Week 6 Lectures PDF

Faculty of Management Bournemouth University Business School Department of Accounting, Finance & Economics Lecture 6 Pricing Decisions & Profitability Analysis Dr Akanga www.bournemouth.ac.uk  Learnin...

Faculty of Management Bournemouth University Business School Department of Accounting, Finance & Economics Lecture 6 Pricing Decisions & Profitability Analysis Dr Akanga www.bournemouth.ac.uk  Learning Outcomes By the end of this unit  Explain how organisations arrive at pricing decisions  Explain other factors that can affect pricing  Understand what we mean by marking up cost and target costing  Understand how to measure customer profitability www.bournemouth.ac.uk  Pricing Decisions Pricing decisions are often the most difficult decisions that managers face Pricing decisions examined include  Profit-maximizing price from the standpoint of economic theory  Pricing of special orders  Marking up costs and target costing  Measuring customer profitability and activity based pricing www.bournemouth.ac.uk  Economic Theory Economic theory suggests that the quantity demanded is a function of the price that is charged The price for any specific good/service is the relationship between the forces of supply and demand. Generally, the higher the price, the lower the quantity demanded If managers can estimate the quantity demanded at various prices, determining the optimal price is straight forward www.bournemouth.ac.uk  Economic Theory The point at which the benefit gained from those who demand the product (marginal revenue) meets the seller's marginal costs is the most optimal market price. For example: suppose that market forces determine that it costs £5 for a widget. This suggests that widget buyers are willing to forgo the utility in £5 in order to possess the widget and that the widget seller perceives that £5 is a fair price in exchange for giving up the widget. www.bournemouth.ac.uk  Economic theory The optimum selling Price (£34) is the price at which marginal revenue (MR) equals marginal cost (MC). The additional revenue earned by the last unit of the product is equal to the additional cost of making that unit = £34 www.bournemouth.ac.uk  Problems with applying economic theory 1. Difficult and costly to derive reasonably accurate estimates of demand. 2. Difficult to estimate cost functions to determine marginal cost at different output levels for many different products. 3. Demand is influenced by other factors besides price. 4. Profit maximization assumed – firms may pursue other goals. www.bournemouth.ac.uk  Role of cost information in pricing decisions Price takers are those firms that have little control over the prices of their products or services. For price takers cost information is of vital importance in deciding on the output and mix of products and services. Price setters are those firms that have some discretion over the setting of selling prices for their products or services. Cost information is of vital importance to price setters in making pricing decisions. Firms may be price setters for some of their products /services and price takes for others. www.bournemouth.ac.uk  Role of cost information in pricing decisions Four situations will be considered: 1. A price setting firm facing a short-run pricing decision 2. A price setting firm facing a long-run pricing decision 3. A price taker firm facing a short-run product-mix decision 4. A price taker firm facing a long-run product-mix decision www.bournemouth.ac.uk  A price setting firm facing short- run pricing decisions Applies where companies are faced with the opportunity of bidding for one time special orders in competition with other suppliers. In this situation only the incremental cost of undertaking the order should be taken into account. Given the short-term one-off nature of the opportunity many costs will be non- incremental. www.bournemouth.ac.uk  A price setting firm facing short- run pricing decisions Bids should be made at prices that exceed the incremental cost and must meet the following conditions: 1. Sufficient capacity must be available to meet the order. 2 The bid price should not affect 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. www.bournemouth.ac.uk  A price setting firm facing long- run pricing decisions Three scenarios considered: 1. Pricing customized products using cost-plus pricing. 2. Pricing non-customized products using cost-plus pricing or demand estimates. 3. Pricing non-customized products using target costing. In the long-term a firm can adjust the supply of resources that are committed to it - therefore a product or service should be priced to cover all of the resources that are committed to it. Price setters have stronger grounds for adopting ABC. www.bournemouth.ac.uk  Cost-plus vs. Target costing Price setting firms sell customized products, where demand is virtually impossible to be estimated, cost- plus pricing should be used.  Price = cost + a mark-up  short term pricing decision vs. long-term pricing decision  Easy and speedy in deciding on the price  Help in predicting the price of other companies  Adjust the mark-up to consider changes in the sales demand www.bournemouth.ac.uk  Pricing customized products using cost-plus pricing 1. An accurate costing system is required since under costing will result in acceptance of unprofitable business and over costing in the loss of profitable business. 