Pricing decisions

Pricing of a product or service refers to the fixation of a selling price to a product or service provided by the firm. Selling price is the amount for which customers are charged for some product manufactured or for a service provided by the firm. The pricing decisions are influenced by both internal and external factors.

Needles, Anderson and Caldwell have suggested external factors and internal factors to be considered for setting a price by a business firm.

Factors to Consider When Setting a Price:

External Factors:

1. Total demand for product or service and its elasticity
2. Number of competing products or services
3. Quality of competing products or services
4. Current prices of competing products or services
5. Customer’s preferences for quality versus price
6. Sole source versus heavy competition (Number of suppliers in the market)
7. Economic and political climate and trends and likely changes in them in future.
8. Type of industry to which the product belongs and future outlook of the industry.
9. Governmental guidelines, if any.

Internal Factors:

1. Cost of product or service
2. Variable costs
3. Full absorption costs
4. Total costs
5. Replacements, Standard or any other cost base
6. Price geared toward return on investment
7. Loss leader or main product
8. Quality of materials and labour inputs
9. Labour intensive or automated process
10. Markup percentage updated
11. Usage of scarce resources
12. Firm’s profit and other objectives
13. Pricing decision as a long-run decision or short term decision or a onetime spare capacity decision

Factors Influencing Pricing Decisions:

Among the many factors influencing the pricing decisions, the three major influences are customers, competitors and costs.

Customers:

Managers examine pricing problems through the eyes of their customers. In­creasing prices may cause the loss of a customer to a competitor or it may cause a customer to choose a less expensive substitute product.

Competitors:

No business operates in a vacuum. Competitors’ reactions also influence pricing decisions. A competitor’s aggressive pricing may force a business to lower its prices to be competitive. On the other hand, a business without a competitor can set higher prices. A business with knowledge of its competitor’s technology, plant capacity and operating policies is able to estimate its competi­tors’ cost, which is valuable information in setting prices. Managers consider both their domestic and international competition in making pricing decisions. Firms with excess capacity because demand is low in domestic markets may price aggressively in their export markets.

Costs:

Costs influence prices because they affect supply. The lower the cost relative to the price, the greater the quantity of product the company is willing to supply. A product that is consist­ently priced below its cost can drain large amounts of resources from an organisation.

In making pricing decisions, all above three factors are important. However, when setting prices, companies weigh customers, competitors and costs differently. Companies selling homogeneous products in highly competitive markets must accept the market price. In less competitive markets, products are differentiated and managers have some discretion in setting prices.

As competition further decreases, the key factor affecting pricing decisions is the customers’ willingness to pay, not costs or competitors. Pricing strategy is now being accepted as a tool for providing customer satisfaction and continuous improvement of the product as well.

Different Methods of Pricing:

The different methods of pricing are generally the following:

1. Total Cost Plus or Full Cost Plus Pricing:

Total cost plus or full cost plus pricing involves all costs plus a profit margin. It includes not only the product’s direct costs but also the indirect costs incurred by the overall company which have to be allocated to different products. An obvious problem in this method is the determination of total costs. If multiple products are manufactured, the cost determination process is complex. In this situation, indirect or non-manufacturing costs have to be distributed among the different products in order to determine finally the full cost of different products.

Advantages:

Full cost plus method has the following advantages:

(1) It is simple to operate if cost structures of products are known.

(2) The pricing decision under full cost approach becomes standardised and such decisions can easily be delegated to lower management.

(3) It ensures recovery of total costs and also provides a reasonable rate of return to the firm.

(4) It helps a business firm to predict the selling prices of other competitive firms, specially of those firms who are having similar cost structures.

(5) This pricing method is important in contracting industries where price of the contracts needs to be determined considering fixed costs also.

(6) This method does not require estimating demand of products before fixing the selling prices. Instead, a standard profit margin on total cost can be used.

(7) This brings stability in the pricing policy and selling price can be justified to customers. On the other hand, prices based on less than total cost such as marginal cost may prompt the customers to believe that the low price will prevail, in absence of which consumers will be dissatisfied and the firm can face serious problem.

