In determining the price of a commodity, a cost/management accountant must rely on valid cost information so as to arrive at a price that will incorporate all the relevant costs. Not all costs that are involved in the production of a commodity will have a direct impact on the price of such commodity, it’s with this understanding that management rely on cost information in making pricing decisions.
Organizations need to decide the prices that are acceptable for their goods and services. However, sometimes the prices are determined by the market forces of demand and supply and thus a firm will have little or no influence on the market prices. This situation occurs in near perfectly competitive markets where products are similar and the consumers also have perfect information on all market variables such as price and quality and thus all players in the market are price takers.
Some organizations produce highly differentiated goods, some with special features that allows them some discretion in setting up their prices. The decisions on how much their products are priced depend on the value that the customer attaches to the products, the actions of competitors and of course the cost. In practice, some firms may be price setters for some of their products and price takers for others. For price setters, cost information is one of the major inputs in the pricing decisions. Price takers will also appreciate the value of cost information in deciding on the mix of their products to which more resources should be assigned given the demand of the product.
In target costing for instance, the first step is always the determination of the target price of the product. This is the price that research has shown that the customers will be willing to pay for a particular product. A desired margin is deducted so as to arrive at the target cost. This margin is determined by the organizations desired return on investment for the whole organization. The firm therefore attempts to design the product in such a way that the target cost is attained so as to maintain the margin. In case the target cost is not attainable, the firm may decide to re-engineer the product, reducing or eliminating some of the features and thus effectively reducing the costs. Where the target costs are not attainable, then the product is abandoned all together, this is a classic example of the role of cost information in pricing decisions. This process involves deep consultations between the product engineers and designers so as to ensure that the product is modified to attain the target cost.
The cost information necessary in making pricing decisions will also depend on the nature of pricing, i.e. whether the pricing decision is to be made in the short run or long run. Short run pricing decisions will consider only incremental costs since these are on off decisions. They include pricing decisions for special orders where the management accountant must decide what costs will have to be considered in arriving at the price of the order since all the costs cannot be included, thus the role of cost information in this case cannot be over emphasized.
Price takers also require cost information in deciding the out put and mix of products and services. Ideally, a company produces a number of products that are priced differently and whose volume of production also varies. Such a company therefore has to obtain adequate cost information for each of the products so as to be able to price them optimally to increase revenues and profitability (Drury,2010).
Role of cost plus pricing model
Cost plus pricing is a simple pricing strategy that involves the accurate computation of the product cost and then adding the additional mark up on the cost to arrive at the company’s desired price
This strategy provides accountants with plausible prices that are easily determined regardless of the number of products handled in the firm. Calculations for cost plus pricing are rather more factual and precise and are likely to be easily defended on moral grounds as opposed to other methods of pricing.
A firm is able to predict the prices in the market. A firm that operates in an industry where the average mark up is say 30 percent may easily predict that competitors will add a similar mark up on their costs. Assuming a similar cost structure for the industry, then a firm is able to predict the industries range of prices for a given product. If all players adopt that particular method of pricing their products, then price stability will be attained.
The most available information to the management accountant is the cost information. This provides a great foundation for the setting up of prices. With a very uncertain economic environment, the accountant is able to set a price that assures the company of some return regardless of the economic environment.
Price increases can be justified on moral grounds on the basis of cost incurred in the production of commodities. A company can justify an increase in the price of its products by proving that the cost of production has also gone up. In response to the main objection that cost-based pricing formulae ignore demand, we have noted that the actual price that is calculated by the formula is rarely adopted without amendments. The price is adjusted upwards or downwards after taking account of the number of sales orders on hand, the extent of competition from other firms, the importance of the customer in terms of future sales and policy relating to customer relations. Therefore it is argued that management attempts to adjust the mark-up based on the state of sales demand and other factors that are of vital importance in the pricing decision.
Limitations of cost plus pricing strategy
Companies are likely to get their prices wrong with this strategy. Capon Neon, a famous marketing researcher once wrote in his book ‘Capeons Marketing Framework’ that firms that employ the cost plus pricing model are likely to lose business due to over pricing or under pricing of their products depending on the nature of the market. Competitors are also more likely to compete on price in this strategy since they are able to predict a company’s prices in advance (Drury,2010).
As earlier stated, cost plus pricing takes into consideration all the costs that are employed in coming up with a product. This means that even fixed costs are incorporated in the products costs. If costs are the main considerations in pricing , then the price should fluctuate from month to month since costs such as sales commissions, raw materials etc vary from time to time meaning that the product cost will not be constant. In the long run, consumers will become sceptical of such price fluctuations and this has a way of eroding brand trusts.
