Pricing Decisions - Nov.

2017 PAC Financial Consultant

PRICING DECISIONS
By Gaedeke - Price is the presentation of value on the product for the purpose of exchange.
By Boone & Kurts - Price is the exchange value of goods or services.

Importances of Price
a) Macro-Economics
- Helps the individual to allocate resources
- Helps the individual to relate the quality and price.
- It is used when the seller wants to position the product to be exceptional or more
prestigious.

b) Individual Firm
- It is the major determinant of the market.
- It affects the firm’s competitive position & therefore it affects the market shell of the firm.

c) Other roles of price

- Determinants of sales revenue.
- Determinants of demand.
- Promotion tool.

Factors for Pricing Decisions

- Firm’s objectives e.g. profit or revenue maximization.
- Market in which the firm operates e.g. Perfect or imperfect competition or monopolistic?
- Demand for the firm’s product(s) - Is demand known for the product?
- Elasticity of demand for the product - Is it elastic or inelastic?
- Costs structure of the firm and product – expected future marginal and fixed costs.
- Availability of substitutes – is the product clearly differentiated or are close substitutes?
- Inflation – is inflation rising, falling or constant.
- Government restrictions or legislations.
- Level of activity - will the firm be working at full or below capacity?
- The competition (extent and nature of competition).
- The product (Stages in the product life cycle).

The Corner stones’ of a Pricing Policy

There are three crucial aspects which make up the pricing policy of an organization.
These are:
 The pricing objective,
 The pricing strategy, and
 The pricing method

1. The Pricing Objective(s)

Kotler identifies six major objectives that may be pursued in a pricing policy. These are:
 Survival - whereby a company is plagued with problems, profit is hardly a matter of
importance and so the company is even willing to cut its prices.
 Maximum Current Profit - the company seeks to maximize current profit, cash flow or rate
of return.
 Maximum Current Revenue - where a company sets out to maximize sales revenue.
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 Maximum Sales Growth – where there is a belief that the higher volume will lead to lower
unit costs and higher long-run profit.
 Maximum Market Skimming – in which case the company sets the highest price it can for
a target segment of the market, and as sales slow down lowers it to attract the next layer of
customers.
 Product Quality Leadership – whereby a company aims at being the product-quality leader
in the market.

2. Pricing Strategies
A company may wish, as a matter of policy, to set high prices, average prices or low prices. The
company may, on the other hand, wish to set optimum prices. In general these are the four
alternative pricing strategies. Optimum prices go hand in hand with the economic approach to
pricing which equates marginal revenue with marginal cost.

New products
Companies introducing new products often choose between pitching their products at a high
price (and make a quick profit if the launch is successful) or at a low price will enable the
product to dig inroads into the market. The latter strategy is known as penetration pricing and the
former is known as (market) skimming.
When a market skimming approach is adopted, products are priced relatively high in the earlier
stages to ‘skim the cream of the market’. The cream of the market is normally insensitive to price
changes. Over a period these prices are reduced so as to enable expansion into the more elastic
sectors of the market.

The Skimming Strategy is appropriate

 Where the product is new or/and different.
 When demand for the product is highly inelastic.
 Where it is general company policy to pursue short-term profits.
 Where the product has a short life cycle and large costs e.g. on research and development
costs have been incurred in getting the product to market, and there is a requirement that
these be recovered as quickly as possible.
 The company considers the future too unpredictable to account for and reckons it is easier to
correct a launch price which is found to be too high than vice versa.
 The size of the market is deemed relatively small (or it might be large, but at the time of the
launch the company does not have a large enough distribution system in operation).
 There are effective entry barriers to new firms(like in the case of monopolies)
 Economies of scale are not expected in the future.
 The technology of production is simple so the company does not expect unit cost to fall
appreciably with experience (technically a leading effect is not anticipated).
 The company wishes to encourage a high-quality image for their new product.

The main advantage associated with the skimming strategy is that the company is able to make
high profit quickly (creaming off the top of the market).
The major disadvantages of skimming strategy are:
1. It focuses on short term profit.
2. The chance of attracting rivals due to a high price or high profits is great.

