Chapter 7 Pricing Policies and Profitability Analysis

LEARNING OBJECTIVES

1. Explain the factors that influence the price of a product.

2. Establish the price/demand relationship of a product.
3. Establish the optimum price/output level when considering profit maximization and
maximization of revenue.
4. Calculate prices using full cost and marginal cost as the pricing base.
5. Discuss the advantages and disadvantages of these pricing bases.
6. Discuss the pricing policy in the context of price skimming, penetration pricing,
complementary product pricing and price discrimination.
7. Appreciate the importance of profitability analysis in decision making.

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1. Factors Influencing the Price of a Product
(Dec 11, Dec 15)
1.1 Several factors underlie all pricing decisions and effective decisions will be based on a
careful consideration of the following.

Influence Explanation/Example
Price sensitivity Sensitivity to price levels will vary amongst purchasers. Those
that can pass on the cost of purchases will be the least sensitive
and will therefore respond more to other elements of perceived
value. For example, a business traveller will be more
concerned about the level of service in looking for an hotel
than price, provided that it fits the corporate budget. In
contrast, a family on holiday are likely to be very price
sensitive when choosing an overnight stay.
Price perception Price perception is the way customers react to prices. For
example, customers may react to a price increase by buying
more. This could be because they expect further price increases
to follow (they are 'stocking up').
Quality This is an aspect of price perception. In the absence of other
information, customers tend to judge quality by price. Thus a
price rise may indicate improvements in quality, a price
reduction may signal reduced quality.
Intermediaries If an organisation distributes products or services to the market
through independent intermediaries, such intermediaries are
likely to deal with a range of suppliers and their aims concern
their own profits rather than those of suppliers.
Competitors In some industries (such as petrol retailing) pricing moves in
unison; in others, price changes by one supplier may initiate a
price war. Competition is discussed in more detail below.
Suppliers If an organisation's suppliers notice a price rise for the
organisation's products, they may seek a rise in the price for
their supplies to the organisation.
Inflation In periods of inflation the organisation may need to change
prices to reflect increases in the prices of supplies, labour, rent
and so on.
Newness When a new product is introduced for the first time there are
no existing reference points such as customer or competitor

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 behaviour; pricing decisions are most difficult to make in such
circumstances. It may be possible to seek alternative reference
points, such as the price in another market where the new
product has already been launched, or the price set by a
competitor.
Incomes If incomes are rising, price may be a less important marketing
variable than product quality and convenience of access
(distribution). When income levels are falling and/or
unemployment levels rising, price will be more important.
Product range Products are often interrelated, being complements to each
other or substitutes for one another. The management of the
pricing function is likely to focus on the profit from the whole
range rather than the profit on each single product. For
example, a very low price is charged for a loss leader to make
consumers buy additional products in the range which carry
higher profit margins (eg selling razors at very low prices
whilst selling the blades for them at a higher profit margin).
Product life cycle During the life of an individual product, several stages are
apparent: introduction, growth, maturity and decline. The
duration of each stage of the life cycle varies according to the
type of product, but the concept is nevertheless important as
each stage is likely to influence the firm’s pricing policy.

2. Markets

2.1 The price that an organization can charge for its products will be determined to a
greater or lesser degree by the market in which it operates.
2.2 Perfect competition ( 完 全 競 爭 ) – many buyers and many sellers all dealing in an
identical product. Neither producer nor user has any market power and both must
accept the prevailing market price.
2.3 Monopoly (壟斷 ) – one seller who dominates many buyers. The monopolist can use
his market power to set a profit-maximising price.
2.4 Monopolistic competition ( 壟 斷 競 爭 ) – a large number of suppliers offer similar,
but not identical, products. The similarities ensure elastic demand whereas the slight
differences give some monopolistic power to the supplier.
2.5 Oligopoly ( 寡 頭 壟 斷 ) – where relatively few competitive companies dominate the
market. Whilst each large firm has the ability to influence market prices, the

