Pricing Methods

Top 6 Pricing Methods (Price Setting Methods)

by S. Jaideep Pricing

Pricing method leads to a specific price. There are various methods used for setting price of the product. Some methods are cost-oriented while some are market-oriented. Each of the methods has its plus and minus points, and applicability. Marketing managers apply the appropriate method for setting the price. The appropriate method can be decided on the basis of the study and analysis of internal and external aspects as well as suitability of the method. Following part describes some widely used pricing methods. See Figure 3.

1. Mark-up Pricing Method:

This is the most commonly used method. The method is also known as cost-plus pricing. In this method, a standard mark-up (or profit margin) is added to the product costs. This method is used in construction business, professions, and even for consumer goods. The method can be used only when company has necessary data about various costs and expected sales. Company may prefer fixed per cent of costs or fixed per cent of selling price.

Let us illustrate the method:

XYZ Company Limited expects annual sales of 100000 units.

Variable cost per unit is Rs. 10.

Fixed cost is Rs. 500000.

Company wishes to earn 20 % mark-up on selling price, or 25% mark-up on costs.

Cost per unit = variable costs + (Fixed costs/ Unit sales)

= Rs. 10 + Rs. 500000/100000

= Rs. 15

Now, company wants 20% mark-up on selling price,

Selling price = unit cost/(1 – desired mark-up)

= Rs. 15/ 0.8

= Rs. 18.75

Alternatively, suppose company wants 25% mark-up on unit cost,

Selling price = unit costs + (15 x 25%)

= Rs. 15 + Rs. 3.75

= Rs. 18. 75.

Naturally, when cost is taken as a base, the rate should be high, as indicated in the example. Company may follow either of approaches, but must know the difference.

Merits:

Keeping in mind a lot of forces affecting market, the mark-up rate may be kept high or low, fixed or variable.

This method is widely used. It offers following merits:

i. It recovers costs as rapidly as possible.

ii. It is relatively a simple method to practice.

iii. If it is used by the entire industry, price tends to be similar. And, price competition can be minimized:’

iv. Experts believe that cost-plus pricing method is fair for both – buyers and sellers.

Demerits:

The method suffers from following limitations:

i. It ignores current demand.

ii. It ignores consumers’ perception of price.

iii. It doesn’t consider competition. (However, mark-up rate may be decided on the basis of competition).

iv. It is difficult to estimate exact sales.

v. The method is meaningful only if price of raw material and other inputs remain unchanged. Otherwise, the method may be misleading.

2. Perceived-value pricing Method:

Perceived-value pricing is a market-oriented method for setting the price. Here, price is based on the consumers’ perceived value of the product. Consumers’ views on price are given priority. Company takes consumers’ perception of value as a key to set the price, and not its own cost and objectives.

Company tries to measure the views of buyers regarding price of the product. Manager explains the consumers about total offers, including core product (key benefits and features), product-related aspects (like brand image, reputation, novelty, etc.), and product- related services (such as after-sales services like free installation, free home delivery, guarantee, etc.) and asks them to estimate price for that product or for total benefits offered by the product.

The key to the perceived-value pricing method is to measure accurately the market’s perception of the offer’s value. The seller with inflated views of his offers will overprice the product while with underestimated views will charge less than what it should be. Market research is needed to estimate market perception of price. Let us take an example,

ABC Company Limited wants to set price for the motorbike by the perceived-value method. Market research officer considers following aspects and takes the views of buyers.

Buyers respond as under:

Rs. 30000 if the bike is similar to competitors’ motorbikes

Rs. 2000 is the price premium for novelty, shape, new getup, and colour.

Rs. 3000 is price premium for the highest mileage per litre petrol.

Rs. 2000 is price premium for replacement guarantee and two extra free services.

Rs. 2000 is price premium for durability and reliability.

Rs. 1000 is price premium for special safety measures.

Rs. 40000 is the normal price as per consumers’ perception.

Rs. 2000 discount is for DIWALI special offer.

Rs. 38000 is final ex-showroom price as per consumers’ views (or perception).

Merits:

This method offers following merits:

i. Perceived-value method matches with consumer orientation.

ii. It considers indirectly competitors’ offers.

iii. It is more realistic than any other method.

iv. Perceived-value can be taken as base, with little adjustment in costs and objectives, the most suitable price can be set.

Demerits:

However, there are certain practical problems in setting price via this method.