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3. There may be firms waiting in the wings who believe they can produce a similar product but
more cheaply either because they know of some cost saving production method or have
access to some cheap factors of production.

Penetration Pricing Strategy

In this strategy, relatively low prices are set in the initial stages, in the anticipation of cost
savings resulting from an expanding market bringing high volumes and movement up the
learning curve. Low starting prices sacrifice short-run for long run profits and discourage
potential competitors. This policy is opposite in nature to the skimming strategy discussed above.

Conditions suitable for Penetration Strategy

 Highly elastic demand for the product
 If significant economies of scale could be achieved, means higher sales volumes would
result in sizeable reduction in costs.
 If the Company wants to discourage new entrants into the market.
 If the Company wants to shorten the initial period of its product life cycle so as to enter the
growth and maturity stages quickly.
 If the competitors cannot imitate the price

Other Pricing Strategies

Premium Pricing
A product is made to appear different from competing products by providing: better quality,
reliability, durability, after – sales service, extended warranties etc. A premium may be charged
for these additional qualities.

Loss Leaders
A company may deliberately under-price a main product to stimulate demand for accessories e.g.
a low priced vehicle may have expensive spares, a low-priced printer may require frequent
purchase of ink cartridges etc.

Price Discrimination/Differentiation
If the market can be split into different segments, each quite separate from the others and with its
own individual demand function, it is possible to sell the same product to different customers at
different prices. Segments need not be geographical locations.
Segmentation could be based on:
 Quantity (build orders at a lower price)
 Function (wholesale price vs. retail price)

Product Bundling
Several products or services are bundled together into a package deal at a lower aggregate price
than the total of the individual parts of the bundle.

Psychological Pricing
This strategy appeals to emotions rather than logic. Customers perceive a large difference
between Tshs. 99 and Tshs. 100 and therefore the former price would be set.

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3. Pricing Methods
When a company sets a price for its goods it hopes that customers will accept that price and
demonstrate their acceptance by purchasing the company’s goods. It is, therefore, of utmost
importance that a company carefully assesses the likely response of customers to a price fixed
for its goods (i.e. whether or not customers will fell that the goods are worth their price) the
assessment of customers’ response is not a mere matter of guesswork, but is build upon
principles of economic reality. Economists refer to the degree of customers’ response to changes
in prices as elasticity of demand. Elasticity of demand for a company’s product will, to a large
extent, influenced by the market in which the company operates.
It is reasonable, therefore, that an understanding of a company’s pricing policy start from an
examination of the two factors.
 Elasticity of demand and
 Type of markets.

Elasticity of Demand
A product is said to be highly elastic if a small change in price leads to a large change in quantity
demanded. Elasticity of demand is given by:
Percentage change in quantity demanded
Percentage change in price
Types of Markets
The ability of any supplier to determine a selling price for goods or services is largely dependent
on the market in which he operates. A common classification of market is given below.
(i) Perfect Competition
Perfect competition occurs where there is:
- A large number of sellers and buyers
- Selling/buying a homogenous product
- Possessing perfect knowledge, and where there are no transportation costs.
In such a market, which admittedly is hard to come by, no individual supplier can influence the
market and therefore there is virtually no pricing decision to be made.
The slightest over-pricing will leave all goods unsold, while under-pricing yields absolutely no
benefit to the seller.

(ii) Monopolistic Competition

Monopolistic competition is characterized by a large number of suppliers selling/providing
similar goods/services. The goods or services are similar but not the same and customers can
discern the slight difference to an extent that gives the supplier monopolistic power. They can
also discern the similarities such that demand for the goods/a service is elastic. Slight differences
in prices may not seriously affect demand, but any difference considered by customers to be
large may well catapult them into the hands of other suppliers.
(iii) Monopoly
A monopoly market exists where a product or service is unique, has no close substitute, has only
one supplier and there are effective barriers to entry in the market of other suppliers, virtually
everybody in this country has been how monopoly companies operate. Urban water supply,
electricity, and other services until recently, are controlled by monopolies. The monopolist is in a
position to set any price he wishes, although usually the extent to which this can be done is
restricted by government.

