LESSON 4

PRICING AND PROFIT ANALYSIS

Pricing Policies – Nature and Objectives

Pricing refers to the determination of the appropriate selling price for a product
or service provided by a firm. All organizations or firms that sells products or
services for a fee must decide on the price to be charged to customers or clients for
the products sold or services rendered.

For profit-oriented organizations, the selling price includes all the costs
incurred to produce and sell the product, or all the costs incurred in rendering
service, plus an acceptable mark-up or profit. In case of not-for-profit organizations,
the price should likewise ensure recovery of costs, plus a satisfactory margin to
finance the organization’s operations and to help the organization survive or remain
as a going concern.

A firm’s pricing policy, therefore which consists of the procedures involved in

setting sales prices, as well as the methods and systems needed for its
implementation, plays a vital role in the attainment of the organization’s objectives-
profit maximization and/or survival as an entity.

One of the most difficult decisions facing a company is pricing. The

accountant is the primary resource the firms turn to when financial data are needed,
whether that information relates to cost or to price. Therefore, accountants must be
familiar with sources of revenue data as well as the economic and marketing
classes, accountants need to be aware of the way demand interacts with supply.

Accounting information is often an important input to pricing decisions.

Organizations that sell products or services that are highly customized or
differentiated from another by special features, or who are market leaders, have
some discretion in setting selling prices. In these organizations, the pricing decision
will be influenced by the cost of the product. The cost information that is
accumulated and presented is therefore important for pricing decisions. In other
organizations, prices are set by overall market and supply and demand forces and
they have little influence over the selling prices of their products and services.

Factors Affecting Pricing Decisions

Having a pricing objective isn’t enough. A firm also has to look at the factors
that affect price. These factors include demand and supply, customers, market
structure, competitor, government laws and regulations and of course the cost of the
product.

Demand and Supply

Customers want high quality of goods and services at a low price. Although
customer demand is studied in detail in marketing classes, accountants need to be
aware of the way demand interacts with supply.
 With all else equal, customers will buy more at lower prices and less at higher
prices. Producers, on the other hand, are able to supply more at higher prices than
they can at lower prices. The market-clearing or equilibrium price is located at the
intersection of the supply and demand curves. At this price the amount that
producers supply just equals the amount that consumers demand. If firms charge a
price that is higher than the clearing market price, demand falls short of supply.
Producers see inventories pile up as consumers buy other goods. If the price is
lower than the market-clearing price, everything that is produced is bought.
Shortages and backlogs occur, signaling the need to increase production and/or to
raise prices.

Factors other than price that influence demand include consumer income,
quality of goods offered for sale, availability of substitutes, demand for
complementary goods, whether the good is as necessity or a luxury, and so on.
However, the basic demand-supply relationship remains, and producers know that
raising prices nearly inevitably results in fewer units being sold. Price elasticity and
market structure are two factors that influence companies’ ability to adjust price.

Customers

How will buyers respond? Three important factors are whether the buyers
perceive the product as offering value, how many buyers there are, and how
sensitive they are to price changes. In addition to gathering data on the size of
markets, companies must try to determine how price sensitive customers are. Will
customers buy the product, given its price? Or will they believe the value is not equal
to the cost and choose an alternative or decide they can do without the product or
service? Equally important is how much buyers are willing to pay for the offering.
Figuring out how consumers will respond to prices involves judgment as well as
research. Price elasticity, or people’s sensitivity to price changes, affects the demand
for products.

Since price effects quantity sold, producers want to know just how much a
price change will change quantity demanded. Expressed mathematically, it is:

Price Elasticity of Demand = Percentage Change in Quantity Demanded ÷ Percentage Change in Price

• If price elasticity is greater than 1, the good is elastic; if less than 1, it is

inelastic.
• If a good’s price elasticity is 0 (no amount of price change produces a change
in demand), it is perfectly inelastic.
• If price elasticity is exactly 1 (price change leads to an equal percentage
change in demand), it is known as unitary elasticity.
(https://www.investopedia.com/terms/p/priceelasticity.asp)

Goods that are price elastic tend to have many substitute, are not
necessities, and take a relatively large amount of consumer income. The demand
for movie tickets, restaurant meals, and automobiles are examples of elastic goods.

