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4: Pricing decisions

Pricing of an organisation’s products or services is an

essential part of its profitability and survival.
Topic List
There are many factors influencing prices and
organisations may have different price strategies.
Pricing policy and the market
Demand
Price strategies
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Pricing policy and Demand Price

the market strategies

1 Demand  Most important factor based on economic analysis of demand

2 Market in which it operates

PERFECT COMPETITION MONOPOLISTIC COMPETITION
A large number of suppliers offer similar
Many buyers and sellers, one product (not identical) products

MONOPOLY OLIGOPOLY
Relatively few competitive companies
One seller who dominates many buyers dominate the market

3 Price sensitivity  Varies amongst purchasers. If cost can be passed on –

not price sensitive
4 Price perception  How customers react to prices. If product price ↑, buy
more before further rises
5 Compatibility with other products  eg operating systems on computers. User wants wide
range of software available
6 Competitors  Prices may move in unison (eg petrol). Alternatively, price
changes may start price war
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7 Competition from  eg train prices ↑ , competition

substitute products from coach or air travel Demand is the most important factor
influencing the price of a product
8 Suppliers  If organisation’s product price ↑ ,
suppliers may seek price rise in supplies
9 Inflation  Price changes to reflect increase in price
Price
of supplies
10 Quality  Customers tend to judge quality by price

11 Incomes  When household incomes rising, price not

Demand
so important. When falling, important
12 Ethics  Exploit short-term shortages through
higher prices?

Demand increases as prices are lowered

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Factors influencing Demand Price

price of a product strategies

Price elasticity of demand (ηη)

A measure of the extent of change in market demand for a good, in response to a change in its price
= change in quantity demanded, as a % of demand ÷ change in price, as a % of price

Inelastic demand Variables which influence demand

 η<1
 Steep demand curve
 Demand falls by a smaller % than % rise in price  The price of the good
 Pricing decision: increase prices
 The price of other goods
Elastic demand  The size and distribution of household incomes
 η>1  Tastes and fashion
 Shallow demand curve
 Expectations
 Demand falls by a larger % than % rise in price
 Pricing decision: decide whether change in cost  Obsolescence
will be less than change in revenue
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Demand and the individual firm The demand equation

Influenced by: The equation for the demand curve is
 Product life cycle P = a - bQ
 Quality P is the price
 Marketing Q is the quantity demanded
– price a is the price at which demand = O
– product b is change in price = elasticity
– place change in quantity
– promotion

The total cost function

Cost behaviour can be modelled using equations and linear regression analysis. A volume-based discount
is a discount given for buying in bulk which reduces the variable cost per unit therefore the slope of the cost
function is less steep.

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Pricing policy and the Demand Price

market strategies

In practice, cost is one of the most important influences on price
Full cost-plus pricing
is a method of
determining the sales
price by calculating the
full cost of the product
and adding a percentage
mark-up for profit.
 Full cost-plus
 Marginal cost-plus
Advantages
Example  Quick, simple, cheap method
Variable cost of production (product A)  Ensures company covers fixed
= $4 per unit costs
Fixed cost of production (product A)
= $3 per unit
Disadvantages
Price is to be 40% higher than full cost  Doesn’t recognise profit-
maximising combination of price
Full cost per unit = $(4 + 3) = $7
and demand
Price = $7 ×
140%  Budgeted output needs to be
100 established
= $9.80  Suitable basis for overhead
absorption needed
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Marginal cost-plus pricing Advantages

is a method of determining the sales price by adding a profit margin  Simple and easy method
onto either marginal cost of production or marginal cost of sales.  Mark-up percentage can be
varied
 Draws management attention
Example to contribution
Direct materials (product B) = $15
Direct labour (product B) = $3 Disadvantages
Variable overhead (product B) = $7  Does not ensure that
Price of product B = $40 attention paid to demand
Profit = $40 – $(15 + 3 + 7) = $15 conditions, competitors’ prices
Profit margin = $15 × 100% = 60% and profit maximisation
$25  Ignores fixed overheads - so
must make sure sales price
high enough to make profit

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Pricing policy and the Demand Price

market strategies

 Market penetration
Other pricing policies low prices when product launched
 New products Market skimming
charge high prices when product launched

 Complementary product pricing use a ‘loss leader’

 Product-line pricing prices reflect cost proportions or demand relationships
 Volume discounting reduction in price for large purchases
 Relevant cost pricing for special orders determine a minimum price
 Price discrimination the practice of charging different prices for the same product for different groups
of buyers