2.To determine the selling price a full cost/long-run cost should be calculated and a mark-up added (i.e. a cost-plus selling price is determined. www.bournemouth.ac.uk  Pricing customized products using cost-plus pricing 3. Cost assignment for pricing should be based on direct cost tracing or cause-and-effect assignments —Arbitrary allocations (e.g. some business/facility-sustaining costs) should be allocated using behavioural drivers or covered within the mark-up. 4. ABC provides a better understanding of cost behaviour for negotiating with customers, the price and size of the orders. www.bournemouth.ac.uk  Advantages of 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. www.bournemouth.ac.uk  Criticisms of cost-plus pricing 1. Ignores demand 2. Does not necessarily ensure that total sales revenue will exceed total cost. 3. Can lead to wrong decisions if budgeted activity is used to unitize costs. 4. Circular reasoning —Volume estimates are required to estimate unit fixed costs and ultimately price. www.bournemouth.ac.uk  Cost-plus vs. Target costing Price taking firms sell non-customized products, then target costing pricing should be used. Target costing is the reverse of cost-plus pricing —The target selling price is the starting point. www.bournemouth.ac.uk  Cost-plus vs. Target costing 1. Four stages are involved: Stage 1: Determine the target price which customers will be prepared to pay for the product. Stage 2: Deduct a target profit margin from the target price to determine the target cost. Stage 3: Estimate the actual cost of the product. Stage 4: If estimated actual cost exceeds the target cost investigate ways of driving down the actual cost to the target cost. 2. Marketing factors and customer research provide the basis for determining selling price (Not cost). www.bournemouth.ac.uk  A price taker firm facing short- run product-mix decisions Applies where opportunities exist for taking on short-term business at a market determined selling price. Cost information required and the same conditions apply as those specified for a price setter facing short-term pricing decisions. If short-term capacity constraints apply the product mix should be based on maximizing contribution per limiting factor www.bournemouth.ac.uk  A price taker firm facing short- run product-mix decisions In the long-term a firm can adjust the supply of resources that are committed to it – Therefore the sales revenue from a product or service should be sufficient to cover all of the resources that are committed to it. Periodic profitability analysis is required to ensure that only profitable products/services are marketed. Profitability analysis should be used as an attention-directing mechanism. www.bournemouth.ac.uk  Example A company expects a return of 20% on the £400,000 investment in a new product. The variable cost of making the product is £7 per unit and the fixed costs associated with the output is £50,000. It is expected that 10,000 units will be produced. What is the selling price that should be set so that the company can make the required return? www.bournemouth.ac.uk  Solution Required return = 20% of £400,000 = £80,000. This equates to a return of £8 per unit (80,000/10,000 units). The Fixed Costs work out at £5 per unit (50,000/10,000). Therefore the selling price would be set at (VC£7 + FC£5+ Return £8) = £20. www.bournemouth.ac.uk  Other factors than Costs Price Sensitivity  How customers react to the change in price  e.g. change cinema prices: someone who rarely goes to the cinema vs. someone who goes to every new release.  e.g. change in train tickets price: someone who can claim travel expenses back vs. someone who travel with family. Price Perception  Customers may react to threatened price increases by buying more as they could be expecting further price increases e.g. petrol. Alternatively, they might put off buying a product if they expect further price decreases (e.g. flat-screen televisions). www.bournemouth.ac.uk  Other factors than Costs Quality  It is common for consumers to judge the higher priced product of two products as being of better quality. Intermediaries  A manufacturer who decides to increase the price of its new music product from €100 to €120 must realise that this could result in the intermediary increasing the onward selling price from €120 to €144 (in order to maintain their own 20% mark-up).  Dell is an example of a company which has concentrated on cutting out intermediaries. www.bournemouth.ac.uk  Other factors than Costs Competitors  Organisations must keep an eye on the pricing policy of their competitors, especially where there is little product differentiation. In petrol retailing, prices tend to move in unison and a price cut by one oil company can indicate the launching of a damaging price war. Price setters vs. Price takers Suppliers  For example: The UK annual budget normally increases the price of a pint of beer by a penny or two but pubs use this to increase the price by 5p a pint. The breweries then charge an extra couple of pence to the pubs in order to take a share of this increase www.bournemouth.ac.uk  Other factors than Costs Inflation  For example: if inflation is 3% and the price of sandwich is increased from £2 to £2.06 then the real increase is zero while the nominal increase is 6p (in reality, what often happens is that the price is increased by 10p to £2.10). The Economic Wealth / Income of a Region  In times of rising incomes, price may be less important to consumers than product quality.  In recessionary times, price increases are often lower as companies try to increase sales by limiting such increases. www.bournemouth.ac.uk  Other factors than Costs Product Range For example: the printer that is sold for a low price with a cartridge of ink supplied. When the cartridge needs to be replaced it may cost as much as the original printer (the printer a “loss leader”). Ethics While recent experience has shown that gas companies fully exploit shortages, some pharmaceutical companies have reduced the prices of their medicines supplied to African and Asian markets. Substitute Products For example, the channel tunnel has helped to constrain price increases imposed by ferry companies while the Eurostar from London to Paris and Brussels has helped reduce the plane fare between the cities. www.bournemouth.ac.uk  Pricing Policies www.bournemouth.ac.uk  Pricing Policies Market Skimming Pricing  Charging a high price when a product is first launched and spending heavily on advertising and sales promotion to obtain sales.  