Effect of Pricing Policy on Profitability Level of an Organization

Effect of Pricing Policy on Profitability Level of an Organization. A Performance appraisal of some selected manufacturing firms.

Pricing Approaches

In many organizations, approaches to pricing take different forms (Adeniji 2002; Drnry 2000 and Pandey 1998):

(i) Hunch: This is borne out years of experience in that business, such decision are intuitive and are not based on any partaking analysis of available data.

(ii) Market Price: This is based on the going price in the market and then works backwards to allowable production costs. Such approach is adopted for standard, stable easily substituted products where close cost controls are employed which mass production and mass selling method are used:

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(iii) Cost- Plus pricing models:- This approach differs from the economics concepts of pricing both in what cost are marked up is determined depending on how cost is defined but mark up percentage may differ. Cost-plus pricing model involves a variety of different methods used to establish the cost depending on the meaning of the word cost to organization.

According to ICAN (2006) the various pricing method encountered in practice are:

  • Full cost based or cost-Plus method
  • Marginal cost based method
  • Minimum price method
  • Pricing based on mark – up
  • Theoretical pricing policy or demand analysis and

To Adeniyi (2004) the pricing approaches methods are as follows:

FULL COST PRICING OR ABSORPTION COST PRICING SYSTEM.

Under this approach, all costs which include fixed and variable costs are ultimately charged or allocated to cost unit and total over heads are then absorbed according to a given level of activity in order to ascertain the total cost of each unit. The cost of a unit of product under this approach therefore consist of direct material, direct labour and variable and fixed overhead. The techniques does not demarcate between fixed and variable components. This is why, it is often referred to as full cost method. It is essentially a long run pricing strategy adopted by firms, which are manufacturing and marketing clearly differentiated products or custom made goods. This approach is applied on a short run policy which could make a firm to price itself out of business and to insist on covering full cost of production in the short run could be on expensive joke for a producer. It is a deficient pricing strategy in times of slack demand and depressed market.

ADVANTAGES OF FULL COST PLUS PRICING MODEL

(a.)    One of the major reasons for the wide spread application of cost plus price methods is that it may help a firm to predict the prices of other firms and this will encourage price stability.

(b)     If the planned level of volume of sales is achieved at the price calculated, total cost will be recorded and a satisfactory profit will be earned.

(c)      A relatively simple way of calculating price, which can be routines and therefore delegated for calculating by a subordinate, One Profit margin percentage and method of calculating unit cost are decided

(d)     Although this approach ignores demand, the price is usually adjusted upwards or down wards after taking account of the sales order on hand, the extent of competition from other firms, the importance of the customer in terms of future sales and the policy relating to customer relations.

LIMITATIONS OF COST-PLUS PRICING MODEL

Adeniyi (2002) and Drury (2000) put for ward a number of limitations of the cost-plus pricing model.

(a.)    The mass objection to cost –plus pricing methods is that they ignore demand. The price is set by adding a margin to cost and this may bear no relationship to the price demand relationship.

(b.)    This approach is circular in reasoning and content because price change affect. Volume of sales, which in turn affect unit, fixed cost, which also leads to further price changes.

(c)      There are many different ways by which fixed cost can be apportioned to product and the effect of this is that the cost will be different depending on which appointment is used.

(d)     It is often opened that this approach serve as a pricing floor’ shielding the seller from lose.

This argument is however base less since it is quite possible for a firm to lose money even though every product is priced higher than the estimated unit cost.

DETERMINING THE MARK-UP PROCEDURE USING ABSORPTION COSTING

The mark-up figure could be found through rule of thumb in the industry or just a company’s tradition that seems to work or could be the result of explicit computation. But generally, it should be such that should cover selling, general and administrative overhead and provide adequate return on investment (RQ1). The formular for determining mark-up percentage using absorption cost is

(Required RQ1 X Investment) SGA Expenses

unit sales X Unit product cost.

MARGINAL COSTING/DIRECT COST APPROACH

The most significant criticism leveled against absorption costing method or full cost pricing according to (Adeniji 2004; and pandey 2001) its failure to distinguish between relevant and irrelevant cost for short term pricing purpose. Direct cost pricing which can also be called variable cost or product cost. Strategy is a pricing strategy that basis its determination of selling price on the direct or variable cost of the firm. It achieves a basis distinction between fixed cost and variable cost and set a price that will cover at least the direct cost of the firm. This is based on the motion that the variable cost are product cost of the firm and any selling that exceeds this unit variable cost would contribute something to the recovery of the firm’s fixed cost. This approach defines a minimum price chargeable on a firm’s product. That minimum price which must be paid for every additional product is the variable cost incurred in making and selling the product.