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 unpredictable reaction from the other giants makes the final industry price
indeterminate. Cartels (同業聯盟) are often formed.
3. Price and Demand Relationship
(Dec 15)
3.1 You know from your personal experience as a consumer that the theory of demand is
essentially true, the higher the price of a good, the less will be demanded.
3.2 If you think about how you decide which goods to buy, you will realize that there are
many factors entering into the decision.
Influence Explanation/Example
Price This is probably the most significant factor. For each of the goods,
the higher the price, the less likely people are to buy it.
Income In general, the more people earn, the more they will buy. The demand
for most goods increases as income rises, and these goods are known
as normal goods.

This does not apply to inferior goods, such as low quality foodstuffs.
These are cheap goods which people might buy when on a low
income, but as their incomes rises, they switch to more attractive
alternatives.
Price of substitute Two or more goods are defined as substitutes if they are
goods interchangeable in giving consumers utility. For example, Coke and
Pepsi are substitutes, a rise in the price of Coke will cause a rise in
demand for the Pepsi, and vice versa.
Price of Complements are goods which must be used together. For example, a
complementary compact disc player is no good without compact discs. If the price of
a complement rises, then demand for another complementary
good will fall.
Taste Taste is influenced by many different things. Advertising may make
something popular or unpopular.
Market size The size of total demand depends on the number of people who are
aware of the good’s existence. Market size can be altered by changes
in the size and structures of the population. If the birth rate falls in
the area, this will have a long-term effect on the total population size
and will have a more immediate effect in reducing the number of
babies, hence influencing the demand for prams ( 嬰 兒 車 ),
equipment and clothing designed for babies.
Advertising In general, it is not only the volume and quality of advertising that

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 can influence demand for a product but also the amount of
advertising in comparison with that for competing products.

4. Price Elasticity of Demand

4.1 Concept of price elasticity of demand

4.1.1 Price elasticity of demand

(a) The price elasticity of demand (PED) is a measure of the extent of change in
demand for a good in response to a change in its price. It is measured as:

The % change in quantity demanded

The % change in price

(b) Demand is referred to as inelastic if the absolute value is less than 1 and
elastic if the absolute value is greater than 1.

4.1.2 Example 1
The price of a good is $1.20 per unit and annual demand is 800,000 units. Market
research indicates that an increase in price of 10 cents per unit will result in a fall in
annual demand of 75,000 units. What is the price elasticity of demand?

Solution:

% change in demand = (75,000 / 800,000) x 100% = 9.375%

% change in price = (0.1 / 1.20) × 100% = 8.333%
Price elasticity of demand = (–9.375/8.333) = –1.125

Ignoring the minus sign, price elasticity is 1.125

The demand for this good, at a price of $1.20 per unit, would be referred to as elastic
because the price elasticity of demand is greater than 1.

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4.2 Special values of price elasticity

4.2.1 There two special values of price elasticity of demand.

(a) Perfectly inelastic (PED = 0). There is no change in quantity demanded,
regardless of the change in price. The demand curve is a vertical straight line.

(b) Perfectly elastic (PED = ∞). Consumers will want to buy an infinite amount,
but only up to a particular price level. Any price increase above this will reduce
demand to zero. The demand curve is a horizontal straight line.

4.3 PED and revenue

4.3.1 PED and revenue

(a) When demand is elastic, total revenue rises as price falls and vice versa.
This is because the quantity demanded in very responsive to price changes.
(b) When demand is inelastic, total revenue falls as price falls because a fall in
price causes a less than proportionate rise in quantity demanded.

4.3.2 It would be very useful to a producer to know whether he is at an elastic or

inelastic part of his demand curve. This will enable him to predict the effect on
revenue of raising or lowering his price.

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5. Profit Maximization

5.1 Profit maximization

Profits are maximized using marginalist theory when marginal cost (MC) =
marginal revenue (MR). The optimal selling price can be determined using
equations. The optimum selling price can also be determined using tabulation.

