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Pricing decisions and profitability analysis

13 important questions on Pricing decisions and profitability analysis

Which costs should be taken into account when a firm has temporary unused facility?

Only the incremental costs of undertaking a special order.

Full cost / long-run cost

The full cost or long-run cost is the estimated sum of all those resources that are committed to a product in the long run. It represents an attempt to allocate a share of all costs to products to ensure that all costs are covered in the cost base.

In the situation where a single standardized product is sold to a large number of customers, what is recommended?

It is recommended that cost-plus selling prices are estimated for a range of potential sales volumes. A firm may choose a selling price that does not maximize profits in the short run, if it enables the firm to force other players out of the market and ensure profitability in the long term.
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What are the attractions of target costing?

- Marketing factors and customer research provide the basis for determining selling price whereas cost tends to be the dominant factor in cost-plus pricing.
- The approach requires the collaboration of product designer, product engineers, marketing and finance staff whose focus is on managing costs at the product design stage. At this stage costs can be most effectively manages because a decision committing in the firm to incur costs will not have been made.

Price taking firm facing short run product mix decisions

Accepting short-term business where the incremental sales revenues exceed incremental short-run costs will provide a contribution towards committed fixed costs that would not otherwise have been obtained. The same conditions apply as for the price setting firm. Besides considering new short-term opportunities organizations may review their existing product mix over a short-term horizon.

A price taking firm facing long run product mix decisions

In the long run, there is a need to undertake periodic profitability analysis to distinguish between profitable and unprofitable products in order to ensure that only profitable products are sold.

On what kind of decisions should a company focus?

Generally, companies should concentrate on long run pricing decisions and short-run decisions should be viewed as representing abnormal situations.

How can mark up percentages be decided?

- By demand factors
- To earn a target rate or return on invested capital

Mark-up to earn a target rate of return on invested capital

A firm can choose a mark-up rate to earn a target rate of return on invested capital. This approach seeks to estimate the amount of investment attributable to a product and then set a price that ensures a satisfactory return on investment for a given volume.

What is the major problem of using a mark-up rate to earn a target rate of return on invested capital?

The major problem of applying this approach is that it is difficult to determine the capital invested to support a product. Assets ar normally used for many different products and therefore it is necessary to allocate investments in assets to different products, which is a process likely to involve arbitrary allocations.

Limitations of cost plus pricing

The main criticism is that demand is ignored. If sales demand falls below the activity level that was used to calculate the fixed cost per unit, the goals sales revenue may be insufficient to cover the total fixed costs. Cost plus pricing will only ensure that all the costs will be met, and the target profits earned, if the sales volume is equal to or bigger than the activity level that was used to estimate total unit costs.

Reasons for using cost plus pricing

Cost plus pricing offer a means by which plausible prices can be found with ease and speed, no matter how many products the firm handles. Moreover, its calculations look factual and precise. In addition, it may help firms predict the prices of other firms.

Penetration price policy

A penetration pricing policy si based on the concept 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.

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The question on the page originate from the summary of the following study material:

Samenvatting FIDM

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