TRIUMPH DYNAMIC PROFESSIONAL TUTORS

PERFORMANCE MANAGEMENT

PRICING POLICY
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.
Nevertheless, cost information is still of considerable importance in these organizations for determining the
relative profitability of different products and services so that management can determine the target product
mix to which its marketing effort should be directed.

The price to be charged to customers for the business’ products or service is seldom one of the most
important decisions to be made by managers. Not all businesses are free to determine their own selling
prices: for example some are unable to influence the external price and are obliged to accept the prevailing
market price for their goods. For these business, cost control is an important fact in maintaining profitability
while other businesses are in a position to select their selling price.

Some products have an established market price. Consumers will not pay more than this price and there is
no reason for a supplier to charge less – the suppliers can sell all that it produces at this price. Under these
conditions, the supplier simply charges the prevailing market price for the product. The objectives
businesses pursue in their pricing policy will affect the price to be charged for each product or service.
Pricing decisions have a major effect on volume sold and, as a consequence, on profit generated. One of the
major considerations of a pricing decision is therefore the effect a change in price will have on volume sold.

OBJECTIVES OF PRICING POLICY

1. Sales maximization and growth: a firm has to set price which assures maximum sales of the product.
2. Making money: some firms want to use their special position in the industry by selling product at a
premium and make quick profit as much as possible.
3. Preventing competition:
4. Early cash recovery: some firms set a price which will create a mad rush for the product and recover
cash early. They may also set a low price as a caution against uncertainty of the future
5. Satisfactory Rate of Return

FACTORS THAT INFLUENCE PRICING DECISIONS

Many factors can influence how companies establish their selling price. They include the following:

INFLUENCE EXPLANATION/EXAMPLE
Sensitivity to price levels will vary among purchasers. Those that can pass on the
Price sensitivity 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
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 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 and a price reduction may signal reduced quality.
If an organisation distributes products or services to the market through
Intermediaries 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.
In some industries (such as petrol retailing) pricing moves in unison; in others,
Competitors price changes by one supplier may initiate a price war.
If an organisation's suppliers notice a price rise for the organisation's products,
Suppliers they may seek a rise in the price for their supplies to the organisation.
In periods of inflation the organisation may need to change prices to reflect
Inflation increases in the prices of supplies, labour, rent, and so on.
When a new product is introduced for the first time there are no existing
Newness reference points, such as customer or competitor 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.
If incomes are rising, price may be a less important marketing variable than
Incomes product quality and convenience of access (distribution). When income levels are
falling and/or unemployment levels rising, price will be more important.
Products are often interrelated, being complements to each other or substitutes
Product range 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 (e.g. selling
razors at very low prices while selling the blades for them at a higher profit
margin).

PRICING STRATEGIES

1. COST-PLUS PRICING

Companies frequently use a pricing approach where they markup cost. A product’s markup is the difference
between the selling price and the cost and is usually expressed as a percentage of cost. That is:
This approach is called Cost-plus pricing because a pre-determined markup percentage is applied to a cost
base to determine the selling price. A company may use absorption costing, standard costing or relevant
costing when determining the cost base. Selling Price = (1+Markup percentage) x Cost

a. Full Cost Plus: selling price is determined by adding a certain mark-up percentage on the total cost
of the production i.e.
Selling Price = Total budgeted production cost + Total budgeted non-production cost + Mark-up
Budgeted sales units
OR
N/Unit
Direct production costs xx
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 Variable production overheads xx
Fixed production overheads xx
Variable non-production overhead xx
Fixed non-production overhead xx
Full Cost xx
Mark-up Percentage xx
Selling Price xx

b. Marginal Cost Plus Pricing: the selling price of a product is determined by calculating the
marginal/variable cost of producing a unit and adding markup. This method considers only the
variable costs of production i.e.
Selling Price = Budgeted variable production cost + budgeted variable non-production cost +
Markup
Budgeted Sales units
c. RETURN ON INVESTMENT PRICING: the selling price is set to achieve a targeted percentage
return on investment
Selling price = budgeted full cost + (target ROI % x Capital employed)
Budgeted sales units
d. OPPORTUNITY COST PRICING (also called Relevant Cost Pricing): this is a marginal cost
approach but also includes within the cost any opportunities forgone. The selling price is determined
by adding up all relevant costs plus the Mark-up percentage.

