Marginal AnalysisPricing decisions tend to heavily involve analysis regarding marginal contributions to revenues and costs. Show
Learning Objectives Identify the characteristics of a marginal price analysis relative to pricing decision making Key TakeawaysKey Points
Key Terms
Marginal Analysis Pricing decisions tend to heavily involve analysis regarding marginal contributions to revenues and costs. Specifically, firms tend to
accomplish their objective of profit maximization by increasing their production until marginal revenue equals marginal cost, and then charging a price which is determined by the demand curve. Marginal Profit Maximization: This series of cost curves shows the implementation of profit maximization using marginal analysis. For example, the marginal revenue curve would have a negative gradient, due to the overall market demand curve.
In a non-competitive environment, more complicated profit maximization solutions involve the use of game theory. In some cases, a firm's demand and cost conditions are such that marginal profits are greater than zero for all levels of production up to a certain maximum. In this case, marginal profit plunges to zero immediately after that maximum is reached. Thus, output should be produced at the maximum level, which also happens to be the level that maximizes revenue. In other words, the profit
maximizing quantity and price can be determined by setting marginal revenue equal to zero, which occurs at the maximal level of output. Fixed CostsFixed costs are business expenses that are not dependent on the level of goods or services produced by the business. Learning Objectives Describe the characteristics of fixed costs and they relate to pricing decisions Key TakeawaysKey Points
Key Terms
Fixed CostsDetermining the cost of producing a product or service plays a vital role in most pricing decisions. Fixed costs are business expenses that are not dependent on the level of goods or services produced by the business. They tend to be time-related, such as salaries or rents being paid per month. They and are often referred to as overhead costs. This is in contrast to variable costs, which are volume-related and are paid per quantity produced. In management accounting, fixed costs are defined as expenses that do not change as a function of the activity of a business, within the relevant period. For example, a retailer must pay rent and utility bills irrespective of sales. In marketing, it is necessary to know how costs divide between variable and fixed. This distinction is crucial in forecasting the earnings generated by various changes in unit sales and thus the financial impact of proposed marketing campaigns. In a survey of nearly 200 senior marketing managers, 60% responded that they found the "variable and fixed costs" metric very useful. Fixed Costs and Variable Costs: The graph breaks down the difference between fixed costs and variable costs. Fixed costs are not permanently fixed—they will change over time—but are fixed in relation to the quantity of production for the relevant period. For example, a company may have unexpected and unpredictable expenses unrelated to production. Warehouse costs and the like are fixed only over the time period of the lease. By definition, there are no fixed costs in the long run. Investments in facilities, equipment, and the basic organization that can't be significantly reduced in a short period of time are referred to as committed fixed costs. Discretionary fixed costs usually arise from annual decisions by management to spend on certain fixed cost items. Examples of discretionary costs are advertising, machine maintenance, and research and development expenditures. Average Fixed Costs For pricing purposes, marketers generally take into account average fixed costs. Average fixed cost (AFC) is an economics term that refers to fixed costs of production (FC) divided by the quantity (Q) of output produced. Average fixed cost is a per-unit-of-output measure of fixed costs. As the total number of goods
produced increases, the average fixed cost decreases because the same amount of fixed costs is being spread over a larger number of units of output. Break-Even AnalysisThe break-even point is the point at which costs and revenues are equal. Learning Objectives Analyze the concept of break even points relative to pricing decisions Key TakeawaysKey Points
Key Terms
Break-Even Analysis In economics and business, specifically cost accounting, the break-even point is the point at which costs or expenses and revenue are equal—i.e., there is no net loss or gain, and one has "broken even."
