Transcript Contribution margin pricing

Chapter 7
The Pricing Decision and
Customer Profitability Analysis
Factors that Influence the Pricing
Decision
Cost of goods sold.
Operating cost structure.
Nature of the product or service.
Competitiveness of the industry.
Sensitivity to global issues.
Legal and environmental issues.
Price elasticity.
Price elasticity of demand
Price elasticity of demand refers to the relationship
between price and demand. It measures the relationship
between a change in price and a change in demand for a
product or service.
Percentage change in demand
Percentage change in price
Where the numerical value is less than or equal to 1, then the price elasticity of
demand is inelastic (demand is less sensitive to changes in price)
Where the numerical value is greater than or equal to 1, then price elasticity is
elastic (demand is sensitive to changes in price)
Illustration 7.1: Price elasticity of
demand
Limitations of economic pricing
theory
It assumes there are no other variables that can
influence demand. For example it ignores the effects
of marketing on sales demand and it effectively
assumes that sales volume is solely a function of
price.
It also assumes that consumers are perfectly
informed about the prices of products and services
and that price is their sole motivation in changing their
spending patterns.
The exact shape of a products demand curve is
extremely difficult to estimate, thus ensuring that
forecast demand at a given price may be misleading.
Accounting-based pricing methods
Accounting-based pricing methods tend to concentrate on
accounting measures such as covering costs and achieving
a required profit rather than factors relating to the external
Environment.
There are three main accounting-based pricing methods
Cost-based pricing.
Contribution margin pricing.
Profit oriented pricing.
Cost based Pricing
Profit mark-up and profit margin
Profit mark-up expresses the profit element as a
percentage of costs whereas profit margin expresses the
same profit element as a percentage of sales.
If the selling price of a product is €100 and the total cost
amounts to €80, then the profit element equals €20.
The profit mark-up that expresses profit as a percentage of
cost, is calculated as €20  €80 x 100 = 25%.
The profit margin that expresses profit as a percentage of
sales, is calculated as €20  €100 x 100 = 20%.
Cost based pricing methods
The pricing decision focuses totally on costs, ensuring
that a selling price is set that covers the costs of running
the business and will be sufficient to provide a profit. The
selling price is arrived at by simply adding to costs a
profit percentage to get the selling price.
P = C + M (C)
Where
P = selling price
C = costs
M = percentage mark-up or profit percentage
based on cost.
Cost based Pricing
Gross margin pricing
Example 7.1: Gross margin pricing
Cost based Pricing
Direct cost pricing
Example 7.2: Direct cost pricing
Example 7.2: Direct cost pricing
Cost based Pricing
Full cost pricing
Evaluation of cost based pricing
The simplicity of cost based pricing is its main
advantage and, as an initial first step in
determining a selling price, it is considered quite
useful. The main criticism of cost based pricing
is that on its own it only focuses on costs and
ignores other factors such as the economic
environment, competition, and the marketing
and sales strategy of the business. It also does
not take into account the required level of
profitability based on the level of investment in
the business.
Contribution margin pricing
Contribution margin pricing focuses on ensuring that each
product or service offers a target contribution towards fixed
costs and profit.
All costs must be classified into their fixed and variable
components.
Contribution margin pricing is based on the premise that
prices are set using variable costs as the base and what
the market will bear as the ceiling.
This ensures that although individual sales may not
provide an overall profit, the sum of all sales will provide
sufficient contribution to cover fixed costs and provide the
required profit.
It can provide a high discretionary element to price setting
Example 7.3: Contribution margin
pricing
Example 7.3: Contribution margin
pricing
Evaluation of contribution margin
pricing
The main advantages of contribution margin pricing is
that it provides great scope for a pricing policy that is
adaptive to changing conditions and takes into account
costs and market conditions in setting a selling price. Its
main criticisms are those that are associated with the
CVP model such as, the assumption that all costs can be
classified as either fixed or variable. It also requires
information on the demand curve and the price elasticity
of demand which is quite difficult to predict. As with cost
based models, it ignores the level of profitability as a
percentage of the capital investment in the business.
