IB Business and Management Pricing 4.4 Outline Today’s objectives: – Discuss importance of pricing – Examine various pricing strategies.

IB Business and Management

Pricing

•4.4 Outline•Today’s objectives:

– Discuss importance of pricing– Examine various pricing strategies

WHY IS THE PRICING DECISION SO IMPORTANT?

Pricing

• Price should be competitive & also profitable– Too high : can discourage customers– Too low : can portray poor image (cheap)

FACTORS AFFECTING PRICING DECISIONS

How much for a cup of coffee?

• What factors would a new coffee shop have to take into consideration when deciding how much to charge?

Factors Affecting Pricing Decisions

Price Makers Vs Price Takers

• Some firms are in a better position than others to set their own prices.

• These firms are called Price Makers• These tend to be businesses who are market

leaders of who operate in industries with little competition

• Other firms have very little power to set their own prices and have to follow the industry levels

• These are know as Price Takers

Pricing Strategies:

– Cost-based – Competition-based– Market-led

COST –BASED PRICING STRATEGIES

Cost Based Pricing Strategies

• Cost-Plus Pricing (Mark-up pricing)• Marginal Cost Pricing (Contribution

Pricing) (HL only)• Full Cost Pricing (HL only)• Absorption cost pricing (HL only)

Cost-Plus Pricing(Mark-Up)

• Involves adding a percentage or fixed amount of profit to the average cost of production to determine the selling price

• Percentage or fixed amount added is called the mark-up or profit margin

• Selling Price = Average Cost + Mark-Up

Cost-Based Pricing(Mark-Up) Example

A company makes mugs.The variable cost of producing each mug is $1.10. The factory currently has fixed costs of $10,000 per month and produces 20,000 mugs per month.a.What is the average cost of production?b. What would the selling price be if the company required a 50% profit margin?What would happen if production dropped to only 10,000 per month?

What are the advantages and disadvantages of this pricing method?

Marginal Cost Pricing (Contribution pricing)

(HL)• Marginal Cost refers to the additional cost s of producing an

extra unit of output.• These are usually the variable cost of each item produced

(unless the business is producing at full capacity)• Once variable costs have been paid, any money left over

goes towards (contributes) fixed costs.• Marginal cost pricing involves calculating the variable cost

of producing each item and adding on an amount which will be used as a contribution to fixed costs

• Selling price = Variable cost per unit + desired contribution

Contribution Pricing - Example

• In what circumstances might this be a better method than working out the average cost?

Cost per mug $

Materials 0.80

Direct Labour 0.30

Indirect costs 0.50

Total 1.60

• The mugs must be for at least $1.10 dollar as this will ensure that all marginal costs are covered

Full Cost Pricing (HL)

• Full cost pricing allows the business to allocate the total fixed costs between all of the products that are sold.

• For multi-product firms it might not be fair to allocate fixed costs evenly between each unit of output

• Some products may incur more fixed costs than others.

• The business must decide on what basis the fixed costs will be shared

Criteria for allocating fixed costs:

• Equally between each product• According to floor space

Full costing - Example

Product Mugs Tea Cups Saucers

Direct Costs (per unit) $1.10 $0.90 $0.50

Floor Space (square metres) 500 500 200

Output (Per Month) 20,000 10,000 10,000

The business has fixed costs of $24,000 per month

Full costing – Allocating costs equally

Product Mugs Tea Cups Saucers

Direct Costs (per unit) $1.10 $0.90 $0.50

Floor Space (square metres) 500 500 200

Output (Per Month) 20,000 10,000 10,000

Total Direct Costs

Indirect Cost Allocation

Total Cost

Cost Per Unit

Selling Price (100% mark up)

The business has fixed costs of $24,000 per month

Full costing – Allocating costs equally

Product Mugs Tea Cups Saucers

Direct Costs (per unit) $1.10 $0.90 $0.50

Floor Space (square metres) 500 500 200

Output (Per Month) 20,000 10,000 10,000

Total Direct Costs 22,000 9,000 5,000

Indirect Cost Allocation 8,000 8,000 8,000

Total Cost 30,000 17,000 13,000

Cost Per Unit 1.50 1.70 1.30

Selling Price (100% mark up) 3.00 3.40 2.60

Full costing – Allocating costs according to floor

spaceProduct Mugs Tea Cups Saucers

Direct Costs (per unit) $1.10 $0.90 $0.50

Floor Space (square metres) 500 500 200

Output (Per Month) 20,000 10,000 10,000

Total Direct Costs

Indirect Cost Allocation

Total Cost

Cost Per Unit

Selling Price (100% mark up)

