Performance Management

B4: Decision Making Techniques | Pricing Decisions (ACCA F5)

B4- Pricing Decisions

Pricing Decisions explains the factors that influence the pricing of a product or service, the price elasticity of demand, explains how to derive the straight line demand equation, how to calculate the optimum selling price and quantity, how to make decisions about increasing production and sales levels, how to determine price and output levels for profit maximization and pricing strategies.

Pricing Decisions

a) Explain the factors that influence the pricing of a product or service.

A key consideration in pricing decisions are the factors that can influence the pricing of a product or service:

  • Price sensitivity
  • Price perception
  • Quality
  • Intermediaries
  • Competitors
  • Suppliers
  • Inflation
  • Newness
  • Incomes
  • Product range
  • Ethics

The factors that influence demand are:

  • Price of other goods
  • Income
  • Tastes or fashion
  • Expectations
  • Obsolescence

b) Explain the price elasticity of demand.

The price elasticity of demand measures how much the demand for a product changes as a result of changes in its price.

Formula: PED = The change in quantity demanded (as % of demand ÷ the change in price (as % of price)

 Note: When the price of a good falls, the demand goes up and the price elasticity is negative. 

Example:

The price of a widget is $2.00 per unit and the annual demand is 350,000 units. Research shows that if the price of the widget increases by 25 cents per unit, demand drops by 40,000 units. What is the price elasticity of demand between prices of $2.00 and $2.25 per unit?

  • Annual demand at $2.00 per unit is 350,000
  • Annual demand at $2.25 per unit is 310,000
  • % change in demand = (40,000 ÷ 350,000) x 100% = 11.429%
  • % change in price = (0.25 ÷ 2.00) x 100% = 12.5%
  • Price elasticity of demand = (-11.429 ÷ 12.5) = 0.914

Therefore, the demand for the widget is inelastic.

 Note: Demand is inelastic if the absolute value is less than one and elastic if the absolute value is greater than 1. 

c) Derive and manipulate a straight line demand equation. Derive an equation for the total cost function(including volume-based discounts).

The straight line demand equation shows the relationship between price and demand.

Formula: Demand equation (P) = a – bQ

  • P = selling price
  • Q = Quantity demanded at that price
  • a = a theoretical maximum price at which there is no demand
  • b = the change in price required to change demand by 1 unit (gradient)

To calculate a:

Formula: a = $(current price) + [ (current quantity at current price ÷ change in quantity when price is changed by $b) x $b]

To calculate b:

Formula: b = change in price ÷ change in quantity

Example:

The current price of a widget is $13. At this price, the company sells 75 items a month. When the company raised the price to $15 they only sold 50 items. Determine the demand equation.

  • P = a – bQ
  • a = $13 + [(75/25) x $2 = $19
  • b = (15 – 12) ÷ (75 – 50) = 0.12
  • Therefore P = 19 – 0.12Q
    • 12 = 19 – 0.12 Q
    • 12-19 = – 0.12 Q
    • Q = 58.33

d) Calculate the optimum selling price and quantity for an organisation, equating marginal cost and marginal revenue.

The optimum selling price can be determined using “tabulation.”

For examples which show how to calculate the optimum selling price, please refer to BPP’s ACCA F5 Performance Management Study Text.

e) Evaluate a decision to increase production and sales levels, considering incremental costs, incremental revenues and other factors.

When evaluating a decision to increase production and sales levels, incremental costs and revenues should be considered.

 Note: The incremental cost of increasing production is the additional cost of producing the extra units per month. 

f) Determine prices and output levels for profit maximisation using the demand based approach to pricing (both tabular and algebraic methods).

For examples which show how to determine prices and output levels for profit maximisation using the demand based approach to pricing, please refer to BPP’s ACCA F5 Performance Management Study Text.

g) Explain different price strategies, including:  i) All forms of cost-plus, ii) Skimming  iii) Penetration, iv) Complementary product, v) Product-line, vi) Volume discounting,  vii) Discrimination, viii) Relevant cost

Pricing decisions also include determining the price of a product or service is an important decision that has to be made by businesses. There are several types of pricing strategies:

  1. Cost-Plus (Full Cost-Plus and Marginal  Cost-Plus) – Deciding the sales price by adding a percentage mark-up for profit to the product cost
  2. Market Skimming – Used for new products and involves charging high prices early in the product’s life ( e.g. electronics)
  3. Market Penetration – Used for new products and involves charging low prices to obtain strong demand
  4. Complementary Product – Pricing products that are bought and used together (e.g. printers and ink)
  5. Product Line Pricing – Using a consistent pricing policy for products that are related
  6. Volume Discounting – Offering a reduction in price when large volumes of a product are purchased
  7. Discrimination – Selling the same product at different to different customers by market segment, product version, place and time.
  8. Relevant Cost – Using a price that will not benefit or hurt the organization.

h) Calculate a price from a given strategy using cost-plus and relevant cost.

For examples which show how to calculate the price using cost-plus and relevant cost, please refer to BPP’s ACCA F5 Performance Management Study Text.

Resources Used

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