Cost-Based pricing: The accountant’s approach

• The traditional approach.

- Calculate the unit cost

- Add a % mark-up (or margin) for profit

• Unit cost may refer to:

1. Full cost (manufacturing & non-manufacturing costs)

2. Full manufacturing cost (Absorption/ ABC)

3. Variable cost (Marginal)

• Mark-up may refer to:

1. Risk involved in the product

2. Competition mark-ups

3. Desired profit / ROCE

4. Type of cost used

5. Type of product

• Important points:

 Mark-Up: Profit = % of cost

 Margin: Profit = % of Selling Price

Customer’s based pricing: The marketer’s approach

• Selling Price: Reflects perceptions of benefits they expect to enjoy from the product.

• Considers costs: Financial objectives must be met.

• If benefits are perceived to be substantial, customers are willing to pay multiple times the

cost price.

• Involves the profiling of the target customer.

• Greater understanding of the customer’s needs/ wants/ values of your customer, the better

placed the pricing procedure is.

Competition-based pricing:

Set a price based on the competition’s prices.

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 1. Same product – easily distinguishable from competition: Competition changes
will not impact our own products’ demand.

2. Same product – Not easily distinguishable from competition: Competition

changes will impact our own products’ demand.

3. Substitute products: The price changes depend on relative price/performance of the

substitute.

Cost-plus Pricing:

• Profit to be added should take into account:

- Price that clients would be willing to pay

- Desired level of sales

- Competition

o Advantages:

i) Widely used and accepted.

ii) Simple

iii) Justifies price increases

iv) Encourages price stability (when competitors have similar cost

structures/ profit margins)

• Disadvantages :

Ignores economic relationship between Price-Demand

No attempt to establish an optimum price

Different costing = different cost

Does not guarantee profit

Fails to recognize the manager’s need to flexibility in pricing

Circular reasoning:

Price increase → Volume decrease → Unit cost increase → Pressure to increase

price further.

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 Market-skimming:

o Charge high prices at the launching of the product.

o Take advantage of the novelty appeal of the product, when demand is initially

inelastic.

o Heavy promotion to encourage sales.

o As the product appeal ages, prices will progressively fall.

o Safeguard against unexpected future increases in costs/ large fall in demand after

novelty fades.

o Appropriate when:

- Product is new/ different from other products in the market (little direct competition).

- Price elasticity of demand is unknown (better start high and decrease gradually).

- Different market segments can be identified & product differentiation can be

introduced.

- Products have a short life cycle.

- Business is risky.

- Rapid changes in fashion/ technology may occur.

- Price setter is short on cash and wants to recover his investment.

- More favorable in cases where barriers to entry exist (patents, prohibitively high

capital, unusually strong brand loyalty).

Market Penetration:

 Charge low prices at the launching of the product to gain acceptance/ market share.

Once this is achieved, prices are increased.

 Appropriate when:

- Discourage new entrants.

- Shorten introduction stage of the product to the market, to accelerate growth

& maturity stages.

- Highly elastic demand.

- When there are significant economies of scale from a high volume of output.

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 To be effective:

- Substantial market for the product.

- Significant anticipated market share.

- Elastic product.

Complementary product:

• A product normally used with another product (e.g. razors + razor blades,

printers + print cartridges).

• Give additional power over customers.

• Lock consumers into ongoing stream of purchases (i.e. only proprietary

consumables can be used in their products).

• Increased cost for customer to switch to alternative products/ suppliers.

• Low Price major product – High Price complementary product:

Encourage purchase and lock consumer to buy complementary product.

• High Price major product – Low Price complementary product: Barrier to

competition entry and lock consumer to buy complementary product.

Product-line pricing:

• Range of products to meet similar needs of different target customers. All

products are related but may vary in terms of style, color, quality etc.

• Capitalize on consumer interest in a number of products within the range.

• Making the price entry point for the basic product relatively cheap.

• Price other items in the range more highly.

Volume-discounting pricing:

• Lower price/unit if a particular quantity is purchased (bulk discounts).

• Quantity discounts: Large order customers.

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 • Cumulative Quantity discounts: Discount increases as the cumulative total

ordered increases.

• Increased loyalty.

• Attract new customers.

• Lower Sales Processing costs: Fewer sales but higher quantities sold each

time.

• Lower Purchasing costs.

• Discounts help to sell items bought primarily on price.

• Clearance of surplus stock.

• Increased use of off-peak capacity.

Price discrimination:

• Selling the same products at different types in different markets.

• Segmentation:

- Time

- Age

- Gender

- Type of service

- Geography

- Quantity

- Customer type

• Works best when:

 Seller can determine selling price.

 Customers can be segregated into different markets.

 Not possible for customers to buy cheap in one market and sell high in

another (black market development?).