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(iv) Oligopoly
This market is characterized by domination by a few major suppliers. Any attempt by one of
them to manipulate prices to his favor will meet retaliatory responses from other suppliers.
However, because suppliers are few, it is possible for all suppliers to concertedly change prices.

Common Pricing Methods

a) Economists Approach/Optimum Pricing
Economic theory suggests that the optimum price for a product or service is that price which
equates marginal revenue and marginal cost. Marginal revenue is the incremental revenue arising
from selling the last unit of output and marginal cost is the incremental cost resulting from
producing such a unit. Of course equating marginal cost and marginal revenue will maximize
profit if just before the sale/production of the last unit; marginal revenue was greater than
marginal cost.
Note: It depends on the establishment of a mathematical relationship between demand and price.
This is not an easy thing to do in practice. In addition, the approach is limited by the following
assumptions:
 It assumes perfect knowledge of all information involved.
 It assumes demand curve and total costs can be identified with certainly.
 Ignores market research costs of acquiring the knowledge of demand.
 It assumes firm has no production constraints.
 It assumes that profit maximization is the firm’s sole objective (i.e. single maximizing
objective).
 It assumes that price is only a function of demand (i.e. other factors such sales promotion,
incomes, tasters and preferences, social and political factors are ignored).

b) Cost-plus Pricing
The word ‘cost’ in ‘cost-plus pricing’ is subject to more than one interpretation. In fact it is
probably more accurate for us to speak of cost-plus methods rather than method. Cost, for
example could be marginal cost (represented by variable costs in the linear cost model).
Alternatively, it could be ‘full factory cost’ where by a unit of output bears a share of fixed
production overheads in addition to variable costs, or it could be ‘full absorption cost, which in
their discussion is taken to mean, variable manufacturing costs plus fixed production overheads
plus a share of non-manufacturing overheads.
The mark-up (the plus) will be influenced by the definition of cost used and by the pricing
strategy adopted. If cost is taken to be marginal cost, then a mark-up will be needed to cover
fixed manufacturing costs, non-manufacturing overheads and profit. If full cost (including
apportioned non-manufacturing overheads) is adopted, the ‘plus’ in cost-plus will be needed to
cover only profit and will be less than if marginal cost had been used.

Illustrative Question
Moja Ltd. manufactures a single product whose cost structure is given below:
Variables costs (per unit) Tshs.
Manufacturing costs:
Direct materials 34
Direct labour 26
Overheads 18

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Other variable cost:

Selling and distribution 2

Fixed cost (per annum) Tshs.

Manufacturing 100,000
Selling and distribution 20,000
Administration 105,000
The company expects to produce and sell 5, 000 units.
Discussion
The company could, for example apply any one of the following alternative formulae to arrive at
the same price:
Marginal cost = 34+26+18+2 = 80
Full factory cost = 34+26+18=(100,000 :- 5,000) = 98
Full absorption cost = 98+2=(20,000+105,000):- 5,000 = 125

Cost Mark-up % Price

Method (Tshs) (Tshs)
Marginal cost 80 87½ 150
Full factory cost 98 53 150
Full absorption cost 125 20 150
It can be seen that the mark-up increase as a less inclusive concept of cost is adopted.

Various reasons have been given for the popularity of cost-based pricing methods. Those
include:
1. They are easy to apply because they comprise of a mathematical rule c + % of ‘C’ For this
reason, price determination can be delegated to relatively junior personnel in the
organization.
2. They give a reasonable starting price which can be amending to take into account other
factors.
3. They are useful for firms which have many products, for all of which it would be difficult to
analyze price/volume relationships.
4. They are useful where it is difficult to identify a ready market for the product.
5. They are often required when tendering for government contracts.

