ACCA F5 Performance Management - 2010 - Study text

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Paper F5

Performancemanagement

CHAPTER

Pricing decisions

Contents

1 Factors that influence price

2 Price elasticity of demand

3 Demand equations, cost functions and

maximising profit

4 Price strategies

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Factors that influence price

 The nature of pricing decisions

 Demand and supply

 Cost

 Income of customers

 Product life cycle

 Quality

 Other factors influencing price

1 Factors that influence price

1.1 The nature of pricing decisions

For many companies, pricing decisions are amongst the most important decisions

management must make. The selling price for a company’s products or services will

affect:

 the volume of sales demand, and

 the profit margin per unit.

Some pricing decisions are for the longer term; companies have to decide the

general price level at which it wants to sell its goods or services. The ability of

companies to decide the general level of selling prices differs according to the size of

the company relative to the size of the market it operates in.

 Companies that dominate their market, and are the largest suppliers to the

market, are often able to decide what selling prices should be. They are ‘price

makers’. Companies that dominate their market might sell their products at low

prices to maintain their dominant market share.

 Companies that do not dominate their market are usually ‘price takers’, which

means that they have to sell their products at about the same price as other

companies in the market. They are unable to sell at lower prices without

incurring a loss; and if they try selling at higher prices, customers will switch to

rival suppliers.

In the short term companies might use other pricing strategies, such as temporary

price reductions or pricing a special job or contract at a low price in order to win the

work and a new customer.

Some of the factors that influence sales pricing decisions are described briefly in the

rest of this section.

1.2 Demand and supply

According to basic microeconomic analysis, the sales price for a product in a market

is determined by demand and supply.

Chapter 4: Pricing decisions

 Demand is the volume of sales demand that will exist for the product at any

given price. As a normal rule, sales demand will be higher when the price is

lower. If the price rises, total sales demand will fall. If the price falls, sales

demand will rise.

 Supply is the quantity of the product (or service) that suppliers are willing to sell

at any given sales price. Higher prices will attract more suppliers into the market

and encourage existing suppliers to produce more. Lower prices will deter some

suppliers, and might drive some out of business if the price fall results in losses.

A simple graph of supply and demand is shown below. In this diagram, the

equilibrium price level is the sales price that would become established in the

market if the factors that affect supply or demand did not change. Here the price

would be $P and the total sales demand for the product would be Q units.

Occasionally, sales demand for a product might rise to such a high level that

producers in the market are unable to meet the demand in full. Until production

capacity can be increased, this situation could result in very large price rises and

very high profit margins for producers.

An example of demand exceeding supply capacity has been the market for oil on

occasions in the past. Oil suppliers are unable to alter their output volumes quickly,

so a large increase in demand for oil can result in very large price increases, at least

in the short term.

Monopoly pricing

Supply and demand in the diagram above is for the market as a whole, and within

the market there might be many different suppliers competing with each other to

win business.

A similar situation applies to companies that are dominant in their particular

market, and supply most of the goods or services sold in the market. In these

‘monopoly markets’, the individual company has a downward-sloping demand

curve, which means that:

Quantity

Q

P

Price

Salesdemand

(higheratlowerprices)

Supply

(loweratlowerprces)

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 as a monopoly supplier to the market, it is in a position to set prices for the

market, but

 if it raises the prices of its products, the demand for its products will fall.

Pricing in a competitive market

In contrast to a monopoly market, companies that sell their products in a highly

competitive market will decide their selling prices by comparing them with those of

competitors.

In order to compete effectively, companies might use short-term pricing tactics such

as price reductions, volume purchase discounts, better credit terms and so on.

1.3 Cost

In the long run, the sales price must exceed the average cost of sales of the product

that a business entity sells. If cost is higher than selling price, the business will make

a loss and cannot survive in the long term. Cost is therefore a major determinant of

price.

Costs are influenced by factors such as:

 suppliers’ prices for raw materials and components

 price inflation

 exchange rate movements

 other elements of cost, such as wage rates and general expenses

 quality: it usually costs more to produce an item to a higher quality standard.

A company may have to decide where it wants to position its product in the market

in terms of quality. Premium pricing (higher-than-average prices) prices can be used

for higher quality products, but customers may prefer lower quality, lower priced

products. A clear understanding of the link between quality and cost will be needed

to help management determine the optimum price/quality mix.

If a company is able to reduce its costs, it should be in a position if it wishes to

reduce its sales prices and compete more aggressively (on price) for a bigger share

of the market.

1.4 Income of customers

Another microeconomic factor influencing sales demand in any market is the level

of income of customers and potential customers for the product.

