Pricing Decisions Management Level Paper P 2 Advanced

Pricing Decisions Management Level – Paper P 2 Advanced Management Accounting Lecture - 24 Vidya Rajawasam ACMA CGMA MBA

Pricing Decisions § § § In the previous lectures we have discussed Introduction Price elasticity of demand Factors affecting price elasticity The profit maximization model The limitations of profit maximization model

Pricing Decisions In this lecture we will discuss § § Pricing strategies based on cost Marginal cost plus pricing Market based pricing strategies Product life cycle

Pricing Decisions Pricing strategies based on cost § Total cost-plus pricing Cost-plus pricing involves adding a markup to the total cost of the product, in order to arrive at the selling price. Unfortunately, since fixed costs are spread over the units of production, the full cost of a product will be a function of the number of units produced, which in turn will be a response to the number of units sold.

Pricing Decisions Pricing strategies based on cost § Total cost-plus pricing Yet sales quantity will depend on the price charged for the product, and so the argument is circular. Where an order is placed with a jobbing company (a company that makes products to order) for a specific quantity of a product made to the customer’s specification, costplus may be an acceptable pricing method.

Pricing Decisions Pricing strategies based on cost § Total cost-plus pricing But for the majority of organisations this is not the case. Other factors will influence the pricing decision, such as competition and product differentiation. Nevertheless it is reassuring to have some knowledge of cost and price at particular volumes, even if the knowledge is not perfect.

Pricing Decisions Pricing strategies based on cost § Total cost-plus pricing If an organisation does use cost as the basis for pricing it has to decide whether to employ a standard mark-up or whether to vary the mark-up according to the market conditions, type of customer, etc.

Pricing Decisions Pricing strategies based on cost Total cost-plus pricing A standard mark-up is used by some organisations, such as government contractors and some job costing companies, but the majority of companies vary the percentage to reflect differing market conditions for their products. The example below demonstrates total cost pricing, using varying cost assumptions of total cost.

Pricing Decisions Pricing strategies based on cost Example A company is replacing product A with an updated version, B, and must calculate a base cost, to which will be added a mark-up in order to arrive at a selling price. The following variable costs have been established by reference to the company’s experience with product A, although they may be subject to an error margin of 10 per cent under production conditions for B:

Pricing Decisions Pricing strategies based on cost Example. . Contd… Direct material Direct labour (1/4 hr @ £ 16/hr) Variable manufacturing overheads (1/4 hr of machine time @ £ 8/hr) Total variable cost per unit £ 4 4 2 10

Pricing Decisions Pricing strategies based on cost Example. . Contd… As the machine time for each B would be the same as for A, the company estimates that it will be able to produce the same total quantity of B as its current production of A, which is 20, 000 units. 50, 000 machine hours may be regarded as the relevant capacity for the purposes of absorbing fixed manufacturing overheads.

Pricing Decisions Pricing strategies based on cost Example. . Contd… Current fixed costs are £ 240, 000 for the production facilities, £ 200, 000 for selling and distribution, and £ 180, 000 for administration. For costing purposes, the 20, 000 units of B can be assumed to consume 10 per cent of the total selling, distribution and administration costs.

Pricing Decisions Solution - Alternative 1, using conventional absorption costing principles and building in the conservative error margin £ Variable production costs (as above) 10. 0 add: allowance for underestimate 10% 1. 0 11. 0 add: fixed manufacturing cost 1/4 hour of machine time @ £ 4. 8/hour (£ 240, 000/50, 000 hours) 1. 2 Base cost 12. 2

Pricing Decisions Solution – Alternative 2, using base cost from alternative 1 plus administrative costs. £ Base cost as under Alternative 1 12. 2 add: fixed administrative costs: (£ 180, 000 10% £ 18, 000 ÷ 20, 000 units) 0. 9 Base cost – alternative 2 13. 1

Pricing Decisions Solution – Alternative 3, using base cost from alternative 2 plus selling & distribution costs. £ Base cost as under Alternative 2 13. 1 add: fixed selling and distribution costs: (£ 200, 000 10% £ 20, 000 ÷ 20, 000 units) 1. 0 Base cost – alternative 3 14. 1

Pricing Decisions Solution – summary Based on the analysis adopted, the base cost varies from £ 12. 2 to £ 14. 1. The base cost rises with each alternative, as an increasing proportion of the total costs is recovered. The profit mark-up built into the pricing formula is therefore likely to fall with each alternative from 1 to 3.

Pricing Decisions Advantages of cost-plus pricing § The required profit will be made if budgeted sales volumes are achieved. § It is a particularly useful method in contract costing industries such as building, where a few large individual contracts can consume the majority of the annual fixed costs and the fixed costs are low in relation to the variable costs.

Pricing Decisions Advantages of cost-plus pricing § Assuming the organisation knows its cost structures, cost-plus is quick and cheap to employ. Its routine nature lends itself to delegation, thus saving management time. § Cost-plus pricing can be useful in justifying selling prices to customers; if costs can be shown to have increased, this strengthens the case for an increase in the selling price.

Pricing Decisions Disadvantages of cost-plus pricing § There will always be problems associated with the selection of a ‘ suitable ’ basis on which to charge fixed costs to individual products or services. Selling prices can show great variation, depending on the apportionment basis chosen. This can lead to over or under-pricing relative to competitors causing the firm to either lose business or make sales at an unintentional loss.

Pricing Decisions Disadvantages of cost-plus pricing § If prices are set on the basis of normal volume, and actual volume turns out to be considerably lower, overheads will not be full recovered from sales and predicted profits may not be attainable. § Cost-plus pricing takes no account of factors such as competitor activity.

