Ellertone Ndalama

MBA, FCCA, ACMA, Bcom (Acc), Dip. Bus.

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Learning Objectives
This lecture, the subsequent case study and the readings should enable you to:

Understand Strategies of pricing:

Market skimming. Penetration Pricing.

Predatory pricing.
Price discrimination. Complementary pricing

Product line pricing Product Life Cycle and pricing. Total Life Cycle Costing and pricing Customer Profitability analysis (CPA). Understand Pricing in Practice. Warwick Business School

Strategic pricing

Forms part of product and / or business marketing strategy. Incorporates an allowance for how the business plans to develop the product over time. Price is uncoupled from cost and demand in the short term.

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Market skimming

Charging a high price (premium pricing) initially to new products and reducing price later. Allows business to cash in or get high returns from customers willing to pay extra to get the product first. Commonly used in the new high tech products, fashion, publishing and IT sectors. Business takes advantage of novelty factor (inelastic demand) or a short term monopoly business enjoys before competitors emerge. Do not use when close substitutes are available. Use where there are barriers to entry.

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Low Pricing Strategy

Penetration Pricing Low (discount) pricing to gain rapid market acceptance of new product or gain a large market share. Use when close substitutes are available. Use when the market is easy to enter.

Predatory pricing Involves establishing prices so low that competitors are driven out of the market. Business can subsequently raise prices once there is no significant competition.

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Price discrimination (differentiation)

Market segmentation - split customers up into different groups (based on age, income, region, gender, employment status, etc.) for marketing management purposes. Each customer group is charged a different price for the same good or service i.e. some pay premium prices; others pay low prices (may considerably enhance revenue). It relies on barriers preventing transfer between markets.

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Examples - price discrimination

Drinks price: 1.50 each (for keen buyers) or 3.90 for three (effectively 1.30 each, for less keen buyer). Train fares - age proxy for willingness to pay. Standard train fare for adults. Reduced fare for children and senior citizens.

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Example - price discrimination

Customer Group
Large drug store chain Small local pharmacies Individual health clubs

Prices per Case

200 232 250

Cases Sold
125,000 100,000 25,000

The company is practicing price discrimination!

Attempt question in appendix 1

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In Practice
Products/Services Price Skimming/ Penetrating
Skimming
Penetrating Skimming Depends!

DVD, Music CD

Chocolate Bar

Digital Camcorder

Holidays

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Complementary pricing

Applies to products that tend to be used together e.g. an oil filter (100) and oil (5 litres for 30) when servicing a car. Company could link the sales of an oil filter (100) with a complementary price on oil (5 litres at a discounted price of 20). This will be worthwhile so long as that allows the company an overall positive contribution to be made.

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Product line pricing

Applies to products that tend to be related to each other. Some sales will involve all products. e.g. if a customer wants to upgrade a utility room, kitchen for example, might need a tumble dryer (700), fridge (600) and cooker (500). A package (for the 3 items) price of 1,500 could be offered. This will be worthwhile as long as the company can make a contribution on the overall deal.

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Product Life Cycle

Sales Introduction Growth Maturity Decline

Positive Profit

Negative Profit Time Cost Life Cycle

R&D Cost Sales Warwick Business School Design High Low Supply Depends High Marketing Customer Manufacture & Services Distribution Stable Depends High Low

Product life cycle and pricing

An infant product may not be capable of yielding a profit given that it requires high proportion of costs and may enjoy only a limited market acceptance. An infant product may have to be priced low to a point which is actually below cost. As a product reaches growth and maturity stages, the price may be raised relative to cost and profit may be harvested. At decline stage product may be priced low reduced customer taste, etc.

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Total Lifecycle Costing

Traces all costs to a product over its

complete lifecycle, from design through to cessation. For many products significant costs are incurred in the early stages of their lifecycle. The pricing and profitability of a product can then be assessed taking all costs into consideration.

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Total-Life-Cycle-Costing

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Illustration Total Life Cycle (3 years) Costing and Pricing R & D and design costs (pre-year 1) Marketing costs Year 1 Year 2 Year 3 Fixed & variable production costs Year 2 Year 3 Fixed and variable distribution costs Year 2 Year 3 Fixed & variable selling costs Year 2 Year 3 Administration costs Year 2 Year 3 Total product life cycle costs Say units produced and sold: Year 1 Year 2 Year 3 Total 250,000

10,000 5,000 5,000 10,000 15,000 5,000 5,000 10,000 5,000 2,000 3,000

20,000

25,000

10,000

15,000

5,000 325,000

8,000 15,000 2,000

25,000 13 15.60

Cost per unit = 325,000 / 25,000 Selling price per unit (say 20% mark-up) = 120% x 13=
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Advantages of total life cycle costing