Recovering R & D costs as quickly as possible and earning high profits early in the product’s life.  This policy is only appropriate where:  New and different products and customers are prepared to pay high prices in the expectation that it carries an exclusive cachet.  The strength of demand and the sensitivity of demand to price are unknown.  Products have a short life cycle and need to recover their development costs and make a profit quickly. www.bournemouth.ac.uk  Pricing Policies Market Penetration Pricing  This policy sets a low price when a new product is launched. This enables the product to obtain a foothold in the market. This policy may be used by an organisation which:  Wishes to dissuade new entrants from coming into the market  Wishes to shorten the initial period of a product’s life cycle in order to enter the growth and maturity stages more quickly.  Can take advantage of economies of scale by producing in larger quantities  Expects demand to increase as prices fall www.bournemouth.ac.uk  Pricing Policies Full Cost Plus Pricing The full cost of production or absorb non-production costs into the product. The % mark-up or percentage margin does not have to be fixed but can vary according to circumstances and demand. It is simple, quick and cheap. Working at full capacity will cover all its fixed costs and make a profit. It can be used to justify selling prices to customers Pricing can be delegated to lower levels of management The relationship between supply and demand may be ignored However, supply/demand relationship is ignored The market and demand conditions are ignored Requires accurate forecasting about costs and production levels It ignores what competitors are doing It ignores where the product is in its life cycle It is fairly inflexible and ignores short term considerations It does not take opportunity costs into account www.bournemouth.ac.uk  Pricing Policies Variable Cost Plus Pricing Many retail organisations use this method. For example, a clothes retailer might add a 200% mark-up to a pair of jeans costing £15 and sell them for £45. The mark up can be adjusted to reflect demand conditions. It attracts management attention to contribution and the effects of higher or lower sales volumes on profits through the Contribution/Sales ratio that we saw in Breakeven analysis. (For example: A selling price of £2 and a variable cost of £1.50 imply that the contribution is 50p and the c/s ratio is 0.25. This means that for every additional £1 of sales 25p is added to contribution/profit.) However, it does not ensure that sufficient attention is paid to the actions of competitors or the market conditions. Also, even though fixed costs must be covered to ensure a profit, fixed costs are ignored in the pricing decision. www.bournemouth.ac.uk  Pricing Policies Opportunity Cost Pricing  The concept of ‘relevant cost’ applies  The opportunity of bidding for one time special orders in competition with other suppliers.  Only the additional cost of undertaking the order should be taken into account.  Bids should be made at prices that exceed the incremental cost and must meet the following conditions:  Sufficient capacity must be available to meet the order.  The bid price should not effect future selling prices and the customer should not expect repeat business at short-term incremental cost.  The order will utilize unused capacity for only a short period and capacity will be released for use on more profitable opportunities. www.bournemouth.ac.uk  Customer Profitability Analysis Analyzing Analyzingthe theactivities, activities,costs, costs,and andprofit profitassociated associated with withserving servingspecific specificcustomers. customers. Customer makes frequent order For various reasons, changes. some customers are less profitable than Customer others. needs special attention. Customer is difficult www.bournemouth.ac.uk to please.  Customer Profitability Analysis Studies Studieshave haveshown shownthat thatonly only20% 20%ofofaacompany’s company’scustomers customers contribute contributeto toprofits. profits.The Theremaining remaining80% 80%generate generatelosses. losses. Possible qualitative reasons to retain unprofitable customers: Customer prestige. Potential future profitability. Loss leader to enter market. Non monetary benefits such as knowledge or expertise. www.bournemouth.ac.uk  Customer Profitability Analysis A A graph graph of of five five of of our our customers customers reveals reveals that that two two of of the the five five are are unprofitable. unprofitable. Question: Why are these two customers unprofitable? www.bournemouth.ac.uk  Customer Profitability Analysis Comparing Comparing the the customer-related customer-related costs costs for for each each customer customer can can reveal reveal helpful helpful insights. insights. Order Order processing processing Special Special packaging packaging costs, costs costs, engineering/design costs for for engineering/design Customer changes, Customer 114114 are are changes, and and special special handling four four times times the the handling costs costs for for Customer Customer 102 102 are are norm norm and and special special above above normal. normal. handling handling costs costs are are www.bournemouth.ac.uk www.bournemouth.ac.uk  Reading List Drury & Tayles (2023) Cost and Management Accounting, 12th Edition. Chapter 10 www.bournemouth.ac.uk