Inputs to Pricing Decisions

Marginal Analysis

Pricing decisions tend to heavily involve analysis regarding marginal contributions to revenues and costs.

Learning Objectives

Identify the characteristics of a marginal price analysis relative to pricing decision making

Key Takeaways

Key Points

  • Firms tend to accomplish their objective of profit maximization by increasing their production until marginal revenue equals marginal cost.
  • At the output level at which marginal revenue equals marginal cost, marginal profit is zero and this quantity is the one that maximizes profit.
  • In some cases, a firm’s demand and cost conditions are such that marginal profits are greater than zero for all levels of production up to a certain maximum; thus, output should be produced at the maximum level.

Key Terms

  • game theory: A branch of applied mathematics that studies strategic situations in which individuals or organizations choose various actions in an attempt to maximize their returns.
  • demand curve: The graph depicting the relationship between the price of a certain commodity and the amount of it that consumers are willing and able to purchase at that given price.

Marginal Analysis

Pricing decisions tend to heavily involve analysis regarding marginal contributions to revenues and costs. Specifically, firms tend to accomplish their objective of profit maximization by increasing their production until marginal revenue equals marginal cost, and then charging a price which is determined by the demand curve.

In business, the practice of setting the price of a product to equal the extra cost of producing an extra unit of output is known as marginal-cost pricing. Businesses often set prices close to marginal cost during periods of poor sales. If, for example, an item has a marginal cost of $1.00 and a normal selling price of $2.00 the firm selling the item might wish to lower the price to $1.10 if demand has waned. The business would choose this approach because the incremental profit of 10 cents from the transaction is better than no sale at all.

In the marginal analysis of pricing decisions, if marginal revenue is greater than marginal cost at some level of output, marginal profit is positive and thus a greater quantity should be produced. Alternatively, if marginal revenue is less than the marginal cost, marginal profit is negative and a lesser quantity should be produced. At the output level at which marginal revenue equals marginal cost, marginal profit is zero and this quantity is the one that maximizes profit.

Since total profit increases when marginal profit is positive and total profit decreases when marginal profit is negative, it must reach a maximum where marginal profit is zero.

The intersection of MR and MC is shown as point A. If the industry is perfectly competitive (as is assumed in the diagram), the firm faces a demand curve (D) that is identical to its marginal revenue curve (MR). Thus, this is a horizontal line at a price determined by industry supply and demand. If the firm is operating in a non-competitive market, changes would have to be made to the diagram.

A cost curve that shows how businesses set prices based on demand.

Marginal Profit Maximization: This series of cost curves shows the implementation of profit maximization using marginal analysis.

For example, the marginal revenue curve would have a negative gradient, due to the overall market demand curve. In a non-competitive environment, more complicated profit maximization solutions involve the use of game theory. In some cases, a firm’s demand and cost conditions are such that marginal profits are greater than zero for all levels of production up to a certain maximum. In this case, marginal profit plunges to zero immediately after that maximum is reached. Thus, output should be produced at the maximum level, which also happens to be the level that maximizes revenue. In other words, the profit maximizing quantity and price can be determined by setting marginal revenue equal to zero, which occurs at the maximal level of output.

Fixed Costs

Fixed costs are business expenses that are not dependent on the level of goods or services produced by the business.

Learning Objectives

Describe the characteristics of fixed costs and they relate to pricing decisions

Key Takeaways

Key Points

  • The distinction between fixed and variable costs is crucial in forecasting the earnings generated by various changes in unit sales and thus the financial impact of proposed marketing campaigns.
  • Fixed costs are not permanently fixed – they will change over time – but are fixed in relation to the quantity of production for the relevant period.
  • Average fixed cost (AFC) is an economic term that refers to fixed costs of production (FC) divided by the quantity (Q) of output produced.

Key Terms

  • discretionary: Available at one’s discretion; able to be used as one chooses; left to or regulated by one’s own discretion or judgment.
  • lease: A contract granting use or occupation of property during a specified period in exchange for a specified rent.