Main limitations include:

i. It is practically difficult to measure perception of the market. Unless relatively a large sample of consumers is contacted, views may be misleading.

ii. A lot depends on the person who estimates buyers’ perception of price. Possibility of bias cannot be ignored.

iii. The method is based on the trust. If their response is not normal, it is a wasteful exercise.

iv. All the limitations of marketing research are equally applicable to this method.

v. It is, compared to the first method, difficult and complex to understand and apply.

3. Going-rate Pricing Method:

This is also said as competitive parity method. Even, sometimes, it is called as competition- oriented pricing. The method is, normally, followed by small firms, said as ‘the followers’ In going- rate pricing method, the company gives less attention to its own costs, objectives, or product demand. But, pricing decision is largely based on competitors’ prices.

The company may charge the same, more, or less than major competitors. The notion is “follow the leader,” or “leader is right.” One must note that company doesn’t select a price, which is far below or much higher than the real. However, competitors’ pricing is taken as a base. And, final price may be set slight high or low depending upon objectives, qualities of product, and services offered.

Merits:

The method can be justified on the following grounds:

i. It is the only way to set the price when costs are difficult to measure and competitors’ response is uncertain.

ii. It considers competitors pricing policies as a base. In contemporary marketing practices, it is more relevant method.

iii. Going rate pricing brings uniform pricing in the industry. It ensures fair return to sellers and harmony in industry.

iv. It may protect consumers’ from cheating and misguiding. They can buy the similar product at a, more or less, same price.

Demerits:

Going-rate pricing method has been criticized as under:

i. This is not an ideal method for pricing because it is one-sided, i.e., only competition factor is considered.

ii. Company’s objectives, costs, qualities, services, and consumers’ perception of value have been ignored.

iii. It is senseless to follow blindly the leaders or strong competitors as every firm has its special problems, opportunities, situations, and capabilities.

iv. Temporary pricing of competitors may lead to erroneous decision.

4. Sealed-bid Pricing Method:

Sealed-bid pricing is followed in construction or contract business. It is also a competitive pricing method. Here, price is selected on the basis of sealed bids (quotation or estimated price) for the jobs.

The firm sets its price on expectations of how competitors will price the product. The firm wants to win the contract requires submitting the lower price than competitors. However, costs and profits are not totally ignored. The firm cannot set price below the costs.

It is called as tender pricing also. In response to the proposal of jobs or works, interested parties (businessmen or marketers) have to fill the tender (send quotation or estimated costs) stating price and conditions of work and send in forms of sealed-bids.

The bid is an offer of price for particular work or product. Generally sealed-bids (sealed envelops containing a bid) are invited for a competitive work. Offers or proposals come from charitable trusts, companies, organisations, or governments. In our country, we say this method as “tender,” and proposal of jobs as a “tender notice.”

Mostly, the tender notice is published in newspapers or circulars. The offer or proposal for work contains type of work or job, time to complete the work, quality of work, and other similar conditions.

In response to the tender or proposal, interested parties have to send sealed-bids stating their prices and conditions within the permitted time. In this method, the party inviting the sealed-bids is customer and those who bid by sealed quotations are the marketers (because they will serve the inviting party).

On a due date – either publicly or otherwise – the sealed-bids (or quotations) are opened, and the bid with lower price and more favourable conditions is selected. Rate of selected bid is the price for the job. The selected bid is given the business. The method has its plus and minus points.

5. Target Return Pricing:

This is one of the cost-oriented methods for setting price of the product. Here, the firm determines that level of price at which it can yield the target return on investment. Here, return on investment is taken as a base for price determination.

Attempts are made to recover the cost of investment. Mostly, government Companies, public utilities, cooperative societies, and the similar organisations fix pricing for their products on this basis to ensure minimum return on investment.

For example, Jai Hind Private Limited company expects to sell 10000 school bags of premium quality in the current year. Fixed costs allocated to this line is Rs. 5, 00000. Variable costs estimated for each bag is Rs. 100. Total investment (covering development, production and marketing) on this line is Rs. 50, 00000. Company wants 20% return on investment.

Return on Investment (ROI) = Rs. 5000000 x 20% = Rs. 1000000

Costs per unit = variable cost per unit + fixed cost per unit

= Rs. 100 + (Rs. 500000 ÷ 10000 units)

= Rs. 100 + Rs. 50

= Rs. 150.

Target return (profit) per unit = Rs. 1000000 + 10000 units = Rs. 100.

Selling price per unit = cost of product + Return on Investment.

= Rs. 150 + 100

= Rs. 250.