Price-inelastic goods have fewer substitutes, are necessities, or constitute a

relatively small percentage of consumer income. Prescription drugs and foods are
examples of price-inelastic goods. Price elasticity also applies in services.
 While price elasticity of demand is difficult to compute in real-word situations,
it is possible to see its effects at work.

Market Structure and Price

Market structure affects price, as well as the costs necessary to support that
price. In general, there are four types of market structure: perfect competition,
monopolistic competition, oligopoly, and monopoly.

A perfect competitive market is a theoretical market structure that features no

barriers to entry, an unlimited number of producers and consumers, and a perfectly
elastic demand curve. (https://www.simplilearn.com/market-structures-rar188-
article). In this market has many buyers and sellers. Firms in a perfectly competitive
market cannot charge higher price than the market price because no one would buy
their products, and they will set a lower price because they can sell all they can
produce at the market price.

At the opposite extreme is a monopoly. In a monopoly, barriers to entry are so

high that there is only one firm in the market and the product is unique. The
monopolistic firm is a price setter. Monopoly has only one provider of a product or
service.

Monopolistic competition, also called competitive market, where there is a

large number of firms, each having a small proportion of the market share and
slightly differentiated products. It has characteristics of both monopoly and perfect
competition, but it is much closer to the competitive situation. In this market there
are various sellers and buyers but the products are differentiated on some basis.
Firms under monopolistic competition with their ability can gain a greater degree
of market share due to which it can increase the prices of its products.

An oligopoly is characterized by a few sellers. Typically, barriers to entry are

high, and they are usually cost related. In oligopoly market there is a small number of
firms that together control the majority of the market share.

Competitors

How competitors price and sell their products will have a tremendous effect on
a firm’s pricing decisions. Because companies want to establish and maintain loyal
customers, they will often match their competitors’ prices. With so many products
sold online, consumers can compare the prices of many merchants before making a
purchase decision.

Government laws and regulations

The economy also has a tremendous effect on pricing decisions. When the
economy is weak and many people are unemployed, companies often lower their
prices. In international markets, currency exchange rates also affect pricing
decisions.
 Pricing decisions are affected by government laws regulations. Regulations
are designed to protect consumers, promote competition, and encourage ethical and
fair behavior by businesses.

Cost of the product

The costs of the product—its inputs—including the amount spent on product

development, testing, and packaging required have to be taken into account when a
pricing decision is made. So do the costs related to promotion and distribution.

Sales Price Determination

Selling price must be set such that it will ensure recovery of costs and
generation of a satisfactory or acceptable amount of mark-up or profit. Based on this,
we can come up with the following basic formula to compute selling price:
SP = C + MU
Where:
SP= Selling price
C= Costs
MU=mark-up

The above formula has two components, costs and mark-up.

Cost Data

The cost data must include manufacturing costs, selling and administrative
expenses. Once any of these items is excluded in the computation, the selling price
will be understated and the company’s profitability will be negatively affected.

If the cost data are expected to remain stable during the period in which
selling price will be in effect, the actual costs may be used in the calculation.
However, if there are expected changes in the cost data, the expected new figure
should be used.

For companies using the standard cost accounting system, it is advisable for
them to use the standard costs in computing the selling price. They should see to it
that the standard costs they are using are realistic and reflective of the current costs
and operating conditions.

The reason for the use of standard costs is to avoid inclusions of operational
efficiencies or inefficiencies (variances) in the selling price. For instance, assume
that the standard unit cost to produce a product is P10, the actual cost incurred
during the previous period amounted to P12. Based on the variance analysis made,
the unfavorable variance of P2 was due to inefficient usage of materials and labor
hours. Basing the selling price, therefore, on the actual cost figure, the result will be
unrealistic, since it does not reflect cost data based on normal operating conditions.

Cost and Price Setting Methods

 Companies use various strategies to set price. Since cost is an important
determinant of supply and is known to the product, many companies base price on
cost. Still other companies use a target-costing strategy, or strategies based on the
initial conditions in the market.

Cost-Based Pricing

Demand is one side of the pricing equation; supply is the other side. Since
revenue must cover cost for the firm to make a profit, many companies start with
cost to determine price. Some studies suggest that approximately 80% of
companies set prices by marking up costs. That is, they calculate product cost and
add the desired-profit. Therefore, cost-based pricing is the process by which
particular costs are marked up by a chosen percentage to arrive at the price for a
product or service. Companies that use cost-based pricing are referred to as price
makers, whereas companies that have little or no control over prices are referred to
as price takers. The mechanics of this approach are straightforward. Usually, there is
some cost base and a markup. The markup is a percentage applied to base cost; it
includes desired profit and any costs not included in the base cost. Companies that
bid for jobs routinely base bid price on cost.