Fixed Costs

Determining the cost of producing a product or service plays a vital role in most pricing decisions. Fixed costs are business expenses that are not dependent on the level of goods or services produced by the business. They tend to be time-related, such as salaries or rents being paid per month. They and are often referred to as overhead costs. This is in contrast to variable costs, which are volume-related and are paid per quantity produced. In management accounting, fixed costs are defined as expenses that do not change as a function of the activity of a business, within the relevant period. For example, a retailer must pay rent and utility bills irrespective of sales. In marketing, it is necessary to know how costs divide between variable and fixed. This distinction is crucial in forecasting the earnings generated by various changes in unit sales and thus the financial impact of proposed marketing campaigns. In a survey of nearly 200 senior marketing managers, 60% responded that they found the “variable and fixed costs” metric very useful.

A graph that shows how fixed costs and variable costs impact total costs.

Fixed Costs and Variable Costs: The graph breaks down the difference between fixed costs and variable costs.

Fixed costs are not permanently fixed – they will change over time – but are fixed in relation to the quantity of production for the relevant period. For example, a company may have unexpected and unpredictable expenses unrelated to production. Warehouse costs and the like are fixed only over the time period of the lease. By definition, there are no fixed costs in the long run. Investments in facilities, equipment, and the basic organization that can’t be significantly reduced in a short period of time are referred to as committed fixed costs. Discretionary fixed costs usually arise from annual decisions by management to spend on certain fixed cost items. Examples of discretionary costs are advertising, machine maintenance, and research and development expenditures.

Average Fixed Costs

For pricing purposes, marketers generally take into account average fixed costs. Average fixed cost (AFC) is an economics term that refers to fixed costs of production (FC) divided by the quantity (Q) of output produced. Average fixed cost is a per-unit-of-output measure of fixed costs. As the total number of goods produced increases, the average fixed cost decreases because the same amount of fixed costs is being spread over a larger number of units of output.

Break-Even Analysis

The break-even point is the point at which costs and revenues are equal.

Learning Objectives

Analyze the concept of break even points relative to pricing decisions

Key Takeaways

Key Points

  • In the linear Cost-Volume- Profit Analysis model, the break-even unit of sales can be directly computed in terms of total revenue and total costs.
  • Unit contribution margin is the marginal profit per unit, or alternatively the portion of each sale that contributes to fixed costs.
  • Break-even analysis is a simple and useful analytical tool, yet has a number of limitations as well.

Key Terms

  • Opportunity Costs: The costs of activities measured in terms of the value of the next best alternative forgone (that is not chosen).
  • break-even point: The point where total costs equal total revenue and the organization neither makes a profit nor suffers a loss.

Break-Even Analysis

In economics and business, specifically cost accounting, the break-even point is the point at which costs or expenses and revenue are equal – i.e., there is no net loss or gain, and one has “broken even.”

A profit or a loss has not been made, although opportunity costs have been “paid,” and capital has received the risk-adjusted, expected return. For example, if a business sells fewer than 200 tables each month, it will make a loss. If the business sells more, it will make a profit. With this information, the business managers will then need to see if they expect to be able to make and sell 200 tables per month. If they think they cannot sell that many, to ensure viability they could:

  • Try to reduce the fixed costs (by renegotiating rent for example, or keeping better control of telephone bills or other costs)
  • Try to reduce variable costs (the price it pays for the tables by finding a new supplier)
  • Increase the selling price of their tables

In the linear Cost-Volume-Profit Analysis model, the break-even point – in terms of Unit Sales (X) – can be directly computed in terms of Total Revenue (TR) and Total Costs (TC) as: where TFC is Total Fixed Costs, P is Unit Sale Price, and V is Unit Variable Cost. The quantity (P – V) is of interest in its own right, and is called the Unit Contribution Margin (C). It is the marginal profit per unit, or alternatively the portion of each sale that contributes to Fixed Costs. Thus the break-even point can be more simply computed as the point where Total Contribution = Total Fixed Cost:

A break-even analysis where the total number of units equals the total fixed costs divided by the unit contribution.

Break-Even Analysis : A break-even quantity can also be found using contribution margin.

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Break-Even Calculation: We can derive the calculation for the break-even quantity from the relation of total revenue to total costs.

