Chapter 15: Pricing - Overview PDF

# Chapter 15: Pricing - Overview ## Management Accounting Snapshot - **Major Influences on Pricing:** - Customers - Competitors - Costs - Environment ## Types of Competitive Markets | Market | Description...

# Chapter 15: Pricing - Overview ## Management Accounting Snapshot - **Major Influences on Pricing:** - Customers - Competitors - Costs - Environment ## Types of Competitive Markets | Market | Description | | :------------------------------------------ | :------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | | Perfect Competition | Many sellers | | | Similar or identical products | | | Equal market share between market participants | | | Entry and exit from market is easy | | Monopoly | Only one seller | | | No product differentiation | | | Profit is maximized for the seller | | | High barriers to enter market for new participants | | Oligopoly | Few sellers that may be interdependent on each other | | | Products can be the same or different | | | Some barriers to enter market, as a few major sellers already have a high market share | | Monopolistic Competition | Many sellers | | | Products are differentiated | | | Few barriers to enter market | ## Product Life Cycle | Stage | Description | | :--------------- | :------------------------------------------------------------------------------------------------------------------------------------------------ | | Development | Product being developed | | Introduction | Sales begin slowly | | Growth | Sales increase | | Maturity | Sales become consistent | | Decline | Sales decline | ## Lesson 1: Introduction to Pricing ### Technical Competencies - Prepares, analyzes, or evaluates operational plans, budgets, and forecasts (3.2.2) - Evaluates sources and drivers of revenue growth (3.4.1) ### Learning Outcomes - Discuss the three major influences on pricing and relevant costs in short and long-term pricing decisions. - Identify four main types of markets and their influences on pricing. - Describe the product life cycle and its effect on product pricing. - Discuss cost-based pricing methods. - Discuss demand-based pricing methods. - Identify other pricing strategies. ## 15.1 Pricing Considerations The success of an organization is largely dependent on its ability to generate revenues; therefore, setting the right price is critical. To set the proper price, an organization must understand its product and costs, its customers, the market and competitors, and the industry's competitive environment. This goes beyond cost or market-based pricing strategies and needs to also consider the structure of the industry and product life cycles. This chapter discusses two major categories of pricing: cost-based and demand-based. ## 15.1.1 Major Influences on Pricing Many factors affect the price an organization charges for its goods or services. Major influences on pricing decisions include: ### Costs - An organization cannot sell a product for less than what it costs to make it, so knowledge of costs and a thorough understanding of cost behavior can enable an organization to price its product to receive the maximum benefit. - This can include both fixed and variable costs, as well as considering both short- and long-term costs, depending on the type of pricing decision. - Regulations that require significant financial resources to follow may impact pricing. - Policies such as tariffs and quotas that arise from the political landscape also need to be factored into pricing. ### Customers - The customers will assist in setting the market price by determining how much they value the good or service and the amount they will pay for the attributes of the product. - The demographics of customers can also affect pricing, as the age and wealth of customers will affect the price they are willing to pay. ### Competitors - Competitors' prices will influence the industry dynamics. - An organization will take competitor pricing into account when considering its own pricing objectives. - When the strategy is to gain market share, prices will be set lower than competitors. - When a differentiation strategy is being pursued, competitive pricing is not as important. ## 15.1.2 Relevant Costs For Pricing Similar to other decision-making, pricing decisions should consider relevant costs only. Relevant costs for a producer's pricing decisions are a function of the time horizon for pricing: - **Short-term decisions** include whether to accept a one-time special order or what product mix to manufacture with limited resources. For these the relevant costs are those that differ between decision alternatives - typically only variable costs. In the short term, an organization is not able to make structural changes, such as adding a new manufacturing line, so these costs are not considered. - **Long-term decisions** consider fixed costs because it is possible to adjust and solve problems, such as selling machinery and freeing up cash flows. In the long-term the analysis shifts, and quantitative tools such as budgeting can be used. It becomes important to also consider price stability, and predictability. When an organization can hold its prices stable, fewer resources are required