The Pricing Decision and

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Chapter 7

• The Pricing Decision and
• Customer Profitability Analysis

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Factors that Influence the Pricing Decision

• Cost of goods sold.
• Operating cost structure.
• Nature of the product or service.
• Competitiveness of the industry.
• Sensitivity to global issues.
• Legal and environmental issues.
• Price elasticity.

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Price elasticity of demand

• Price elasticity of demand refers to the
  relationship between price and demand. It
  measures the relationship between a change in
  price and a change in demand for a product or
  service.

Percentage change in demand Percentage change in
price
Where the numerical value is less than or equal
to 1, then the price elasticity of demand is
inelastic (demand is less sensitive to changes in
price) Where the numerical value is greater than
or equal to 1, then price elasticity is elastic
(demand is sensitive to changes in price)
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Illustration 7.1 Price elasticity of demand
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Limitations of economic pricing theory

• It assumes there are no other variables that can
  influence demand. For example it ignores the
  effects of marketing on sales demand and it
  effectively assumes that sales volume is solely a
  function of price.
• It also assumes that consumers are perfectly
  informed about the prices of products and
  services and that price is their sole motivation
  in changing their spending patterns.
• The exact shape of a products demand curve is
  extremely difficult to estimate, thus ensuring
  that forecast demand at a given price may be
  misleading.

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Accounting-based pricing methods

• Accounting-based pricing methods tend to
  concentrate on
• accounting measures such as covering costs and
  achieving
• a required profit rather than factors relating to
  the external
• Environment.
• There are three main accounting-based pricing
  methods
• Cost-based pricing.
• Contribution margin pricing.
• Profit oriented pricing.

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Cost based PricingProfit mark-up and profit
margin

• Profit mark-up expresses the profit element as a
  percentage of costs whereas profit margin
  expresses the same profit element as a percentage
  of sales.
• If the selling price of a product is 100 and the
  total cost amounts to 80, then the profit
  element equals 20.
• The profit mark-up that expresses profit as a
  percentage of cost, is calculated as 20 ? 80 x
  100 25.
• The profit margin that expresses profit as a
  percentage of sales, is calculated as 20 ? 100
  x 100 20.

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Cost based pricing methods

• The pricing decision focuses totally on costs,
  ensuring that a selling price is set that covers
  the costs of running the business and will be
  sufficient to provide a profit. The selling price
  is arrived at by simply adding to costs a profit
  percentage to get the selling price.

P C M (C) Where
P selling price C costs M percentage
mark-up or profit percentage based on cost.
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Cost based PricingGross margin pricing
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Example 7.1 Gross margin pricing
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Cost based PricingDirect cost pricing
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Example 7.2 Direct cost pricing
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Example 7.2 Direct cost pricing
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Cost based PricingFull cost pricing
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Evaluation of cost based pricing

• The simplicity of cost based pricing is its main
  advantage and, as an initial first step in
  determining a selling price, it is considered
  quite useful. The main criticism of cost based
  pricing is that on its own it only focuses on
  costs and ignores other factors such as the
  economic environment, competition, and the
  marketing and sales strategy of the business. It
  also does not take into account the required
  level of profitability based on the level of
  investment in the business.

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Contribution margin pricing

• Contribution margin pricing focuses on ensuring
  that each product or service offers a target
  contribution towards fixed costs and profit.
• All costs must be classified into their fixed and
  variable components.
• Contribution margin pricing is based on the
  premise that prices are set using variable costs
  as the base and what the market will bear as the
  ceiling.
• This ensures that although individual sales may
  not provide an overall profit, the sum of all
  sales will provide sufficient contribution to
  cover fixed costs and provide the required
  profit.
• It can provide a high discretionary element to
  price setting

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Example 7.3 Contribution margin pricing
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Example 7.3 Contribution margin pricing
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Evaluation of contribution margin pricing

• The main advantages of contribution margin
  pricing is that it provides great scope for a
  pricing policy that is adaptive to changing
  conditions and takes into account costs and
  market conditions in setting a selling price.
  Its main criticisms are those that are associated
  with the CVP model such as, the assumption that
  all costs can be classified as either fixed or
  variable. It also requires information on the
  demand curve and the price elasticity of demand
  which is quite difficult to predict. As with cost
  based models, it ignores the level of
  profitability as a percentage of the capital
  investment in the business.