Break-Even and Pricing Decisions

The break-even point is one of the simplest analytical tools in management. It helps to provide a dynamic view of the relationships between sales, costs, and profits. A better understanding of break-even, for example, is expressing break-even sales as a percentage of actual sales. This can give managers a chance to understand when to expect to break even (by linking the percent to when in the week/month this percent of sales might occur). In terms of pricing decisions, break-even analysis can give a company a benchmark quantity of goods to be sold. This quantity can then be used to derive the average fixed and variable costs, the sum of which can be used as the basis for markup pricing, et cetera. Some limitations of break-even analysis include:

  • It is only a supply side (i.e. costs only) analysis, as it tells you nothing about what sales are actually likely to be for the product at these various prices.
  • It assumes that fixed costs (FC) are constant. Although this is true in the short run, an increase in the scale of production is likely to cause fixed costs to rise.
  • It assumes average variable costs are constant per unit of output, at least in the range of likely quantities of sales (i.e. linearity).
  • It assumes that the quantity of goods produced is equal to the quantity of goods sold.
  • In multi-product companies, it assumes that the relative proportions of each product sold and produced are constant (i.e., the sales mix is constant).

Organizational Objectives

For the vast majority of business entities, the ultimate objective should be to increase profits, often through a better pricing strategy.

Learning Objectives

Illustrate how an organization’s objectives impact its pricing decisions

Key Takeaways

Key Points

  • A business can cut its costs, it can sell more, or it can find more profit with a better pricing strategy.
  • When costs are already at their lowest and sales are hard to find, adopting a better pricing strategy is a key option to stay viable.
  • A pivotal factor in determining a price is how consumers will perceive it.

Key Terms

  • viable: Able to be done, possible.

Organizational Objectives

For the vast majority of business entities, the ultimate objective should be to increase profits. Pricing strategies for products or services encompass three main ways to achieve this. A business can cut its costs, it can sell more, or it can find more profit with a better pricing strategy.

When costs are already at their lowest and sales are hard to find, adopting a better pricing strategy is a key option to stay viable. Merely raising prices is not always the answer, especially in a poor economy. Too many businesses have been lost because they priced themselves out of the marketplace. On the other hand, too many business and sales staff leave “money on the table. ” The objective is to adopt a pricing strategy and manage costs such that profit will be maximized.

One strategy does not fit all, so adopting a pricing strategy is a learning curve when studying the needs and behaviors of customers and clients.

Laws Of Price Sensitivity

A pivotal factor in determining a price is how consumers will perceive it. In their book,The Strategy and Tactics of Pricing, Thomas Nagle and Reed Holden outline nine “laws” that influence how a consumer perceives a given price and how price-sensitive they are likely to be with respect to different purchase decisions. They are:

  1. Reference price effect – The buyer’s price sensitivity for a given product increases the higher the product’s price relative to perceived alternatives. Perceived alternatives can vary by buyer segment, by occasion, and other factors.
  2. Difficult comparison effect – Buyers are less sensitive to the price of a known or more reputable product when they have difficulty comparing it to potential alternatives.
  3. Switching costs effect – The higher the product-specific investment a buyer must make to switch suppliers, the less price sensitive that buyer is when choosing between alternatives.
  4. Price- quality effect – Buyers are less sensitive to price the more that higher prices signal higher quality. Products for which this effect is particularly relevant include: image products, exclusive products, and products with minimal cues for quality.
  5. Expenditure effect – Buyers are more price sensitive when the expense accounts for a large percentage of buyers’ available income or budget.
  6. End- benefit effect – This effect refers to the relationship a given purchase has to a larger overall benefit and is divided into two parts. Derived demand: The more sensitive buyers are to the price of the end benefit, the more sensitive they will be to the prices of those products that contribute to that benefit. Price proportion cost: The price proportion cost refers to the percent of the total cost of the end benefit accounted for by a given component that helps to produce the end benefit, such as with computers. The smaller the given component’s share of the total cost of the end benefit, the less sensitive buyers will be to the component’s price.
  7. Shared-cost effect – The smaller the portion of the purchase price buyers must pay for themselves, the less price sensitive they will be.
  8. Fairness effect – Buyers are more sensitive to the price of a product when the price is outside the range they perceive as “fair” or “reasonable” given the purchase context.
  9. The framing effect – Buyers are more price sensitive when they perceive the price as a loss rather than a forgone gain, and they have greater price sensitivity when the price is paid separately rather than as part of a bundle.
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Oil Price Sensitivity: The graph shows the price fluctuation of oil after consumers have significant access to information regarding the commodity.

Other Inputs to Pricing Decisions

Pricing decisions can have a variety of inputs, such as value-added considerations, legal price requirements, competitive positioning, and discounting.