to manage pricing, which improves planning and forecasting, and builds better relationships with customers, who would like to keep their costs stable. ## 15.1.3 Structure of Industry/Market The structure of a market has a significant impact on how an organization sets and pursues its pricing strategy. The number and relative strength of competitors will influence a firm's ability to set prices and obtain market share. Where an industry is not dominated by a single or small group of participants, competition often exists. The characteristics of a market, which influences its structure, include the following: - Number of competitors in the market. - Number of customers and their ability to influence prices. - How much products differ from those of the competitor. - Relationship between sellers. - Ability of an organization to penetrate a new market. The four most common market structures are discussed below. These structures are somewhat theoretical in that there are few real-life examples that perfectly mirror the description of each type of market. However, many markets have characteristics of these four types of markets: ### Perfect Competition - Perfect competition exists when there are many competitors in the market and consumers have a wide range of options available. - Goods and services are identical or very similar. Individual market participants have a hard time distinguishing their value proposition versus their competition, as their goods and services are largely commoditized. - Sellers are independent of each other. - In a perfectly competitive market, market participants have equal market shares and tend to only earn moderate profits that are considered average for the industry in which they operate. - There are few barriers to entering and exiting the market in a perfectly competitive environment. - For example, most of the agriculture industry is like perfect competition, such as the apple industry. There are many apple producers, so customers have numerous options, the product is very similar between producers. There are few barriers to enter and exit the market, as almost any person or organization can grow apples. ### Monopoly - When one organization controls a particular market, it is a monopoly. - The organization can charge what it wants, without regard for customers, and serve who it pleases to maximize economic profit. - There are no or few minor competitors in the market in a monopoly, and there is no differentiation in the product or service because it can be obtained by only one seller. - There are very high barriers to enter the market, as other organizations cannot compete. - For example, Canada Post has a monopoly on the domestic-letter market in Canada through stamps. Canada Post is the only source to purchase stamps used to send letters within Canada, and there are no other competitors. Due to regulation, no other organizations can enter the domestic-letter market, although in the package market Canada Post is one of many delivery companies. ### Oligopoly (Cartel) - When a small group of organizations can control the market, this is known as oligopoly (also called a cartel). - These participants can earn profits using implicit collusion to set prices and bring stability to the market, so sellers can be interdependent on one another. - Organizations in an oligopolistic market can sell similar of differentiated products or services. - There are relatively high barriers for entry into oligopolistic markets, as the main sellers have such a high market share. - For example, the cell phone carrier market in Canada is an oligopoly controlled by three organizations. There are also a small number of other carriers, but these smaller organizations collectively control only 10% of the market. - Another example of a legal oligopoly that uses collusion to control market prices is the Organization of the Petroleum Exporting Countries (OPEC). By coordinating policies and oil exported onto the world markets, OPEC can influence the price of oil, though this power has been diminishing with the development of oil resources in non-OPEC countries. ### Monopolistic Competition - Many industries are somewhere between the two extremes of a monopoly and perfect competition, called monopolistic competition. - There are many independent market participants that offer differentiated products to attempt to win customers. - A monopolistic competitive market fosters innovation and creativity, allowing for certain market participants to create a competitive advantage, which enables them to earn sustainable, economic profit. - There are few barriers to enter the market for new participants. - For example, the fast-food industry is a monopolistic competition in Canada. There are many different organizations selling similar food, and each attempts to differentiate itself from its competitors to gain customers and earn a sustainable profit. ## 15.1a Let's Look At An Example - The following are examples of markets in Canada that can be identified as one of the four main types of markets: - Purchase of goods online - Crown corporation providing hydroelectric power - Canadian airline industry - Hairdressers and barbers | Market | Type | Explanation | | :------------------------------- | :--------------- | :------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ | | Purchase of goods online | Perfect Competition | There are many competitors who sell online, and so there is lots of competition between sellers. The goods purchased online are all the same or identical, so the product is homogenous. Since there are so many sellers, it is unlikely (although not impossible) that there is collusion between sellers. There are few barriers to setting up an online store or closing the online store. | | Hydroelectricity | Monopoly | There is only one electricity provider and one product - electricity. There is no need to differentiate the product. New providers cannot enter the market (due to regulation) and there is no price competition, although prices are set by provincial regulators. | | Airline Industry | Oligopoly | There are two major airlines in Canada, and several smaller airlines that have a small market share. While the major airlines do not collude, they can work together implicitly to set prices for all major routes in Canada. | | Hairdressers and barbers | Monopolistic Competition | There are many hairdressers and barbers, and each attempt to differentiate itself from its competitors, such as by providing different services like shaving or hair colouring. It is relatively straightforward to enter the market because there are few barriers to entry. | ## 15.1.4 Product Life Cycle Although an important influence on pricing, the type of market is not the only influence on pricing. Some organizations consider the total costs that relate to a product over its entire product life cycle. A product life cycle is the sequence of stages through which a product goes during its lifespan. Entirely new industries, such as computers and smartphones, have sprung from technologies that are evolving with shorter product lifespans. This has happened so rapidly that these products become obsolete within a few months of their market introduction. Organizations are constantly monitoring and reassessing product life-cycle costs and revenues as the time available to sell a product and recover the investment in it shrinks with changing market preferences. Product life-cycle management consists of managing a product or service through its introduction, growth, maturity, and decline stages. This cycle can be represented by a bell-shaped curve that measures sales revenue for a product over time. - **Development:** The product is being developed and can't earn revenue until released to the market. - **Introduction:** Sales begin slowly (rising concave curve). - **Growth:** Sales increase, sometimes very quickly (rising convex curve). - **Maturity:** Sales level off and become more consistent (relatively flat curve). - **Decline:** Sales start to fall off; this may happen very sharply or much more gradually (falling curve). ## 15.1b Let's Look At An Example - Determine the life-cycle stage in each scenario below: - Sales of CanCan Inc.'s 250 ml glass jars have been stable for the last 20 years. - Home Fort Co.'s most popular product is bamboo flooring. Sales have been growing for the last five years and are expected to continue each year. - Ishing Ltd. is developing a new cloud-based teaching platform that the company believes will revolutionize post-secondary education. It is expected to be released next year. - Revenue related to October Co.'s Green Man costumes have decreased significantly after the cancellation of the related television show. - Beward Co. plans to release its next mobile app, Secret Hatch, in two months. The organization has a waiting list of 100,000 customers who plan to purchase the app. - Gary's Luxury Sailboats released its latest model in the current year: the Fortune 1550. Sales were only 4% of Gary's total sailboat sales for the year but are expected to increase. | Company | Stage | Description | | :------------------ | :--------------- | :--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | | CanCan Inc. | Maturity | Sales of this product have been stable for many years and is not increasing or decreasing. | | Home Fort Co. | Growth | Sales of this product have increased for the last five years and are expected to increase in the future. | | Ishing Ltd. | Development | The product has not been released and isn't earning any revenue at this time. | | October Co. | Decline | Revenue is decreasing for this product. | | Beward Co. | Development | Although there is a waiting list of customers who want to buy the app, the organization is not currently making sales or earning revenue. | | Gary's Luxury Sailboats | Introduction | The product has just been released in the current year and sales are just starting. | ## 15.2 Cost-Based Pricing Regardless of which costs are or are not relevant for decision-making, many organizations routinely use cost-based pricing—they set prices as a function of cost. In cost-based pricing, a business factors in fixed costs as well as variable costs when setting a long-term price for its products. - Consider a garden centre that sells seedlings and gardening supplies and purchases its products from a garden wholesaler. The garden