Session 03-12/18/2016 SESSION 03 PRICING DECISIONS GDM MANAGING FINANCE Nadun Kumara Accounting Management Accounting Financial Accounting Batch 32) 1
Session 03-12/18/2016 Session 03 Synopsis 1. Introduction to Pricing - T 2. Objectives of Pricing - T 3. based on Economic Theory Economic Theory Based Pricing - C 4. based on Practical Strategies Practical Pricing Strategies T + C 5. Other Factors Affecting the Pricing Decision - T 1. Introduction to Pricing Batch 32) 2
Session 03-12/18/2016 DEFINITION Pricing is where a company sets up a value for a product to be sold in the market, where that value would cover the cost and a margin (profit) for the company. PRICE = COST + PROFIT 2. Objectives of Pricing Batch 32) 3
Session 03-12/18/2016 OBJECTIVES OF PRICING Maximising Profits Maximising Market Share VS. OBJECTIVES OF PRICING 1. Maximising Profits 1 To maximise the profits, revenue should be maximised. 2 3 4 To maximise the revenue, the selling price per unit should be increased. However, this selling price per unit increase should be conducted while monitoring the impact towards the company s demand and profitability. This is because demand would fall if the price is too high, and this demand fall would lead to a fall in profits. Therefore, the solution is to Identify the Selling Price that maximizes profits, but does not affect the demand (lower the demand) Batch 32) 4
Session 03-12/18/2016 OBJECTIVES OF PRICING 2. Maximising Market Share 1 2 3 4 5 In order to maximise market share, the demand should be increased. The demand to increase (for customers to demand more), the customer should see value for money in the product that the company offers. If the customer does not see value for money, they would either rejecct the product or switch into another similar product. If the customer reject the product or switch into another similar product, it would affect the market share as the demand would fall as a result of the high selling price. Therefore, the solution is to Set the selling price that offers value for money so that demand increases and the market share is maximised Pricing Economic Theory based Pricing Practical Pricing Batch 32) 5
Session 03-12/18/2016 3. based on Economic Theory Economic Theory Based Pricing Pricing 3. Economic Theory based Pricing Batch 32) 6
Session 03-12/18/2016 PROFIT MAXIMISATION with economic theory Thus, now we aim at the 1 st objective of pricing; which is to maximise profits, while considering the economic theory. We use a few assumptions KEY ASSUMPTIONS PROFIT MAXIMISATION with economic theory KEY ASSUMPTIONS Selling Price & Demand show a linear relationship. y = a + bx p = a + bd Batch 32) 7
Session 03-12/18/2016 PROFIT MAXIMISATION with economic theory KEY ASSUMPTIONS There are no stocks. That means; Production = Sales = Demand PROFIT MAXIMISATION with economic theory KEY ASSUMPTIONS Revenue is maximised when; MARGINAL REVENUE (MR) = 0 Marginal revenue is the additional revenue earned by selling one additional unit from the existing position. Batch 32) 8
Session 03-12/18/2016 PROFIT MAXIMISATION with economic theory KEY ASSUMPTIONS Profit is maximised when; MARGINAL REVENUE (MR) = MARGINAL COST (MC) PROFIT MAXIMISATION with economic theory KEY ASSUMPTIONS If price = p, and demand = x ; p = a + bx MR = a + 2bx Batch 32) 9
Session 03-12/18/2016 PROFIT MAXIMISATION with economic theory KEY ASSUMPTIONS There are no external factors that influence the demand, other than the price. PROFIT MAXIMISATION with economic theory QUESTION Calculate the number of units to be sold and selling price per unit, in order to maximise the profits (profit maximisation). use MR = MC assumption Calculate the number of units to be sold and selling price per unit, in order to maximise the revenue (revenue maximisation). use MR = 0 assumption Use the 6 STEPS. Batch 32) 10
Session 03-12/18/2016 PROFIT MAXIMISATION with economic theory Calculate the number of units to be sold and selling price per unit, in order to maximise the profits. 6 Steps 1) Develop two p = a + bx formulas using the question s information. 2) Find a and b by solving the two formulas and develop a selling price (p) formula for the question s scenario. 3) Develop a MR formula using the p formula found in the above step. ( MR = a + 2bx ) 4) Go into, MR = MC and find x. (x = number of units to be sold) 5) Use x which was found above, in the p formula to find the selling price (p). 6) x= number of units to be sold to maximise the profits p = selling price to maximise the profits REVENUE MAXIMISATION with economic theory Calculate the number of units to be sold and selling price per unit, in order to maximise the revenue. 6 Steps 1) Develop two p = a + bx formulas using the question s information. 2) Find a and b by solving the two formulas and develop a selling price (p) formula for the question s scenario. 3) Develop a MR formula using the p formula found in the above step. ( MR = a + 2bx ) 4) Go into, MR = 0 and find x. (x = number of units to be sold) 5) Use x which was found above, in the p formula to find the selling price (p). 6) x= number of units to be sold to maximise the revenue p = selling price to maximise the revenue Batch 32) 11