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Profit oriented pricing

• The focus is on profit and the return on
  investment required.
• It involves calculating a total sales figure that
  should achieve a return on investment that will
  satisfy investors
• The technique is an extension of the cost based
  and contribution pricing methods with an extra
  variable, profit or return, as part of the
  equation.
• The total estimated sales figure, divided by
  expected forecast demand will give a selling
  price which will ensure the required level of
  profitability for investors, provided costs and
  demand levels remain as forecast.

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Example 7.4 Profit oriented pricing
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Example 7.4 Profit oriented pricing
Or alternatively
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Evaluation of profit oriented pricing

• Profit oriented methods are effectively cost
  based methods taking into account a required rate
  of return (profitability and investment). Thus
  their advantages include those of the cost based
  method with the added advantages that this method
  focuses on profit and investment. The main
  criticisms are, that as with cost based methods,
  it does not focus on the market, price elasticity
  of demand, competition and the economic
  environment and thus is considered quite insular.

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Example 7.5 Pricing hotel accommodation
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Example 7.5 Pricing hotel accommodation
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Example 7.5 Pricing hotel accommodation
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Market based pricing strategies

• Going rate pricing / competition oriented pricing
• Perceived value / psychological pricing
• Loss leader / decoy pricing
• Two-part pricing
• Camouflage pricing

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Multi-stage approach to pricing
Select the target market
Determine the floor price (cost price)
This is the cost of goods but could take into
account clearance lines and loss leaders.
Determine the ceiling price (competitors price)
This is the price charged for the item by
competitors. Provides a reasonable upper limit.
A target mark-up can be applied in order to
achieve the required profit objectives.
Apply a mark-up
Adjust and select the price
If necessary adjust the price (fine tune) to be
consistent with store policy.
The main benefits of the multi-stage approach are
that it incorporates more than one factor and
allows for adjustments or fine tuning to be made.
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Price lining Setting up a number of distinct
prices for a product range. Prices could be
limited to say 25, 32 and 40.
Odd pricing Uses prices like 19.95 or 99.99 to
give impression of lower price. Even pricing Uses
prices like 130 to give impression that price is
not most important factor and prestige would be
tarnished by using odd pricing.
Fixed pricing The price set is the only
acceptable price and will not be bargained
down. Flexible pricing Allows for the expectation
that price can be negotiated down or a bargain
struck.
Pricing Tactics
Multiple unit pricing Providing discount for two
or more items
Complementary goods Promotional price for one
item may encourage purchase of complementary
products at full price.
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Customer Profitability Analysis (CPA)

• Customer profitability analysis (CPA) focuses on
  how individual customer or customer groups
  contribute to profit.
• It is derived from the Pareto principle that
  about 20 per cent of customers account for 80 per
  cent of profit.
• The focus is to ensure that the most profitable
  customers or customer groups receive comparable
  attention from the organisation.

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Benefits of CPA

• By focusing on the most profitable customers and
  providing an improved or commensurate service,
  customer relations improve and customer retention
  increases. Also by identifying the attributes of
  this group, other similar customers may be
  attracted to the organisation.
• By having a knowledge of why certain customers or
  customer groups do not significantly contribute
  to profit (and may actually reduce profit),
  management can assess the difficulties and work
  on solutions that benefit the organisation as
  well as the customer.

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CPA requires

• The process requires the use of an activity based
  costing system and involves gathering detailed
  cost and revenue information for each customer or
  customer group
• Sales details These would include the price
  charged to the customer including any details on
  cash and quantity discounts.
• Cost details These would involve focusing on the
  resources consumed by different customers. These
  cost drivers (the activities that create the
  customer cost) need to be separately identified
  and a cost driver rate associated with the
  activity. Examples of cost drivers under CPA
  would include order costs, sales visits, delivery
  costs, special delivery costs, credit collection
  and non-standard product requirements

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Illustration 7.4 Customer profitability analysis
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Illustration 7.4 Customer profitability analysis