Cost-based pricing methods have their limitations. These include:

1. The fact that prices can affect demand is ignored.
2. They can lead to circular reasoning where pries affect cost and cost affects prices
3. Where full cost is used. Fixed costs have to be apportioned on an arbitrary basis.
4. Cost-based prices can encourage inefficiency as they do not provide any impetus for cost
reduction.

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QUESTIONS ON PRICING DECISIONS

Question 1
You are provided with the following demand and cost functions for MWITA Company:
Demand function: P = 80 – 3Q, where P is the unit selling price and Q is quantity in thousands.
Cost function: TC = Q2 + 20Q +100, where TC is total cost in “000s”
REQUIRED:
(i) Determine the optimal price and quantity to maximize profits and then show the
maximum profit and sales revenue generated.
(ii) Determine the quantity and price for maximum revenue and then determine the
maximum profit and sales revenue generated.
(iii) Show whether profit obtained in part (i) and revenue obtained in (ii) above are at
maximum point or not.

Question 2
a) Explain FIVE advantages and pitfalls of the contribution approach to pricing.
b) You have been informed by the Company’s marketing controller that the price/ demand
relationship is a linear function. It is further estimated that the demand for the product would
increase by 600 units for every decrease of Tshs 1 in selling price and the vice versa. At the
unit price of Tshs 1,600 per unit, demand is estimated to be 240,000 units. The total cost
function is given by TC = Tshs (400Q + 180,000,000), where TC is the total cost function
and Q is quantity demanded.
REQUIRED:
(i) Compute the price and quantity when revenue is maximized and determine the maximum
revenue point.
(ii) Recommend the optimum price and quantity and compute the maximum profit.
(iii)Explain why it is difficult to achieve optimum price in practice?

Question 3
You are the Chief Accountant of a successful medium sized chemical producing Company which
is well known in your industry for its innovative approach to both the marketing and production
functions. Recently, the Chemists in your Company discovered a means of producing a new
product- insect repellent – which they feel is more effective than competing products. The
President has requested that you, in conjunction with marketing and production specialists,
prepare a report on the feasibility of successfully marketing this new product.
The production specialists have determined that the repellent could be produced by either of two
processes having the following characteristics and cost functions:
Maximum Initial Cost
Process Capacity required Investment required Functions
(Litres) (Tshs) (Tshs)
A 28,000 300,000 90,000/yr + 7.75/litre
B 34,000 600,000 160,000/yr + 4.25/litre
After a thorough investigation, the marketing specialist has determined a demand function for the
new repellent which is given by: P = 20 – 0.25Q, where P = Price per litre and Q is the quantity
demanded in thousands of litres.
REQUIRED: Determine which production process, and what level of production should be
chosen in order to maximize return on original investment.

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Question 4
A shoe maker produces shoes every month at an average cost of Tshs 3Q + 160 + 400/Q per pair.
The demand function for this product is P + 11Q = 1280, where P is the price in Tshs per pair
and Q is the number of pairs of shoes demanded.
i. Determine the optimal price and the pairs of shoes to produce for maximum profit
ii. Determine the optimal price and the pairs of shoes to produce for maximum revenue.

Question 5
a) What do you understand by cost based pricing? Under what circumstances will the business
be able to use cost based pricing?
b) Mate Company may wish to sell 500,000 units of its products in order to attain a desirable
market share. The Company has some discretion to set up its price for the product it sells. If
it will attain the planned sales volume, its production costs are expected to be as follows:
Tshs
Raw materials 20
Direct labour 12
Overhead 30
Factory costs 62
In addition to production costs, the company also incur Tshs 30,750,000 as administrative costs
and Tshs 32,750,000 as distribution costs. The following was the financial position of the
company at the time of planning its operations;
Mate Company Ltd
Budgeted Statement of Financial Position as at April 30, 2013
Tshs Tshs
Creditors 40,592,000 Cash 500,000
Interest payable 1,200,000 Debtors 25,592,000
Loan 20,000,000 Stocks 24,200,000
Capital 151,000,000 Fixed assets 180,000,000
Retained earnings 16,500,000 229,292,000
229,292,000
The Company appraises its projects based on the weighted average cost of capital, which
currently is equal to 12%.
REQUIRED: Suggest a mark-up on full costs and the price that will earn the Company a desired
return on capital.