centre prices its inventory based on its costs, so if the wholesaler raises its prices in a year with poor weather, the garden centre will also raise its prices. In a year with sunny weather, the demand may increase, but the garden centre will not raise its prices unless its costs increase. - Some organizations enter into a type of cost-based pricing called **cost-plus pricing**, in which revenue is calculated by adding a markup to cost. For example, a retail store might use a markup of 80%, so that an article of clothing costing $50 would be priced at $50 + (80% x $50) = $90. The **advantage** of the **cost-plus approach** is that it provides a price based on a profit target, or target return on investment (ROI). If the customers find the price reasonable and the profit target is based on the costs of an efficient supplier with a target ROI that reflects market expectations, the price reflects a stable, long-term equilibrium price that will support demand and supply. There are several different approaches to cost-based pricing: | Strategy | Description | Key Points | | :---------------- | :--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | :------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ | | Life-cycle costs | Prices are set so that the costs are recuperated over the entire product life-cycle, plus a markup. | Costs for each stage of the product's life are estimated (development, introduction, growth, maturity, and decline). This ensures a profit over the entire life cycle of a product. | | Target-based pricing | A target price is set and then a suitable profit is deducted to determine the target cost. | Target prices are set based on the customers' perceived value of products. This ensures a set profit on sales. | | Cost-based contracts| Prices are determined by reimbursing costs plus a suitable margin. | This requires an understanding of competitors' technologies, products, costs, and financial conditions. This allows more control over prices because the organization can control some cost drivers (such as materials and labour). Customers must be willing to pay the prices set by the organization. | | Variable product costs | Variable costs are marked up set a selling price. | This is suitable in non-competitive markets. This ensures a positive contribution margin. | | Full absorption costs| Prices are set by marking up the full cost of products to set a selling price. | This is required for financial reporting. This is easy to use. Prices are set so that all costs will be recovered. | ## 15.3 Demand-Based Pricing In contrast to cost-based pricing, demand-based pricing focuses on two things: the value to customers and the demand (competition). If the demand curve is **elastic** (that is, a small change in price leads to a large change in volume), then slight decreases in prices can greatly increase sales, and vice versa—a slight increase in prices can greatly reduce sales. An elastic demand curve is more prevalent in a competitive environment. - For example, if the price of gasoline is $1.15 per litre at all the gas stations in a small city and one station reduces its price to $1.10, that station will pick up business until it either raises prices back to $1.15 or the other stations' prices drop to $1.10. If other stations do not match the price, the volumes at the $1.10 station would rise dramatically, which might more than make up for the $0.05 reduction in price, as fixed costs would be spread over many more units. - If the demand curve is **inelastic**, prices could rise substantially, and volume would not be affected as much. For example, the price of prescription medication is often considered inelastic because the demand is unlikely to change when prices rise or fall. This is because the demand for this medication is based on the needs of the patient/customer, not on the price. When there is a monopolistic or oligopolistic market, the organization decides what return it wishes to achieve given a certain cost structure and then sets its prices to achieve that return. This approach usually applies to organizations with an inelastic demand curve, such as utility providers. **Demand-based pricing** uses consumer demand to determine a perceived value; this is the core focus of this pricing strategy. It will test consumers' price sensitivity to products to arrive at the final selling price. There are several different approaches within demand-based pricing: | Strategy | Description | Key Points | | :------------------ | :------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | :----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | | Predatory pricing | Products are deliberately priced below costs to drive out competitors and restrict supply. | Deliberate price cutting or offers of "free gifts/products". Forces smaller/weaker rivals/out of business or prevents new entrants. Works in the short term but not in the long term. Anti-competitive and illegal if it can be proven, but very difficult to prove. | | Penetration pricing | The price is set low to attract customers and gain market share, and then raised later once market share is gained. | Price set to "penetrate the market". Low price to secure