CIMA Paper P2 Advanced Management Accounting Ian Kusano and Nathi Thela
8 Chapter The Pricing Decision 1
The Pricing Decision Objectives: - In this chapter we will learn about the alternative strategies that an organisation may adopt in the pricing of its products or services. The price to be charged to customers for the business’s products or - services is often one of the most important decisions to be made by managers. - Not all businesses are free to determine their own selling prices - some are unable to influence the external price and are obliged to accept the prevailing market price for their goods - For these businesses cost control is an important factor in maintaining profitability. - Other businesses are in a position to select their selling price. The objectives that they pursue in their pricing policy will affect the price to be charged for each product or service. - This chapter, however, concentrates on the link between price and volume , and its resulting effect on profit. 2
The Pricing Decision - Considering the impact of a change in price on demand is key to management. - The Price elasticity of demand = measures the change in demand as a result of a change in its price - Be aware of the factors that influences the price elasticity. The profit maximisation model ▪ A mathematical model can be used to determine an optimal selling price . ▪ The model is based on the economic theory that profit is maximised at the output level where marginal cost is equal to marginal revenue. ▪ Basic Principle to understand: It is worthwhile a firm producing and selling further units where the increase in revenue gained from the sale of the next unit exceeds the cost of making it (i.e. the marginal revenue exceeds the marginal cost ). 3
Session Content Economists’ Accountants’ Approach Approach The Pricing Decision MR = MC Cost Plus Marketing Strategies 4
Demand Based Approach Inverse relationship between price and quantity demanded P Q 5
Demand Based Approaches Tabular Approach Algebraic Approach • All combinations MC = MR • Max profit 6
Algebraic Approach Procedure 1. Establish the linear relationship: P = a – bQ – the basic price equation Marginal revenue, MR = a – 2bQ - is the additional 2. revenue from selling one extra unit Establish the marginal cost – is the cost from making 3. one more unit. It is usually the variable cost 4. MC = MR, solve to find Q 5. Substitute Q into price equation to get optimum price 6. Calculate max profit if required 7
Algebraic Approach Procedure At a price of $200, a company will be able to sell 1,000 units of its product in a month. If the selling price is increased to $220, the demand will fall to 950 units. It is also known that the product has a variable cost of $140 per unit, and fixed costs will be $36,000 per month. Required: (a) Find an equation for the demand function (that is, price as a function of quantity demanded); (b) Write down the marginal revenue function; (c) Write down the marginal cost; (d) Find the quantity that maximises profit; (e) Calculate the optimum price; (f) What is the maximum profit? 8
Example 1. Maximum demand for a company’s product M is 100,000 units per annum. The demand will be reduced by 40 units for every increase of $1 in the selling price. The company has determined that profit is maximised at a sales volume of 42,000 units per annum. Required: (a) What is the profit maximising selling price for product M? 9
Example 2. Another product, K, incurs a total cost of $10 per unit sold, as follows. $ per unit Variable production cost 4 Variable selling cost 2 Fixed production cost 3 Fixed selling and administration cost 1 Total Cost 10 The marginal revenue (MR) and demand functions for product K are: MR = 200 – 0.4x p = 200 – 0.2x Where p – price, x = quantity demanded per period. What is the profit-maximising selling price of product K, and what quantity will be sold per period at this price? 10
Limitations 1. It is unlikely that organisations will be able to determine the demand function for their products or services with any degree of accuracy. 2. The majority of organisations aim to achieve a target profit, rather than the theoretical maximum profit. 3. Determining an accurate and reliable figure for marginal or variable cost poses difficulties for the management accountant. 4. Unit marginal costs are likely to vary depending on the quantity sold. For example bulk discounts may reduce the unit materials cost for higher output volumes. 5. Other factors, in addition to price, will affect the demand, for example, the level of advertising or changes in the income of customers. 11
Tabular Approach Procedure The tabular approach is sometimes the best to define optimum profit and the associated selling price. $ $ $ $ $ $ Price per unit 22 20 19 18 17 15 Variable Cost per unit (6) (6) (6) (6) (6) (6) Contribution per unit 16 14 13 12 11 9 Number of units sold 50,000 60,000 70,000 80,000 90,000 90,000 Total Contribution ($000) 800 840 910 960 990 810 Less fixed costs (stepped, $000) (200) (200) (280) (280) (360) (360) Net Profit ($000) 600 640 630 680 630 450 12
Cost Plus Pricing Disadvantages Advantages • Widely used and • Ignores the market accepted • Different absorption • Simple methods • Can be delegated • Doesn’t guarantee • Justification for price profit increases • Which cost ? • Encourages price stability • Inflexible • Circular reasoning 13
Marketing Based Approaches: New Products First of its Kind Market Skimming Penetration Pricing • Initial low price • Initial high price • High volumes • High profits 14
Marketing Based Approaches: New Products Cont. Following a Competitor Penetration Discount Price Differentiation Premium 15
Product Life Cycle Intro Growth Maturity Decline Sales Volume Time 16
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