If an organization does use cost as the basis for pricing it has to decide
whether to employ a standard mark-up or whether to vary the mark-up according to
the market conditions, type of customer, etc.

Ex1: A wishes to produce a new product, B, and must calculate a base cost, to which
will be added a mark-up in order to arrive at a selling price. The following variable
costs have been established (per unit):

Direct Materials P10

Direct Labor 8
Overhead (1/4 hr. x P8 per hr.) 2
Total P20

The company estimates 20,000 of production and requires ¼ machine hour to

complete 1 unit. The variable cost for selling and administrative expenses are P1
and P.75 per unit respectively. Current fixed costs are P200,000 for the production
facilities for 50,000 hrs. capacity, P140,000 for selling and distribution, and
P180,000 for administration. For costing purposes, the 20,000 units of B can be
assumed to consume 10 per cent of the total production, selling, distribution and
administration costs.

Determine the selling price if the mark up is 25% of the base cost.

Option 1 Using conventional absorption costing principles (product cost or

manufacturing cost)

Direct Materials P10

Direct Labor 8
Overhead
Variable 2
Fixed 1
Total Base Cost P21
 Selling Price = Base cost + mark-up
= P21 + (P21x 25%)
= P26.25

Option 2. Same as 1 but including administrative cost (product cost plus

administrative cost)

Computed amount in number 1 P21

Administrative cost .90
Total Base Cost P21.90

Selling Price = Base cost + mark-up

= P21.90 + (P21.90 x 25%)
= P27.375

Option 3. Same as 2 but including selling and distribution cost (full cost)

Computed amount in number 2 P21.90

Selling and distribution cost .70
Total Base Cost P22.60

Selling Price = Base cost + mark-up

= P22.60 + (P22.60 x 25%)
= P28.25

If the company includes the product costs and both selling and administrative
costs, the company is implementing full costing method.

Option 4. The use of variable cost pricing

The variable cost pricing is also called contribution approach pricing method
where all costs that vary with the product will be included in the cost amount that will
be the basis in computing the mark up.

Direct Materials P10

Direct Labor 8
Variable Overhead 2
Variable selling 1
Variable administrative .75
Total Base Cost P21.75

Selling Price = Base cost + mark-up

= P21.75 + (P21.75 x 25%)
= P27.1875

Option 5. Conversion cost pricing

In cases where multiple products are manufactured by a firm, and the

conversion cost requirements vary from one product to another, some price setters
contend that the mark-up must be based on conversion cost alone. Conversion cost
is the sum of direct labor and factory overhead.
 Direct labor cost P8
Overhead cost 2
Total Base Cost P10

Selling Price = Base cost + mark-up

= P10 + (P10 x 25%)
= P12.50

Option 6. Materials Cost Pricing

Some products are manufactured using a production process where the most
significant element is the cost of materials, requiring a minimal amount of labor,
overhead and operating costs. The mark up will be based on the materials cost.

Total Base Cost – Materials cost P10

Selling Price = Base cost + mark-up

= P10 + (P10 x 25%)
= P12.50

Target Costing and Pricing

Target costing sets the cost of a product or service based on the price (target
price) that price for a product is most acceptable to consumers. Then, it is the job of
the company's engineers to design and develop, working with financial inputs from
the accountants, the product such that cost and profit can be covered by that price.
Target costing often becomes particularly important during periods of intense
competition or challenging economic conditions. In these situations, increasing sales
revenue is more difficult than usual, and therefore, increasing profit requires
companies to decrease their costs. Accounting and other consulting firms provide
clients with expertise in effectively executing target costing. Retail stores engage in a
form of target costing when they look for goods which can be priced at a particular
level to appeal to customers.

Other Pricing Strategies

There are many different pricing strategies, and it may come as a surprise to
would-be accountants that cost is only one of many methods and is certainly not
universally used as the key method for pricing.