Profit oriented pricing
The focus is on profit and the return on investment
required.
It involves calculating a total sales figure that should
achieve a return on investment that will satisfy
investors
The technique is an extension of the cost based and
contribution pricing methods with an extra variable,
profit or return, as part of the equation.
The total estimated sales figure, divided by expected
forecast demand will give a selling price which will
ensure the required level of profitability for investors,
provided costs and demand levels remain as forecast.
Example 7.4: Profit oriented
pricing
Example 7.4: Profit oriented
pricing
Or alternatively…
Evaluation of profit oriented
pricing
Profit oriented methods are effectively cost
based methods taking into account a required
rate of return (profitability and investment). Thus
their advantages include those of the cost based
method with the added advantages that this
method focuses on profit and investment. The
main criticisms are, that as with cost based
methods, it does not focus on the market, price
elasticity of demand, competition and the
economic environment and thus is considered
quite insular.
Example 7.5: Pricing hotel
accommodation
Example 7.5: Pricing hotel
accommodation
Example 7.5: Pricing hotel
accommodation
Market based pricing strategies
Going rate pricing / competition oriented pricing
Perceived value / psychological pricing
Loss leader / decoy pricing
Two-part pricing
Camouflage pricing
Multi-stage approach to pricing
Select the target market
Determine the floor price
(cost price)
This is the cost of goods but could take
into account clearance lines and loss
leaders.
Determine the ceiling price
(competitors price)
This is the price charged for the item by
competitors. Provides a reasonable upper
limit.
Apply a mark-up
A target mark-up can be applied in order
to achieve the required profit objectives.
Adjust and select the price
If necessary adjust the price (fine tune) to
be consistent with store policy.
The main benefits of the multi-stage approach are that it incorporates more
than one factor and allows for adjustments or fine tuning to be made.
Price lining
Setting up a number of
distinct prices for a product
range.
Prices could be
limited to say €25, €32 and
€40.
Fixed pricing
The price set is the only
acceptable price and will not be
bargained down.
Flexible pricing
Odd pricing
Uses prices like €19.95 or €99.99 to
give impression of lower price.
Even pricing
Uses prices like €130 to give
impression that price is not most
important factor and prestige would
be tarnished by using odd pricing.
Pricing
Tactics
Allows for the expectation that
price can be negotiated down or
a bargain struck.
Multiple unit pricing
Providing discount for two or more items
Complementary goods
Promotional price for one item may encourage
purchase of complementary products at full
price.
Customer Profitability Analysis
(CPA)
Customer profitability analysis (CPA) focuses on how
individual customer or customer groups contribute to
profit.
It is derived from the Pareto principle that about 20
per cent of customers account for 80 per cent of
profit.
The focus is to ensure that the most profitable
customers or customer groups receive comparable
attention from the organisation.
Benefits of CPA
By focusing on the most profitable customers and
providing an improved or commensurate service,
customer relations improve and customer retention
increases. Also by identifying the attributes of this
group, other similar customers may be attracted to the
organisation.
By having a knowledge of why certain customers or
customer groups do not significantly contribute to
profit (and may actually reduce profit), management
can assess the difficulties and work on solutions that
benefit the organisation as well as the customer.
CPA requires
The process requires the use of an activity based costing
system and involves gathering detailed cost and revenue
information for each customer or customer group:
Sales details: These would include the price charged to the
customer including any details on cash and quantity discounts.
Cost details: These would involve focusing on the resources
consumed by different customers. These cost drivers (the
activities that create the customer cost) need to be separately
identified and a cost driver rate associated with the activity.
Examples of cost drivers under CPA would include order costs,
sales visits, delivery costs, special delivery costs, credit
collection and non-standard product requirements
Illustration 7.4: Customer
profitability analysis
Illustration 7.4: Customer
profitability analysis