The business has fixed costs of $24,000 per month

Full costing – Allocating costs according to floor

spaceProduct Mugs Tea Cups Saucers

Direct Costs (per unit) $1.10 $0.90 $0.50

Floor Space (square metres) 500 500 200

Output (Per Month) 20,000 10,000 10,000

Total Direct Costs 22,000 9,000 5,000

Indirect Cost Allocation 10,000 10,000 4,000

Total Cost 32,000 19,000 9,000

Cost Per Unit 1.60 1.90 0.90

Selling Price (100% mark up) 3.20 3.80 1.80

ABSORPTION COSTING

Absorption costing

• Absorption costing is an extension of full costing• It attempts to more accurately allocate fixed costs

by apportioning each fixed cost by a different criteria

• It is a fairer method than full costing but more complicated to calculate

• Criteria could be:– Floor Space– Number of Employees– Machinery Utilised– Output

Absorption Costing - Example

Product Mugs Tea Cups Saucers

Direct Costs (per unit) $1.10 $0.90 $0.50

Floor Space (square metres) 500 500 200

% of machinery 50 30 20

Output (Per Month) 20,000 10,000 10,000

The business has fixed costs of $24,000 per month.These are :Rent $12,000Marketing $8,000Depreciation $4,000On what basis might these costs be most fairly allocated?

Absorption costingProduct Mugs Tea Cups Saucers

Direct Costs (per unit) $1.10 $0.90 $0.50

Floor Space (square metres) 500 500 200

% of machinery 50 30 20

Output (Per Month) 20,000 10,000 10,000

Total Direct Costs

Rent Allocation

Marketing Allocation

Depreciation Allocation

Total Cost

Cost Per Unit

Selling Price (100% mark up)

Absorption costingProduct Mugs Tea Cups Saucers

Direct Costs (per unit) $1.10 $0.90 $0.50

Floor Space (square metres) 500 500 200

% of machinery 50 30 20

Output (Per Month) 20,000 10,000 10,000

Total Direct Costs 22,000 9,000 5,000

Rent Allocation 5,000 5,000 2,000

Marketing Allocation 4,000 2,000 2,000

Depreciation Allocation 2,000 1,200 800

Total Cost 33,000 17,200 9,800

Cost Per Unit 1.65 1.72 0.98

Selling Price (100% mark up) 3.30 3.44 1.96

Questions:1.Calculate the unit contribution for each product (3)2.Calculate the cost of each product if a full costing method was used with floor space as the criteria3.How much profit would be made by each of the products4. If the company decided to use absorption costing, identify which would be the most appropriate criteria to allocate each of the fixed costs (4)5. Using your answer to question 3, use absorption costing to calculate the unit costs of each of the 3 products (6)6. Calculate the profit made on each product (3)

Answers – Question 2 and 3

• Penny• ($7 x 15,000) + $25,500 = $130,500• $130,500,500/15,000 = $8.70• $14 - $8.70 = $5.30 x15,000 = $79,500• James• ($5 x 15,000) + $25,500 = $100,500• $100,500/15,000 = $6.70• $10 - $6.70 = $3.30 x15,000 = $49,500• Lori• ($10 x 15,000) + $34,000 = $184,000• $184,000/15,000 = $12.27• $20 - $12.27 = $7.73 x 15,000 = $115,950

COMPETITION-BASED PRICING

Competition-based Pricing

• Based on prices charged by competitors• Prices can be set less than, equal to or

greater than the competition• Does not consider production cost or level of

demand

Competition-based Pricing Strategies:

• Price Leadership• Predatory Pricing (HL)• Going Rate Pricing (HL)

Competition-based Pricing Strategies

Price Leadership• Used by best-selling products or brands• Few substitutes in consumers’ eyes• Dominant product can set its own price while

competitors follow the leaderGoing-Rate Pricing (HL)• Refers to average rate charged by competitors in an

industry

Competition-based Pricing Strategies

Predatory Pricing (HL)• Temporarily reducing price in an

attempt to force rivals out of the industry

• Used when an existing firm is threatened with new competition

Predatory pricing?

MARKET-LED PRICING STRATEGIES

Market-led Pricing• Based on customer demand and the prices that

customers are prepared to pay for a product

Pricing Strategies• Penetration Pricing• Skimming

• Price Discrimination (HL)• Loss Leader (HL)• Psychological Pricing (HL)• Promotional Pricing (HL)• Premium Pricing (HL)

Pricing Strategies for New Products

Pricing Strategies for any product

Penetration Pricing• This strategy involves setting prices low

initially to get customers interested• The price will then be increased • What are the risk of using this strategy?• Customers may not be prepared to pay the

higher price• Can you think of any examples of products

which use this strategy?• Magazines, CD’s, Fizzy drinks

Skimming

This strategy involves setting prices high initially then lowering prices later on.

