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Pricing Products and Services:

After studying this chapter you should be able to:

  1. Compute the profit maximizing price of a product and service using the price elasticity of demand and variable cost.
  2. Compute the selling price of a product using the absorption costing approach.
  3. Calculate the target cost for a new product or service.
  4. Calculate and use billing rates used in time and material pricing.

Pricing is not a problem for some businesses. They make products or provide a service that is in competition with others, identical products or services for which a market price already exists. Customers will not pay more that this price, and there is no reason to charge less. Under these circumstances, the company simply charges the prevailing market price. Markets for basic raw materials such as farm products and minerals follow this pattern.

Here we are concerned with the more common situation in which a company is faced with the problem of setting its own prices. Clearly, the pricing decision can be critical. If the price is too high, customers will avoid purchasing the company's products. If the price is set too low, the company's costs may not be covered.

the usual approach in pricing is to mark up cost. A product's markup is the difference between its selling price and its cost. The markup is usually expressed as a percentage of cost. This approach is called cost plus pricing because the predetermined markup percentage is applied to the cost base to determine a target selling price.

Selling price = Cost + (Markup Cost)

For example, if a company uses a markup of 50%, to the costs of its products to determine the selling price. If a product costs $10, then it would charge $15 for the products.

Two key issues must be addressed when the cost plus approach to pricing is used. First, What cost should be used? Second, how should the markup be determined? Several alternatives approaches are considered here, starting with the generally favored by economists.

Price Elasticity of Demand--Economists' Approach to Pricing:

If a company raises the price of a product, unit sales ordinarily falls. Because of this, pricing is a delicate balancing act in which the benefits of higher revenues per unit are traded off against the lower volume that results from charging higher prices. The sensitivity of unit sales to changes in prices is called the price elasticity of demand. Click here to read full article.

Absorption Costing Approach to Cost Plus Pricing:

The absorption costing approach to cost plus pricing differs from the economists' approach (price elasticity of demand) both in what costs are marked up and in how markup is determined. Under the absorption costing approach to cost plus pricing, the cost base is the absorption costing unit product cost rather than variable costing. Click here to read full article.

Target Costing:

Target costing is the process of determining the maximum allowable cost for a new product and then developing a prototype that can be profitably made for that maximum target cost figure. Click here to read full article.

Time and Material Pricing in Service Companies:

Some companies--particularly in service industries-- use a variation of cost plus pricing called time and material pricing. Under this method, two pricing rates are established--one based on direct labor time and other based on the cost of direct materials used. Click here to read full article.

In Business| Do Consumers Really Respond To Prices? You Bet They Do:

Jess Stone street Jackson is the founder of Kendall-Jackson (K-J) winery, which specializes in making popular wines that are good enough to command a premium price. Jackson, who is now a billionaire, prices his wines a few dollars high than other mainstream wines. For example, if a Clos du Bois chardonnay costs $9 at retail, Jackson will charge $11 for his chardonnay. When chardonnay became the range in the late 1990s, Jackson tried pushing up his prices by another few dollars over the competition. But unit sales dropped by 18%. Jackson rolled back his prices and the the volume recovered.

Source: Tim W. Ferguson, "Harvest Time," Forbes, October 16, 2000, pp. 112-118


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