The visibility of ALL costs (over life cycle) is increased, so Facilitates better decision-making and cost control. R & D and design (RDD) costs would have to be seen in the context of the expected trading results, therefore Preventing a serious over spend at this stage or under pricing at the launch point. Individual costs and profitability for products is more accurate, this Facilitates performance appraisal and decision-making, and

Means that prices can be determined with better knowledge of the true costs.
More accurate feedback can take place when assessing whether new products are a success or a failure, since RDD costs are also taken into account.
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Customer Profitability Analysis (CPA)

The traditional approach focusses on what profit one made from products or services. CPA involves expressing results in terms of what profit (revenue streams less service costs) or profit margins is associated with particular customers or groups of customers. Customer specific costs are attributed through a process of ABC.

CPA aids customer relationship management e.g.

Dropping more costly and less profitable customers. Re-engineering customer profitability by reducing associated customer costs or increasing customer associated revenues (i.e. price discrimination?). Understanding customer profitability is key to creating a competitive advantage for a business in the new economy.
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Pareto analysis
The adaptation of a mathematical model for business management purposes. The substance of the model is that 20% of events account for 80% of outcomes. In the context of CPA, this model suggests that most of the profits earned by a business will come from a small proportion of customers. The rest of the customer relationships may make little contribution. The problem is to identify who the profitable customers are and take appropriate actions based on this knowledge.

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Summary
Strategies of pricing

Product Life Cycle and pricing.

Total Life - Cycle Costing and pricing.

Customer Profitability analysis (CPA).

Understand Pricing in Practice

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References

Atkinson, A.A., R.D.Banker, R.S.Kaplan, and S.M.Young (2001), 'Management Accounting', Prentice Hall Inc, NJ. Atrill, P., and E. McLaney (2004), Accounting and Finance for Non-Specialists, FT Prentice Hall, London Drury, C., (2004), Management and Cost Accounting, International Thomson, London. Garrison, R.H. and Noreen, E.W., (2005), Managerial Accounting, McGraw Hill, Boston Hansen, D.R., and M.M.Mowen (2000), Management Accounting, SouthWestern College Publishing, Ohio. Hilton, C (2005). Managerial Accounting. McGraw Hill, Boston. Horngren, C.T., G.Foster, and S.M.Datar (2000), Cost Accounting, Prentice Hall International, Inc., NJ. Guilding, C., Drury, C, and Tayles, M. (2005) An empirical investigation of the importance of cost-plus pricing, Managerial Auditing Journal, 20 (2): 125-137. Lucas, M. (2003) Pricing decisions and the neoclassical theory of the firm, Management Accounting Research, 14: 201-217. [An easier version is available at Management Accounting, June 1999:77 (6)].
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Articles:

Appendix 1: Discriminatory Pricing

Annual production of Accue check machine averages 200,000 units. A large chain store (Boots) purchases about 40% of its production. Several thousand independent retail drugstores and medical supply stores (Lloyds etc) purchase the other 60%. Bernse ltd. incurs the following costs of production per box.

Direct material Direct Labour Overhead Total

2.2 1.05 0.75 4.00

It has one sales person assigned to the chain store account at a cost of 65,600 per year. Delivery is made in 1000 unit batches about three times a month at a delivery cost of 600 per batch. Four sales people service the remaining accounts. They call one of the stores and incur salary and mileage expenses of appx. 39900 each. Delivery costs vary from store to store, averaging 0.45 per unit. Bernse ltd charges the chain store 6.25 per box and the independent stores 6.5 per box. Required: Is Bernse Ltds Pricing policy supported by cost differences in serving the two Warwick Business School of customer? Support your answer with relevant calculations. different classes

Appendix 1:Discriminatory Pricing

Chain Store Costs
Salesperson salary.......... 65,600 Delivery cost................... 48,000* Total ............................ 113,600 Number of cases............... 80,000 Cost per case ............. 1.42

39,900 x 4

Independent Store Costs

Sales support ...... ... 159,600 Delivery cost .... 54,000** Total ................. 213,600 Number of cases 120,000 Cost per case ......... 1.78 (0.6 x 200,000 = 120,000 units) (120,000 unit @ 0.45) = 54,000**

(0.4 x 200,000 = 80,000 units) (80,000/1000 = 80 batches@600) = 48,000*

Yes, the cost differential of 0.36 (1.78 1.42) per case more than justifies the price differential of 0.25 per box.
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Seminar week 7: Mike and John Summers

Pricing approaches. Pricing strategies. Product life cycle monitoring and reviewing prices during cycle. Factors affecting pricing. Actual pricing in practice: Price taker target pricing. Price setter cost plus pricing

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