5.2 In economics, profit maximisation is the process by which a firm determines the price
and output level that returns the greatest profit. There are two common approaches to
this problem.
(a) The Total revenue (TR) – Total cost (TC) method is based on the fact that
profit equals revenue minus cost.
(b) The Marginal revenue (MR) – Marginal cost (MC) method is based on the
fact that total profit in a perfect market reaches its maximum point where
marginal revenue equals marginal cost.

5.3 From the graph above it is evident that the difference between total costs and total
revenue is greatest at point Q. This is the profit maximising output quantity.

5.4 Example 2
AB has used market research to determine that if a price of $250 is charged for
product G, demand will be 12,000 units. It has also been established that demand will
rise or fall by 5 units for every $1 fall/rise in the selling price. The marginal cost of
product G is $80.

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 Required:

If marginal revenue (MR) = a – 2bQ when the selling price (P) = a – bQ, calculate
the profit-maximising selling price for product G.

Solution:

b = change in price / change in quantity = $1 / 5 = 0.2

a = $250 + 12,000 × 0.2 = $2,650

MR = 2,650 – (2 × 0.2)Q = 2,650 – 0.4Q

Profit are maximized when MR = MC, i.e.

80 = 2,650 – 0.4Q

Q = 6,425

Now, substitute the values into the demand curve equation to find the profit-
maximising selling price

P = a – bQ

P = 2,650 – 0.2 × 6,425 = $1,365

5.5 The optimum selling price can also be determined using tabulation. To determine the
profit-maximising selling price:
(a) Work out the demand curve and hence the price and the total revenue (P ×
Q) at various levels of demand.
(b) Calculate total cost and hence marginal cost at each level of demand.
(c) Finally calculate profit at each level of demand, thereby determining the price
and level of demand at which profits are maximized.

Question 1
An organisation operates in a market where there is imperfect competition, so that to sell
more units of output, it must reduce the sales price of all the units it sells. The following data
is available for prices and costs.

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 Total output Sales price per unit (AR) Average cost of output (AC)
Units $ $ per unit
0 - -
1 504 720
2 471 402
3 439 288
4 407 231
5 377 201
6 346 189
7 317 182
8 288 180
9 259 186
10 232 198

The total cost of zero output is $600.

Required:

Complete the table below to determine the output level and price at which the organisation
would maximise its profits, assuming that fractions of units cannot be made.

Units Price Total Marginal Total Marginal Profit

revenue revenue cost cost
$ $ $ $ $ $
0
1
2
3
4
5
6
7
8
9
10

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6. Pricing Strategies

6.1 Cost-plus pricing

(Dec 09, Jun 10, Dec 10, Dec 11, Jun 12, Dec 14, Jun 15)

6.1.1 Cost-plus pricing

Full cost-plus pricing is a method of determining the sales price by calculating the
full cost of the product and adding a percentage mark-up for profit.

6.1.2 In practice cost is one of the most important influences on price. Many firms base
price on simple cost-plus rules (costs are estimated and then a profit margin is added in
order to set the price).
6.1.3 The 'full cost' may be a fully absorbed production cost only, or it may include some
absorbed administration, selling and distribution overhead.
6.1.4 A business might have an idea of the percentage profit margin it would like to earn,
and so might decide on an average profit mark-up as a general guideline for pricing
decisions.
6.1.5 Advantages of full cost-plus pricing
(a) It is a quick, simple and cheap method of pricing which can be delegated to
junior managers.
(b) Since the size of the profit margin can be varied, a decision based on a price in
excess of full cost should ensure that a company working at normal capacity
will cover all of its fixed costs and make a profit.
6.1.6 Disadvantages of full cost-plus pricing
(a) It fails to recognise that since demand may be determining price, there will
be a profit-maximising combination of price and demand.
(b) There may be a need to adjust prices to market and demand conditions.
(c) Budgeted output volume needs to be established. Output volume is a key
factor in the overhead absorption rate.
(d) A suitable basis for overhead absorption must be selected, especially where
a business produces more than one product.