(8) Full cost pricing is consistent with absorption costing system.

(9) If similar technologies and techniques are employed within an industry, such that there is likely to be broad comparability of cost structures between different firms operating in the industry, then widespread use of cost-plus methods can lead to a high degree of price stability.

Disadvantages:

Full cost method has the following disadvantages too:

(1) It ignores demand and competition and may result into under-pricing or over-pricing of products.

(2) Fixed costs are likely to be distributed on some arbitrary basis as there are different methods of apportionment and thus total costs of different products will be different depending on which apportionment method is used.

(3) In full cost pricing, the choice of volume or capacity base is very important. There are different concepts of capacity starting from maximum to normal or lower, or expected and different unit product costs will emerge under these concepts. It means selling prices will be subject to wider fluctuations.

(4) This method does not distinguish between relevant costs (e.g., variable costs and incremental fixed costs) and irrelevant costs (fixed costs).

(5) The proper treatment of fixed cost presents a problem in full costs pricing. As volume increases, the fixed cost and full cost per unit decreases. If price follows cost, price goes down and further spurs demand. Unfortunately, the opposite is more distressing. As volume decreases, full cost increases. As price goes up, demand falls and volume declines again a downward spiral. Hence, any attempt to consider the demand situation in establishing the full cost of the product involves circular reasoning.

(6) This method cannot always shield the firm from a loss. When the product is priced higher the unit cost (considering the fixed costs as well) and sales demand falls below the volume level used to calculate the fixed cost per unit, the total sales revenue will be inadequate to cover the total fixed costs. In other words, full cost pricing will ensure recovery of total costs and earning of target profit when sales volume is equal to or more than the volume or capacity level which has been used to estimate total unit costs.

Within full cost plus method, some other cost bases can be used for determining the selling price such as manufacturing cost plus or conversion cost plus.

Manufacturing Cost plus Pricing:

Manufacturing cost (or product cost) plus pricing includes cost incurred specifically for manufacturing the product plus a profit margin. The profit margin added to this cost must cover all operating expenses and generate a satisfactory level of profit. Using the information given in the earlier example, a cost of? 500 will be used. To this cost, a higher profit margin needs to be added to cover non-manufacturing overheads as well as to provide a satisfactory level of profit to the firm.

Conversion Cost plus Pricing:

Conversion cost plus pricing uses conversion cost for deter­mining the selling price and to this cost a profit margin is added. This pricing methods is generally followed when the customer provides the materials. This method depends on the assumption that greater profits can be realised if efforts are directed to products requiring less labour and overhead because more units can be produced and sold.

Situations under which Full Cost plus Pricing can be used:

Most companies rely on full cost information reports when setting prices.

There is economic justification for reliance on full costs for pricing decisions in three types of circumstances:

1. Many contracts for the development and production of customised products and many contracts with government agencies specify that prices should equal full costs plus a markup. Prices set in regulated industries such as electric utilities also are based on full costs.
2. When a firm enters into a long term contractual relationship with a customer to supply a product, most activity costs are likely to emerge and full costs become relevant for the long term pricing decisions.
3. The third situation is representative of many industries. When demand is low, firms adjust the prices downward to acquire additional business based on the lower incremental costs when surplus capacity is available. Conversely, when demand for products is high, firms adjust the prices upward based on the higher incremental costs when capacity is fully utilised.

Because demand conditions fluctuate overtime, prices also fluctuate overtime with demand conditions. Although the fluctuating short-term prices are based on the appropriate incremental costs, over the long run, their average tends to equal the price based on the full costs that will be recovered in a long term contract. In other words, the price determined by adding on a markup to the full costs of a product serves as a bench mark or target price from which the firm can adjust prices up or down depending on demand conditions.

On the strengths and weaknesses of full cost-based prices, Decoster et al. observe the following:

(i) Although the cost-based pricing formula is simple, it does not agree with economic theory, because it ignores the relationships between demand and price and between price and volume. The price determined by full cost plus a markup may be so high that there are no customers. If so, some of the volume potential of the firm will be idle. There is a circularity problem. Volume is used to determine price in the full cost based pricing formula, yet the number of units the company sells and therefore the firm’s volume may depend on price.

