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)

Determine the ceiling price

(competitors price)

Apply a mark-up Adjust and select the price

This is the cost of goods but could take into account clearance lines and loss leaders.

This is the price charged for the item by competitors. Provides a reasonable upper limit.

A target mark-up can be applied in order to achieve the required profit objectives.

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

Allows for the expectation that price can be negotiated down or a bargain struck.

Pricing Tactics 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.

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