If company wants to earn 20% ROI (Return on Investment), the selling price should be Rs. 250. If RIO is more, definitely selling price will go up and vice versa.

This method can be used only when company is capable of estimating accurately the sales, variable costs, and fixed costs. The price so determined will be meaningful only if the company can achieve expected sales. Here, we assume that company might have estimated sales keeping in mind quality of product on one hand, and competition on the other hand.

6. Break-even Analysis Method:

Some companies set the price for their products by Break-Even Analysis (BEP method). It is a managerial tool that establishes relationship among costs, volume of sales, and profits. It is also known as cost-volume-profit analysis.

It involves developing tables and/or charts that help a company to determine at what level of sales, the revenue will be equal to the total costs. Under this method, attempts are made to find out volume of sales at which total costs are just equal to the sales revenue. This is such a level of sales at which there is no profit, no loss.

Sales Revenue = Total Costs.

This level is called BEP (break-even point), at which the firm has neither profits nor losses. The firm just covers its total costs. When sales revenue exceeds the total costs, the result is profit; and when sales revenue is less than total costs, the result is loss. Thus, BEP is the position of sales at which sales revenue is just equal to total costs. BEP can be calculated either by a formula or by a chart.

Formula Method:

BEP can be calculated using formula as under:

For example,

Hindustan Products Pvt. Ltd. gives following details:

Selling price is = Rs. 200 per unit.

Variable cost is = Rs. 100 per unit.

Fixed cost is = Rs. 500000.

Contribution is = selling price – variable costs

= (Rs. 200 – Rs. 100) = Rs. 100

Let’s calculate BEP by using the Formula

BEP = Fixed Cost + Contribution

= Rs. 500000 + Rs. 100

= 5000 units.

Or

Sales Revenue is (5000 units x Rs. 200) Rs. 1000000. If the company achieves sales of 5000 units, there is no profit, no loss position. Pricing is the decisive or critical factor in the break-even analysis. An increase in selling price enables the firm to reach break-even point much rapidly, that is, at less sales volume; and, lowering price needs to achieve more sales volume, assuming costs will be equal.

Based on ability of the firm to achieve sales, the price is set accordingly. By trial and error method, a table can be prepared with different level of price to see how much sales a company must achieve to offset costs against sales revenue. And, suitable price can be picked up.

Graphic Method:

By trial and error method, a table can be prepared to find out the break­even point and can be presented graphically; the same result can be arrived at. We may take different level of sales at fixed price to find out break-even point.

BEP is essentially a tool for mark-up or cost-plus pricing. It can be said as an extension of mark-up pricing method. Here, it is assumed that sales will remain stable at different level of the selling price. (This is hardly possible). Similarly, fixed and variable costs remain unchanged.

This method is used only when data on sales, costs, etc., are accurately available. While estimating sales, apart from the BEP at particular price, market forces should also be considered. But, all depends on the estimates. It is a useful tool. However, for setting price of the product, it should be used with care and caution. It may be used along with other price setting methods.

PRICING : Factors, Methods and Economic Approach

Pricing Decisions: Influencing Factors, Methods and Economic Approach

by Rohit Agarwal Pricing Decisions

Pricing Decisions: Influencing Factors, Methods and Economic Approach!

Factors Influencing 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:

i. Total demand for product or service and its elasticity

ii. Number of competing products or services

iii. Quality of competing products or services

iv. Current prices of competing products or services

v. Customer’s preferences for quality versus price

vi. Sole source versus heavy competition (Number of suppliers in the market)

vii. Seasonal demand or continual demand

viii. Life of product or service

ix. Economic and political climate and trends and likely changes in them in future.

x. Type of industry to which the product belongs and future outlook of the industry.

xi. Governmental guidelines, if any.

Internal Factors:

a. Cost of product or service

i. Variable costs

ii. Full absorption costs

iii. Total costs

iv. Replacements, Standard or any other cost base

b. Price geared toward return on investment

c. Loss leader or main product

d. Quality of materials and labour inputs

e. Labour intensive or automated process

f. Markup percentage updated

g. Usage of scarce resources

h. Firm’s profit and other objectives

i. 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.

An example of price calculation using cost plus method is as follows:

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.

For example, selling price calculation may be as follows:

Total manufacturing costs Rs 500

Add: Profit margin (50% on manufacturing cost) Rs 250

Selling price Rs 750

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.

Short-Run vs. Long-Run Pricing Decisions:

The time horizon of the decision is critical in computing the relevant costs in a pricing decision. The two ends of the time horizon are: Short-Run and Long-Run.

