Pricing and product mix decisions

Chapter 20Pricing and product mix decisions20-1Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-SmithOutlineMajor influences on pricing decisionEconomic profit-maximising modelsPricing strategiesStrategic pricing of new productsCompetitive biddingLegal restrictions on pricingProduct mix decisions20-2Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-Smith20-3Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-SmithMajor influences on pricing decisionsMarket positioningCompanies position themselves in certain markets and this may influence product pricesA firm with a reputation for very high quality and prestigious products may set a high price, consistent with that imageAn overemphasis on price cutting can damage a product’s image and reduce profitability20-4(cont.)Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-SmithMajor influences on pricing decisions (cont.)Product costsIn the long term, firms must produce at a cost below selling priceThe importance of product cost in price setting varies across industryEven when a firm sets a price below cost, it is still important to have an awareness of product cost20-5Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-Smith(cont.)Major influences on pricing decisions (cont.)Customer valueUnderstanding customer value is a critical aspect in price settingThe difference between the value that a customer gains by owning and using a product, and the price paid for the product is the net value to the customerBusinesses must understand the specific aspects of a product or service that provide value to the customer20-6Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-Smith(cont.)Major influences on pricing decisions (cont.)Competitors’ behaviourCompetitors’ pricing behaviour can affect a company’s pricing decisionsWhen considering the reaction of competitors and customers, management must take care to define its product and market it correctlyPredicting competitors’ reactions to its products and pricing strategy is a difficult but important task for management20-7Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-Smith(cont.)Major influences on pricing decisions (cont.)Legal, political and ethical issuesManagers must adhere to the laws when setting pricesThe law generally prohibits companies from discriminating between customers in setting pricesPolitical pressures may lead to intervention in the setting of pricesEthical considerations may need to be considered, including deceptive practices20-8Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-SmithEconomic profit-maximising modelsEconomic models focus on the optimal price and sales quantity that will maximise profitPrice elasticity is the impact of price changes on sales volumeCross-elasticity is the extent to which a change in a product’s price can affect the demand for a substitute product20-9Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-Smith(cont.)Economic profit-maximising models (cont.)Demand is elastic if a price increase has a large negative impact on sales volumeDemand is inelastic if a price change has little or no impact on sales quantityMeasuring price elasticity is an important objective of market research into pricing20-10Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-SmithLimitations of the economic modelDifficult to precisely determine the firm’s demand curve and marginal revenue curveMany factors affect product demandNot valid for all forms of marketsDifficulty of measuring marginal cost- most costing systems are not designed to do this20-11Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-SmithPricing strategiesValue-based pricingWhere customers’ perceptions of the value of the product or service guide the pricingA firm need to understand customers needs and their perceptions of valueEconomic-value pricingSpecifically estimates the costs and benefits experienced by the customer, which extend beyond the initial purchase priceOften used in industrial markets20-12Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-Smith(cont.)Pricing strategies (cont.)Cost-plus pricingMost firms consider product costs, to some degree, when setting prices-Why?Difficult to do thorough market analysis for all products-need quick, straightforward methods to set priceCosts give management a starting pointCosts provide a floor below which prices cannot fall in the long run 20-13Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-SmithCost-plus pricingCost-plus pricing formulasPrice = cost + (markup percentage × cost)Markup percentage is dependent on the definition of product cost usedTwo issuesWhat is the best definition of cost to be used in the cost-plus pricing formula?How is the desired markup determined?20-14Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-SmithProduct costing definitionsAbsorption cost pricing formulasProvide a justifiable price- perceived to be equitable to all partiesUsually provided by a firm’s costing systemCost-effective to use in pricingDisadvantagesObscures the cost behaviour patterns of the firm Not consistent with CVP analysis20-15Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-Smith(cont.)Product costing definitions (cont.)Variable cost pricing formulasDoes not obscure the cost behaviour pattern by unitising fixed costs Variable cost data is useful for short-term pricing decisionsDisadvantages In the long term, prices must be set to cover all costs and a normal profit marginManagers must use high markups when using variable cost20-16Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-SmithDetermining the markupReturn on investment (ROI) pricingSelling price is determined by using the required rate of return to determine the markup on costThe profit margin is based on the firm’s target return on investmentAverage investment × target ROI = target profit20-17Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-SmithMarkup percentage20-18Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-SmithTime and material pricingCost-plus pricing using separate labour and materials chargesLabour charge includes a charge for labour-related overhead and profit marginMaterial charge includes a charge for material-related overhead20-19Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-Smith(cont.)Time and material pricing (cont.) 20-20Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-SmithCost-plus pricing: summary and evaluationEffective price setting requires a constant interplay between market considerations and cost awarenessCost-plus pricing may be used to establish a starting point for setting pricesCost-plus pricing formulasSimple Can be applied mechanically to update prices for multiple productsCan be used with a variety of cost definitions 20-21Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-SmithProduct cost distortion and pricing: the role of activity-based costingConventional volume-based product costing systems may overstate some product costs and understate other product costsABCMeasures the extent to which each product consumes costs of key support activitiesWill provide more accurate product costs to inform prices20-22Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-SmithStrategic pricing of new productsThe newer the concept of the product, the more difficult is the pricing decisionSkimming pricingA high initial product price to reap high short-term profits on a new productOver time, the price will be loweredPenetration pricingA low initial price of a new product to attract market share 20-23Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-SmithCompetitive biddingTwo or more companies submit sealed bids (or prices) for a product or project, to a potential buyerCost analysis involves similar issues to that of accepting or rejecting a special orderSpare capacityIf price exceeds the incremental costs of producing the product, this will contribute towards covering the company’s fixed cost and generating a profit20-24Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-Smith(cont.)Competitive bidding (cont.)No spare capacityIncremental costs still relevantOpportunity costs must be assessedA bid price should cover the opportunity costThe bid price may be higher than when spare capacity existsMarketing and strategic issues need to be considered20-25Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-SmithLegal restrictions on pricingAustralian Competition and Consumer Commission (ACCC) has power to outlaw the following behavioursPredatory pricingPrice discrimination Resale price maintenance Price-fixing contracts20-26Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-SmithProduct mix decisionsDetermining the most appropriate range of products to offer to consumersProduct mix decisions are linked to pricing as prices influenceProfitability Customer behaviour and competitors reactions20-27Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-SmithTactical product mix decisions involving limited resourcesTactical product mixUse contribution margin per unit of the scarce resource, not contribution margin per unitConsider implications of the decision on customer behaviour and competitor reactions Limited resources may include floor space, machine time, raw materials, labour hoursMultiple scarce resources  use linear programming20-28Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-SmithLong-term product mix decisionsAll relevant costs are considered in the final decisionFor loss-making products, firms can choose toIncrease product priceTry to reduce the cost of the productOffer customer incentives Retain the product as it is part of a range Discontinue the product20-29Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-SmithSummaryPrices are influenced by market positioning, product cost, customer value, competitor behaviour and legal, political and ethical issuesPricing strategies include value-based pricing, economic pricing and cost-based pricing Cost-based pricing involves defining the relevant product cost and determining a markupFor some new products skimming pricing and penetration pricing may be usedPricing special orders and determining competitive bid prices involves an analysis of relevant costs 20-30Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-Smith(cont.)Summary (cont.)In tactical product mix decisions the focus is on maximising profitability, within the constraint of a scarce resourceIn long-term product mix decisions, customer behaviours and competitors’ reactions are important20-31Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-SmithPrepared by Kim Langfield-Smith