high volumes. Intent is to lower costs over the long term by gaining production and distribution economies of scale before competitors. Suitable for products with long product life. May be useful if launching into a new market. | | Price-skimming | Goods are sold at a high price for a time, so that sales revenue is needed to cover the costs for several products; prices are then lowered or revised. | High price, limited volumes. Short window of opportunity. Suitable for products that have short life cycles or that will face competition at some point in the future (such as after a patent runs out). | | Price bundling | Several products or services are combined, and a lower price for the whole is charged. The seller changes prices as her combined product demand and service supply changes. | Offered when customers purchase more than one product or service from an organization. The more you buy, the less you pay per item. Package deals. | | Peak-load pricing | Higher price for a product or service is charged when capacity demand is high. | Prices adjusted to demand and volume. The higher the demand, the higher the price. Algorithms often used for pricing processes, known as congestion pricing or surge pricing. | | Loss-leader pricing | Product is sold at a price below cost to stimulate the sales of other goods or services. | Products sold below cost. Customer draw to stimulate sales of more profitable goods or services. Purchases of other items more than cover "loss" on item sold. | ## 15.3a Let's Look At An Example - Determine the demand-based pricing strategy used for the following products: - Trail Bus takes hikers to a popular hiking trail twice a day. On weekdays, the organization charges $35 per ride; on weekends, it charges $55 per ride, as it is more popular. - At Mexico Sushi, customer can purchase rolls individually or in combos. The price per roll in a combo is lower than if each roll was purchased individually. - Sattler Co. has released its newest printer: the Newman 4000. It has been priced below Sattler's other products so that the organization can gain a higher market share. The price will be increased next year once it has many customers. - Belle's Beauty Supplies has lowered its lipstick and blush prices to cost to gain a larger market share. The organization anticipates greater sales of these products will increase sales of other products, which have a higher profit per product. - Greater Plumber Ltd. charges customers $20 an hour in labour, whereas other plumbers in town charge an average of $80 an hour. This has caused two plumbers to go out of business, as other plumbers cannot compete on price. - Playtime Games released its Super Top toy in October in time for the holiday season. Only 10,000 units were manufactured, and the organization can charge a premium price of $100 due to the limited quantity. - Canada Virtual Trophies has a new product that provides virtual medals and trophies rather than plastic or metal physical trophies. It is the only Canadian virtual trophy company and has priced its trophies very low to obtain some of the physical trophy market. Once it gains customers, the organization plans to raise prices. | Product | Demand-based pricing strategy | | :------------------- | :-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | | Trail Bus Ride | Peak load pricing - Weekends are more popular for hiking, so the trail bus prices its rides higher. For weekdays, when demand is lower, prices are also lower. | | Sushi Rolls | Price bundling - The organization charges a lower price per roll if a customer purchases a combo. | | Printer | Penetration pricing - The price of the new printer is artificially low and will be increased once the organization has increased its market share. | | Beauty Supplies | Loss-leader pricing - The price of two products have been lowered so that sales of other more profitable products will increase. | | Plumbing Services | Predatory pricing - Labour prices are set at 25% of that of competitors to drive them out of business and gain an even greater market share. | | Super Top toys | Price skimming - There are a limited number of toys available, so the organization is charging a high price. | | Virtual Trophies | Penetration pricing - The organization does not have any clear competitors and is charging low prices to convince customers that they should purchase virtual trophies instead of physical trophies. Once the organization has penetrated the market, prices will be raised. | ## 15.4 Other Pricing Strategies In addition to the cost-based and demand-based pricing strategies described in the previous sections, an organization may set prices based on other factors. These include the following strategies: - **Value-based pricing**: is the practice of setting prices based on a trade-off between the perceived value to the consumer and the producer's incentive to produce the product (which is a function of price and cost). Value-based pricing uses value curves, which rank the attributes of the firm's cost-volume-profit against those of its main rivals to see which firm offers the most value for the price charged. - **For example**, luxury car manufacturers use value-based