In the linear Cost-Volume-Profit Analysis model, the break-even point—in terms of Unit Sales (X)—can be directly computed in terms of Total Revenue (TR) and Total Costs (TC) as: where TFC is Total Fixed Costs, P is Unit Sale Price, and V
is Unit Variable Cost. The quantity (P—V) is of interest in its own right, and is called the Unit Contribution Margin (C). It is the marginal profit per unit, or alternatively the portion of each sale that contributes to Fixed Costs. Thus the break-even point can be more simply computed as the point where Total Contribution = Total Fixed Cost: Total Contribution=Total Fixed CostsUnit Contribution ×Number of Units=Total Fixed CostsNumber of Units= Total Fixed CostsUnit Contribution\begin{array}{rcl}\text{Total Contribution}&=&\text{Total Fixed Costs}\\ \text{Unit Contribution }\times\text{Number of Units}&=&\text{Total Fixed Costs}\\ \text{Number of Units}&=&\frac{\text{Total Fixed Costs}}{\text{Unit Contribution}}\end{array} We can derive the calculation for the break-even quantity from the relation of total revenue to total costs. TR= TCP×X=TFC+V×XP×X−V×X=TFC(P−V) ×X=TFCX=TFC P−V\begin{array}{rcl}\text{TR}&=&\text{TC}\\ \text{P}\times\text{X}&=&\text{TFC}+\text{V}\times\text{X}\\ \text{P}\times\text{X}-\text{V}\times\text{X}&=&\text{TFC}\\ \left(\text{P}-\text{V}\right)\times\text{X}&=&\text{TFC}\\ \text{X}&=&\frac{\text{TFC}}{\text{P}-\text{V}}\end{array} Break-Even and Pricing DecisionsThe break-even point is one of the simplest analytical tools in management. It helps to provide a dynamic view of the relationships between sales, costs, and profits. A better understanding of break-even, for example, is expressing break-even sales as a percentage of actual sales. This can give managers a chance to understand when to expect to break even (by linking the percent to when in the week/month this percent of sales might occur). In terms of pricing decisions, break-even analysis can give a company a benchmark quantity of goods to be sold. This quantity can then be used to derive the average fixed and variable costs, the sum of which can be used as the basis for markup pricing, et cetera. Some limitations of break-even analysis include:
Organizational ObjectivesFor the vast majority of business entities, the ultimate objective should be to increase profits, often through a better pricing strategy. Learning Objectives Illustrate how an organization's objectives impact its pricing decisions Key TakeawaysKey Points
Key Terms
Organizational Objectives For the vast majority of business entities, the ultimate objective should be
to increase profits. Pricing strategies for products or services encompass three main ways to achieve this. A business can cut its costs, it can sell more, or it can find more profit with a better pricing strategy. Laws Of Price SensitivityA pivotal factor in determining a price is how consumers will perceive it. In their book,The Strategy and Tactics of Pricing, Thomas Nagle and Reed Holden outline nine "laws" that influence how a consumer perceives a given price and how price-sensitive they are likely to be with respect to different purchase decisions. They are:
Oil Price Sensitivity: The graph shows the price fluctuation of oil after consumers have significant access to information regarding the commodity. Other Inputs to Pricing DecisionsPricing decisions can have a variety of inputs, such as value-added considerations, legal price requirements, competitive positioning, and discounting. Learning Objectives List a few of the key considerations to pricing aside from simple expense-oriented break-even analyses Key TakeawaysKey Points
Key Terms
Pricing DecisionsThe pricing decision is an important one, both for profitability and competitive positioning. Organizations must take into account supply, demand, competition, expenses, profit margins, differentiation, quality, and legal concerns. The simplest methods of determining price include concepts such as break-even points, fixed/variable cost analysis, and marginal analysis. However, there are other concerns that need to be investigated when determining price. Pricing InputsLooking at cost structures and determining break-even points is not always enough when it comes to effective pricing strategies. As a result, marketers should be familiar with the legalities of pricing (for certain commodities in particular), the value added to the consumer (willingness to pay), competitive positioning, and potential discounts. Legal ConcernsPrice Ceiling: When considering pricing decisions, understanding price floors and price ceilings is important.For some products, governments will set firm price controls (i.e. price ceilings or price floors) to ensure ethical and/or accessible pricing for a given population. Just as the name implies, price floors and price ceilings will set minimum or maximum prices for some goods. This is particularly applicable to rent, real estate, banking, food and other core necessities. When operating in an industry with price ceilings or price floors, firms must adapt their pricing strategy to these legalities and ensure compliance. Value-Added PricingIn a perfectly practical and efficient market, the expenses would almost always lead to the appropriate price through competitive forces. However, we do not live in a world of perfect markets. As a result, there are a number of value-adds that consumers receive that are not easy or intuitive to measure from a strictly financial perspective. These include:
Competitive PositioningAnother input to pricing is the basic premise of differentiation to achieve higher value. This is not so much an exception to the above mentioned value-added pricing, but more of a facet of this. Branded items, for example, are often quite similar to generic versions of the same item. However, these brands add intangible value to the product above and beyond the cost of producing it. Buying brand name goods may be differentiated based upon celebrity sponsors, premium perception, social value or a wide variety of other differentiated factors. These can enable organizations to differentiate for a price premium (i.e. they can charge more for having a strong brand/position). DiscountingThere are also a number of reasons why an organization may offer discounts. Discounting is particularly useful when it comes to B2B transactions, in which a client might buy a few thousand of a given product and receive a wholesale price that is significantly lower than the price of buying each product individually. There are also situations in which a product may be sold at a price that is actually less than the cost of producing it. This is most often done when a perishable item will soon go bad anyway. In such a situation, selling at a loss is better than getting nothing at all (opportunity cost!). Conclusion All and all, pricing is a bit more complicated than simply understanding the expenses involve. Marketers must understand social value, legal considerations, branding, discounting, and the functional value of products and services in order to capture the full potential of a given item. Pricing can be a great opportunity to capture better margins than the competition,
or could offer the ability to make a mistake and lose market share! Licenses and AttributionsCC licensed content, Specific attribution
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