Illustration 1: Ennerdale has been asked to quote a price for a one-off contract. The following information is
available:
Materials
The contract requires 3,000 kg of material K, which is a material used regularly by the company in other
production. The company has 2,000 kg of material K currently in stock which had been purchased last
month for a total cost of N19,600. Since then the price per kilogram for material K has increased by 5%.
The contract also requires 200 kg of material L. There are 250 kg of material L in stock which are not
required for normal production. This material originally cost a total of N3,125. If not used on this contract,
the stock of material L would be sold for N11 per kg.
Labour
The contract requires 800 hours of skilled labour. Skilled labour is paid N9.50 per hour. There is a shortage
of skilled labour and all the available skilled labour is fully employed in the company in the manufacture of
product P. The following information relates to product P.
N per unit N per unit
Selling price 100
Less:
Skilled labour 38
Other variable costs 22
(60)
40
Required
Prepare, on a relevant cost basis, the lowest cost estimate that could be used as the basis for a quotation.

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Illustration 2: Ritter Company wants to set the selling price on a product that has just undergone some
design modifications. The company has invested N100,000 in operating assets to sell an estimated sales
volume of 10,000 units. Its required return on investment (ROI) in its operating assets is 20%. The
accounting department has provided the following cost estimates for the redesigned product:
Per Unit Total
Direct materials N6
Direct labour N4
Variable manufacturing overhead N3
Fixed manufacturing overhead N70,000
Variable selling and administrative expenses N2
Fixed selling and administrative expenses N60,000
Required: Compute the selling price of a product using the absorption costing approach to cost-plus pricing.

Illustration 3: Xerox ltd has two products A and B with the following cost patterns.
A B
N N
Direct material 27 24
Direct labour @ N5/hr 20 25
Variable production overheads @ N6/hr 3 6
50 55
Fixed overheads are N300,000 per month absorbed on the basis of direct labour hours. The budgeted direct
labour hours are 25,000 per month. The manager have been told of the superiority of ABC and decided to
investigate it. Activity analysis produced the following results.
Activity Cost driver A B Total
Set ups Production runs 30 20 40,000
Material handling Production runs 30 10 150,000
Inspection inspections 880 3520 110,000
300,000
Budgeted production is 1250 units of A and 4000 units of B

Required:
Given a markup of 20%, what prices should be charged for product A and B under;
i. Full cost pricing
ii. ABC pricing

Illustration 4: A golf club manufacturer is about to launch a new product, the Wild Thing Driver. Buildings
and equipment needed for production will cost N2,000,000, and working capital requirements are estimated
at N10 per unit per annum. Expected sales levels are 40,000 units per annum. Variable production costs are
N30 per unit.
Fixed production costs will be N300,000 per annum and fixed non-production costs will be N100,000 per
annum.
Required:
(a) Calculate selling price using:
(i) Full cost plus 20%.
(ii) Marginal cost plus 40%.
(iii) Target ROI of 10%.
(b) If actual sales are only 20,000 units and selling price was set using full cost plus 20%, calculate profit for
the year.

Illustration 5: Tigger has budgeted to make 50,000 units of its product, timm. The variable cost of a timm is
$5 and annual fixed costs are expected to be $150,000.

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The financial director of Tigger has suggested that a profit margin of 25% on full cost should be charged

for every product sold.

The marketing director has challenged the wisdom of this suggestion, and has produced the following
estimates of sales demand for Timms.

Price per unit Demand

$ Units

9 42,000

10 38,000

11 35,000

12 32,000

13 27,000

Required

(a) Calculate the profit for the year if a full cost price is charged.

(b) Calculate the profit-maximising price.

Assume in both (a) and (b) that 50,000 units of Timms are produced regardless of sales volume.

