Why are Pricing decisions very important to an organization?
Pricing decisions are very important decisions organizations need to make. It can make or mar a business. If prices are too high, there is a tendency that consumers avoid your products and move on to similar products with lower prices. On the other hand, if prices are too low, to the point of not being able to cover your average variable costs or fixed costs, you might need to shut down your business.
Now that we have established the importance of pricing decisions, let’s move on to the next section which would be taking a critical look at factors influencing an organization’s pricing policy. I hope you enjoy.
Factors influencing an organization’s pricing policy
1)Price sensitivity: The price sensitivity of a product greatly influences how an organization would set its price. If the product is highly elastic, the organization might not be able to fully pass on the cost of purchases. On the other hand, those that can pass on the cost of purchases will be least sensitive or least elastic.
2) Quality of the product: The quality of the product determines the reasonable price range the company can peg its price at. If a company’s product can be differentiated from competitors, and people perceive its product to be of better quality, then your product might be able to command a higher price.
3) Competitors: Depending on the type of market you are in, you may need to watch your competitor’s every move. In some industries pricing moves in unison, while in others a price change by one participant may lead to price wars. For an example of price wars as a result of competition, check out Pepsi Co’s case study analysis.
Another example is the competition by the major telecommunication networks in Nigeria (Globacom, Airtel, Mtn, Etisalat). The service most contested for by these giants is internet service. Globacom has always been the network to steer up price reductions and price wars on internet data plans between the big four telecommunication networks in Nigeria. After a poor internet service in the month of May (as a result of their 3G and 3.5G servers being down due to optimization), Globacom decided to shock the Nigerian internet market with an irresistible offer in a bid to retain their infuriated customers, and if lucky, cart away some of their competitors’ customers.
How irresistible could the offer have been?. Well, it was too good to be true. At the prevalent price, they doubled the data cap of all their internet bundles. I subscribed to their 3,000 plan prior to the revised offer, and that plan availed me 6gb worth of data. The revised plan however offers 12gb now at that same price. Awesome right? it sure is! Although i am very impressed with their revised plans, I must confess that during the month of May I was appalled at their service. I barely received network for the internet i subscribed to. After about 10 days of no internet service, i called their customer care line and after a lackadaisical reply, I made up my mind to migrate to one of their competitors at the end of my subscription period.
Exactly three days before the end of my subscription, Globacom hit me with this wonderful offer, and all was forgiven. I even ended up subscribing to higher plan with a value of 8,000 NGN, and a data cap of 48gb. This is what has been powering my phone and laptop ever since; I discontinued the exorbitant charge for internet service I was receiving from a 4G network for my laptop. You see, they were successful in retaining me and even stealing me away from one of their competitors.
How did the others react? Airtel, Mtn and Etisalat responded immediately by reducing their previously exorbitant data prices; although they are still higher than Glo’s plan if you look at the cost per gigabyte (gb). These communication networks are oligopolists and it is in the nature of oligopolists to watch closely every action their competition takes in order to give a suitable reaction. If they do not, they might end up losing some of their market share.
Let’s see some other reactions a firm might give in response to a price reduction by its competitor.
- It would maintain the existing price if it expects that only a small market share would be lost, and if it would be more profitable to keep prices at their existing level.
- The firm might decide to maintain its price, while further differentiating its product from its competitors. Differentiation could be by product upgrade, product change, advertising or prolonged after sales service.
- It may raise its price and use mot to finance a major upgrade of its product, and launch advertising campaigns to emphasize the new and improved quality of the product.
4) Suppliers: If an organization increases the price of its products, with no real reason behind it, its supplier may also want to “take a bite out of the cake” by increasing the cost of supplies. The end result is the passing of the cost to the consumers, especially if the product is price inelastic. To mitigate this, some organizations adopt a backward integration strategy whereby they begin to produce what was previously supplied to them.
5) Inflation: During periods of inflation, a firm might need to change prices to reflect increases in the price of supplies, and increase in the price of other factors of production such as rent and labour. During this period, an organization incurs what is called menu cost. Read more on menu cost.
6) Product Range: If a company produces products that are substitutes for each other, or complements to each other, the pricing manager is going to have to look at the big picture and develop pricing strategies to profit from the whole range of products rather than focusing on the profit on each single product.
7) Market: The market for the product plays a big role in determining what price an organization would set for its products. They are basically four types of market scenarios, and I would be analyzing how these markets can affect the pricing of a product.
