Chapter 7

The Pricing Decision and

Customer Profitability Analysis

Factors that Influence the Pricing

Decision
Cost of goods sold.
Operating cost structure.
Nature of the product or service.
Competitiveness of the industry.
Sensitivity to global issues.
Legal and environmental issues.
Price elasticity.

Price elasticity of demand

Price elasticity of demand refers to the relationship
between price and demand. It measures the relationship
between a change in price and a change in demand for a
product or service.
Percentage
Percentagechange
changein
in demand
demand
Percentage
Percentagechange
changein
inprice
price
Where the numerical value is less than or equal to 1, then the price elasticity of
demand is inelastic (demand is less sensitive to changes in price)
Where the numerical value is greater than or equal to 1, then price elasticity is
elastic (demand is sensitive to changes in price)

Illustration 7.1: Price elasticity of

demand

Limitations of economic pricing

theory
It assumes there are no other variables that can
influence demand. For example it ignores the effects
of marketing on sales demand and it effectively
assumes that sales volume is solely a function of
price.
It also assumes that consumers are perfectly
informed about the prices of products and services
and that price is their sole motivation in changing their
spending patterns.
The exact shape of a products demand curve is
extremely difficult to estimate, thus ensuring that
forecast demand at a given price may be misleading.

Accounting-based pricing methods

Accounting-based pricing methods tend to concentrate on
accounting measures such as covering costs and achieving
a required profit rather than factors relating to the external
Environment.
There are three main accounting-based pricing methods
Cost-based pricing.
Contribution margin pricing.
Profit oriented pricing.

Cost based Pricing

Profit mark-up and profit margin
Profit
Profitmark-up
mark-upexpresses
expressesthe
theprofit
profitelement
elementas
asaa
percentage
percentageof
ofcosts
costswhereas
whereasprofit
profitmargin
marginexpresses
expressesthe
the
same
sameprofit
profitelement
elementas
asaapercentage
percentageof
ofsales.
sales.
IfIfthe
theselling
sellingprice
priceof
ofaaproduct
productisis100
100and
andthe
thetotal
totalcost
cost
amounts
amountsto
to80,
80,then
thenthe
theprofit
profitelement
elementequals
equals20.
20.
The
Theprofit
profitmark-up
mark-upthat
thatexpresses
expressesprofit
profitas
asaapercentage
percentageof
of
cost,
cost,isiscalculated
calculatedas
as20
2080
80xx100
100==25%.
25%.
The
Theprofit
profitmargin
marginthat
thatexpresses
expressesprofit
profitas
asaapercentage
percentageof
of
sales,
sales,isiscalculated
calculatedas
as20
20100
100xx100
100==20%.
20%.

Cost based pricing methods

The pricing decision focuses totally on costs, ensuring
that a selling price is set that covers the costs of running
the business and will be sufficient to provide a profit. The
selling price is arrived at by simply adding to costs a
profit percentage to get the selling price.
PP==CC++M
M(C)
(C)

Where
Where
PP==selling
sellingprice
price
CC==costs
costs
M
M==percentage
percentagemark-up
mark-upor
orprofit
profitpercentage
percentage
based
basedon
oncost.
cost.

Cost based Pricing

Gross margin pricing

Example 7.1: Gross margin pricing

Cost based Pricing

Direct cost pricing

Example 7.2: Direct cost pricing

Example 7.2: Direct cost pricing

Cost based Pricing

Full cost pricing

Evaluation of cost based pricing

The simplicity of cost based pricing is its main
advantage and, as an initial first step in
determining a selling price, it is considered quite
useful. The main criticism of cost based pricing
is that on its own it only focuses on costs and
ignores other factors such as the economic
environment, competition, and the marketing
and sales strategy of the business. It also does
not take into account the required level of
profitability based on the level of investment in
the business.

Contribution margin pricing

Contribution margin pricing focuses on ensuring that each
product or service offers a target contribution towards fixed
costs and profit.
All costs must be classified into their fixed and variable
components.
Contribution margin pricing is based on the premise that
prices are set using variable costs as the base and what the
market will bear as the ceiling.
This ensures that although individual sales may not provide
an overall profit, the sum of all sales will provide sufficient
contribution to cover fixed costs and provide the required
profit.
It can provide a high discretionary element to price setting

Example 7.3: Contribution margin

pricing

Example 7.3: Contribution margin

pricing

Evaluation of contribution margin

pricing
The main advantages of contribution margin pricing is
that it provides great scope for a pricing policy that is
adaptive to changing conditions and takes into account
costs and market conditions in setting a selling price. Its
main criticisms are those that are associated with the
CVP model such as, the assumption that all costs can be
classified as either fixed or variable. It also requires
information on the demand curve and the price elasticity
of demand which is quite difficult to predict. As with cost
based models, it ignores the level of profitability as a
percentage of the capital investment in the business.

