Pricing Products and Services:
After studying this chapter you should be
able to:
-
Compute the profit maximizing price of
a product and service using the price elasticity of demand and variable cost.
-
Compute the selling price of a product
using the absorption costing approach.
-
Calculate the target cost for a new
product or service.
-
Calculate and use billing rates used in
time and material pricing.
Pricing is not a problem for some
businesses. They make products or provide a service that is in competition
with others, identical products or services for which a market price already
exists. Customers will not pay more that this price, and there is no reason
to charge less. Under these circumstances, the company simply charges the
prevailing market price. Markets for basic raw materials such as farm
products and minerals follow this pattern.
Here we are concerned with the more common
situation in which a company is faced with the problem of setting its own
prices. Clearly, the pricing decision can be critical. If the price is too
high, customers will avoid purchasing the company's products. If the price
is set too low, the company's costs may not be covered.
the usual approach in pricing is to mark up
cost. A product's markup is the difference between its selling price
and its cost. The markup is usually expressed as a
percentage of cost. This approach is called cost plus pricing because the
predetermined markup percentage is applied to the cost base to determine a
target selling price.
Selling price = Cost + (Markup ×
Cost)
For example, if a company uses a markup of
50%, to the costs of its products to determine the selling price. If a
product costs $10, then it would charge $15 for the products.
Two key issues must be addressed when the
cost plus approach to pricing is used. First, What cost should be used?
Second, how should the markup be determined? Several alternatives approaches
are considered here, starting with the generally favored by economists.
Price Elasticity of Demand--Economists' Approach to Pricing:
If a company raises the price of a product, unit sales ordinarily falls.
Because of this, pricing is a delicate balancing act in which the benefits
of higher revenues per unit are traded off against the lower volume that
results from charging higher prices. The sensitivity of unit sales to
changes in prices is called the price elasticity of demand.
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Absorption Costing Approach to Cost Plus Pricing:
The
absorption costing approach to cost plus pricing differs from the
economists' approach (price elasticity of demand) both in what costs are
marked up and in how markup is determined. Under the
absorption costing approach to cost plus pricing, the cost base is the
absorption costing unit product cost rather than
variable costing.
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Target Costing:
Target costing is
the process of determining the maximum allowable cost for a new product and
then developing a prototype that can be profitably made for that maximum
target cost figure.
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Time and Material Pricing in Service Companies:
Some companies--particularly in service
industries-- use a variation of cost plus pricing called time and
material pricing. Under this method, two pricing rates are
established--one based on direct labor time and other based on the cost of
direct materials used.
Click here to read full article.
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In Business|
Do Consumers Really Respond To Prices? You Bet They Do:
Jess Stone street Jackson is the founder of
Kendall-Jackson (K-J) winery, which specializes in making popular wines
that are good enough to command a premium price. Jackson, who is now a
billionaire, prices his wines a few dollars high than other mainstream
wines. For example, if a Clos du Bois chardonnay costs $9 at retail,
Jackson will charge $11 for his chardonnay. When chardonnay became the
range in the late 1990s, Jackson tried pushing up his prices by another
few dollars over the competition. But unit sales dropped by 18%. Jackson
rolled back his prices and the the volume recovered.
Source: Tim W. Ferguson, "Harvest Time,"
Forbes, October 16, 2000, pp. 112-118 |
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