Essentially direct cost pricing is a distress pricing strategy which is mostly applied in distress economic environment that is, in times of keen competition, slack demand, space and idle capacity in the factory and rising production cost.

RETURN ON INVESTMENT PRICING

Return on investment pricing is a strategy calculated in arriving at a definite price when invested capital are involved for the purpose of earning returns and the return on investment has become a major indicator of efficiency and profitability. Return on investment index is a measure of the intensity of capital usage, where selling price fails to return or reflect the effect of capitalization, it will create an illogical price structure and could mislead management to the extent that proper dividend and growth might not be attained.

STEPS INVOLVED IN RETURN ON INVESTETN PRICING.

  1. To determine the total cost of production.
  2. Determine the extent/level of capital employed, which is the long-term capitalization of the firm.
  3. Determine the desired rate of return on investment capital.
  4. Determine the mark-up factor based on total cost and desire the rate:

mark-up factor (MUF) = CE  X        DRR

TC

Where:        CE    = Capital employed

DRR  = Desired rate of return

TC      = Total cost.

  1. Selling price: Cost per unit + (MUF X Cost per unit)

TARGET COSTING

Pricing a new product is a special challenging decision problem. The newer the concept of the product, the more difficult the pricing decision is. Pricing a new product is more difficult than pricing a mature product because of the magnitude of the uncertainties involved. New products entail many uncertainties. Inspite of these uncertainties, manufacturers adopt two widely different strategies in pricing new products see (Adeniji 2006 Drury 2004 Garrison 1995, Egbunike 2005). One of the first strategy is called SKIMMING Pricing in which a high initial Price is set for a new product in order to reap short run profits. As time goes on, the price will reduced gradually.

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The second strategy is PENETRATION Pricing where the initial price is set, relatively low. By setting a low price for a new product, management hopes to penetrate a new market quickly and deeply so as to gain large market share. This strategy is used for product that are of good quality but, do not stand out as vastly better than competition products with this strategy in place, manufacturers then determine cost of the product and take decision to target the cost.

Target costing involves the computation of the cost for which the product must be manufactured in order to provide the firm with acceptable profit margin.

PRICING SPECIAL ORDERS/DIFFERENTIAL COST PRICING SYSTEM.

A company often receives a short-term special order for its products at a lower price than usual. In normal times, the company may refuse such an order, since it will not field a satisfactory profit.

If times are bad, however such an order should be accepted, if incremental costs are involved. The company is better off to receive some revenue, above its incremental costs than to receive nothing at all, such a price, one lower than the regular price is called the contribution price. This approach to pricing is called contribution approach or the variable pricing model. This approach could be called competitors bidding approach.

CONDITIONS THAT SHOULD BE CONSIDERED IN DIFFERENTIAL COST PRICING.

          According to Adeniji (2004) the conditions are

  1. The firm should be operating below full capacity.
  2. The need exists to produce for markets distinct from

the firms regular market.

  1. Differential cost refers to variable cost with fixed cost excluded.
  2. Additional order that the firm wants to produce must fall within the installed capacity. The following factors affect differential cost pricing model:
  3. The additional production must fall within the firms installed capacity. The special order must not be allowed to affect the market position for the firms regular product. Where possible, the additional production must be sold under different brand name and market.
  4. Every care should be taken to ensure that the conventional price on additional production does not spark-up price war.
  5. The price at which the additional product is sold should at least exceed the differential cost.

CONVERSION COST PRICING

This is a pricing strategy that determines selling prices by marketing the total conversion cost. Conversion cost involves expenses in respect of direct labour and factory over head (both fixed and variable cost). It is discovered that this cost has direct impact on transforming the direct materials into finished products.

Under this situation, the conversation cost differential between the products must be reflected in the selling price of the products. If the conversion cost is neglected or ignored, the selling price computed would be misleading. The format for such computation is here presented below

FORMAT WITH CONVERSION WITHOUT CONVERSION
A B A B
Direct Materials X X
Direct labour X X X X
Factory Overhead X X X X
Selling & Dist O/H X X
Total conversion XX XX XX XX
50% Mark-up X X X X
Add Direct Materials X X X X
Selling & Distr. O/H X X
Selling Price XXX XXX XXX XXX

ADVANTAGES OF CONVERSION COST APPROACH

According to (Adeniji 2004; Egbunike 2006) they are

  1. It provides a more realistic pricing tool where a remarkable differential exist, in the cost of converting raw material into finished product.
  2. The conversion cost pricing reflects the difference in time factor used in converting a product.

