Pricing Strategies and methods

Cost Plus Pricing:

Cost-plus pricing is a strategy that is used to determine the retail and/or wholesale price of goods and services offered for consumption. Businesses of all sizes tend to use this simplistic pricing model as a guideline for arriving at sale prices that will allow the company to cover all costs associated with the production and sale of the products, and still make a reasonable profit from the effort. 

     The method determines the price of a product or service that uses direct costs, indirect costs, and fixed costs whether related to the production and sale of the product or service or not. These costs are converted to per unit costs for the product and then a predetermined percentage of these costs is added to provide a profit margin.

Advantages of cost-plus pricing

1.Easy to calculate

2.Minimal information requirements

3.Easy to administer

4.Tends to stabilize markets - insulated from demand variations and competitive factors

5.Insures seller against unpredictable, or unexpected later costs

6.Ethical advantages

7.It is readily available

8.Price increases can be justified in terms of cost increases

Disadvantages 

1. tends to ignore the role of consumers

2. tends to ignore the role of competitors

3. use of historical accounting costs rather than replacement value

4.use of “normal” or “standard” output level to allocate fixed costs

5. inclusion of sunk costs rather than just using incremental costs

6.ignores opportunity costs

Calculations:

There are several ways of determining cost, and the profit can be added as either a percentage markup or an absolute amount. One example is:

P = (AVC + FC%) * (1 + MK%)

where:

§       P = price

§       AVC = average variable cost

§       FC% = percentage allocation of fixed costs

§       MK% = percentage markup

For example: If variable costs are 30 Rs, the allocation to cover fixed costs is 10 Rs, and you feel you need a 50% markup then you would charge a price of 60 Rs:

P = (30 + 10) · (1 + 0.50)

P = 40 · 1.5

P = 60

Marginal Cost Pricing:

The marginal cost of an additional unit of output is the cost of the additional inputs needed produce that output.  More formally, the marginal cost is the derivative of total production costs with respect to the level of output.

Marginal cost and average cost can differ greatly.  For example, suppose it costs Rs.1000 to produce 100 units and Rs.1020 to produce 101 units.  The average cost per unit is Rs.10, but the marginal cost of the 101st unit is Rs.20.

Note that the marginal cost may change with volume, and so at each level of production, the marginal cost is the cost of the next unit produced.

M=dTc/dQ

In general terms, marginal cost at each level of production includes any additional costs required to produce the next unit. If producing additional vehicles requires, for example, building a new factory, the marginal cost of those extra vehicles includes the cost of the new factory. In practice, the analysis is segregated into short and long-run cases, and over the longest run, all costs are marginal. At each level of production and time period being considered, marginal costs include all costs which vary with the level of production, and other costs are considered fixed costs.

Price Penetration:

Penetration pricing is a strategy employed by businesses introducing new goods or services into the marketplace. With this policy, the initial price of the good or service is set relatively low in hopes of "penetrating" into the marketplace quickly and securing significant market share. "This pricing approach," wrote Ronald W. Hilton inManagerial Accounting, "often is used for products that are of good quality, but do not stand out as vastly better than competing products."

In most instances, companies will only consider a lower price if revenue is projected to increase, i.e. demand is elastic with respect to price.  But, since the ultimate objective is profitability, a revenue increase is necessary but not sufficient: profits may decrease even if revenues increase since a company typically incurs higher total product cost (fixed plus variable) when volume increases, unless scale economies or experience effects are sufficiently large that variable costs per unit decline.

More specifically, the penetration price is usually set higher than the firm's marginal cost to bolster profitability.  In some special cases, though, the penetration price may actually be lower than marginal cost.  For example, a firm may be willing to incur initial losses  (i.e. price below cost) if substantial future-related profitable sales are expected from complementary sales, upgrades, or price increases.

Price Skimming:

 Skimming Price, a strategy wherein the initial price for the product is set quite high for a relatively short time after introduction. Even though sales will likely be modest with skimming, the profit margin is great. This pricing approach is most often used for high-prestige or otherwise unique products with significant cache. Once the product's appeal broadens, the price is then reduced to appeal to a greater range of consumers. "The decision between skimming and penetration pricing," said Hilton, "depends on the type of product and involves trade-offs of price versus volume. Skimming pricing results in much slower acceptance of a new product, but higher unit profits. Penetration pricing results in greater initial sales volume, but lower unit profits."