- Perfect competition: It is characterized by the sale of homogeneous products (i.e the same product). Here there are many buyers and many sellers in the market. Prices are usually fixed and neither buyer nor seller has any power over the price of the product; they both must accept the prevailing market price. In essence, sellers in a perfect competition are price takers.
- Monopolistic competition: The market is characterized by similar heterogeneous products which are mostly differentiated by branding and packaging. Hence, they are not perfect substitutes. Because the products are similar, price would be somewhat elastic. This is because a consumer who is indifferent about the packaging or branding may prefer to move to competitors with similar products at a lower price. Unlike the perfect competition where sellers are outright price takers, monopolistic competition gives sellers a little power to determine prices due to the slight differences in products. It should be noted that if sellers end up setting an unrealistic price, they may end up losing a major part of their market share, if not all.
- Oligopoly: The Globacom & co discussed above is an example of oligopoly market. An oligopoly market is a market where relatively few competitive companies determine the market price, and there is a large barrier to entry in the form of enormous startup costs or lack of technical know-how. In this market, every player has the ability to influence the market prices, and the unpredictable reaction from other players makes it difficult to project what market prices would be in the future. Competition by oligopolists benefit the end users as either quantity is increased, along with quality, or price is reduced. Anyway it goes, the end user ends up getting more for less. The oligopolists end up bearing the brunt of their competition. This is the reason why most oligopolists form a cartel with their competitors for the purpose of price harmony. A cartel is an association of manufacturers or suppliers for the purpose of maintaining prices at a high level and restricting competition. It should be noted that cartels are illegal in the United States, and any company caught would be heavily fined.
- Monopoly: A monopoly is a market characterized by a single seller and many buyers. In this market, the single seller dominates many buyers and the control of either price or quantity; he can control one at a time but not both. So it is either he increases the price while keeping the quantity constant, or he reduces the quantity while keeping price constant. In this sense, a monopolist can use his market power to set a profit maximizing price.
8) Demand: The demand for a product is a major factor producers need to take into cognizance when setting prices. As a rational consumer, you would prefer more (quantity) for less (price) wouldn’t you? Although there are some goods known as ostentatious goods that increase in demand as the price increases.
The law of demand states that all factors being equal, the higher the price of a good, the lower will be the quantity demanded, and the lower the price of a good, the higher will be the quantity demanded (note this doesn’t apply to ostentatious good). Price elasticity of demand measures the responsiveness of quantity demanded to a change in price. Elasticity of demand is a major factor that affects the pricing of the product. When demand is very responsive to a change in price of a product, we say demand is elastic. On the other hand, if the quantity demanded is not very responsive to a change in price, we say demand is inelastic.
Information from elasticity can assist management in making pricing decisions. For example, a product is highly elastic and the company raises its price, consumers would run away from such a product and move over to its competitors. The end result is that the company loses both market share and overall profits. Read more on elasticity of demand and how it affects pricing decisions.
Establishing the optimum selling price
Let’s assume that management has carried out some research and have drafted estimates of sales demand at different price levels, and also of expected total cost at different volume levels. From this information, we can determine what the optimum selling price should be. Lets take an example:
Assume that the estimate of sales demand is as follows:
|Price||Units of sales||Total revenue||Marginal revenue|
Estimates of total costs at different volume levels:
|Price||Demand output||Total Costs||Marginal Costs|
After we have received the information of estimated sales and estimated costs, we go ahead to draw up a table of estimated profit.
|Price ($)||Units sold||Total revenue||Total Cost||Profit|
From the above computation, it is quite palpable that profits are maximized at a selling price of $44 when 23 units are sold. We arrive at the conclusion that based on the information received; our optimum selling price would be $44 at 23 units sold. This is because as you can see from the table, profits are maximized at that level.
The role of cost information in pricing decisions.
In our discussion of markets, under factors influencing an organization’s pricing policy, we said that sellers in a perfect competition are price takers, and we can deduce from the discussion that the remaining 3 types of sellers (Monopolistic competition, Oligopoly and monopoly) are to some extent price setters. In this section, we would be having a close look at the role of cost information in pricing decisions for both price setters and price takers. We would be breaking the discussion down to four categories which are:
- A price setting firm facing short run pricing decisions
- A price setting firm facing long run pricing decisions
- A price taker firm facing short run product mix
- A price taker firm facing long run product mix decision
Let’s start with the first one:
Price setting firms facing short run pricing decisions.