TIME AND MATERIAL PRICING

Under this method, two pricing rates are established. One based on direct labour and the other based on the cost of direct material used.

This pricing method is widely used by many professionals such as physicians and dentists, also its used in repair shops and in printing shops. Time and materials rates are usually market determined. In other words, the rates are determined by the interplay of supply and demand and by competitive conditions in the industry.

However, some companies set the rates using a process similar to the process followed in the absorption costing approach to cost-plus pricing. In this case the rate includes allowances for selling, general and administrative expense, other direct and indirect cost, and a desired profit.

MINIMUM PRICE METHOD

According to I CAN (2006): a minimum price is the price that would have to be charged so as to cover:

(a)     The incremental cost of producing and selling the item.

(b)     The opportunity cost of the resource consumed in making and selling the item.

A minimum price generally will leave the business no better or worse off than if it did not sell the item, that is no gain no loss.

Basically the essential point about minimum price should be considered.

(a)     It is based on relevant cost, and

(b)     It is very much unlikely that a minimum price will actually be charged because if it is charged, it will not provide the business with any incremental profit. However, the minimum price of an item would generally show an absolute minimum below which the price should not be fixed. The incremental profit is that which would be obtained from any price that actually charged in excess of the minimum for example, the minimum price is N200 and the actual price charged is N240, then the incremental profit on the sale would be N40 however, if there are no scare resources and a company has spare capacity. The minimum price of a product would be an amount which equates the incremental cost of contribution towards profit.

OTHER PRICING METHODS/APPROACHES.

The other pricing methods that may be adopted by companies as pointed by I CAN (2006) are as follows:

(a)     Intuitive pricing: This involves pricing by the feel of the market and can vary from a pure guess to well informed attempt to interpret part data and future trends. It is occasionally used to adjust the cost-plus price according to the management’s perception of likely demand completion e.t.c

(b)     Experimental pricing: This involves the selection of a statistical test markets to create a statistical model which is used to manipulate the price among markets in order to arrive at a price which maximizes profits. It can be used when there is a pricing decision concerning a new profit.

(c)      Incremental cost pricing: It is based on the concept that a price should be such that incremental cost is less than the incremental revenue.

(d)     Pricing in a multi product situation: From a more objective view, companies are seen not to be producers of only one but a multiple of products. However, two issues are of importance in a multi-product environment, namely:

(i)      Pricing substitute goods, for example pharmaceutical where two methods are in use.

(a)     Uniform margin on the entire range of similar products.

(b)     Varying the size of the margin depending on the cost of each product in the range.

(ii)     Pricing complementary goods such as bread and butter – since the demand for the product increases the demand for its complement.

(e)      Demand Oriented pricing: It is in the attitude of customers influencing pricing decisions, that is, the price a customer is willing to pay for a product and it is not simply a consequence of the product itself.

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PRICING POLICIES

The pricing policy adopted by a firm’s may in ways vary. They are classified into 3 which according to Bush and Housing (1995) are as follows:

  1. Cost Oriented Pricing
  2. Demand oriented Pricing.
  3. Competition oriented pricing

COST ORIENTED PRICING

To produce a product, the cost of production is inevitable, so a good under standing of the cost component will result to a healthy pricing policy. Its advantage over the demand oriented pricing is that demand is difficult to estimate while cost are impossible to estimate (though difficult to allocate). A brief description of cost will be necessary to usher us to the cost based pricing.

ESTIMATING COST: A company that wants to charge a price must do so to cover its cost of production, distribution and selling expenses.

TYPES OF COST:

Broadly, a firm cost take two forms, fixed and variable cost.

Fixed costs are those cost that do not vary with production on sales revenue.

While variable costs are cost that vary directly with the level of production these costs tends to be constant per unit produce e.g cost of raw materials used for production.

Total cost consist of the sum of the fixed and variable cost for many given level of production. Average cost is the total cost divided by the numbers of unit produced.

DEMAND ORIENTED PRICING

Demand oriented pricing reflect the demand and decision for a product. Demand may be elastic or inelastic. According to carter (1997) if demand changes not with a small change in price, we say the demand is inelastic. But if demand changes considerably, demand is elastic.

Demand is likely to be less elastic under the following conditions:

(a)     There are less or no substitute or competitors.

(b)     Buyers do not readily notice the prices

(c)      Buyers are sure to change their buying habit and search for lower prices.