6.1.7 Example 3
A company budgets to make 20,000 units which have a variable cost of production of
$4 per unit. Fixed production costs are $60,000 per annum. If the selling price is to
be 40% higher than full cost, what is the selling price of the product using the full
cost-plus method?

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 Solution:

Full cost per unit = variable cost + fixed cost

Variable cost = $4 per unit
Fixed cost = $60,000/20,000 = $3 per unit
Full cost per unit = $4 + $3 = $7
Selling price using full cost-plus pricing method = $7 × 140% = $9.80

6.2 Marginal cost-plus pricing

(Jun 15)

6.2.1 Marginal cost-plus pricing

Marginal cost-plus pricing/mark-up pricing involves adding a profit margin to the

marginal cost of production/sales.

6.2.2 Whereas a full cost-plus approach to pricing draws attention to net profit and the net
profit margin, a variable cost-plus approach to pricing draws attention to gross profit
and the gross profit margin, or contribution.

6.2.3 Example 4
A product has the following costs.
$
Direct materials 5
Direct labour 3
Variable overheads 7

Fixed overheads are $10,000 per month. Budgeted sales per month are 400 units to
allow the product to breakeven.

Required:

Determine the profit margin which needs to be added to marginal cost to allow the
product to break even.

Solution:

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 Breakeven point is when total contribution equals fixed costs.

At breakeven point, $10,000 = 400 (price – $15)

$25 = price – $15
Price = $40
Profit margin = (40 – 15)/15 × 100% = 166.67%

6.2.4 Advantages of marginal cost-plus pricing

(a) It is a simple and easy method to use.
(b) The mark-up percentage can be varied, and so mark-up pricing can be adjusted
to reflect demand conditions.
(c) It draws management attention to contribution, and the effects of higher or
lower sales volumes on profit. For example, if a product costs $10 per unit and
a mark-up of 150% ($15) is added to reach a price of $25 per unit,
management should be clearly aware that every additional $1 of sales revenue
would add 60 cents to contribution and profit ($15 ÷ $25 = $0.60).
6.2.5 Disadvantages of marginal cost-plus pricing
(a) Although the size of the mark-up can be varied in accordance with demand
conditions, it does not ensure that sufficient attention is paid to demand
conditions, competitors' prices and profit maximisation.
(b) It ignores fixed overheads in the pricing decision, but the sales price must be
sufficiently high to ensure that a profit is made after covering fixed costs.

6.3 Market skimming pricing

6.3.1 Market skimming pricing

Price skimming involves charging high prices when a product is first launched in
order to maximize short-term profitability. Initially there is heavy spending on
advertising and sales promotion to obtain sales. As the product moves into the later
stages of its life cycle (growth, maturity and decline) progressively lower prices are
charged. The profitable 'cream' is thus skimmed off in stages until sales can only be
sustained at lower prices.

6.3.2 The aim of market skimming is to gain high unit profits early in the product's life.
High unit prices make it more likely that competitors will enter the market than if
lower prices were to be charged.

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6.3.3 Such a policy may be appropriate in the cases below.
(a) The product is new and different, so that customers are prepared to pay high
prices so as to be one up on other people who do not own it.
(b) The strength of demand and the sensitivity of demand to price are unknown.
It is better from the point of view of marketing to start by charging high prices
and then reduce them if the demand for the product turns out to be price elastic
than to start by charging low prices and then attempt to raise them substantially
if demand appears to be insensitive to higher prices.
(c) High prices in the early stages of a product's life might generate high initial
cash flows. A firm with liquidity problems may prefer market-skimming for
this reason.
(d) The firm can identify different market segments for the product, each
prepared to pay progressively lower prices. It may therefore be possible to
continue to sell at higher prices to some market segments when lower prices
are charged in others.
(e) Products may have a short life cycle, and so need to recover their development
costs and make a profit relatively quickly.
6.3.4 Products to which the policy has been applied include mobile phone, computers, video
recorders, etc.

