Pricing decisions and Pricing decisions and profitability analysisprofitability analysis

Price is the assignment of value, or the amount the consumer must exchange to receive the offering.

Price represents the value of a good/service among potential purchases and for ensuring competition among sellers in an open market economy.

 Whenever a firm takes a pricing decision, the following points are relevant to it:

• Nature and type of competition prevailing in the market

• Firm’s objectives• Firm’s internal and external environment• Likely demand for the product• Departments concerned about pricing

How companies price a product or service ultimately depends on the demand and supply for it

Three influences on demand & supply:1. Customers2. Competitors3. Costs

The economists’ pricing model

• Assumption- The firm will attempt to set the selling price at a level where profits are maximized.

• For Monopolistic/imperfect competition the model assumes that the lower the price , the larger will be the volume of sales.

– The quantity demanded is a function of the price that is charged

– Generally, the higher the price, the lower the quantity demanded

Pricing– Management should set the price that

provides the greatest amount of profit

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Price Elasticity

The impact ofprice changes on

sales volume

Demand is elastic ifa price increase has alarge negative impact

on sales volume.

Demand is inelastic ifa price increase has

little or no impact on sales volume.

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Quantity made

and soldper month

Determining the Profit-Maximizing Price and QuantityRupees

per unit

Demand

Marginalrevenue

q*

p*

Marginalcost

Profit is maximized where marginal cost equals

marginal revenue, resultingin price p* and quantity q*.

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Determining the Profit-Maximizing Price and Quantity

Total revenueRupees Total cost

Total profit at the profit-maximizingquantity and price,

q* and p*.

Quantity made

and soldper month

q*

p*

Calculating optimal selling prices using differential calculus

Assume that a firm has the following demand and cost functions:

Demand function:P= 200-0.4QCost function:TC= 7000+ 70QCalculate the optimal price and sales in units at that

point.

Difficulties with applying economic theory

• Assuming that a firm’s demand curve is known. The precise quantification of the demand schedule for a firm’s products is not easy.

• Total cost & marginal cost functions for various output level are likely to provide only an approximation of the true cost function.

• There are many other factors which influence the quantity demanded in addition to price. 

Eg: quality of the sales effort, the design and packaging of the product, the channels of distribution and credit terms 

• Assuming that firms are profit maximizes, but many legal and social goals and constraints influence management’s desire for profit.

Eg: stability, growth and security are other important goals to managers.

Who determines the price?• Price takers- when there is a competitive

market and the company has no influence on price. (little or no influence over the price)

• Price makers- companies that influence the price.

(have some discretion over setting prices)

Influences on Price• Customer demand• Competitors’ behavior/prices/actions• Costs• Regulatory environment – legal,

political and image related

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Product Life Cycle

http://www.hss.caltech.edu/~mcafee/Classes/BEM106/PDF/ProductLifeCycle.pdf

Cost-based pricing formulae

Company estimates cost of production• Adds a markup to cost to arrive at price which

allows for a reasonable profit

Benefits• Simple approach

Limitations• What % markup to use?• Inherently circular for manufacturing firms• Requires considerable judgment and

experimentation

Cost base Rs Mark-up percentage

Cost-plus selling

price(Rs)

Direct variable costs 200 150 500

Direct non-variable costs 100

Total direct costs 300 70 510

Indirect costs 80

Total costs 380 40 532

Higher level sustaining costs 60

Total costs 440 20 528

Establishing target mark-up price percentages

• Target mark-up percentages are likely to be varied from product line to product line to correspond with well established differences in custom, competitive position and likely demand.

• It vary depend on the business

– Luxury goods-low sales- high mark- up eg: jewelry shop

– Non- luxury goods- high sales- low cost mark-up- Eg: Supermarket

Target rate of return on invested capital

• This approach seeks to estimate the amount of investment attributable to a product then set a price that ensures a satisfactory return on investment.

Eg: cost per unit is Rs 100, annual volume is 10,000 units. If Rs 1000,000 investment is required and the target rate of return is 15%, the target mark-up will be,

15%* 1,000,000 = Rs 15 per unit 10,000 units

Limitation- Difficult to determine the capital invested to support a product. This process is likely to involve arbitrary allocations.

Limitations of cost-plus pricing• Ignores demand 

– Ignores price demand relationship– Assume that prices should depend solely on costs

 • Circular reasoning The approaches involve circular reasoning because

price changes affect the volume of Sales, which in turn affect unit FC which will also lead to further price changes.

• Common fixed costs Fixed overheads are apportioned to products on same

arbitrary basis. There are many different ways by which FC can be apportioned.

The overall effect is that the selling price calculation will vary according to which apportionment method is used.

• Pricing floorIt is claimed that cost-based pricing

formula serves as a pricing “floor” shielding the seller from a loss.

There is no guarantee that total sales revenue will be in excess of total costs even when each product is priced above “cost”.

Reasons for using cost-based formulae– Encourages price stability– Target mark-ups adjusted– Minor revenue producing products.

Pricing reviews

• Sales in units and value– Previous year comparisons– Different markets/channels comparisons– Budget versus actual comparisons

• Forecast versus budget comparison

• Competitors prices and conditions of sales

• Inquiries from potential customers about a product

• Types of customers getting the most and largest price