(d)     Buyers think the higher prices are justified by quality improvement, normal inflation. If demand is elastic rather than inelastic, sellers will consider lowering the price. A lower price will produce more total revenue all things being equal. Demand Oriented pricing policy include:

(i) Perceived value pricing: Firms applying this policy the buyer perception of value, not the sellers cost as the key to pricing. They use the non price variables in the marketing mix to build up perceived value in the buyer mind. Price is set to capture the perceived value. The key to perceived value pricing is to accurately determine the markets perception of the offer’s value. Sellers with either an inflated view or an under estimated view may either over price or under price the product.

(ii)     Value pricing: Firms that adopt this policy recently charge fairly low prices for a high quality offering..

Value pricing states that the price should represent a high value to consumers. The prices generally reflects the value of the product.

This type of pricing involves reengineering the company’s operations to truly become the low cost producers without sacrificing quality and lowering one price significantly attract a large number of value conscious customers.

(iii)    Loss leaders pricing: This form of pricing is used mainly by super market and departmental stores. They drop prices on well known brands to stimulate demand. The problem with this pricing is that it may dilute the brand image as well as cause complaint from other retailers who charged the actual  prices. Their prices usually do not cover cost.

(iv)    Price lining: This form of pricing policy is used by offering goods in a limited number of price lines for example women’s street dresses at N50 to N60 and N50 to N90. The price lines supposedly are based upon difference in workmanship, material and design, all of which are cost consideration and upon consumer’s expectation, which is a demand consideration.

Pricing liming is a means of exploiting quality differentials. Two advantages of this type of policy is that it simplifies the pricing structure and eliminates the need for frequent pricing decision.

COMPETITION ORIENTED PRICING

When there is price change, it affects customers (demand), competitors, distributors and so on. When there is a price change competitors are most likely to react where the number of firm or industry is small. The product is homogenous and the buyers are usually informed.

According to carter (1997) a firm can estimate its competitor’s reaction from two advantageous points. One is to assume that the competitors treat each price change as a fresh challenge and reacts in a set way to price changes.

In the first case, the company will have to figure out what lies in the competitors self interest. It will lead to researching the competitor’s current financial situation, along with recent sales and capacity, customer loyalty and corporate objective. If the competitors have a market share objective, it may react on some other strategy such as increasing the advertising budget, or improving the product quality, responding to competitor’s price change. In a market characterized by high product similarity a firm has little choice but to meet a competitors price cut down or it will certainly lose market share.

When a competitor raises its price in a homogenous product market, the other firms might not match it except the price increase will benefit the whole industry. In non homogenous product markets a firm has more discretion in reacting to a competitors price change. Buyers choose the vendor on many consideration service quality reliability and other factors.

These factors desensitize buyers to minor price differences.

Market leaders face aggressive price cutting by smaller firms trying to build market share. The leaders have several options which include:

  1. Maintaining price
  2. To raise perceived quality.
  3. To reduce price.
  4. To increase price and improve quality.

Drury (2000) while discussing pricing polices, argued that cost information is only one of many variables that must be considered in the pricing decision. The final price that is selected will depend upon the pricing policy of the company.

According to Drury (2000), these are two pricing policies that a firm can select from. They are:

  1. Price – Skimming Policy
  2. Penetration pricing policy.

A price skimming policy is an attempt to exploit those sections of the market that are relatively insensitive to price changes. For example, high initial price may be charged to take advantage of the novelty appeal of a new product when demand is initially inelastic. In summary pricing policy offers a safe guard against unexpected future increases in costs, or a large fall in demand after the novelty appeal had declined. Once the market becomes saturated, the price can be reduced to attract that part of the market that has not yet been exploited. A Skimming pricing policy should not be adopted when a number of close substitutes are already being marketed. Here the demand curve is likely to be elastic, and any price in excess of what or that being charged for a substitute product by a competitor is likely to lead to a large reduction in sales.

A penetration pricing policy is based on the consent of charging low prices initially with the intention of gaining rapid acceptance of the product. Such a policy is appropriate when close substitutes are available or when the market is easy to enter. The low price discourages potential competitors from entering the market and enables a company to establish a large share of the market. This can be achieved more easily when the product is new, than later on when buying habits have become established.

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PRICING STRATEGIES

Garrison (1995), argued that there are two basic pricing strategies available to price setters in pricing new product. They include:

  1. Skimming pricing: It involves setting a high initial price for a new product with a progressive lowering of the price as time passes and as the market broadens and matures. The purpose of Skimming pricing is to maximize short run profits.