6.4 Market penetration pricing

6.4.1 Market penetration pricing

Penetration pricing is a policy of low prices when a product is first launched in

order to obtain sufficient penetration into the market.

6.4.2 A penetration policy may be appropriate in the cases below.

(a) The firm wishes to discourage new entrants into the market.
(b) The firm wishes to shorten the initial period of the product's life cycle in
order to enter the growth and maturity stages as quickly as possible.
(c) There are significant economies of scale to be achieved from a high volume
of output.
(d) Demand is highly elastic and so would respond well to low prices.

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6.5 Complementary product pricing

6.5.1 Complementary product pricing

(a) Complementary products are goods that tend to be bought and used together.
(b) Complementary products are sold separately but are connected and dependant
on each other for sales, for example, an electric toothbrush and replacement
toothbrush heads. The electric toothbrush may be priced competitively to
attract demand but the replacement heads can be relatively expensive.

6.5.2 A loss leader ( 犧 牲 品 定 價 ) is when a company sets a very low price for one
product intending to make consumers buy other products in the range which carry
higher profit margins. Another example is selling razors at very low prices whilst
selling the blades for them at a higher profit margin. People will buy many of the high
profit items but only one of the low profit items – yet they are 'locked in' to the former
by the latter. This can also be described as captive product pricing (附屬產品定價
法).

6.6 Price discrimination (價格歧視)

6.6.1 Price discrimination

The use of price discrimination means that the same product can be sold at
different prices to different customers. This can be very difficult to implement in
practice because it relies for success upon the continued existence of certain market
conditions.

6.6.2 There are a number of bases on which such discriminating prices can be set.
(a) By market segment. A cross-channel ferry company would market its services
at different prices in England and France, for example. Services such as
cinemas and hairdressers are often available at lower prices to old age
pensioners and/or juveniles.
(b) By product version. Many car models have 'add on' extras which enable one
brand to appeal to a wider cross-section of customers. The final price need not
reflect the cost price of the add on extras directly: usually the top of the range

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 model would carry a price much in excess of the cost of provision of the
extras, as a prestige appeal.
(c) By place. Theatre seats are usually sold according to their location so that
patrons pay different prices for the same performance according to the seat
type they occupy.
(d) By time. This is perhaps the most popular type of price discrimination. Off-
peak travel bargains, hotel prices and telephone charges are all attempts to
increase sales revenue by covering variable but not necessarily average cost of
provision. Railway companies are successful price discriminators, charging
more to rush hour rail commuters whose demand is inelastic at certain times of
the day.

6.7 Market-based pricing

(Jun 12, Dec 14, Jun 15)

6.7.1 Market-based pricing

Prices are determined in an attempt to capture market share.

6.8 Target pricing

(Dec 10, Jun 12)

6.8.1 Target pricing

Target pricing is the price at which a seller projects that a buyer will buy a
product. Target costing determines the cost of a product or service according to the
target price that a customer is willing to pay and it is an estimated long-run cost.

6.9 Ethical pricing

(Dec 09)

6.9.1 Ethical pricing

Sometimes pricing policy should be based on certain ethical principles. Business

without ethics is a sin. While setting the prices, some moral standards are to be
followed. The pricing policy has to secure reasonable amount of profits to a firm to
preserve the interests of the community and promote its welfare.

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7. Profitability Analysis

7.1 Introduction

7.1.1 In running a business, management has to know the profitability of their products,
customers and other business segments as they want to know what segment they
should focus on. To achieve such purpose, they should be able to distinguish between
absolute profitability and relative profitability.
7.1.2 Absolute profitability is measured by the segment’s incremental profit, which
represents the difference between the revenues from the segment and the costs that
could be avoided by dropping the segment. In other words, it measures the effect of
adding or dropping a segment on the company’s profits.