pricing by understanding which features affect the customers' perception of value. This can be accomplished through soliciting customer opinions and market research of the competition, and then setting vehicle prices based on the customers' perceived value. - **A reverse engineering strategy**: involves disassembling competitor's products to determine their costs and then attempting to gain a market share. Depending on the industry and competitors, there can be legal implications when copying a competitor's products, such as for violating copyrights or trademarks. ## 15.4.1 Pricing For Not-For-Profits and The Public Sector By nature, **not-for-profit organizations (NPOs)** do not intend to earn a profit and therefore prices are set to cover the costs of the good or service being offered. This is often in the form of fees charged to those who use the services of the NPO, such as user fees to attend a program. **Public sector organizations**: are like NPOs, in that they exist to serve the public, rather than to earn a profit. However, public sector organizations can have resources that are highly desirable to the public and are sold, such as mineral or timber resources. These markets have no competitors, and sales are often made through a public auction, in which customers bid their best price to secure the government's resources. ## Lesson 2: Pricing - Overview - Summary Problem - **Technical Competencies:** - Prepares, analyzes, or evaluates operational plans, budgets, and forecasts (3.2.2) - Evaluates sources and drivers of revenue growth (3.4.1) - **Learning Outcome:** - Discuss pricing considerations and pricing approaches. ## Summary Problem **Svelte Co. is a clothing manufacturer and retailer that specializes in professional and comfortable workwear. The well-established organization has been selling clothing in Canada for 20 years. In the last several years, Svelte's sales have been relatively stable, and the organization is looking for new ways to gain customers and satisfy its existing customers.** **Within the workwear industry, there are many companies like Svelte; some focus on fashion, whereas other attempt to be cost leaders. Svelte differentiates itself from its competitors by focusing on comfortable fabrics and styles, as well as using brightly coloured materials.** ### Required - Describe the major influences on pricing that Svelte should consider. - Identify the structure of the industry that Svelte operates within. - Identify which stage of the product life cycle Svelte is in. - Discuss one cost-based pricing approach and one demand-based pricing approach that Svelte might use for its products. ### Solution - The major influences on pricing for Svelte are costs, customers, and competitors: - **Costs**: Svelte must understand its product costs so that its clothing can be priced higher than cost, resulting in profit for the organization. Product cost will include both variable and fixed costs, and it may also include an analysis of long-term and short-term costs. - **Customers**: Svelte's customers determine the value in their products and will pay according to what they think the clothing is worth. As adult professionals, they are likely willing to pay a higher price than customers of discount clothing brands would typically pay. - **Competitors**: The competition within the workwear industry also affects the price, as Svelte's products will be compared to its competitors. If Svelte's clothing is more expensive than comparable competitors' products, Svelte is unlikely to gain new customers and keep its existing customers, unless its products are different in some way from its competitors. - The workwear industry is likely to be **monopolistic competition** because there are many independent market participants that differentiate themselves through cost or fashion. - Svelte is in the **maturity stage** of its product life cycle because its products are well established, and its sales are stable. - The following are examples of cost-based and demand-based pricing approaches that may be utilized by Svelte. Other well-supported approaches are acceptable. - **Cost-based pricing methods** - **Target-based pricing**: If Svelte is having a difficult time competing on price, it may use target-based pricing. Under this method, Svelte would first determine the price that its customers are willing to pay and then deduct its required profit. The result is the target cost. Svelte would then use this information to ensure that its product cost is no higher than its target cost. - **Full absorption costs**: Using this method, Svelte would calculate the product costs for each of its product and then apply a markup percentage to costs to set the price. This would ensure that Svelte is earning a profit on each sale; however, its products may not be priced competitively, as no comparison is made to its competitors' products. - **Demand-based pricing methods** - **Price bundling**: For Svelte, this would involve bundling together some of its products and selling them for a price that is less than the individual cost of each product. For example, a sweater may be sold with a pair of pants as an outfit, resulting in a lower price for