• Premium Pricing - premium pricing is pricing above competition on a

permanent basis. This can only be done if the product appears ‘different ’and
superior to competition, which normally means establishing a brand name
based on one of the following:
-Quality
-Image/style
-Reliability/robustness
-Durability
-After-sales service
 -Extended warranties

• Market Skimming - a technique where a high price is set for the product
initially, so that only those who are desperately keen on the product will buy it.
Then the price is lowered, making the product more accessible. When the
next group of customers have had a chance to buy at that price, the price is
lowered again, and so on. The aim of this strategy is usually to maximize
revenues.

• Penetration Pricing- occurs when a company sets a very low price for the new
product initially. The price will usually be below total cost. The aim of the low
price is to establish a large market share quickly by encouraging customers to
try the product and then to repeat buy. If a company succeeds with this type
of pricing it wins a large market share very quickly which competitors will find
hard to break into.

• Price differentiation- this pricing strategy can be done 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.

• Loss Leader Pricing – occurs when the price is set below cost ( the product or
service is sold at a loss) to attract customers who will buy items with
significantly positive margins. When a product range consists of one or more
main products and a series of related optional ‘extras’, which the customer
can ‘add on’ to the main product, the supplier can set a relatively low price for
the main product and a high one for the ‘extras’. Obviously, the aim is to
stimulate sufficient demand for the former to ensure the target return from
sales of the latter. Example: Gillette razors were sold at 1/5 of the cost to
manufacture them but only Gillette blades fitted and these were sold at a price
of 5 cents. The blades cost only 1 cent to manufacture and so Gillette made
large profits once it had captured the customer.

• Product Bundling - Bundling is putting a package of products together to

make, for example, a complete kit for customers, which can then be sold at a
temptingly low price. It is a way of creating value for customers and increasing
company profits. It is a strategy that is often adopted in times of recession
when organizations are particularly keen to maintain sales volume.

• Pricing with additional features - The decision to add extra features to a

product is a similar decision to bundling products. Most people prefer to have
extra features incorporated into the product but they may not be prepared to
pay the extra price.

The Legal System and Pricing

Government also plays an important role in pricing. Overtime many laws

have been regulating the way in which firms set prices. Collusion by companies to
set prices and the deliberate attempts to drive competitors in the business is
prohibited.

Predatory Pricing

This is the practice of setting prices below cost for the purposes of injuring
competitors and eliminating competition. It is important to know that pricing below
cost is not necessarily predatory pricing. Sometimes companies set prices below
cost for promotion and practice penetration pricing. Predatory pricing in the
international market is called dumping, which occurs when companies sell below
cost in other countries, and domestic industry is injured.

Price Discrimination

This refers to charging different prices to different customers for essentially

the same product.

Profit Measurement

The amount of satisfactory profit refers to the maximum profit level that the
firm can possibly earn in given business environment. This profit level may likewise
be called target profit which a price setter may use as guide in computing the selling
price. It may be expressed in a total amount in pesos, a per unit figure, or as a
certain percentage based on some other data such as costs, sales or capital
employed in business.

Profit is a measure of the difference between what the firm puts into making
and selling a product or service and what it receives. There are a number of
definitions of profit. Some are used for external reporting and some for internal
reporting. Firms are interested in measuring profit and there are a number of reasons
for measuring profits. These include determining the viability of the firm, measuring
managerial performance, determining whether or not a firm adheres to government
regulations, and signaling the market about the opportunities for others to earn profit.

For external financial reporting purposes, absorption costing approach is used

in measuring profit. Absorption costing assigns all manufacturing costs, direct
materials, direct labor and manufacturing overhead both fixed and variable to each
unit of product. When a unit of product is finished, it takes these three costs into
inventory with it. When it is sold, these manufacturing costs are shown in the income
statement as cost of goods sold. The income statement format for absorption costing
approach is shown below:

Sales XXX
Less: Cost of Goods Sold XXX
Gross Profit XXX
Less: Operating Expenses
Marketing Expense XXX
Administrative Expense XXX XXX
Operating Profit XXX
 For performance evaluation and management, firms use the variable costing
approach in measuring profit. This approach avoids the problems inherent in making
overhead a variable cost. Variable costing assigns only unit-level of variable
manufacturing costs to the product; these costs include direct materials, direct labor,
and variable overhead. Fixed overhead is treated as a period cost and is not
inventoried with the other product costs. Instead, it is expensed in the period
incurred. The result of treating fixed manufacturing overhead as period expense is
to reduce the factory costs that are inventoriable.

