The pricing decision and its importance

Pricing applies to both products and services, and is important for both non-profit and profit making organisations as it affects future cash flows and profits. Pricing can be applied to external or internal (e.g. transfer pricing) products or services. Pricing is part of the marketing mix [price, product, place, promotion], therefore it is likely to affect the other ‘three P’s’, meaning it has an affect on other cost figures.

As mentioned in my article on ‘Competitive Strategies and Business Tools, one of the main aims of companies is to impose a psychological perception of product or service quality. There are two main types of quality perception pricing; perceived quality pricing and penetration pricing. The perceived quality pricing strategy is applied by setting a remarkably high initial price, which is then reduced over time. The initial high price puts across the perception to customers that the product or service is of a better quality to similar items on the market. Penetration pricing follows that the business sets a very low price (lower than the market) to try and undercut competitors.

Product Life Cycle

A product life cycle is used to identify the stages through which a product (generally) or service normally passes through, relating sales to the time the product or service is in existence.

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  1. Introductory stage: higher selling prices as customers more willing to pay for new product.
  2. Growth stage: slightly lower prices, people who werent willing to pay a high intial price are more likely to buy.
  3. Maturity stage: slightly lower selling price, try to sustain sales e.g. new features.
  4. Decline stage: low price, look at contribution from sales and decide if the product should be discontinued.

The price of the product depends on the stage of the product life cycle, however there is a greater opportunity for price variation in the introductory stage of the product.

Methods of Pricing

There are many different methods used by managers to price products and services, and I will look at a few of the most common methods below.

Market based pricing essentially ‘does what it says on the tin’ – the product or service price is based purely on the market value of that item i.e. in line with competitor prices. A quick example of where this pricing method is used is in the oil industry – petrol prices and petrol stations are almost all the same, with fluctuations of differences of a few pence between them. One advantage of this method is that it allows businesses to gain greater market share, as the price is the same across the market so customers tend to be less loyal. However, a major disadvantage of this method is that it doesn’t particularly account for costs, as the market price may be lower than the unit cost of production, therefore the item may in fact make a loss.

Variable cost plus pricing focuses on products or services whereby the business uses variable costing. The mark-up (the difference between the selling price and variable cost) should total the fixed costs, including the required profit. Table An advantage of this method is that it is good for short-term pricing as it allows the business to offer competitive low prices. However, the disadvantage with this type of pricing is that the business may not make enough contribution to cover fixed costs, and also it may be difficult to increase prices once price-conscious customers become accustomed to the lower prices.

The final traditional pricing method is total cost plus pricing which simply adds an additional amount (mark-up) to the total production cost per unit to cover profit. This method is very similar to variable cost plus, with the distinct differing factor that the total cost of production includes fixed costs. This is an advantage over variable cost plus as managers can be more confident that all fixed costs are covered. Similarly, as the method is as simple as adding a mark-up for profit, it is seen as a quick and easy way to price products and services. Despite this, there is often great difficulty in deciding the amount (mark-up) that should be added to the unit price to cover profit. This may depend on the type of product being sold or service being offered (considering margins).

Financial and Non-Financial Factors in Pricing

I’m sure you are able to think of many financial considerations that may need to be made by a business, but here are a few anyway;

  • the amount of profit required by the company
  • the cash generation possibilities
  • the cost of product (production, variable, fixed etc.) or service
  • coverage of all costs; variable, fixed, overheads etc.
  • using up spare capacity (else these are wasted costs)
  • the effect of competition on the price and demand for the product/service

However, businesses also need to consider non-financial factors that have the potential to affect the financial factors. Examples of these non-financial factors are;

  • relationship to other products/services; loss leaders, substitutes, complimentary products/services
  • strength factors in the marketing mix;
    • price (low or high etc.)
    • product (uniqueness of the product)
    • place (where the product is sold e.g. high-end retailer, recognised brand etc.)
    • promotion (discounts to customers – third part sellers, or directly to end users)
  • stage in product life cycle – as discussed above
  • nature of the market; external, internal e.g. staff café

Price-Demand and Supply-Demand Relationships

The price-demand relationship shows the link between the price of a product or service, and the consumer demand for it. This relationship is generally linear; showing that when prices are high demand is low, and when prices are low, demand is high. Demand Businesses should consider the impact of customer demand for the product or service when deciding upon a price. Not all businesses will be affected by this relationship; for example, businesses that sell everyday essentials such as supermarkets may not be affected as much by customer demand, as we all need food.

As well as the price-demand relationship, businesses should also take into account the relationship between price and supply. This relationship is also generally linear; showing that when the price increases supply increases and when price decreases supply also decreases. Supply This relationship is caused by the fact that businesses will supply fewer products and services sold at lower prices, as there is less money to be made, however they will supply more if the price is higher as there is more money to be made.

In order to obtain a reasonable selling price, businesses can combine these two graphs to see where supply and demand intercept. Market Equilibrium This interception point is called the market equilibrium, and links all three elements (price, demand, supply) together. As market equilibrium assumes that there is neither a shortage nor surplus, it helps to identify the effects on the elements if conditions change.

The Role of Accounting Information in Pricing

As discussed previously, businesses need to consider reducing prices according to the stage in the product life cycle. Therefore, accountants need to allow for this, so the price may be set to include a reduction or increase so as to still generate either profit or contribution in the future. Overheads need to be accounted for in the product price, and it is up to the accountants of the organisation to decide how the overheads should be absorbed e.g. factory-wide blanket rate, departmental rate etc. and this has a profound effect on product price – particularly where several products are being made. Mark-ups and margins may be applied to unit variable or production costs, and it is often difficult to decide the additional sum or percentage – particularly on an expensive job. Using the businesses standard mark-up rate may not get a good reaction from the customer, so sometimes the margin changes to satisfy all criteria, whilst still covering costs and generating a profit. Price may only cover certain costs e.g. variable costing where only variable costs are included in the price and the contribution covers fixed costs, but may not cover all overheads. Accountants need to make sure somehow that all costs are covered – an essential part of scorekeeping.  

Featured image courtesy of http://www.trinityp3.com/wp-content/uploads/2013/01/Value-based-pricing.jpg

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