Profit oriented pricing

The focus is on profit and the return on investment
required.
It involves calculating a total sales figure that should
achieve a return on investment that will satisfy
investors
The technique is an extension of the cost based and
contribution pricing methods with an extra variable,
profit or return, as part of the equation.
The total estimated sales figure, divided by expected
forecast demand will give a selling price which will
ensure the required level of profitability for investors,
provided costs and demand levels remain as forecast.

Example 7.4: Profit oriented

pricing

Example 7.4: Profit oriented

pricing

Or alternatively

Evaluation of profit oriented

pricing
Profit oriented methods are effectively cost
based methods taking into account a required
rate of return (profitability and investment). Thus
their advantages include those of the cost based
method with the added advantages that this
method focuses on profit and investment. The
main criticisms are, that as with cost based
methods, it does not focus on the market, price
elasticity of demand, competition and the
economic environment and thus is considered
quite insular.

Example 7.5: Pricing hotel

accommodation

Example 7.5: Pricing hotel

accommodation

Example 7.5: Pricing hotel

accommodation

Market based pricing strategies

Going rate pricing / competition oriented pricing
Perceived value / psychological pricing
Loss leader / decoy pricing
Two-part pricing
Camouflage pricing

Multi-stage approach to
pricing
Select
Selectthe
thetarget
targetmarket
market
Determine
Determinethe
thefloor
floorprice
price
(cost
(costprice)
price)

This is the cost of goods but could take

into account clearance lines and loss
leaders.

Determine
Determinethe
theceiling
ceilingprice
price
(competitors
(competitorsprice)
price)

This is the price charged for the item by

competitors. Provides a reasonable upper
limit.

Apply
Applyaamark-up
mark-up

A target mark-up can be applied in order

to achieve the required profit objectives.

Adjust
Adjustand
andselect
selectthe
theprice
price

If necessary adjust the price (fine tune) to

be consistent with store policy.

The main benefits of the multi-stage approach are that it incorporates more
than one factor and allows for adjustments or fine tuning to be made.

Price lining
Setting up a number of distinct
prices for a product range.
Prices could be limited to say
25, 32 and 40.

Flexible pricing

Uses prices like 19.95 or 99.99 to

give impression of lower price.

Even pricing
Uses prices like 130 to give
impression that price is not most
important factor and prestige would
be tarnished by using odd pricing.

Fixed pricing
The price set is the only
acceptable price and will not be
bargained down.

Odd pricing

Pricing
Tactics

Allows for the expectation that

price can be negotiated down or
a bargain struck.

Multiple unit pricing

Providing discount for two or more items

Complementary goods
Promotional price for one item may encourage
purchase of complementary products at full
price.

Customer Profitability Analysis

(CPA)
Customer profitability analysis (CPA) focuses on how
individual customer or customer groups contribute to
profit.
It is derived from the Pareto principle that about 20
per cent of customers account for 80 per cent of
profit.
The focus is to ensure that the most profitable
customers or customer groups receive comparable
attention from the organisation.

Benefits of CPA
By focusing on the most profitable customers and
providing an improved or commensurate service,
customer relations improve and customer retention
increases. Also by identifying the attributes of this
group, other similar customers may be attracted to
the organisation.
By having a knowledge of why certain customers or
customer groups do not significantly contribute to
profit (and may actually reduce profit), management
can assess the difficulties and work on solutions that
benefit the organisation as well as the customer.

CPA requires
The process requires the use of an activity based costing
system and involves gathering detailed cost and revenue
information for each customer or customer group:
Sales details: These would include the price charged to the
customer including any details on cash and quantity discounts.
Cost details: These would involve focusing on the resources
consumed by different customers. These cost drivers (the
activities that create the customer cost) need to be separately
identified and a cost driver rate associated with the activity.
Examples of cost drivers under CPA would include order costs,
sales visits, delivery costs, special delivery costs, credit
collection and non-standard product requirements

Illustration 7.4: Customer

profitability analysis

Illustration 7.4: Customer

profitability analysis