Chapter 23: Pricing Decisions

Normal Pricing Overview Pricing is a critical and complex managerial decision influenced by market conditions, business strategy, and production costs. Companies can approach pricing differently based on their position as price-takers or price-setters: 1. Price-Setters: These companies have significant control over setting their prices, often using cost-plus pricing methods. They add a markup to the cost of a product to establish the selling price. 2. Price-Takers: These companies face competitive markets and have limited control over pricing. They tend to use target costing to ensure profitability at a competitive market price. Three Normal Pricing Methods Here are three common approaches to determining product pricing: 1. Total Cost Method (Cost-Plus Pricing) o This method is used by price-setters who want to cover all costs (fixed and variable) and add a desired profit margin. o The formula: Selling Price = Cost per Unit + Markup per Unit o Example: A headphone company expects to produce 10,000 units and wants a 20% markup. It calculates the selling price by accounting for all production costs and applying the desired markup. 2. Target Cost Method o Useful for price-takers dealing with competitive pressures, where the market price limits pricing flexibility. o The goal is to determine whether costs can be reduced to achieve a target profit at the expected selling price. o Example: If a headphone’s market price is $80 and the target profit is $14, the target cost must be $66. If costs exceed this, adjustments are needed. 3. Variable Cost Method o This method adds a markup to variable costs, which must cover fixed costs and achieve the target profit. o Example: Using the same headphone company data, setting a target profit of $140,000 results in a selling price of $84 per unit by focusing on variable costs plus markup. Alternative Pricing Approaches Companies may also use more dynamic or customer-centric pricing strategies: • Value-Based Pricing: Pricing is based on customer willingness to pay, focusing on maximizing perceived value. • • Example: Starbucks adjusts prices based on perceived value. Auction-Based Pricing: Prices are set through competitive bidding. o Example: Priceline uses this to sell travel services. Dynamic Pricing: Prices fluctuate based on supply, demand, or external factors. o Example: Uber’s surge pricing responds to peak demand periods. o Special Pricing Decisions Special pricing often involves unique circumstances, such as large orders at reduced prices. The decision to accept special offers depends on their impact on overall income: 1. Analyzing Special Offers o Focus on incremental costs rather than historical or average costs. o Fixed costs that do not change are irrelevant unless the special order incurs additional specific costs. o Example: FasTrac’s decision to accept a special order at $8.50 per unit (below its normal $10.00 selling price) was based on the ability to utilize idle capacity without affecting current business. 2. Special Offer Example o A special order is accepted if it adds to overall profit. In FasTrac’s case, a special 10,000-unit order generated an extra $18,000 in profit, despite a lower price, because it used idle capacity and incurred minimal additional fixed costs. o Conversely, a similar offer should be rejected if it reduces profitability. For example, a potential order for a company producing 8,000 units per month was turned down because it would have decreased income by $1,200 due to additional incremental costs. Key Decision Rule • • Accept a Special Offer if it increases income. Reject a Special Offer if it decreases income. Conclusion Managers must tailor pricing strategies to their market position and conditions, balancing cost recovery with competitiveness. Understanding when to use each pricing method and how to evaluate special offers ensures companies make profitable and strategic decisions.