Customers who want the product before any one else will pay a high price

When the price is lowered other customers will be prepared to buy the product

Can you think of any examples?Mobile phones, Games Consoles

Price Discrimination

• Different prices are charged to different customers

• This can only be done if customers are not able to re-sell to each other

Loss Leaders

• A short-term pricing strategy whereby certain products are sold at below cost price

• The aim is that other full price products/complementary products will also be purchased

Psychological Pricing

• Prices are set at price points that have a psychological impact on customers

Promotional Pricing

• Short term pricing offers used as part of the firms promotional strategy

• Works for products with price elastic demand• Could be used as an extension strategy• Is often used to boost cashflow

Prestige/Premium Pricing

• Setting a permanently high price because of the image, reputation or status associated with the product

Which pricing strategies/tactics are

being used here?

Which Pricing Strategies?

Which pricing strategy/strategies would you suggest for these products….

Why?

Ways to ‘increase’ prices without increasing price -

Winkler• Revise the discount structure• Change the minimum order size• Charge for delivery and special services• Invoice for repairs on serviced equipment• Charge for engineering, installation• Charge for overtime on rushed orders• Collect interest on overdue accounts• Change the product whilst keeping the price

the same

DEMAND AND SUPPLY (HL)

Demand

• Demand is the quantity of a product that consumers are willing and able to buy at a stated price over a certain period of time

Influences on Demand Price Price of rival products Fashion Social Trends Availability How well the product is promoted Seasonality Weather Economy

The Demand CurvePR

ICE

£

QUANTITY

Demand

The quantity demanded increases as the price falls

Q1 Q2Q3

Shifts in the Demand Curve

PR

ICE

£

QUANTITY

D2

D1

D3

A right shift in the demand curve means that at any given price, more of a good is demanded

A left shift in the demand curve means that at any given price, less will be demanded

Summary

• Demand refers to the quantity of a good that will be bought over a period of time at a given price

• A change in price will result in a movement along the demand curve

• A change in other variables will result in a shift in the demand curve

Supply

• Supply is the amount of a good or service that producers are willing to supply at a given price

Example – Farming

• A farmer has limited space to grow crops.

• They will make decisions on how much to supply of each product depending on the market price

Supply and Price

• When the price is low, very few producers will be able to make a profit- so the supply is small.

• At high prices even inefficient producers can make a profit so supply is large

• Firms will make more of a thing if they get a good price

SUPPLY FOR A PRODUCT INCREASES AS PRICE INCREASES

The Supply CurvePR

ICE

£

QUANTITY

S

D

Q1 Q3Q2

Factors causing a shift in the supply curve

• Costs of production• Technology• The price of other related goods• Legislation• Other government interventions• The weather• Producer cartels

Shifts in the Supply CurvePR

ICE

£

QUANTITY

S1

S2

S3

Q1Q2 Q3

Questions:What would happen to the supply Curve?1. Corn – A drought reduced corn crops by

40%?2. Houses – The UK government relax

planning permission laws 3. Potatoes – The CAP announce that there

will be subsidies available for land used to grow potatoes

4. Petrol – There is a 10% increase in the price of crude oil

5. Beef – scientific advances in grass seed means that cattle feed prices decrease

The equilibrium point

S

D

PR

ICE

£

QUANTITY

Equilibrium

Equilibrium Quantity Demanded

Equ

ilibr

ium

Pric

e

Equilibrium

• The point at which the supply and demand for a product in the market are equal

• Producers want to sell at a high price. Consumers want to sell at a low price. The market forces them to make a compromise

Interaction of Supply and Interaction of Supply and DemandDemand

PR

ICE

£

QUANTITY

S

D

Exercise

PricePrice DemandDemand SupplySupply

£3£3 180180 2020

£6£6 160160 4040

£9£9 140140 6060

£12£12 120120 8080

£15£15 100100 100100

£18£18 8080 120120

£21£21 6060 140140

£24£24 4040 160160

£27£27 2020 180180

The table shows the supply and demand for T-shirts at a McFly concert.

1. Sketch a demand and supply diagram using the data

2. What is the equilibrium price and quantity? (State and label on your diagram)

3. What would happen at a price of £6?

4. What would happen at a price of £21