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.

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

We saw in previous lectures activity based costing refined the process of allocating production overheads to obtain accurate product costs.

Pricing Strategies
Profit maximisation model Cost plus pricing Premium pricing Skimming the market Penetration pricing Price differentiation Loss leader pricing
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Economist view: the demand curve

price D

quantity
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Economists optimum price and output when MC=MR

TR profit TC

Optimum quantity

volume
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The economists 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 economists 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.

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
Natures Garden believe that every 100% increase in the selling price of their applealmond 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

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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?

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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 products maximum cost and developing a prototype that can be profitably made for that figure.

Target = Cost

Anticipated _ Desired 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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