Pricing Decisions Disadvantages of cost-plus pricing § Cost-plus overlooks the need for flexibility in the different stages of a product’s life cycle. It takes no account of the price customers are willing to pay and price elasticity of demand.

Pricing Decisions Review MCQs What is statement is true related to the cost plus pricing? a. Involves adding a mark-up to the total cost of the product, in order to arrive at the selling price b. Identifies the detail variable costs related to new products. c. Identifies the financial and business risks. d. Non of the above

Pricing Decisions Review MCQs What is statement is true related to the cost plus pricing? a. Involves adding a mark-up to the total cost of the product, in order to arrive at the selling price b. Identifies the detail variable costs related to new products. c. Identifies the financial and business risks. d. Non of the above

Pricing Decisions Review MCQs What are the advantages of cost plus pricing are? a. Cost-plus pricing takes no account of factors such as competitor activity b. Useful method in contract costing industries such as building c. Cost-plus pricing cannot be used in justifying selling prices to customers d. Non of the above.

Pricing Decisions Review MCQs What are the advantages of cost plus pricing are? a. Cost-plus pricing takes no account of factors such as competitor activity b. Useful method in contract costing industries such as building c. Cost-plus pricing cannot be used in justifying selling prices to customers d. Non of the above.

Pricing Decisions Marginal cost-plus pricing To the accountant, marginal cost is the same as variable cost. Some of the reasons for using it in preference to total cost are as follows: § It is just as accurate as total cost-plus pricing. A larger mark-up percentage is added because both fixed costs and profit must be covered, but the uncertainty over the fixed costs per unit remains in both pricing methods.

Pricing Decisions Marginal cost-plus pricing § Knowledge of marginal cost gives management the option of pricing below total cost when times are bad, in order to fill capacity. § It is particularly useful in pricing specific one-off contracts because it recognizes relevant costs and opportunity costs as well as sunk costs.

Pricing Decisions Marginal cost-plus pricing § It also recognizes the existence of scarce or limiting resources. Where these are used by competing products and services it must be reflected in the selling price if profit is to be maximised. If there is a scarce or bottleneck resource, the aim must be to maximize the total contribution from the limiting factor.

Pricing Decisions Marginal cost-plus pricing The contribution that each alternative product or service makes from each unit of the scarce resource must be calculated and a suitable profit margin added.

Pricing Decisions Marginal cost-plus pricing A company has been producing A successfully for a number of years, and demand appears to be static into the foreseeable future at a market price of £ 15 per unit. A market has just developed in product B, which the company could produce without additional investment in plant, and without increasing or retraining the existing labour force. Unfortunately, however, B uses the same basic direct material as product A, material C – which is in short supply. The company must determine a minimum selling price for B, below which it would not be worthwhile to divert resources from A. Costs for the two products are given in the Table.

Pricing Decisions Marginal cost-plus pricing Product A £ Direct material: 6 units of C @ £ 0. 60 3. 60 Direct labour: 1/2 hour @ £ 6. 00 3. 00 Variable overhead 2. 40 9. 00 Selling price 15. 00 Contribution 6. 00 B £ 5 units of C @ £ 0. 60 3. 00 1/2 hour @ £ 6. 00 3. 00 1. 00 7. 00

Pricing Decisions Marginal cost-plus pricing Contribution per unit of material C £ 6 6 units £ 1 A produces a contribution of £ 6 using 6 units of C, that is, a contribution per unit of C, the limiting factor, of £ 1. ` B uses five units of C. The company must therefore seek a contribution of £ 5 (5 units of material C £ 1). So the price must cover the cost of the unit and the lost contribution from C, i. e. be at least £ 7 £ 5 £ 12.

Pricing Decisions Marketing-based pricing strategies There are many different pricing strategies, and it may come as a surprise to would-be accountants that cost is only one of many methods and is certainly not universally used as the key method for pricing.

Pricing Decisions Marketing-based pricing strategies Premium pricing is pricing above competition on a permanent basis. This can only be done if the product appears ‘ different ’ and superior to competition, which normally means establishing a brand name based on one of the following; § Quality § Image/style § Reliability/robustness

Pricing Decisions Marketing-based pricing strategies Premium pricing § Durability § After-sales service § Extended warranties. In order to establish a brand, heavy initial promotion is required and the name must be constantly advertised or promoted thereafter. Brand names, such as, Levi, Mars, Coca-Cola, etc. , require many millions of pounds spent on them each year.

Pricing Decisions Marketing-based pricing strategies Premium pricing The benefit is a higher selling price generating a larger profit per unit and customer loyalty, making the product relatively price inelastic. These benefits must, of course, outweigh the cost of keeping the brand name in front of the customers.

Pricing Decisions Review MCQs The objectives of marginal cost pricing are? a. Increase the marginal revenue significantly b. Aims to maximize the total contribution from the limiting factor c. There is a lot of confusion with regard to its application. d. Non of the above.

Pricing Decisions Review MCQs The objectives of marginal cost pricing are? a. Increase the marginal revenue significantly b. Aims to maximize the total contribution from the limiting factor c. Require significant d. Non of the above.

Pricing Decisions Review MCQs What is true related to the Premium pricing? a. Very difficult to obtain inflation rates related to industry levels. b. Pricing above competition c. There is a lot of confusion with regard to its application. d. Non of the above.

Pricing Decisions Review MCQs What is true related to the Premium pricing? a. Very difficult to obtain inflation rates related to industry levels. b. Pricing above competition c. There is a lot of confusion with regard to its application. d. Non of the above.

Pricing Decisions Lecture Summary We have discussed the § § Pricing strategies based on cost Marginal cost plus pricing Market based pricing strategies Product life cycle

Pricing Decisions Management Level – Paper P 2 Advanced Management Accounting Lecture - 24 Vidya Rajawasam ACMA CGMA MBA