Learning Objectives

List a few of the key considerations to pricing aside from simple expense-oriented break-even analyses

Key Takeaways

Key Points

  • Pricing is an important decision, as it impacts both profitability and competitive positioning.
  • One particularly important pricing consideration are the legal requirements in some industries ( price floors and ceilings). For example, rent-controlled housing will have price limitations an organization will have to adhere to.
  • Functional value, social value, monetary value, and psychological value should all be taken into consideration when setting prices.
  • Differentiation and competitive positioning relative to other industry incumbents is another important pricing consideration. Differentiation can often lead to higher margins (though often lower volume).
  • For perishable goods or items which may go out of fashion (technology, clothing, etc.), discounting is a useful way to ensure that the organization gets some capital back for producing it (even if it sells at a loss on a per unit basis).

Key Terms

  • perishable: Liable to perish, especially naturally subject to quick decomposition or decay.

Pricing Decisions

The pricing decision is an important one, both for profitability and competitive positioning. Organizations must take into account supply, demand, competition, expenses, profit margins, differentiation, quality, and legal concerns. The simplest methods of determining price include concepts such as break-even points, fixed/variable cost analysis, and marginal analysis. However, there are other concerns that need to be investigated when determining price.

Pricing Inputs

Looking at cost structures and determining break-even points is not always enough when it comes to effective pricing strategies. As a result, marketers should be familiar with the legalities of pricing (for certain commodities in particular), the value added to the consumer (willingness to pay), competitive positioning, and potential discounts.

Legal Concerns

For some products, governments will set firm price controls (i.e. price ceilings or price floors) to ensure ethical and/or accessible pricing for a given population. Just as the name implies, price floors and price ceilings will set minimum or maximum prices for some goods. This is particularly applicable to rent, real estate, banking, food and other core necessities. When operating in an industry with price ceilings or price floors, firms must adapt their pricing strategy to these legalities and ensure compliance.

A graph that shows the basic economic principles of supply and demand as they relate to the price.

Price Ceiling : When considering pricing decisions, understanding price floors and price ceilings is important.

Value-Added Pricing

In a perfectly practical and efficient market, the expenses would almost always lead to the appropriate price through competitive forces. However, we do not live in a world of perfect markets. As a result, there are a number of value-adds that consumers receive that are not easy or intuitive to measure from a strictly financial perspective. These include:

  • Functional Value: This is a typical example of demand, where the product is valued at how well it accomplishes a function (i.e. fulfills the need).
  • Monetary Value: This is another typical value example, where the cost of resources and production correlate cleanly with the price.
  • Social Value: The value a consumer receives can actually be social as well as economic. This is to say that some products provide intangible value to users. Fashion is a good example here, as some fashion items return margins that are enormous due to the social perception of a given fashion item (expensive bags, for example).
  • Psychological Value: Some items have value to an individual for personal reasons. A collector, for example, may pay far more than an item is worth due to a strong love for something. People who collect video game action figures, or deluxe editions, for example.

Competitive Positioning

Another input to pricing is the basic premise of differentiation to achieve higher value. This is not so much an exception to the above mentioned value-added pricing, but more of a facet of this. Branded items, for example, are often quite similar to generic versions of the same item. However, these brands add intangible value to the product above and beyond the cost of producing it. Buying brand name goods may be differentiated based upon celebrity sponsors, premium perception, social value or a wide variety of other differentiated factors. These can enable organizations to differentiate for a price premium (i.e. they can charge more for having a strong brand/position).

Discounting

There are also a number of reasons why an organization may offer discounts. Discounting is particularly useful when it comes to B2B transactions, in which a client might buy a few thousand of a given product and receive a wholesale price that is significantly lower than the price of buying each product individually. There are also situations in which a product may be sold at a price that is actually less than the cost of producing it. This is most often done when a perishable item will soon go bad anyway. In such a situation, selling at a loss is better than getting nothing at all (opportunity cost!).

Conclusion

All and all, pricing is a bit more complicated than simply understanding the expenses involve. Marketers must understand social value, legal considerations, branding, discounting, and the functional value of products and services in order to capture the full potential of a given item. Pricing can be a great opportunity to capture better margins than the competition, or could offer the ability to make a mistake and lose market share!