Let me paint a picture here to explain: You are producing a product X but production is not yet at full capacity, and you receive a one-time special order for the product at a selling price slightly lower than the normal selling price, should you accept the order? Well it depends. Most of the resources required to fulfil the order, for example plant and machineries, packaging equipment etc have already been acquired, so it should not count towards making a decision. What would really matter in this case would be the incremental cost likely to be incurred as a result of taking this one-time special order. Examples of incremental costs that could be incurred include:
- Extra materials required to fulfil the order
- Extra overtime or labour costs
- Costs of special equipment, if any, that would be required to fulfil this order
If this type of one-time special order occurs, the price setting firm should ensure that the price agreed upon exceeds any incremental cost that would be incurred to fulfil the order. Any excess of revenues over incremental costs will provide a contribution towards fixed costs, and after settling fixed costs, serve as profit for the organization.
So remember guyz, it is not compulsory that the bid price of the special order is the same or higher than the normal selling price. So far the company is not producing at full capacity, and the bid price is higher than the incremental costs, then the order can be considered for acceptance.
To reiterate, any bid for a one-time special order must fulfil the following conditions before being accepted.
- Sufficient capacity is available for all resources that are required to fulfil the order. Ie the company must not be producing at full capacity, and also opportunity costs of the scarce resources must be covered by the bid price.
- The bid price would not affect the future selling price of the product
- The bid price must cover any incremental cost
- The order will utilize unused capacity for only a short period, and capacity would be freed up for better opportunities if and when they come.
Price Setting firms facing long run pricing decisions
There are three situations that can occur in pricing decisions for price setters in the long run. They are:
- Pricing customized products
- Pricing non-customized products
- Target costing for pricing non-customized products.
Now let’s take them one after the other:
Pricing customized products: In pricing of customized products in the long run, the firm should seek to price their product or service at a price that covers all the resources that are committed to it. I.e the full cost or long run cost. To be able to achieve this, (setting an optimal price in the long run) the firm must device a suitable costing system that would prevent under costing or over costing its products.
The resulting effect of under costing is that prices may be set at a price too low to cover the long run resources committed to a product, and this is a risk to the business. On the other hand, over costing might chase away profitable business opportunities. For example, orders that are pricey may be lost to competitors selling similar goods at a lower price. Also, high prices discourage both existing and potential clients of the business.
Full cost or long run cost mentioned above refers to the sum of the cost of all these resources that are committed to a product in the long run. Price setters usually tend to use the Activity Based Costing system in the long run as opposed the marginal costing system in the short run.
Let’s take an example using the Activity Based Costing System (ABC):
Mowe Company Ltd recently received a price quotation from one of its regular customers for an order of 1000 units with the following characteristics:
|Direct Labor per unit||2 hours|
|Direct material Per unit produced||$40|
|Machine hours per unit produced||2 hours|
|Number of components and material purchases||10|
|Number of production runs for the components prior to assembly||5|
|Average set up time per production||2hours|
|Number of deliveries||2|
|Number of customer visits||4|
|Engineering design and support||70 hours|
|Customer Support||40 hours|
Cost details for the activities required for production are:
|Activity||Activity Cost driver rate|
|Direct Labor processing||$18 per Labor hour|
|Machine processing||$20 per machine hour|
|Purchasing and receiving materials and components||$150 per purchase|
|Scheduling production||$200 per set up|
|Setting up machines||$140 per set up|
|Packaging and delivering||$500 per delivery|
|Invoicing and accounts administration||$150 per customer order|
|Marketing and order negotiation||$400 per customer visit|
|Customer support activities including after sales service||$70 per customer service hour|
|Engineering design and support||$50 per engineering hour|
Computation of product pricing decision using ABC system
|Unit level expenses|
|Direct materials (1000 x $40)||40,000|
|Direct labor (1000 x 2hrs x $18)||36,000|
|Machining (1000 x 2hrs x 20)||40,000||116,000|
|Batch level expenses|
|Purchasing and receiving materials (10 x $150)||1,500|
|Scheduling production (5 x $200)||1,000|
|Setting up machines (5 production runs x 2hrs x $40)||1,400|
|Packaging and delivery (2 deliveries @ $500 per 1)||1,000||4,900|
|Product sustaining expenses|
|Engineering design and support (70hrs x 50)||3,500||3,500|
|Customer Sustaining expenses|
|Marketing and order negotiation (4 visits x $400)||1,600|
|Customer support (40hrs x $70)||2,800||4,400|
|Total Cost of resources (excluding facility sustaining costs)||128,800|
Alongside the above cost estimation, management would want to add a fair share of facility sustaining costs. After apportioning a share of the facility sustaining costs, management can go ahead to get the selling price at total cost of resources + share of facility sustaining cost + mark-up towards profit contribution.
