Chapter 7 - Pricing

Question 1

What are the three main factors that are relevant when considering what price to charge

Answer 1

Costs-you want to charge more than the cost of making a product

Competitors - have to charge similar to competitors

Customers - price we charge affects how many we would sell, balance selling price with units sold to see what the ultimate price should be based on demand. Profit per unit might be lower but we sell more so overall profit is higher 

Question 2

What are the different types of pricing

Answer 2

Cost plus pricing (Full cost plus, marginal cost plus and opportunity cost plus)

Optimal pricing tableau approach

Optimal pricing equations

Price elasticity of demand

Question 3

What is cost plus pricing

Answer 3

Using cost plus pricing the selling price is calculated by estimating the cost per unit of a product and adding an appropriate percentage markup

There are three main types of cost plus pricing

Full cost plus-this includes a share of overheads and also often include non-production costs (fix costs)

Marginal cost plus-the price of the product is determined by calculating the marginal or incremental cost of producing a unit and adding a markup (without fixed costs)

Opportunity cost plus-this is marginal cost approach but also included within the cost any opportunities for gone and it is a relevant costing approach

Question 4

What are the advantages and disadvantages of full cost plus

Answer 4

Advantages

Easy to implement
Standard policy – can use this approach on all product lines
Guarantees a profit because all costs are included

Disadvantage (outweigh the advantages)

Ignores competition
Ignores effect of price on demand
Absorption of fixed overheads - the problem is that we absorb on a budgeted demand total, what if we sold more products, the cost should be lower because the absorbed fixed overheads should be lower and what if we don’t sell enough, we might not make a profit as overheads increase (this is the big problem which is why other use marginal cost plus)!!

Question 5

What are the advantages and disadvantages of marginal cost plus

Answer 5

Advantages

Easy
Standard policy
No need to absorb fixed overheads

Disadvantages
Ignores competition
Ignores effect of price on demand
What % do we add to ensure to cover fixed overheads so that we make a profit as the cost total is the contribution not the profit like with full cost pricing.

Question 6

Is cost plus pricing any good

Answer 6

No because it struggles to deal with fixed overheads both the full cost and marginal cost are both poor standards to adopt. Not many companies adopt cost plus pricing, you do seem to see it with restaurants selling wine for example they may sell wine and a 200% onto the price that you can pay in the supermarket

Question 7

What is optimal pricing tableau approach

Answer 7

For many products but not all it is the case that a higher selling price will result in lower demand and vice versa

It could therefore be worthwhile to reduce the selling price and sell more provided of course that this results in a higher total profits

There are two processes in the exam For optimal pricing and the tableau approach looks at drawing a table where we look at selling price and cost and the demands at different levels of selling price

(one major disadvantage of cost plus approach is pricing is that it’s completely ignores the possible effects of the selling price on the level of demand)

Question 8

Two ways to be tested on optimal pricing tableau approach

Answer 8

1. This is the easy approach where you are given selling price demands cost per unit and quantity for cost and with this information you can work out the total revenue the total cost and therefore the total profit and decide what selling price is best to sell at.
2. This is the trickier approach rather than looking at total profits to determine which selling price gives the most profits we look at the marginal revenue and marginal cost (marginal means additional). For example if selling price is $16 and total revenue is $1600 I’m at $15.50 the total revenue is $3100 then the marginal revenue is $1500 because that is the additional revenue by dropping the price. Do the same calculation for the total cost and if the marginal revenue is more than the marginal cost then you know it is worth dropping the price because the difference between the two is the increase in profits. Keep dropping the price until the marginal cost exceeds the marginal revenue and at this point you know to choose the last price when marginal revenue exceeded marginal cost

Question 9

What is price elasticity of demand

Answer 9

Many products will have a change of demands based on the effects of selling price others may not for example milk as this is an essential products people don’t buy more less milk based on the small incremental price changes.

A measure of the size of the effect on demand of a change the selling price is called the price elasticity of demand and can be calculated by

% change in demand / % change in price

Imagine current price is £16 and demand is 100 and the next lower change is £15.50 where demand is 200. Price has decreased by 3.125% but demand has gone up by 100% therefore the PED is -32 remember it is a negative as the price is -3.125% less than before

A high PED Means that the demand is very sensitive to changes in the price or elastic (like above)

A low PED Means that the demand is not very sensitive to changes in price or inelastic

Question 10

What is the price/demand equation (optimal pricing equation not tablear)

Answer 10

P = a - bQ

P = selling price
Q = quantity demanded at that price
a = Theoretical maximum price (price when demand is zero, remember it is linear!)
b = The change in price divided by change in demand

Remember that for this equation we assume that it is linear for example if the selling price was $15 and Demand was 5000 and we were told in the question that a $1 reduction in price increases the demand by 100 then it isalso to be assumed that a $2 increase has 200 increase in demand of $4 decrease as a 400 change etc

Question 11

How to calculate the selling price at which profit will be maximised (optimum pricing -equations)

Answer 11

This was hard but you do this by following the steps:

1. Find out what a and b is in the price demand equation (p=a-bQ)
2. Now we need to know that q is and we do this by differentiating however we can’t be expected to differentiate in the exam so are given a formula which is MR = a-2bQ. REMEMBER THE OPTIMUM POSITION IS WHEN MARGINAL REVENUE = MARGINAL COSTS. Therefore MC (marginal costs) are always the variable costs given in the exam (ignore the fixed costs). We know what a and b is for the MR equation and as MR = MC we can use algebra to work out what Q is.
3. Once we have Q plug it into the price demand equation and from there you can work out p ( selling price)

Question 12

What is a pricing strategy and what are the main examples to consider

Answer 12

In particular circumstances for particular reasons the company may decide on a special strategy with regards to its pricing policy and the main ones are:

1. Penetration pricing-charge low price to gain market share with intention of raising prices
2. Price skimming charge high price of first and reduce overtime for example when televisions first came out the flat screen TVs were really expensive because they knew a portion of the public would pay ridiculous amounts for them and when they bought them they reduce the price
3. Product line pricing-different versions of the same product at different prices for example with iPhones and more memory bigger screen et cetera
4. Complimentary products-Razors
5. Price discrimination-sell same product to different markets at different prices e.g. prices in different countries or ticket prices on buses for different ages
6. Volume discounting - Bulk buying a toilet rolls