Short-Run Pricing Decisions:

Short-run decisions include pricing for a one-time-only special order with no long term im­plications. The time horizon is typically six months or less. Business firms can encounter situations where they are faced with the opportunity of bidding for a one-time special order in competition with other suppliers. In this situation, only the incremental costs of undertaking the order should be taken into account. It is likely that most of the resources required to fill the order have already been acquired and the cost of these resources will be incurred whether or not the bid is accepted by the customer.

In manufacturing companies, incremental costs of one-time special order will include:

(i) Additional materials required to comply with the order.

(ii) Additional labour, overtime and other labour costs.

(iii) Power, fuel and maintenance costs for the machinery and equipment required to fulfill the order.

In service companies, incremental costs of providing some additional services would be very less. For instance, the incremental cost of accepting one-time special business by a hotel would comprise the cost of additional meals, bathroom facilities and laundering.

In most situations, incremental costs to be incurred relate to unit-level activities. The companies have already resources incurred for batch, product and service-sustaining activities.

According to Colin Drury, any bid for one-time special orders that is based on covering only short-term incremental costs must meet all of the following conditions:

1. Sufficient capacity is available for all resources that are required to fulfill the order. If some resources are fully utilised, opportunity costs of scarce resources must be covered by the bid price.

2. The bid price will not affect the future selling prices and the customer will not expect repeat business to be priced to cover short term incremental costs.

3. The order will utilise unused capacity for only a short period and capacity will be released for use on more profitable opportunities. If more profitable opportunities do not exist and a short term focus is always adopted to utilise unused capacity, then the effect of pricing a series of special orders over several periods to cover incremental costs constitutes a long term decision. Thus, the situation arises whereby the decision to reduce capacity is continually deferred and short-term incremental costs are used for long-term decisions.

Long-Run Pricing Decisions:

Short-run pricing decisions are not appropriate for long-run pricing policy since short-run pricing policy is subject to short-run demand and supply conditions. Most firms use full cost information while setting long-run pricing decisions. In the long-run, firms can adjust the supply of virtually all of their activity resources.

Therefore, a product or service should be priced to cover all of the resources that are committed to it. If a firm is unable to generate sufficient revenues to cover the long run costs of all its products and its business sustaining costs, then it will make losses and will not be able to survive. There is a need for determining accurately the long-run or full costs of individual products or services so that product pricing decisions for the long-run can be made satisfactorily.

Target Pricing:

A target price is the estimated price for a product or service that potential customers will be willing to pay. This estimate is based on an understanding of customers’ perceived value for a product and competitors’ responses. The target price forms the basis for calculating target costs. A target cost is the estimated long-run cost of a product or service and when a product or service is sold, the target price enables the company to achieve targeted profit. Target cost is derived by subtracting the target profit from the target price.

Developing target prices and target costs requires the following four steps: 

Step 1:

Develop a product that satisfies the needs of potential customers.

Step 2:

Choose a target price based on customers’ perceived value for the product and the prices competitors charge.

Step 3:

Derive a target cost by subtracting the desired profit margin from the target price.

Step 4:

Estimate the actual cost of the product.

Step 5:

If estimated actual cost exceeds the target cost, investigate ways of driving down the actual cost to the target cost. As stated earlier, managers generally use a cost-based approach for long-term pricing decision and in this cost-based approach a markup is added to the cost base.

On cost-plus pricing and target price, Horngreen, Datar and Foster make the following ob­servation.

“The target pricing approach reduces the need to go back and forth among prospective cost- plus prices, customer reactions, and design modifications. Instead, the target-pricing approach first determines product characteristics and target price on the basis of customer preferences and expected competitor responses. Market considerations and the target price then serve to focus and motivate managers to reduce costs (“cost down”) and achieve the target cost and the target operating income. Sometimes the target cost is not achieved. Managers must then redesign the product, or work with a smaller profit margin.”

Life Cycle Product Costing and Pricing:

Business firms need to consider how to cost and price a product over a multiyear product life cycle. The product life cycle considers the time from initial research and development on a product to when customer servicing and support is no longer offered for that product. Life cycle costing tracks costs attributable to each product from start to finish. Life cycle costs provide important information for pricing. A product life cycle budget highlights to managers the importance of setting prices that will cover all life cycle costs. Life cycle budgeting is related closely to target pricing and target costing.

A different notion of life cycle costs is customer life cycle costs. Customer life cycle costs focus on the total costs incurred by a customer to acquire and use a product or service until it is replaced. Customer life cycle costs can be an important consideration in the pricing decision.