Cost plus pricing has been criticized as an incentive to inefficiency. As long as the customer is willing to pay the production costs plus a premium, then there is no incentive to be more efficient, or to find faster and more efficient means of producing goods. Logically, if costs of production reduce, then the price also goes down and this means that the company is losing out on profits. Meanwhile, lack of efficiency means that the company is not getting a competitive edge over other players and will lose in the long run
In their book,’ Pricing with confidence’, Reed Holden and mark Burton explain that ‘cost plus pricing ignores demand, image and market positioning and also ignores the role of the customer and the value they derive’. Simply put, even if a brand pair of shoes costs $5 to produce, the customer will be willing to spend in excess of $100 just because a super soccer star is donning that shoe. Proponents of cost plus pricing will surely miss out on this opportunity.
Costs plus pricing assumes that since the product is priced way above cost, then the company cannot run at a loss. This has been criticized since it’s possible for a firm to be running at a loss besides the high price. If sales demand falls below the activity level used to compute the fixed cost per unit, the total revenue may not be adequate to cover the fixed costs thus the company is in a loss making position
Use of standard output to allocate costs
Cost plus pricing uses standard output to allocate fixed costs to products, this may usually leads to a wrong allocation of costs thus leading to a over pricing of products.
Alternative pricing strategies
In this pricing strategy, goods are sold at a high price so as to reduce the number of sales required to break even. This pricing strategy is generally used when a company wants to recoup its initial investment in research and development for the product and other initial costs or in cases where the company wants to shield itself against future cost increases. Its meant to attract the first adopters of a good who may not be price conscious or whose demand for the product may be high such that they may not bother the price levels, They may even be rich people who understand the use of the product better than others or simply have more to spare. Used mostly in electronic equipment that is first taken to the market at quite high prices (Hermann, 1989). This strategy is however not used for along periods of time. In order to increase market share, the company must therefore reduce the prices to attract the masses.
Value based pricing,
In this strategy a company sets prices primarily on the perceived value that the customer attaches to the product, rather than on actual cost, competitor prices, market prices or even the historical prices. It’s a complicated pricing model that is depended upon the understanding of the value to customers and how such customers measure the value of the goods they buy. Research methods are employed to determine the value and willingness of customers to pay, thus assisting in arriving at the product price.
As the name suggests, predatory pricing is the practice of selling goods at such a low price that competitors are not able to survive in the market. The idea is to make the price so low that it’s unprofitable for competitors to remain in the market and thus they are forced to close shop. This leaves the company as the only sole player and can increase the prices at will. This mode of pricing is considered anti competitive and is illegal in many countries (Drury,2010)
This pricing model relies on the belief that certain price endings have a psychological impact. In this strategy, prices are prices as odd numbers sometimes ending with 99 or 95. It’s believed that this pricing strategy drives demand that’s greater than if the Customers were completely rational.
It relies on the premise that consumers will always ignore the least significant digits of the price of a commodity. Fractional prices often suggest to the customer that the product is priced at the least possible prices (Ronald,2006)
In this model, the company decides in advance the target price of a commodity, so as to have a given return, after deciding the price; the company manufactures the product in such a way that it achieves the target product cost so as to attain the given return on the selling price.
This is a pricing model where the price of a particular commodity is set at a given value so as to attain a set target rate of return for given production volume. It’s mostly used by public utilities companies mostly oil and gas whose initial capital outlay is high or by manufacturers whose capital investments is deterrent such as auto manufacturers. In car manufacture for instance, the auto maker decides in advance the class of car they are making and can even determine the price before hand. This method of pricing would be entirely useless to a low capital or small establishments since it doesn’t consider the market demand and products can be manufactured and not sold for a very long time thus distorting the company’s budget
Competitor based pricing
In this pricing strategy, the company adopts prices similar to that of the competitors in this model; the firms do not compete on the prices but on other platforms. It’s used mostly where there are lots of choices and consumers have near perfect information on the product offerings and prices. The company doesn’t therefore have much choice in its pricing decisions. It’s applicable mostly in areas where the products are generally similar and little differentiation is possible, especially in the oil industry.
This is a pricing model geared towards stimulating demand over a specific period of time. They include end of year sales, special offers, “Buy two get one free” etc.
This strategy increases the demand in the short run also as maybe to clear space for incoming stocks or even to clear stocks that is slow moving.
This is a model of pricing in which a company introduces the product in the market at a very low price usually below the cost so as to get customers interested. This strategy is also employed when the company intends to deter other players from entering them market thus enabling the market to attain a large market share. This strategy is quite appropriate where there are very close substitutes and in a market where entry is not restricted. Once the company or product is established, then the company can comfortably adjust the prices
This is a strategy of selling the same product at a different price in different locations. It’s majorly practiced by monopolists who have considerable market power to influence prices in the market. For this strategy to work, the producer or supplier has to segment the market and also ensure there are enough measures to discourage beneficiaries from reselling the product or service and thus become competitors (Harvard Business School,2010). A good example is the entry fees to Game Park, while the scenery is the same to everyone, children could pay lesser than adults, or nationals could pay less than tourists.