ADVANTAGES OF COST-PLUS PRICING

1. The required profit will be made if budgeted sales volumes are achieved
2. It is a particularly useful method in contract costing industries such as building
3. Cost-plus pricing can be useful in justifying selling prices to customers; if costs can be shown to
have increased, this strengthens the case for an increase in selling price
4. Cost-plus is quick and cheap to employ
5. cost-plus saves management time

DISADVANTAGES

1. selection of a suitable basis on which to charge fixed costs to individual products or services.
2. Cost-plus pricing takes no account of factors such as competitor activity
3. Cost-plus overlooks the need for flexibility in the different stages of a product’s life cycle
4. It takes no account of the price customers are willing to pay and price elasticity of demand

ECONOMIST MODEL

The Economist model is premised on the Theory of Demand (Demand Curve). There is an inverse
relationship between Price and Quantity demanded hence, the higher the price, the lower the quantity
demanded and vice versa. The selling price for a commodity will be determined by the price elasticity of the
product/service. This is a very important information for an organization while setting the price for
products/service. Where the Demand for a product is unresponsive to changes in price, the product is said to
be inelastic; in this case, an organization may set a price so as to maximize profit. However, where the price
of a product causes a change in its demand, the product is said to be elastic; therefore care must be taken

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when setting the price for such a product/service. The following factors affect the price elasticity of a
product:

1. Availability of substitutes
2. Disposable income
3. Necessities
4. Habit
5. Complementary products

The Demand Curve is expressed as an equation thus:

P = a – bQ

Where,

P is the price which would achieve a given demand Q

a = Price when Q is 0
B is the slope of the line – it shows by how much the price must change to achieve a given increase in
demand i.e. b = change in price
Change in quantity

PROFIT MAXIMIZATION MODEL

A mathematical model can be used to determine an optimal selling price. The model is based on the
economic theory that profit is maximized at the output level where marginal cost equals marginal revenue.
i.e. MR=MC. Marginal Revenue is the increase in total revenues resulting from selling one more unit of a
product/service. It can be derived from the demand function as follows:

P = a – bQ;
Revenue = Price x Quantity
Therefore, Revenue = aQ – bQ2
Marginal Revenue = a – 2bQ
Illustration 1: Maximum demand for a company’s product M is 100,000 units per annum. The demand will
be reduced by 40 units for every increase of £1 in the selling price. The company has determined that profit
is maximised at a sales volume of 42,000 units per annum.

What is the profit maximising selling price for product M?

Illustration 2: ALG Co is launching a new, innovative product on to the market and is trying to decide on
the right launch price for the product. The product’s expected life is three years. Given the high level of
costs which have been incurred in developing the product, ALG Co wants to ensure that it sets its price at
the right level and has therefore consulted a market research company to help it do this. The research, which
relates to similar but not identical products launched by other companies, has revealed that at a price of N60,
annual demand would be expected to be 250000 units. However, for every N2 increase in selling price,
demand would be expected to fall by 2000 units and for every N2 decrease in selling price, demand would
be expected to increase by 2000 units. A forecast of the annual production costs which would be incurred by
ALG Co in relation to the new product are as follows:
Annual
production
(units) 200 000 250 000 300 000 350 000
N N N N
Direct
Material 2,400,000 3,000,000 3,600,000 4,200,000

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Direct labour 1,200,000 1,500,000 1,800,000 2,100,000
Overheads 1,400,000 1,550,000 1,700,000 1,850,000

Required:
(a) Calculate the total variable cost per unit and total fixed overheads. (3 marks)
(b) Calculate the optimum (profit maximizing) selling price for the new product AND calculate the resulting
profit for the period.
Note: If P = a-bx then MR = a - 2bx. (7 marks)
(c) The sales director is unconvinced that the sales price calculated in (b) above is the right one to charge on
the initial launch of the product. He believes that a high price should be charged at launch so that those
customers prepared to pay a higher price for the product can be ‘skimmed off’ first.
Required: Discuss the conditions which would make market skimming a more suitable pricing strategy for
ALG, and recommend whether ALG should adopt this approach instead. (5 marks)

Illustration 3: Ella Ltd recently started to manufacture and sell product DG. The variable cost of product
DG is N4 per unit and the total weekly fixed costs are N18 000. The company has set the initial selling price
of product DG by adding a mark-up of 40 per cent to its total unit cost. It has assumed that production and
sales will be 3000 units per week. The company holds no stocks of product DG.
Required:
(a) Calculate for product DG:
(i) the initial selling price per unit; and
(ii) the resultant weekly profit. (3 marks)
The management accountant has established that a linear relationship between the unit selling price (P in N)
and the weekly demand (Q in units) for product DG is given by:
P = 20 – 0.002Q
The marginal revenue (MR in N per unit) is related to weekly demand (Q in units) by the equation:
MR = 20 – 0.004Q
(b) Calculate the selling price per unit for product DG that should be set in order to maximize weekly profit.
(c) Distinguish briefly between penetration and skimming pricing policies when launching a new product.