As the income of customers rises, they are more likely to want to buy more of the

product. When demand is growing because income levels are rising, there is a

tendency for prices to rise.

 In an economy as a whole, rising income occurs when the national economy is

growing, and prices will rise. (The authorities might try to prevent excessive

inflation, but prices will nevertheless increase.)

Chapter 4: Pricing decisions

 When income in an economy is falling, there is an economic recession, and there

might even be some price falls.

1.5 Product life cycle

The product life cycle was explained in an earlier chapter on life cycle costing. As a

product goes through the different stages of its life cycle, sales prices will change.

 Introduction stage. During the introduction stage of its life cycle, the product is

introduced to the market. If the product is new, and there are no rival products

on the market, there is a choice between a market skimming policy for pricing or

a market penetration policy. These policies are explained later.

 Growth stage. During the growth stage of the life cycle, demand for the product

increases rapidly, but more competitors enter the market. If the market is

competitive, each firm might have to lower its prices to win a share of the

growing market. However, because sales demand is strong, prices and profit

margins are likely to be fairly high (although falling). Some companies might try

to identify a specialist ‘niche’ in the market, where they have more control over

pricing of their products. Similarly, companies might try to keep prices higher

by differentiating their product from those of competitors on the basis of quality

or other distinguishing features (such as design differences).

 Maturity stage. When a product reaches the maturity stage of its life cycle, total

sales demand in the market becomes stable, but the product may become a

‘commodity’. Firms must then compete for market share, often by cutting prices.

Companies might use product differentiation strategies to keep the price of their

product higher than it might otherwise be, but prices generally will be lower

than during the growth stage of the life cycle.

 Decline. Eventually, the market demand for a product declines. When sales

demand falls, companies leave the market. Those that remain keep on selling the

product as long as they can make a profit. Prices might remain very low. In some

cases, however, a product might acquire ‘rarity value’, allowing companies to

raise prices. However, since unit costs will also be higher, it is still difficult to

make a profit.

1.6 Quality

Some customers will often be willing to pay more for better quality and companies

may set prices higher than the market average because their products have a better-

quality design or more features that provide value to customers.

Quality is often ‘real’, and can be provided by better-quality materials (for example

in clothing products) or by greater reliability of performance or better performance

(for example in motor cars).

Quality may also be ‘perceived’ rather than real, and customers will pay more for a

branded product than for a similar or near-identical product with no brand name or

a ‘cheaper’ brand name.

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1.7 Other factors influencing price

There are other influences on pricing decisions and the general level of selling prices

in a market.

 The price of ‘substitute goods’. Substitute goods are goods that customers could

buy as an alternative. Companies might set the price for their product in the

knowledge that customers could switch to an alternative product if they think

that the price is too high. For example, if the price of butter is too high, more

customers might switch to margarine or other types of ‘spread’.

 The price of ‘complementary goods’. Complementary goods are items that

customers will have to buy in addition to complement the product. The pricing

of complementary products is explained in more detail later, as a pricing

strategy that companies may use.

 Consumer tastes and fashion. High prices might be obtained for ‘fashion goods’.

 Advertising and marketing. Sales demand can be affected by sales and

marketing activities, including public relations activity. Strong consumer interest

in a product or service could allow a company to set a higher price.

In addition to general factors influencing price, such as supply and demand,

competition and cost, companies will use one or more different pricing strategies to

decide the sales prices for their products or services.

A number of different pricing strategies are described in a later section of this

chapter.

Chapter 4: Pricing decisions

Price elasticity of demand

 Price elasticity of demand: its meaning and measurement

 Elastic and inelastic demand

 Elasticity and setting prices

2 Price elasticity of demand

2.1 Price elasticity of demand: its meaning and measurement

Within a market as a whole, there is an inverse relationship between selling price

and sales demand. At higher prices, total sales demand for a product will be lower.

For individual companies in a monopoly position in their market (or niche of the

market) the same rule applies: if prices are raised, demand will fall.

The price elasticity of demand (PED) is a measurement of the change in sales

demand that would occur for a given change in the selling price.

It is measured as:

The change in quantity demanded as a percentage of original demand

The change in sales price as a percentage of the original price

Price elasticity of demand has a negative value, because demand rises

(positive) if the price falls (negative), and demand falls if the price

rises.

Example

The following estimates have been made of total sales demand for product X:

 An increase in the price from $9 to $10 will result in a fall in daily demand from

2,000 to 1,600 units

 A fall in the price from $5 to $4 will result in a rise in daily demand from 8,000 to

9,000 units.