customers. - **Penetration pricing**: In this approach, Svelte would lower the cost of its products to gain a larger market share. Once it has gained some of its competitors' customers, the company would then increase the price to ensure that it is still earning a profit. ## End-of-Chapter Practice **Practice Problem 1 (20 Minutes)** Wan Co. has developed an innovative new mobile application (app) called Personal Pet Vet (PPV) that helps pet owners track the health of their pets. Wan is currently in its final stage of development and is considering how it will price PPV. Because anyone can make an app, there are many organizations in the market that have pet-based apps. Each has its own specific focus, and some are focused on pet health. However, no competitor currently allows owners to upload pictures of their pets and use artificial intelligence to diagnose common illnesses, like PPV. During development, Wan has incurred mainly labour costs, as developers are in high demand in the area. The organization rents an office and has significant information technology expenditures. Once the app is released, the labor costs will decrease slightly, but the organization focuses on keeping the app operating. ### Required: - Describe the major influences on prices for Wan and provide recommendations to assist Wan with pricing for PPV. - Identify the structure of the market that Wan operates within - Describe the product life cycle for PPV. **Practice Problem 2 (25 Minutes)** Amelia is a commercial helicopter pilot who plans to offer two-hour helicopter tours to various venues from her home airport in Hamilton, Ontario. Tours would focus primarily on Toronto and Niagara Falls. She estimates that she will be able to sell 500 tours per year. She plans to keep the helicopter for 10 years and then retire. Amelia's costs are as follows: - **Flight operating Costs:** - Variable operating costs per flying hour: $300 - Variable overhead costs per flying hour: $25 - Fixed annual ground-related costs: $50,000 - **Selling and administrative costs:** - Fixed sales, general, and administration per year: $150,000 - Variable sales, general, and administration costs: $18 per flying hour - Developing the tour business: $250,000 - Costs incurred to close the tour business: $50,000 Amelia's goal is to make a profit equal to 10% markup over total costs. ### Required: - Describe three cost-based pricing methods that Amelia may use to determine the price of a two-hour helicopter ride. - Calculate the total cost and suggested price of a two-hour helicopter ride based on the following methods: - Variable costing, with a 50% markup on costs. - Full costing, with a 10% markup on costs. - Life-cycle costing, with a 10% markup on cost. - Recommend the cost-based pricing method that would be most appropriate for Amelia and justify your recommendation with case facts. **Practice Problem 3 (15 Minutes)** Claudio is opening a new daycare and setting the monthly prices. He estimates monthly costs of operating the daycare to be as follows: - Rent expense: $4,000 - Insurance: $500 - Utilities: $350 - Wages and benefits: $9,000 - Supplies $600 - Depreciation: $150 - Total monthly cost: $14,600 Based on the number of staff and the size of the space, Claudio estimates he can accommodate 20 children. Because there is a shortage of daycares in his area, Claudio is considering setting his monthly price based on demand rather than costs. After doing market research, he found the average price per month for one child in the area is $1,000. ### Required: - Describe four demand-based pricing strategies that Claudio may use to set his monthly price. ## Solution to Practice Problem 1 - **Competency**: 3.4.1 Evaluates sources and drivers of revenue growth (Entry Level C) - **Knowledge Items:** - Industry structure - Pricing strategies - Monopoly, oligopoly, and monopolistic competition (Entry Level C) - Factors that affect demand for a product or service and have an impact on pricing (Entry Level C) - Production differentiation, mix, and marketing - Product life cycle (stages, characteristics, market positioning, dimensions, domestic and international markets) (Entry Level C) - **The major influences on prices of the PPV app are as follows:** - **Information technology costs**: Once it is complete, labour costs will decrease slightly, but considering developers are in high demand, Wan should expect these costs to continue to be relatively high. - **Customers**: PPV's customers are pet owners that care about the health of their pets. Potential customers could have relatively high disposable incomes because they can afford to own pets, and they may be willing to pay a premium for easy access to pet health care. Other customers may not have a lot of disposable income as they are using an app to diagnose their pet, instead of going to a vet. Wan should consider doing market research to determine how much customers would be willing to pay. - **Competitors**: There are very few competitors with similar apps, and none have the same innovative new features as PPV. Wan will be trying to gain market share, but since there are no direct competitors, it may be able to charge a premium for the app. Wan