7.2 Product and supplier profitability analysis

7.2.1 Product and supplier profitability analysis allow the management to identify the true
costs associated with their products and supplies.
7.2.2 Normally, it takes into account those initial costs (such as purchase, transport,
receiving and reject cost), on going costs (such as storage and overheads), finance and
customer return costs for different product or product groups.

7.2.3 Example 5
In general, it can be elaborated as follows (assuming two products groups);
Product A Product B Total
$ $ $
Sales 150,000 250,000 400,000
(37.5%) (62.5%) (100%)
Expenses
Variable costs
Materials & supplies 15,000 22,000 37,000
(% of revenue) (10%) (8.8%) (9.25%)
Labour 2,000 3,500 5,500
(% of revenue) (1.33%) (1.4%) (1.38%)
Distribution 3,000 5,000 8,000
(% of revenue) (2%) (2%) (2%)
Marketing 12,000 10,000 22,000
(% of revenue) (8%) (4%) (5.5%)

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 Other - 5,000 5,000
(% of revenue) (2%) (1.25%)
Total variable costs 32,000 45,500 77,500
(21.3%) (18.2%) (19.4%)

Fixed costs
Location 10,000 10,000 20,000
(% of revenue) (6.67%) (4%) (5%)
Administration 5,000 6,000 11,000
(% of revenue) (3.33%) (2.4%) (2.75%)
Labour 3,000 3,000 6,000
(% of revenue) (2%) (1.2%) (1.5%)
Others 2,000 3,000 5,000
(% of revenue) (1.33%) (1.2%) (1.25%)
Total fixed costs 20,000 22,000 42,000
(13.3%) (8.8%) (10.5%)
Operating profit 98,000 182,500 280,500
Operating surplus (%) 65% 73% 70.1%
Profit contribution (%) 34.9% 65.1% 100%

When management considers the resource allocation and strategy formulation, it can
determine whether the company should put more emphasis on a particular product or
whether they would allocate the costs differently to get a better margin for the
product group.

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7.3 Customer profitability analysis (CPA)

7.3.1 CPA is very important to decision making of management, as best customers implies
customers who contributes the highest sales. Thus, we need to understand what
products and services customers buy and the associated product and services costs
when designing business strategies.

7.3.2 Example 6
A simple CPA can be conducted as follow:
Customer A Customer B Total
$ $ $
Sales 150,000 250,000 400,000
(37.5%) (62.5%) (100%)
Cost of sales
Ongoing service & support 17,000 25,500 42,500
Other direct customer costs 15,000 20,000 35,000
Total cost of sales 11,800 204,500 322,500
(78.7%) (81.8%) (80.6%)
Other costs
Customer acquisition 10,000 10,000 20,000
Customer marketing 5,000 6,000 11,000
Customer termination 5,000 6,000 11,000
Total other customer costs 20,000 22,000 42,000

Profit by customer groups 98,000 182,500 280,500

(34.9%) (65.1%) (100%)

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 Examination Style Questions

Question 2 – Marginal cost plus pricing and special order

(HKIAAT PBE II Management Accounting December 2003 Q6)

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Question 3 – Cost plus pricing, target pricing and balanced scorecard

(HKIAAT PBE II Management Accounting and Finance December 2010 Q6)

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Question 4 – Customer profitability analysis

REQUIRED:

(a) Determine the profitability of each customer type using the traditional approach of
assigning customer-related activity costs in proportion to the sales revenue earned by
each customer type. Discuss the problems of this measure of customer profitability.
(5 marks)
(b) By using the activity rates to assign customer-related activity costs to each customer
type, re-calculate the profitability of each customer category. Discuss how you, as a
manager, would use this information. (11 marks)
(c) Describe briefly the nature of value-added and non-value-added activities and give an
example of each type of activity. (4 marks)
(Total 20 marks)
(HKIAAT PBE II Management Accounting December 2007 Q3)

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