Management Accounting – Pricing
March 15, 2010 Leave a comment
If you have a business you want to make sure that you price your products and services appropriately. Your prices should be consistent with the business strategy and also linked to the cost of producing the product or service.
Two pieces or terminology to remember:
- Price makers: Set their own price
- Price takers: Have to accept what the market dictates (this can be either a competitor or a customer)
You’ve probably heard of supply and demand before. The basic premise here with supply and demand is that if you sell lots of a product you can afford to reduce the price per unit, and conversely if your sales are low you’ll have to increase the price.
The elasticity of demand
With this concept, ‘elasticity’ refers to how responsive the demand is to a change in price.
For example, if the price of Dairy Milk goes up by £1, the demand will probably decrease accordingly. Therefore chocolate has quite an elastic demand. If B&Q decide to raise the price of a lightbulb by £1, the demand probably won’t change much (people always need lightbulbs but nobody needs chocolate), so you could say lightbulbs have an inelastic demand.
The issues you might expect come into play when it comes to setting prices:
- Predicting demand: If you price it too high the demand might not be as you expect
- Effect on other products: You might cannibalise one of your other products (how many people who own iPhones would buy an iPod aswell?)
- Estimating cost: It might cost you more to produce the product or service than you estimate
- Short term vs long term
Types of pricing
There are four main types that I’ll go through in turn. They are:
- Full cost plus pricing
- Marginal cost pricing
- Target pricing
- Market based pricing
Full cost plus pricing
To do this you estimate the full cost of a product (like in earlier posts) and then add the required profit margin on to this (usually based on the target ROCE)
A company recently completed a job for the full cost of £125. The company’s total costs for the current period are estimated to be £300,000, and their target profit for this period is £125,000. How much should the company charge for the job?
Let’s work through the solution.
If the company wants £125,000 in relation to £300,000 costs, then for every £1 of cost they need to make (£125,000 ÷ 300,000) = 41.7p of profit.
That means, for the £125 of costs the job will incur, they need to make (£0.417 × £125) = £52.13 of profit.
Therefore the target price will be (£125 + £52.13) = £177.13
Marginal cost pricing
Marginal costing is a little different in that it only considers the variable costs. It’s normally used when there’s no opportunity to sell at a price that will cover the full costs. Therefore that makes it short term.
An Oceanic Airways flight is due to take off in one hour, with 20 unsold seats. What is the minimum price that the seats can be sold at so that the airline wouldn’t be any worse off as a result?
Think about this one. If those seats aren’t sold, the flight still has to take off with empty seats. So that means if they go out and sell each of those 20 seats for a penny each, they’ll still be 20p better off than if they hadn’t sold them.
Therefore the answer to the question is zero. If they give the seats away for free they are still no worse off than if they let the plane take off with empty seats.
With this, a target price is set (market research is used to work out what this is, for example you might set the target price of a laptop at £499 to undercut the competitors who sell theirs for £549).
Then you work backwards to find out the target profit margin, and arrive at the target cost. If this is higher than the actual cost then you need to find a way of saving money to reduce the costs.
Market based pricing and strategies
There are a couple of strategies that can make business sense.
- Price penetration: Sell the product cheap to start with in order to gain market share, then increase the price later to make more profit
- Price skimming: Start off at a high price and sell to rich people, then reduce the price and gain more market share