Pricing decisions

Difficulties when applying economic theory.

Economic theory assumes that a firm can estimate a demand curve for its products; The basic model of economic theory assumes only price influences the quantity demanded; The marginal cost curve for each individual; The marginal cost curve for each individual product can only be determined after considerable analysis and the final result may only represent an approximation;

Who are price takers?

price takers are those firms that have little control over the prices of their products or services

Who are price setters?

price setters are those firms that have some discretion over the setting of selling prices for their products or services.

What situations can we recognise?

1. a price setting firm facing short-run pricing decisions 2. a price setting firm facing long-run pricing decisions 3. a price taking firm facing short-run product-mix decisions 4. a price taking firm facing long-run product-mix decisions

In short run pricing decisions what incremental costs consist of?

Extra materials that are required to fulfill the order; Extra labour and overhead costs; Any other extra costs; Given the short-term one-off nature of the opportunity many costs will be non-incremental.

What are the characteristics of the short-run pd?

1. Sufficient capacity must be available to meet the order 2. The bid price should not effect future selling prices and the customer should not expect repeat business at short-term incremental cost 3. The order will utilize unused capacity for only a short period and capacity will be released for use on more profitable opportunities.

What are characteristics of long run decisions?

In the long run firms can adjust the supply of virtually all of their activity recourses Product should be priced to cover all of the; Product should be priced to cover all of the resources that are committed to a product in the long run

Long product-mix decisions

A firm has to decide which products to sell given their market prices; There is a need to undertake periodic profitability analysis; Activity-based profitability analysis should be used

Short run product mix decisions

Sufficient capacity is available for all resources that are required from undertaking the business; • The company will not commit itself to repeat longer-term; The company will not commit itself to repeat longer term business that is priced to cover only short-term incremental costs; The order will utilize unused capacity for only a short period and capacity will be released for use on more profitable opportunities

What are the basic approaches to setting prices?

market methods; cost-plus methods

How do we divide market methods?

Demand-based concept; Competition-based concept

How do we divide cost-plus methods?

Total cost concept; Product cost concept; Variable cost concept

What is total cost concept?

Under the total cost concept, all costs of manufacturing a product plus the selling and 1) Total Cost Concept selling and administrative expenses are included in the total cost to which the markup is added.

What is product cost concept?

Under the product cost concept, only the costs of manufacturing the product, termed the product costs, are included in the cost amount per unit to which the cost amount per unit to which the markup is added.

What is the variable cost concept?

Under the variable cost concept, only variable costs are included in the cost amount per unit to which the markup is added

Features of cost-plus pricing

• Target mark-ups seek to provide a contribution to non- assigned costs and profit.; Target mark-ups are also adjusted to reflect demand, types of products, industry norms, competitive position, etc.

Criticisms of cost-plus pricing

Ignores demand; Does not necessarily ensure that total sales revenue will exceed total cost.; Can lead to wrong decisions if budgeted activity is used to unitize costs.; Circular reasoning —Volume estimates are required to estimate unit fixed costs and ultimately price.

Reasons for using cost plus pricing

1. May encourage price stability; 2. Demand can be taken into account by adjusting the target mark-ups; 3. Simplicity; 4. Difficulty in applying sophisticated procedures where a firm markets hundreds of products/services; 5. Used as a guidance to setting the price but other factors are also taken into account; 6. Applied to only the relatively minor revenue items

What is target costing?

Target costing is a method of setting prices that combines market-based pricing with a cost-reduction emphasis. A future selling price is anticipated, using the selling price is anticipated, using the demand-based or the competition-based methods

What is the cost drift?

The planned cost reduction

Costs can be reduced in a variety of ways such as:

Simplifying the design; Reducing the cost of direct materials; Reducing the direct labor costs; Eliminating waste

What is differential revenue?

Differential revenue is the amount of increase or decrease in revenue that is expected from a course of action as compared to an alternative.

What is Differential cost?

Differential cost is the amount of increase or decrease in cost that is expected from a course of action as compared to an alternative.

What is differential income (or loss)?

It is the difference between the differential revenue and the differential costs. Differential income indicates that a decision is expected to be profitable, while a differential loss indicates the opposite.

What is differential analysis?

Sometimes called incremental analysis, focuses on the effect of alternative courses of action on revenues and costs.

What happens when the company is operating at full capacity?

If the company is operating at full capacity, any – If the company is operating at full capacity, any additional production increases fixed and variable manufacturing costs.

What happens when the company is operating below full capaity?

If the company is operating below full capacity, any additional production does not increase fixed manufacturing costs.