Management Accounting

Lecture 7

Product Pricing Decisions

Introduction

The three major influences on pricing are:

Customers

Competitors

Costs

For an organisation to survive it needs to make a profit – i.e. selling price must exceed costs.

Costs are a major consideration – vital to obtain accurate product or service costs.

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Allocation of Costs

Direct costs easily traced to products.

Problems with manufacturing overheads

Inaccurate charging of overheads could lead to:

Incorrect pricing of goods/ services

Less profitable products pushed to gain market share

May lose market due to overpricing of products

Decision to buy in products rather than manufacture

Managers mis-focused

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We saw in previous lectures activity

based costing refined the process of

allocating production overheads to

obtain accurate product costs.

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Pricing Strategies

Profit maximisation model

Cost plus pricing

Premium pricing

Skimming the market

Penetration pricing

Price differentiation

Loss leader pricing

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price

quantity

D

D

Economist view: the demand curve

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TR

TC

£

volume

profit

Optimum quantity

Economists’ optimum price and output when MC=MR

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The economist’s approach

to pricing

• Elasticity of demand: a measure of how the volume of sales is affected by a change in price.

• Demand is inelastic if unaffected by price (e.g. designer goods).

• Demand is elastic if affected by price (e.g. grocery prices are affected by supermarket pricing wars).

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The economist’s approach to

pricing (cont.)

• Price elasticity of demand can be used

to calculate the profit-maximising

price for a company.

• Profit-maximising price is affected by

how sensitive unit sales are to price.

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Determining the profit maximising price

• The price elasticity of demand is computed as follows:

d = In (1 + % change in quantity sold)

In (1 + % change in price)

• The profit maximising price can be set by using the following formula:

Profit maximising price on variable cost

= d x Variable cost

(1 + d )

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Example

• Nature’s Garden believe that every 100%

increase in the selling price of their apple-

almond shampoo would result in a 15%

decrease in the number of bottles of

shampoo sold. If the variable cost of a

bottle of shampoo is £2 determine the

profit maximising price.

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Problems with economists’

model • difficult to estimate demand

curve/elasticity

• non-price forms of competition

• difficult to estimate true marginal cost

curve for each product

• problems with time periods - long

versus short-run

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Problems with economists’ pricing

model (cont.)

• problems with product mix

• surveys - most managers prefer to mark

up some version of full, not variable, costs

• mark-up is based on desired profits rather

than on factors related to demand

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Cost-based pricing models

• cost-plus- used in regulated/monopoly

situations

• target costing- used on more

competitive situations

w.b.seal, 2005 14

Cost-plus pricing

• Mark up = difference between selling

price and cost

• Cost-plus pricing=

Selling price= Cost + (mark up % x Cost)

• What cost should be used?

• How should the mark up be

determined? 15

Absorption costing approach

• The first step in absorption costing is to compute the unit product cost.

• The mark up must be large enough to cover SG&A expenses and provide an adequate return on investment (ROI).

• The ROI will be attained only if the forecasted unit sales volume is attained.

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Price Quotation Sheet

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Problems with absorption costing

• Managers think approach is ‘safe’.

• But what if sales are only 7000 units?

• ROI becomes negative!

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The structure of target costing

Target cost (Allowable Cost) =

Expected Sales Price – Target Profit

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Target costing

Target costing is the process of

determining a new product’s maximum

cost and developing a prototype that can

be profitably made for that figure.

Target = Anticipated _ Desired Cost Selling Price profit

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Hitting the Target

• Target costing is not just a pricing model.

• It is also a cost management model.

• Target costing involves designing to cost and quality targets set by competitive conditions.

• It takes a longer term perspective by considering the life-cycle of a product.

• Examines all ideas for cost reduction:

- from product planning stage,

- to development stage.

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Some problems with

target costing • may reveal unpalatable view of internal

operations

• may be too time-consuming

• ok for car industry (Toyota)

• too slow for electronics- time to market must be minimised

• still need to estimate costs

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Using target costing

• Instead of starting with a product and

determining costs and prices, target

pricing starts with the price and then

determine allowable costs.

• The anticipated market price is taken as

a given.

• Most of the cost is determined at the

design stage of the product.

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Revenue and yield management

• Yield management is a practice of achieving high capacity utilization through varying prices according to market segments and time of booking. It is applicable in industries like hotels, airlines etc., which are characterized by high fixed costs and perishability.

• An empty room in a hotel or an empty seat in a plane will represent lost revenue. Managers always like to sell all rooms at the highest rate but they know that there is a trade-off between high occupancy and high room rates.

• At the time of planning sales, price and market segment the resolution lies with control over rates.

• The key performance metric in this model is the; Yield percentage = Actual revenue/Maximum potential revenue

• Yield percentage depend on the average price × the number of units sold (hotel rooms, airline seats etc.). The maximum potential revenue is a full hotel or plane charging the maximum price.

• Yield management may be used to segment the market and offer different prices to different segments at different booking times

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Summary

• Pricing is a delicate balancing act.

• Managers often reply on cost-plus formulas to set target prices.

• In absorption costing approach, the cost base is absorption costing unit product cost and mark up.

• Companies using target costing set prices, then design products at an allowable cost.

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