Pricing 2: Practical aspects

This first article in this series dealt with the theoretical aspects of pricing. This one deals with practical pricing approaches.

The influences on product pricing

The influences on pricing decisions are often listed as:

• Cost – the selling price should cover the cost of production. Costs can be calculated in a number of different ways: marginal cost, total absorption cost, lifecycle cost and relevant cost. A cost-plus approach is then used so that a mark-up is added to the cost to produce a price. No company would ignore a cost-plus approach but as we will see it will not always give the best answers to pricing decisions.
  
  
• Customers – what are they prepared to pay for the product? In effect this relates to the price elasticity of demand for the product and its demand function as explained in the first article. If costs are too high, no-one will buy products – or not in a high enough volumes.
  
  
• Competitors – Are there any? What is the strength of competition? What are they charging? If many competitors are selling very similar products then companies have little flexibility in their pricing: all have to fall in line with the current market price. If a company is a monopoly supplier, it has much more freedom to choose its selling price. Note that monopolists are not guaranteed to make a profit: they might be trying to sell a product no-one wants.

There are a number of different approaches to pricing which a company can adopt. In the rest of this article we will look at these different approaches.

Cost-based pricing

Marginal cost
If the marginal cost for a product was $120, and the company had a policy of adding a mark-up of 25% then the selling price would be $150. That would generate a contribution of $30/unit. Whether the total contribution covers fixed costs so that the company breaks into profit depends on the fixed costs and the volume sold.

There is no point in setting a selling price below variable cost unless the company were contractually obliged to (for example, costs rose after the sales contract was signed) or the company was prepared to lose money initially to break into a new market eg promotional discounts.

Total absorption cost
If the marginal cost was $120, and the fixed overhead absorption rate were $40 per unit then the total absorption cost is $160. Adding a mark-up of 20% would give a selling price of $192. That would generate a potential profit of $32/unit.

An advantage of this approach is that if the product was not selling well at $192 the company could consider lowering the price. If it wanted to keep a mark-up of 20%, it would have to find ways of lowering the $160 cost of the product. The total absorption cost contains both variable and fixed costs, therefore the company is unlikely overlook the importance of trying to reduce fixed production costs as well as reducing variable production costs.

Lifecycle costing
Lifecycle costing takes in to account all costs over a product’s life: pre-production costs, production costs and post-production costs. In the long run, the total revenue generated by a product should be no less than the total costs needed to design, make and close down the product’s production.

For example:

Initial design costs and production line machinery purchase = $2m

Variable production costs and the fixed costs incurred over the product’s life = $10m

Production close-down costs (eg clean-up costs + potential redundancy costs - machinery scrap value) = $1m

So, the lifetime cost of the product is $13m.

If the company estimated that it will make and sell 2 million units of the product, the lifetime cost per unit will be $6.50 and if a long-term profit is to be made the selling price must be set above that.

Lifecycle costing emphasises the importance of taking all costs into account to try to ensure that these are covered by the decision to embark on the production of a new product. In particular it can draw attention to the importance of the up-front costs as spending more on product design might save much more during subsequent production. This would lower the overall life-time costs and allow a profit to be made at a lower, more attractive selling price.

Relevant costing
Relevant costing uses relevant cash flows to assess the cost of the product or contract. These are future cash flows caused by making the product or entering the contract.

For example, a contract required the use of:

1. Components currently in inventory which had cost $12,000.  They are not currently used in the business, but they could be sold for $10,500.
2. New components that must be bought for $15,000.
3. An additional member of staff for one year with a $20,000 salary.
4. Currently idle staff who would be set to work on the new contract - $16,000 salary.

These items would be handled as follows:

1. $12,000 is a sunk/past cost and is irrelevant. However, the company does lose out on an inflow of $10,500 if the components are used instead of being sold. This is a relevant cost for the contract.
2. This is relevant. It is an additional cash outflow caused by the contract.
3. This is relevant. It is an additional cash outflow caused by the contract.
4. This is irrelevant as it has no incremental cash flow effect. The staff are being paid and will continue being paid, but they will simply be asked to spend time working on the new contract.

The total relevant cost is therefore: $10,500 + $15,000 + $20,000 = $45,500.

This represents the minimum price that should be demanded for the contract. Any amount less than this and the company would be worse off.

The big flaw in all cost-plus based approaches to pricing is that simply because there is a mechanism for arriving at a selling price does not mean that any units at all will sell at that price. The company could be very inefficient so that costs and resulting selling prices are so outrageously high that no customers will buy the goods. Even if the resulting prices are not very high, competitors might be offering the goods at a lower price.

All cost-based methods are entirely inward-looking and pay no attention to customers or competitors. The approach is simple to apply and is often used in practice,  but the company must  look at the price it has arrived at and consider if it is realistic.