Session 03-12/18/2016 Maintaining and increasing the Market Share with Economic Theory Next we aim at the 2 nd objective of pricing; which is market share maximisation, while considering the economic theory (negative relationship between price and demand/price elasticity). Economic theory argues that the buyers would re-act to any change in the selling price and that this relationship between demand and price is negative. Batch 32) 12
Session 03-12/18/2016 Maintaining and increasing the Market Share with Economic Theory PRICE ELASTICITY OF DEMAND (PED) This is the measure which measures the degree of the demand responsiveness towards the changes in the selling price. PED = % CHANGE IN QUANTITY DEMANDED If, % CHANGE IN SELLING PRICE PED < 1 = Demand is less responsive (inelastic demand) PED > 1 = Demand is highly responsive (elastic demand) Maintaining and increasing the Market Share with Economic Theory PRICE ELASTICITY OF DEMAND (PED) % CHANGE IN QUANTITY DEMANDED % CHANGE IN SELLING PRICE Batch 32) 13
Session 03-12/18/2016 4. based on Practical Strategies Practical Pricing Strategies Pricing 4. Practical Pricing Batch 32) 14
Session 03-12/18/2016 When a company is trying to set a selling price, they have to consider to set a selling price which would cover their cost and the profit margin requirement as well as to set a selling price which would suit the external market s selling price. This means, they would be working towards achieving two conflicting objectives (maximising profits vs maximising market share) maximising profits maximising mkt share In this case, a company may use one of the methods out of the following two approaches: 1. COST BASED APPRAOCH 1.1 Full Cost Plus Approach 1.2 Marginal Cost / Variable Cost Plus Approach 2.1 Market Penetration Strategy 2.2 Market Skimming Strategy 2.3 Price Discrimination Strategy 2.4 Premium Pricing Strategy 2.5 Loss Leader Strategy Batch 32) 15
Session 03-12/18/2016 PRACTICAL PRICING STRATEGIES COST / FULL COST of a product Direct Costs Indirect Costs Direct Materials Direct Labour Direct Other Costs Variable Overheads Fixed Overheads VARIABLE costs FIXED costs 1. COST BASED APPROACH 1.1 - Full Cost Plus Approach Here, the company will take its full cost (Fixed Cost + Variable Cost) and the Opportunity Cost together to come towards the FINAL COST of the product. Finally, they will add a profit markup on that Final Cost to come down to the final selling price. Selling Price = (VARIABLE COST+FIXED COST+OPPORTUNITY COST) + PROFIT MARK-UP Batch 32) 16
Session 03-12/18/2016 1. COST BASED APPROACH 1.2 Marginal Cost / Variable Cost Plus Pricing Here, the company will take its marginal cost / variable cost only to come towards the FINAL COST of the product. Finally, they will add a profit mark-up on that Final Cost to come down to the final selling price. Selling Price = VARIABLE COST + PROFIT MARK-UP In this case, a company may use one of the methods out of the following two approaches: 1. COST BASED APPRAOCH 1.1 Full Cost Plus Approach 1.2 Marginal Cost / Variable Cost Plus Approach 2.1 Market Penetration Strategy 2.2 Market Skimming Strategy 2.3 Price Discrimination Strategy 2.4 Premium Pricing Strategy 2.5 Loss Leader Strategy Batch 32) 17
Session 03-12/18/2016 2.1 Market Penetration Strategy Under this strategy, the emphasis is to capture a large market share, by selling at a relatively lower price. This is a volume driven strategy, that could be practiced when the target market is price sensitive. 2.1 Market Penetration Strategy Examples: Batch 32) 18
Session 03-12/18/2016 2.1 Market Penetration Strategy Examples: 2.2 Market Skimming Strategy This strategy is practiced with a high introductory selling price which generates super profits during the initial stage of the product. It can be practiced on a unique product with a short life cycle, where the company is focussed on innovation. This is more of a price driven strategy than volume driven. Batch 32) 19
Session 03-12/18/2016 2.2 Market Skimming Strategy Examples: 2.3 Price Discrimination Strategy This is where the same product or service is sold to two different customers at two different selling prices. However, the product or service would be offering the same satisfaction to both customers. Batch 32) 20
Session 03-12/18/2016 2.3 Price Discrimination Strategy Examples: Demographic Discrimination Geographic Discrimination Time Discrimination 2.4 Premium Pricing Strategy This is where extra-ordinary high selling prices are charged from customers, for high-class, branded products. Normally, customers buy these products to indicate their purchasing power to the society. These product are manufactured in small batches with limited circulation. Batch 32) 21
Session 03-12/18/2016 2.4 Premium Pricing Strategy Examples: 2.5 Loss Leader Pricing Strategy This is where the main product would be initially introduced to the market at a low selling price, where the company would make losses from each unit sold from the main product. However, the EXTRAS that follow, will be sold at a relatively higher selling price, where the company would focus on profitability through the sale of these EXTRAS. Batch 32) 22
Session 03-12/18/2016 2.5 Loss Leader Pricing Strategy Example: 5. Other Factors Affecting the Pricing Decision Batch 32) 23
Session 03-12/18/2016 OTHER FACTORS affecting the Please refer the text book pg. 204 & 205 Concluding Remarks Batch 32) 24
Session 03-12/18/2016 Batch 32) 25