One strong argument in favour of Skimming pricing is that it offers some protection against unexpected cost in the production and marketing of a product. It is most effective in those markets where entry is relatively difficult.

(ii)     Penetration pricing: It involves setting low initial prices in order to gain quick acceptance in a broad portion of the market. It calls for the sacrifice of some short run profit in order to achieve a bit long run market position.

A limitation of penetration pricing is if the cost is un-expectantly high, the firm may be forced to raise process in future and such a product may lose market acceptance.

Other pricing strategies include:

  1. Premium prices: These are price that suggest something about the quality of the product, the prices are usually higher than the market average. Its price is a way of communicating to customers that product quality warrants a higher price.
  2. Umbrella pricing: A dominant firm holds its price higher than necessary in other to protect and defend a number of small competitors.
  3. Keep all prices: It is purposely designed to discourage potential market entrants or deter firms already in the market, keep all price is a signal to combat. It is practically only for large firms with ample resources.

PRICING STRATEGIES OF SMALL SCALE MANUFACTURING FIRMS.

Having discussed the various pricing policies of a firm or that which a firm can adopt, there is a need to discuss those basic considerations that a small scale manufacturing firm must look into in adopting pricing strategies.

The pricing strategy of small scale manufacturing firm can ultimately determine its fate. Small scale manufacturing firms, owners can ensure profitability and longevity by playing close attention to their pricing strategy.

Cannon (1996) in his book: Guide to small Business information” argued that the lowest pricing policy does not win for small firms because larger competitors with deep pockets and the ability to compete lower operating cost will destroy any small business trying to complete on price alone. Avoiding the low price strategy, small firms have to look at the demand in the market by examining three factors.

These include:

  1. Competitive Analysis: small business should not just. Look at their competitors pricing but also at the whole package they offer.
  2. Ceiling price: Is the highest price the market will bear. Firm must survey customers to determine pricing limits. The highest price in the market may not be the ceiling price.
  3. Price Elasticity: If the demand for the production or service is less elastic, you can then have a higher ceiling on prices. How elastic demand depends on limited competitors, buyers perception of quality and customers not habituated looking for the lowest price in the industry.

After reviewing these considerations including your cost and profit goal as set in the business, a small scale manufacturing firm may then be in a position to choose the best pricing policy for its firm. But usually a Price war may erupt leading to such firms as they way not be able to cover cost.

STRATEGIES FOR AVOIDING A PRICE WAR

A small scale manufacturing firms may avoid a price way by:

(a) Enhance Exclusively: Products or services that are exclusive to your business, provide protection from falling prices.

(b) Drop high maintenance goods: There may be products or services in your business that have high customer service and maintenance cost. Such lines should be dropped.

(c)      Branding: This is very effective, It helps the firms to develop their brand name or product name in the market.

(d)     Localizing: Target a particular market or locality.

(e)      Value added: Find value your business can add to stand out in the market place. Be the most unique business in the category.

PROFIT PLANNING

We have been able to establish that, it is the price the firm offers that determines its revenue. Hence a firm sales activity is its back bone.

A firm’s plan for profit is summarized in form of an income statement that serves as the sales and profit objective and budget for cost profit planning must be incorporated into the budgeting process so desired level of profit.

A budget is a detailed outline of the acquisition and use of financial and other resource over some time period. It represents a plan for the future expressed in formal quantitative terms.

The act of preparing a budget is known as budgeting control.

Budgeting has a great advantage of co-ordinating the activities of an entire organization by integrating the plans and objectives of the various parts to achieve the desired target or profit. By doing so, budgeting ensures that the plan and objectives of the parts are consistent with broad goals of the entire organization.

The following budget needs are to be prepared to help reflect the planned profit:

  1. Sale budget: Includes a computation of expected cash.
  2. Production budget: It involves the production budget for the coming years.
  3. Direct material budget: Includes a computation of expected cash payment for raw materials.
  4. Cash budget: It is used to generate how much cash will be generated from operations.
  5. Direct labour budget: It is prepared to show the labour that all will be required in the production process.
  6. Manufacturing overhead budget: It is prepared to show all cost of production apart from the direct material and direct labour.
  7. Selling and administrative expense budget: It contains a list of anticipated expenses for the budget period that will be incurred in area other than manufacturing.
  8. Budgeted income statement: This is one of the key schedules in the budget process. It tells how profitable operations are anticipated to be in the forth coming period. After it has been developed, it stands as a bench mark against which subsequent company performance can be measures.

Effect of Pricing Policy on Profitability Level of an Organization. A Performance appraisal of some selected manufacturing firms.

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