LIMITATIONS OF THE PROFIT-MAXIMIZATION MODEL

1. It is unlikely that organizations will be able to determine the demand function for their
products/services with any degree of accuracy
2. The majority of organizations aim to achieve a target profit rather than the theoretical maximum
profit
3. Determining an accurate and reliable figure for marginal cost posses difficulties for management
accountant
4. Other factors, in addition to price, will affect the demand, for example, the level of advertising or
changes in the income of customers.

OTHER PRICING STRATEGIES

Premium Pricing: this 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, Durability, After-sales service, extended
warranties.

Market Skimming: this is 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. The aim of this strategy is to maximize revenue and also used to prolong the life of older
products. The policy is an attempt to exploit the section of the market that are insensitive to price changes. A

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skimming pricing policy should not, however, be adopted when a number of close substitutes are already
being marketed

Market Penetration: companies set a very low price for the new product initially. The price will be usually
low below total cost. The aim is to establish a large market share quickly by encouraging customers to try
the product and the to repeat buy. It is hoped to establish a dominant market position, which will prevent
new entrants coming into the market.

Price Discrimination: if the market can be split into different segments, each quite separate from the others,
and with its own individual demand, it is possible to sell the same product to different customers at different
prices.

Complementary Product Pricing: the use of one product often requires the purchase of a second product.
This pricing strategy requires understanding of the impact that the price of one product may have on demand
for the other.

Home Study

After spending N500 on market research, Bobco Engineering wants to bid on an important one-off contract
and needs to ensure its costing is both competitive and commercially rational. To complete the project it will
need to devote the following resources to its construction:
 1,500 kg of standard steel regularly used in its production process. It currently has inventory of
6,000kg purchased at an average price of N8/kg. With recent market conditions, the purchase cost is
now N9.35/kg.
 500 kg of speciality steel. It has 500 kg of such steel in inventory. This was purchased 16 months
ago at N12/kg. As it has not been used since purchasing, the auditors insisted on a write-down to
estimated net realizable value of N4/kg. The purchasing manager figures that he can sell it for scrap
at N2/kg. If sold, the costs to remove it from the warehouse and deliver it would be N1,000
 380 hours of unskilled labour. Although the existing union contract pays N6/hour for such labour,
extra workers would have to be hired in the "temporary" labour market at N7/hour.
 196 hours of semi-skilled labour being paid N9/hour under the existing union contract.
Currently, there is a surplus of such labour in the plant.
 51 hours of skilled labour being paid N18/hour under the current union contract. The workers
are currently busy in another department, where they are producing output which is sold for N96 and
which uses N15 of direct material, N9 of skilled labour, N27 of semi-skilled labour, N15 of variable
overheads and N8 fixed-cost overheads allocated. It takes a half hour of skilled labour to work on
this existing product. The department head has agreed to release his skilled workers but he must be
compensated so he is no worse off.
 Use of equipment which was scheduled to be disposed of this period for N12,000. If used in the
project, it will have to be disposed of later at an estimated selling price of N4,000.
 Exclusive use of a piece of manufacturing equipment (a fibrillator) which will not survive its
use in the project. The machine originally cost N51,000 and currently has a carrying (i.e. book)
value of N6,000. It could be currently sold in the used fibrillatory market for N8,000 (because new
ones cost N45,000). If it was left in its existing use, it could generate cash flows with an estimated
present value of N5,000.
 38 kg of Ecotox which was originally purchased for N600/kg. Under current government
environmental rules, Bobco will have to pay N3,000 for the recycling company to take it away if it is
not used in the contract.
Required:
Calculate the price which Bobco should bid for the contract on the assumption that it wishes to charge
a price equal to relevant cost plus 25%.

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