Question 6
Magari Company specializes in the production of a range of motor vehicles. It is about to launch
a new product, the ‘Kantinka’, a unique motor vehicle which is capable of providing
unprecedented levels of speed using a minimal amount of fuel. The technology used in the
Kantinka is unique, so Magari Company has patented it so that no competition can enter the
market within two years. The Company’s development costs have been high and it is expected
that the product will only have a five-year life cycle.
Magari Company is now trying to ascertain the best pricing policy that they would adopt for the
Kantinka’s launch onto the market. Demand is very responsive to price changes and research has
established that, for every Tshs 1,500,000 increase in price, demand would be expected to fall by
1,000 units. If the company set the price at Tshs 73,500,000 only 1,000 units would be
demanded.
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The costs of producing each motor vehicle are as follows:

Tshs
Direct materials 4,200,000
Labour 1,200,000 (15 hours at Tshs 80,000 per hour. See note A below)
Fixed overheads 600,000
Total cost 6,000,000
Note A: The first motor vehicle took 15 hours to make and labour costs Tshs 80,000 per hour. A
95% learning curve exists, in relation to production of the unit, although the learning curve is
expected to finish after making 100 units. Magari Company’s management have said that any
pricing decisions about the Kantinka should be based on the time it takes to make the 100th unit
of the product. All other costs are expected to remain the same up to the maximum demand
levels.
REQUIRED:
a) Establish the demand function (equation) for motor vehicle units.
b) Calculate the marginal cost for each motor vehicle unit after adjusting the labour cost as
required by note (a) above.
c) Calculate the optimum price and quantity.
d) Explain what is meant by a ‘Penetration Pricing’ strategy and a ‘Market Skimming’ strategy
and discuss whether either strategy might be suitable for Magari Company when launching
the ‘Kantinka’.

Question 7
Vinyago Craftworks Ltd (VCL) is a newly established maker and distributor of unique mninga
sculptures. VCL management are inexperienced in making and selling process of their mninga
sculptures and are yet to decide the selling which will maximize both sales revenue and profit of
the company. VCL management have heard of marginalist theory, a neo-classical theory of the
firm which is based on two rules: MC = MR, the theory which is likely to help them established
selling price for their sculptures.
You have been identified as a management consultant who could help VCL management, and
you have been provided with the following information:
(i) The cost of making the first sample of a sculpture included:
Direct material 2 pieces of mninga @ Tshs 20,000 40,000
Sculpturing labour 50 hours @ Tshs 1,000 50,000
Variable overhead (50% of sculpturing labour) 25,000
115,000

(ii) Budgeted fixed costs per annum include:

Rental charges Tshs 50,000,000
Administration expense Tshs 80,000,000

(iii)VCL management expects the sculpturing time to gradually improve with experience and has
estimated 80% learning curve for the first 16 sculptures, after which a steady state production
time will apply with labour time per sculpture being equal to the 16th sculpture.

(iv) It has been established that, the current price of similar mninga sculptures in the market is
Tshs 120,000 and at this price 100,000 units are demanded. Experience in this market

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indicate if price for similar sculptures increase or decrease by Tshs 10,000, quantity demand
will increase or decrease by 25,000 units.

(v) Currently, 20 units of mninga sculptures have been ordered by a newly established resort.
Note: The learning curve formula is y = axb. At the learning rate of 0.8 (80%), the learning
factor (b) is equal to -0.322. All figures should be rounded off to one decimal place.
REQUIRED:
a) Determine sales maximizing selling price and the maximum sales revenue at this sales point.
b) Determine profit maximizing selling price and the maximum profit at this selling price.
c) Explain what is meant by a ‘Penetration Pricing’ strategy and a ‘Market Skimming’ strategy
and discuss the cases that would make VCL to use such pricing strategies when launching
their mninga sculptures.

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