Pricing non-customized products
What if an organization wants to give discounts for large and unknown volumes of a product it already sells to thousands of different customers, and they are seeking your help as an accountant to develop a pricing strategy, what do you do? Well it is easy. Once you can get the estimates of total costs for a range of activity levels, you can determine the selling price and discounts to be given on the range of volumes.
Let’s take an example:
Efiko Enterprise limited produces and sells product enigma in an already established market. In a bid to increase market share and also strengthen customer loyalty, Efiko seeks to offer discounts for large sales volume. They believe discounts should start from single order values of 20,000 units to 120,000 units. Nonetheless, they seek to maintain their contribution of $20 per unit. Note that the normal selling price is $150. You are required to calculate the acceptable selling price for the acceptable single order units.
|Sales Volume (000’s)||20||40||60||80||100||120|
|Total Cost (‘$000’s)||2500||4950||7300||9600||11950||14300|
|Required profit contribution ($)||400||800||1200||1600||2000||2400|
|Required Sales revenue ($000’s)||2900||5750||8500||11200||13950||16500|
|Required SP to achieve target contribution||145||143.75||141.67||140||139.5||139.167|
|Discounts on selling price of $150||3.33%||4.167%||5.55%||6.67%||7%||7.2%|
Derivation of figures:
Required profit contribution = ($20 per unit contribution x sales volume)
Required sales revenue = (Total cost + Required profit contribution)
Required Selling price to achieve target contribution = (Required sales revenue / sales volume
Discounts on selling price of $150 = [($150 – Required selling price to achieve contribution) / $150]
Target Costing for pricing non customized products
In Target costing, we determine our target selling price first, and then we set a desired profit. After doing this, we deduct our desired profit from our target selling price to arrive at our target cost. The main aim is to ensure that future cost will not be higher than the target cost. Read more on target costing.
Price taker firm facing short run product mix-decisions
As with the price setting firm in the short run, a price taker firm may accept one-time orders if the incremental sales revenues exceed incremental sales costs, and if it provides contribution towards committed fixed costs.
Conditions a special order must meet before it is accepted in the short run is:
- The firm is not yet at full capacity, and there is enough capacity available for all resources that are required for undertaking the order.
- The order would not affect the normal pricing of the product, and the company would not commit itself to repeat orders that are priced to cover only short term incremental costs.
- The order will utilize unused capacity for only a short period and the capacity will be released for use on more profitable opportunities.
Apart from one-time special orders, an organization might want to review their existing product mix over a short term horizon. To do this, they carry out a profitability analysis of each of the products, measuring the incremental revenues against incremental costs, and then comparing it with other products.
The basic rule is that in the short term, products should be retained if their incremental revenues exceed their incremental costs. If however there are short term constraints, and sales demand exceeds its productive capacity, then the product mix should be based on maximizing contribution per limiting factor.
Price taker firm in the long run
Similar to a price setter firm facing long run pricing decisions, a price taker firm in the same situation (i.e in the long run) should also seek to produce products that exceed the cost of all resources committed to it. To analyze this, we undertake periodic profitability analysis to distinguish between profitable and unprofitable products. Activity based profitability analysis should be used to evaluate each product’s long run profitability.
In the long run, when making a decision on discontinuation of products, a critical study is advised. This is because a product in a product group might be making loses, but still contributes positively to towards the total fixed cost of the firm. So we have to analyze if the product is making some contribution towards it’s share of fixed costs, or if it is not making any contribution towards covering its own variable cost talk less of its share of fixed cost.
Lets take an example. The following products represent the product mix of a company, the management has employed your services as an accountant to advise them on the discontinuation of any under-performing product in order to boost total profit. Through your analysis, you obtained the following information below. You are to advise management on the product to discontinue if any.
|Variable Cost (‘$000)||80||60||45||75|
|Share of fixed cost||(10)||(15)||(10)||(5)|
From the example above, product C makes a positive contribution towards covering its share of fixed cost, but it is insufficient to cover the total cost associated with the product. Product D on the other hand makes a negative contribution which doesn’t add anything towards covering its share of fixed cost.
When making a decision on whether to discontinue product C or D, we need to check if any of the products make a positive contribution towards covering fixed cost. After doing this, it is advisable to continue the product (Product C) that makes a positive contribution towards fixed cost (if there are no better or more profitable opportunities), and discontinue the product (product D) that makes a negative contribution.
My apologies for this note being so long. Hope you enjoyed it and learnt a great deal from it. Thanks and God bless.
Colin Drury., Management Accounting for Business
Jae sim., Joel siegel., Schaum’s outline of managerial accounting