It is also worth noting that using costs to determine prices might under-estimate a viable selling price. For example, a cotton t- shirt might cost $3 to make but if a fashionable brand’s logo can be sewn on to it the potential selling price will be hugely boosted by the brand association even though the logo costs next to nothing to apply. Using a cost-plus approach in this case would set a lower selling price than customers would be willing to pay.

Price skimming and penetration pricing

Price skimming is when a new product is launched at a very high price. The seller assumes that there will be enough customers who are willing to pay a lot to be one of the first to have the product. At the early stages of a new product launch output is often limited so high prices with low volume makes sense. Eventually, the price is lowered to skim off another layer of customers. The price is quickly forced down until it reaches a stable level. This approach is common in the mobile phone and technology markets.

In contrast, penetration pricing means going into the market with an aggressively low price. The aim is to win a large market share and to sell large volumes. Large volumes can lead to low unit costs (for example, fixed costs are spread more thinly) and this can allow the company to make profits even at low prices. Indeed, the market domination achieved can make it difficult for new competitors to enter the market because they may find it difficult to match the market leader’s economies of scale needed to earn profits at a low selling price.

Complementary product pricing

The initial product is sold at a low price to attract customers. Having enticed the customer to buy the initial product, subsequent training, maintenance and consumables are sold at relatively high prices.

An example is seen in ink-jet printers: cost of the printer $70; cost of a set of replacement ink cartridges $30!

Most profits are made on the follow-up sales rather than the initial product.

Product-line pricing

A product-line is a group of products from a manufacturer that are similar in design, functionality and target customer. They present a range of features and different prices. For example:

• Mobile phones: different screen sizes, resolutions, speed and camera resolutions.
• Cars: different engines, paint quality, interior fittings.
• Hotel rooms: different sizes of room, different types of bed, suites, rooms with or without a view.

The advantages of product-line pricing are:

• Buyers can adjust their purchases to suit their pocket and their requirements without having to go to a different supplier.
• People like reference points when choosing. The basic car at a relatively low price can attract interest. That sets the entry level price for a new car (and provides some price justification), then buyers can decide whether to trade up to a better model possibly concentrating on the price increments rather than the total price.
• People like choice. If only one level of trim and engine were offered you would certainly look elsewhere before choosing.
• The increase in price between a basic model and a better model is usually much greater than the increase in costs needed to make the better model. This allows sales staff to profitably up-sell the better model.

Volume discounting

Most people like bulk-buy deals as they see a way of saving money. For example, buy one and get 50% off the second.

Volume discounts are often used in business-to business sales as larger purchases create economies of scale for the seller (one large shipment to a customer is cheaper to organise than two small ones). This also has the effect of increasing the supplier’s market share.

In turn, retailers benefit from the cheaper prices and they may decide to pass on this discount to their end customers. Retailers’ lower purchase costs mean that they maintain their profits even if they charge lower prices to their customers. You may have seen large supermarkets (who are able to negotiate large volume discounts) offering goods more cheaply than their smaller competitors. If the supermarket can offer very keen prices then more customers will enter their stores and probably make other purchases there too.

Price discrimination

Price discrimination means offering the same goods in different markets at different prices.

Examples include:

• Pharmaceuticals priced radically differently in different countries depending on the wealth of each country’s patients or health services.
• Advance purchase tickets for travel often cost much less than walk-on fares. Here, the two markets are people who can plan in advance and those who must travel unexpectedly.
• In the USA electrical and photographic goods are often sold much more cheaply than, say, in the UK. Often if an item cost $100 in the USA it will cost about £100 in the UK.

What the sellers are trying to do is to maximise their profits in each country. As explained in the first pricing article, profits are maximised when marginal revenue equals marginal cost so sellers adjust their prices in each market to achieve this.

For the scheme to work, it needs to be difficult for goods sold in the cheaper market to be bought there then transferred to the more expensive market, either for the buyer’s personal use or to be sold on at a profit. So, for example, pharmaceuticals that have identical chemical formulae will have different brand names, colour, shape and regulatory approval so that patients will feel nervous about using irregular (grey) imports. Similarly, electrical goods bought in the USA may not work so well elsewhere because they might require the USA voltage of 110, electricity frequency of 60Hz and will come with a different electrical plug. Price discrimination works very well in service industries.

Conclusion

Pricing can be a fascinating area. Whereas, apart from commodities, many costs are within accountants’ control, pricing goods means interacting with suppliers, customers, the economy and competitors. It is rarely completely clear that the correct price is being charged for long-term profit maximisation. Even if the ‘correct’ price were being charged today, it is unlikely to be stable: new products, production technology, competitors and changes in customer taste will ensure that pricing decisions have to be continuously revisited.

Written by Ken Garrett, a freelance lecturer and writer