into the demand equation, P = a – 0.125Q. Now we are also given
information that when price is $65 per unit, quantity demanded is 800 units, put this
information inside the equation and we will have 65 = a – 0.125 (800), so a = 165.
3. Our demand equation is P = 165 – 0.125Q, with this we can get MR already
because MR = a – 2bQ, the only difference is there is a “2” in front of bQ, so MR =
165 – 2 (0.125)Q and finally MR = 165 – 0.25Q.
4. For profit maximisation, MC = MR, we know our MC is $28 per unit from the
information, now put into the equation and it will look like this: 28 = 165 – 0.25Q,
therefore Q = 548.
5. Okay we got out optimal quantity of 548 units, now put this into the demand
equation:
P = 165 – 0.125 (548) and therefore P = $96.50.
In conclusion, our optimal selling price is $96.50 and optimal quantity is 548 units.
Total cost function including volume-based discount
You are required to derive equation for total cost function and the equation is the one
that you seen in F2, y = a + bx (this is covered in quantitative analysis topic).
Sometime company provides volume-based discount for those who purchase in
bulk, volume-based discount will reduce the variable cost per unit, b will therefore be
lower if more units are purchased. (Don’t confuse this one with demand equation,
they are totally different thing, this is probably for your understanding and it is rare to
be asked in exam).
Decisions to increase production and sales
If you are required to evaluate a decision to increase production and sales levels, you
will need to consider incremental costs, incremental revenues and other factors. If the
incremental revenue – incremental cost result in an incremental profit, then this
decision can be taken. Read through my article on relevant costing to understand what
is relevant for decision making.
Pricing strategies
There are a number of different pricing strategies that you should learn, normally you
will be asked to apply the pricing strategies, so you have to suggest suitable pricing
strategies in different situation:
1. Marginal cost-plus – the price is based on the mark-up of marginal cost. Some
managers prefer this method because of its consistency with CVP analysis and
special-order decision making(which require relevant costing). On the negative
side, prices may be set too low, so if this was used, the mark-up percentage should be
made higher.
Talking of mark-up percentage, it is useful to learn how to determine it, you know
that mark-up is profit/costs, so to determine the mark-up percentage, we need to have
a target profit and this can be calculated in many ways following the company or
shareholder’s desire.
For example, shareholder requires company to have return on capital employed
(ROCE) of 20% and company has capital employed of $1000000. Annual variable
costs are estimated to be $100000, calculate the mark-up percentage that the company
would like to set.
Solution: Target profit = $1000000 x 20% = $200000, therefore mark-up % on
marginal cost = $200000/$100000 x 100% = 200%.
2. Absorption cost-plus – absorption costs include direct material, diract labour,
variable production overhead and fixed production overhead. This reminds managers
that all elements of production must be covered by the selling price. These data are
readily available because absorption cost is used for valuing inventory. However, this
will be inconsistent with CVP analysis and fixed production overhead is
distorting when production level is different from budget (it uses overhead absorption
rate which can cause over-absorption and under-absorption).
3. Total cost-plus – total costs will include all production costs plus non-production
costs. If this was used, the mark-up percentage should be reduced so that the price
will not be too high. But this is also subject to the disadvantage of using fixed
costs just like absorption cost-plus.
When a new product is developed, there are two pricing strategies that are frequently
used and each will be used based on the situation.
4. Price skimming – enter the market at a high price to earn as much profits as
possible before competition enters the market. This strategy is used if the new product
is “a unique new product that has not existed in the market before”, a good example
for this is the i-pad, Apple company used price skimming when they first launched ipad.
5. Penetration pricing – go in the market at a very low price, this is to gain the market
share. This strategy is used if the new product is “a unique new product that existed in
the market”, a good example is Samsung galaxy, since i-pad is already existed in the
market and people prefer to buy i-pad, Samsung galaxy is priced at much lower price
than i-pad in order to catch customers’ attention.
The rest of the strategies will be as follow:
6. Target pricing – this uses target costing in product pricing, company will do market
research to determine the price at which a product will sell, this is discussed in my
target costing article.
7. Activity-based pricing – activity-based costing Is used to set price, therefore the
price will be more realistic as the costs calculated are more accurate, this is discussed
in my activity-based costing article.
8. Fixed price tender – the goods will be advertised as being for sale and interested
buyers are asked to tender (make an offer and indicate the price they are willing to
pay). The minimum price that company can sell can be calculated based on relevant
costing and then mark-up.
9. Complementary pricing – this is used when marketing a set of products that tend to
be bought and used together. Products sold have some connection to each other. A
good example is printer and ink, a loss leader (ie. printer, which will be priced at a
low price, company might make a loss by selling this product) may be used to attract
customers to buy. The ink is actually the one that carries a high profit margin and
customers will eventually buy the ink.
10. Product-line pricing – this is applied when selling a range of inter-related or
similar products, for example different colour of pens. All products in the line may
have the same or about the same price.
11. Volume-discounting – a reduction in price will be given for large quantity of
purchases.
12. Price discrimination – the same product is sold at different prices to different
customers. Discrimination prices can be set based on market segment, product
version, place and time.
13. Relevant cost-plus – the prices are set based on the accurate understanding of the
real costsof the product or service. This is normally use in special-order decision, read
my article on short-term decision making.
Mark-up and margin
Just be careful in exam whether the company uses mark-up or margin, it is easy so
mistake must not be done, here is an example to demonstrate the difference.
Cost per unit of product A is $15, company wishes to mark-up 100% or margin 50%,
calculate both price.
Solution: mark-up 100%, price = $15 x 200% = $30. Margin 50%, price = $15 x
100/50 = $30. Both produced same price.
In conclusion, you must be able to apply pricing knowledge into different situation,
this article should be sufficient to give you some idea about different pricing
strategies and how to use economist’s model.