(ii) A principal reason (for the wider use of pricing policies based on full cost) is the inability of the decision maker to quantify the demand curve. This inability to apply economic theory leads the business manager to apply intuitive judgment coupled with trial-and-error methods. Many decision-makers begin with a full cost approach and then, on the basis of buyer’s reaction, adjust the price. In this way, the full cost based price represents a first approximation a target price whose markup must be adjusted to meet the actual market place.

(iii) Another reason for the adoption of full costs-based prices is the belief that theory repre­sent a “floor” or “safe” price that will prevent losses. This safety factor is more illusory than real. Although the per-unit sales price will cover the per-unit full cost, losses may still be incurred if the sales volume is not achieved.

(iv) Perhaps the most convincing reason for the use of cost-based prices is that the costs of a particular firm are comparable with costs of other firms in the industry. One firm’s costs are reason­able estimates of its competitors’ costs, and hence its prices are likely to be comparable to those of its competitors. If most companies use similar facilities to perform similar activities, they will have similar full costs, and thus, similar prices if they produce at about the same volume level.

2. Marginal Cost Plus Pricing:

This method, also known as contribution approach, uses only variable costs as the basis for pricing. Fixed costs are not added to the product, service or contract. This pricing method emphasises the relationship between prices and costs that vary directly with sales. It ignores fixed costs altogether. However, fixed cost should be taken into account in determining the profit margin to be added to variable costs to arrive at the selling price.

Marginal cost approach helps a business firm to enter into new markets easily, to increase its competitive position in the existing markets, to survive during trade depressions, to utilise spare available capacity, to dispose off surplus or obsolete stock, to make profitable special order decisions.

Marginal cost-plus pricing brings some disadvantages to the firm as well. For instance, recov­ery of fixed costs may be doubted. There is likely to be undesirable competition for cutting prices to a lower level. In case management decides to increase lower marginal cost pricing, it may face dissatisfaction from the consumers.

Using the information given in the earlier example, marginal costs of Rs 350 can be used to set the selling price. Obviously, it indicates the cost below which the price should not fall; otherwise the company would have losses. Also, a higher profit margin can be added to marginal cost which may work as a long term selling price even for normal sales. For instance, if the profit margin of 100% is added to marginal costs of Rs 350, the selling price will be Rs 700.

Marginal cost plus method is useful in those situations where a firm has recovered its total fixed costs from sales in the normal market but is unable to increase its further sales in that market. If still spare capacity is available, the firm may attempt to sell to some other customers or markets at lower (marginal cost-plus) price which will provide some contribution towards fixed cost and thus profit will increase. For a long-term pricing policy, it is necessary that a higher profit margin should be added to marginal cost to recover both variable and fixed costs in the long run. A smaller profit margin will lead to low sales revenue which will not be sufficient to recover fixed costs.

3. Differential Cost Plus Pricing:

This method involves adding a markup on differential cost which is the increase in total cost resulting from the production of additional units. Differential cost pricing differs from variable cost pricing in which a mark up on variable cost is added, whereas both variable costs and fixed costs are included in the differential costs on which a markup is determined. This method can be applied where some revenue above differential cost may be received rather than no revenue at all. Such additional revenue makes some contribution towards the recovery of fixed costs which are already incurred.

4. Standard Costs:

Standard costs represent the costs that should be attained under effi­cient operating conditions at a normal capacity. The cost-based methods have some adverse implications and include costs due to inefficient manufacturing, wasteful operations etc. That is, it is likely that unnecessary costs may be assigned to the product. On the other hand, standard costs use costs from efficient operations plus the agreed profit. Also, pricing can be done more quickly.

However, before standards are used as a basis for pricing decisions, care should be taken to see that the standards established reflect current conditions. While using standard costs, variances must be controlled carefully to ensure that prices reflect realistic production costs. If standard costs differ from actual costs significantly, the standard costs should be modified to conform to real operating situations.