Pareto Analysis in Pricing Decisions:

Vilfredo, an Italian economist, has propounded that 70% – 80% of value represents 20% – 30% of volume.

This proposition can be noticed in many business areas such as the following:

(i) Stock Control

(ii) Customer profitability

(iii) Quality control

(iv) Pricing of a product in a multiproduct situation

(v) Activity-Based Costing (20% cost drivers are responsible for 80% of total cost)

In pricing decisions, Pareto Analysis is very useful to a multiproduct company. Pareto Analysis may indicate that 80% of a firm’s sales revenue come from 20% of its products. Such analysis helps the management to design appropriate pricing strategies for 80% of its product groups so that they can contribute more in overall sales revenue of the firm.

Those products which constitute 20% of the total products may require a different pricing strategy. This may signal to the management to adopt a more sophisticated and competitive advantage pricing because these products are essential for the company survival. Further, attempts should be made by a firm to convert 80% products (which cur­rently contribute poorly to total sales) into more profit making products.

Economic Approach to Pricing:

In many cases, cost information is of vital importance in pricing decisions. The discussion in the preceding sections has focused on how pricing decisions are influenced by the cost of the product, actions of competitors and the extent to which customers value the product.

In economics, the basic assumption is that a firm will attempt to set the selling price at a level where profits are maximised. The firm has a profit maximising goal and known cost and revenue functions. Typically increase in sales quantities require reduction in selling prices, causing marginal revenue (the varying increment in total revenue derived from the sale of an additional unit) to decline as sales increase. Increase in production causes an increase in marginal cost (the varying amount in total cost required to produce and sell an additional unit of production).

In economic theory, profits are maximised at the sales volume where marginal revenues equal marginal costs. Firms continue to produce as long as the marginal revenue derived from the sale of each additional unit exceeds the marginal cost of producing that unit. Economic theory provides a useful framework for thinking about pricing decisions. The ideal price is the one that will lead customers to purchase all the units a firm can provide upto the point where the last unit has a marginal cost exactly equal to its marginal revenue.

Economists argue that pricing should be set with a recognition of demand considerations not just of costs. They show mathematically—after making appropriate assumptions—that firms in a somewhat monopolistic situation can maximize their profits at the price-output combination where marginal revenue equals marginal costs. In situations in which managers know the algebraic form of both the demand and the cost curves, it is a simple computation to calculate the price-output combi­nation that maximizes company profits.

In practice, however, managers rarely follow the economists’ prescriptions. Two big factors have limited the applicability of the economists’ pricing model:

1. Difficulty in estimating the demand curve

2. Difficulty in estimating the cost curve

Economic theory is seldom used for pricing decisions. There are many difficulties such as the following:

First, economic models assume that a firm can estimate a demand curve for its products. Most firms have hundreds of different products and varieties and it is therefore an extremely difficult task to estimate demand curves at the individual product level. The problem becomes even more complex when competitive reactions are taken into account since these are likely to impact on the price/demand estimates that have been incorporated in the demand curve.

Second, economic theory assumes that only price influences the quantity demanded. However, in reality, demand of a product is influenced by many factors such as product quality, packaging, advertising and promotion, after-sales service etc. Therefore, any theory which uses only price factor to determine customer demand would not be able to measure it correctly.

Morse, Davis and Hartgraves observe:

“Perfect competition and an indefinite time period are required to achieve equilibrium prices where marginal revenues equal marginal costs. In the short run, most for-profit organisations attempt to achieve a target profit rather than a maximum profit. One reason for this is an inability to determine the single set of actions that will lead to profit maximisation. Furthermore, managers are more apt to strive to satisfy a number of goals (such as profit for investors, job security for themselves and their employees, and being a good corporate citizen) than to strive for the maximization of a single profit goal. In any case, to maximise profits, a company’s management would have to know the cost and revenue functions of every product the firm sells. For most firms, this information cannot be developed at a reasonable cost.”

Price Indifference Point:

A price indifference point is the sales level at which a firm’s net income is same between two pricing alternatives. The price indifference point indicates the volume of sales at which the new price gives a profit equal to the profit of old sales volume and price. In case, sales volume at new price is lower than sales volume at old price (when there is price indifference point), firm should reject the price increase since firm’s profit will decrease. In contrary to this, if expected sales volume with price increase is greater than the price indifference point, profit will increase. Price indifference point’s concept is very useful in short-term decision making situations.