The variable-costing income statement (contribution margin approach) is set

up differently form the absorption costing income statement approach. The format
for variable costing income statement is shown below:

Sales XXX
Less: Variable Costs
Variable Cost of Goods Sold XXX
Variable Marketing & Administrative Expense XXX XXX
Contribution Margin XXX
Less: Fixed Costs
Fixed Overhead Costs XXX
Fixed Marketing and Administrative Expense XXX XXX
Operating Profit XXX

Analysis of Profit-related Variance

To evaluate performance, management want to compare the actual profit

earned with that of expected profit. In case these two differs, variance occurs. Profit
variances center on the difference between budgeted and the actual prices, volume
and contribution margin.

Sales Variance

Actual revenue may differ from expected because the actual price and/or
quantity sold differs from the expected. This results to sales variance.

Sales variance is a measure used to determine the difference between actual

sales and budgeted sales. It helps companies understand the reasons for the
discrepancies between their projected sales figures and actual outcomes, allowing
them to refine their strategies accordingly.

Sales variance can be divided into two primary components:

• Sales price variance and:
• Sales Volume Variance

The sales price variance is the difference between the price at which a
business expects to sell its products or services and what it actually sells them for. It
is computed by getting the difference between actual price and expected price
multiplied by the actual quantity or volume sold. It helps in analyzing the impact of
selling more or fewer units than planned.

Sales price variance (SPV)= (Actual Price – Budgeted price) x Quantity Sold
 Sales volume variance refers to the difference of units actually sold from the
budgeted at a specific price within a specified period. It helps in understanding the
impact of selling products at prices different from what was planned.

Sales Volume (SV) = (Actual quantity sold – Budgeted quantity sold) X Expected
price

Putting the two variances together makes the overall sales variance. The formula for
overall sales variance is:

Overall Sales Variance (OSV) = Sales Prive Variance + Sales Volume Variance
or
Overall Sales Variance (OSV) = Actual sales - Budgeted Sales

Results of variances could be favorable or unfavorable. Favorable variance

increases the profit above the expected or budgeted, while unfavorable variance
decreases profit below the expected or budgeted.

EXAMPLE: Suppose SAMPAGUITA COMPANY produces a particular model of

calculators. For the upcoming quarter, the company has budgeted to sell 1,000 units
of the calculators at a price of P1,000 each. However, at the end of the quarter, the
company sold only 850 units for a higher price of P1,150 each.

Step 1: Calculate the Budgeted Sales and Actual Sales

• Budgeted (Expected) Sales = 1,000 units x P1,000= P1,000,000
• Actual Sales = 850 units x P1,150 = P977,500

Step 2: Break down the variances

• Sales Price Variance:
= (Actual Price – Budgeted price) x Quantity Sold
= (P1,000 – P1,150) x 850 units
= P150 x 850 units
= P127,500 F (Favorable, because they sold each unit at a higher price
than planned)

• Sales Volume Variance:

= (Actual units sold – Budgeted Units) X Budgeted price
= (850 units – 1,000 units) x P1,000
= -150 units x P1,000
= -P150,000 U (Unfavorable, because they sold fewer units than
expected)

Step 3: Analyze the Overall Sales Variance

• Overall Sales Variance = Sales Prive Variance + Sales Volume
Variance
= P127,500F + P150,000U = P22,500 U (Unfavorable)

• Overall Sales Variance = Actual Sales – Budgeted Sales

= P977,500 – P1,000,000= P22,500 U (Unfavorable)
 In this case, even though the company managed to sell the products at a
higher price than planned (a favorable price variance), they didn’t sell as many units
as they expected (an unfavorable volume variance). The net effect led to an overall
sales variance of P22,500, meaning the company’s actual sales were P22,500 less
than they had expected or budgeted for.

Contribution Margin Variance

When sales and costs are put together contribution margin variance can be
calculated. Contribution margin is computed by deducting variable costs from sales
and contribution margin determines the difference between the actual and budgeted
contribution margin.
Contribution Margin Variance = Actual Contribution Margin - Budgeted Contribution Margin

The variance is labeled as favorable if the actual contribution margin is higher

than the budgeted, unfavorable if actual is less than the budgeted.