Required

Calculate the price elasticity of demand for product X at a price of:

(a) $9

(b) $5

Paper F5: Performance management

Answer

(a) If the price is increased from $9 to $10

The change in quantity demanded as a percentage of original demand

= - 400/2,000 = - 0.20 or - 20%.

The change in price as a percentage of the original price = $1/$9 = + 0.111 or +

11.1%.

PED = - 0.20/ + 0.111 = - 1.8.

(b) If price is reduced from $5 to $4

The change in quantity demanded as a percentage of original demand

= + 1,000/8,000 = + 0.125 or + 12.5%.

The change in price as a percentage of the original price = - $1/$5 = - 0.20.

PED = + 0.125/- 0.20 = - 0.625.

2.2 Elastic and inelastic demand

Sales demand for a product could be either elastic or inelastic in response to changes

in sales price.

 Demand is elastic if its value is above 1. (More accurately, demand is elastic if its

elasticity is a figure larger than – 1.)

 Demand is inelastic if its value is less than 1. (More accurately, demand is

inelastic if its elasticity is a figure below – 1, between 0 and – 1.)

The significance of elasticity

Price elasticity of demand affects the amount by which total sales revenue from a

product will change when there is a change in the sales price.

If demand is highly elastic (greater than 1, ignoring the minus sign):

 increasing the sales price will lead to a fall in total sales revenue, due to a large

fall in sales demand, and

 a reduction in the sales price will result in an increase in total sales revenue, due

to the large rise in sales demand.

Profit might increase or decrease when the sales price is changed, depending on

changes in total costs as well as the change in total revenue.

If demand is inelastic (less than 1, ignoring the minus sign):

 increasing the sales price will result in an increase in total sales revenue from the

product, because the fall in sales volume is fairly small, and

Chapter 4: Pricing decisions

 reducing the sales price will result in lower total sales revenue, because the

increase in sales demand will not be enough to offset the effect on revenue of the

fall in price.

A product does not necessarily have high or low price elasticity of demand at all

price levels. The same product might have a high price elasticity of demand at some

sales prices and low price elasticity at other prices.

2.3 Elasticity and setting prices

An understanding of the price elasticity of demand for products can help managers

to make pricing decisions:

 If demand is inelastic, raising selling prices will result in higher sales revenue.

Since fewer units will be sold, it should be expected that total costs will fall.

Higher revenue and lower total costs mean higher profits. If management

believe that sales demand for their product is price-inelastic, they might

therefore consider raising the sales price.

 If demand is inelastic, reducing the sale price will lead to lower total sales

revenue. Sales demand will increase, and so the costs of sales are also likely to

increase. Profits are therefore likely to fall.

 If demand is elastic, an increase in the sales price will lead to a fall in total sales

revenue. Sales demand will also fall. If managers are thinking about an increase

in the sales price, they will have to consider whether the fall in total costs (due to

the lower volume of sales) will exceed the fall in total revenue.

 If demand is elastic, reducing the sales price will increase total sales revenue

from the product, but total sales volume will increase. The effect, as with raising

sales prices for a product with high price elasticity of demand, could be either

higher or lower total profits. There is a risk that if one company reduces its sales

prices and elasticity of demand is high, this could lead to a ‘price war’ in which

all competitors reduce their prices too. At the end of a price war, all sellers are

likely to be worse off.

Companies might try to reduce the price elasticity of demand for their products by

using non-price methods, such as improving product quality, improving service

and the use of advertising and sales promotions.

Paper F5: Performance management

Demand equations, cost functions and maximising profit

 Straight-line demand equation

 Total cost function

 Maximising profit

 Problems using a demand equation

 Incremental revenue and incremental cost

3 Demand equations, cost functions and maximising

profit

If a demand equation and a cost function can be obtained for a product, it will be

possible to calculate the sales price and sales volume) at which profit would be

maximised.

3.1 Straight-line demand equation

A demand equation is an equation for the relationship between total sales demand

for a product and the selling price. If a demand equation is drawn on a graph, with

price on the y axis and sales demand/volume on the x axis, the equation would

slope down from left to right.

For the purpose of the F5 examination, only straight-line demand equations are

examinable. A straight-line demand equation would be shown on a graph as

follows:

In reality a demand equation is unlikely to be accurate at very high levels of price or

very low levels of sales demand. This is why the demand equation in this diagram is

shown with a dotted line at each end.

Demand/volume

Price

P

ACCA F5 Performance Management - 2010 - Study text - Emile Woolf Publishing

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