Pricing Decisions: The Role of Cost Information In the Pricing Decision
You are working in the management accounting department of ABC which manufactures a range of consumer electronics products. The current range comprises 50 different products and the company launches around 10 new products every year.
Your manager has asked you to write a paper which addresses issues relating to pricing decisions for all the company’s products, with a particular focus on the prices set for new products.
The current approach used by the company is a cost based approach by which a predetermined percentage is added to the estimated full cost of the product. However the directors of the company have recently questioned this approach.
You are required to discuss the following in your paper:
- The role of cost information in the pricing decision.
- The advantages and limitations of the company’s current approach.
- A range of alternative strategies for pricing products which could be adopted by the company, including a discussion of the circumstances for which the different strategies would be appropriate.
Discussions have been taking place within the company concerning the pricing of one of the products to be launched within the next three months. The current planned selling price is £60 per unit and at this price it is expected that 5,000 units will be sold over the next year. However the marketing director has suggested that the sales quantity and profits from this product could be increased by reducing the unit selling price. The production director disagrees and believes that the selling price would have to be increased to improve the level of the profit.
You are required to:
- Analyse the relationship between selling price and the level of profit for this product based on the information provided in this briefing.
- Within your paper, present your analysis in an appropriate format. This analysis should include an appropriate chart or charts as an integral part of your paper.
- Provide a full commentary on your analysis. This discussion should include the assumptions in and the limitations of your approach, a discussion of the views of the two directors related to the conclusions of your analysis and an assessment of the relevance to the organisation’s pricing decisions in the light of your answer to part a).
Note: you should use a spreadsheet for the calculations which underpin the analysis presented in the paper. Your spreadsheet must be submitted to support your paper.
The company estimates product costs based on apportionment of overheads to products using labour hours. Prices set are based on full cost plus a 25% profit mark-up.
The following information relates to this product:
- The manufacture of each unit of the product requires materials costing £24 and 30 minutes of direct labour at a rate of £25 per hour.
- The variable overhead costs per unit are £5.50 per unit.
- Fixed costs for the year to be apportioned to this product are expected to be:
- Production costs: £24,000
- Administration and management costs: £5,000
- Selling costs: £1,000
- Some market research has recently been carried out to try and determine the effect on the level of sales demand if changes were made to the selling price of the product. This market research has suggested that reducing the selling price to £57 would increase the sales volume to 5,250 units for the year whereas increasing the selling price to £63 would result in a fall in sales to 4,750 units during the same period.
(10%) Discussion of the importance of cost information for pricing
(10%) Discussion of the advantages and limitations of the company’s current approach.
(25%) Review of alternative strategies for pricing products.
(10%) Analysis of scenario
(25%) Commentary on spreadsheet analysis and presentation of results.
(10%) Effective communication and appropriate style of presentation.
(10%) Use and presentation of academic research to support arguments.
The role of cost information in the pricing decision
Cost is one of the factors that affect pricing decisions, hence cost information is an important factor in coming up with pricing decisions (University of Minnesota, 2015). Costs can influence prices through its effect on supply. In this regard, a company will be willing to supply more products the more the cost is lower relative to the price. It is often the case that as the firm increases supply of a product, the cost of producing an additional unit initially decreases. However, a point is reached where the cost of producing an additional unit begins to rise. The company will be willing to continue to supply its products for as long as the profit it makes from selling extra units exceeds the cost of producing them (the extra units). Another way that costs influence pricing is that all the costs incurred by the firm should be recouped through its product sales (Meehan et al., 2011; Smith, 2011). This means that the higher the units of a product that a firm sells, the less each unit is required to contribute towards covering the fixed costs. This in turn implies that the firm can afford to set a lower price for its products if it applies a cost-based approach to pricing or can make higher profits if applies value-based pricing (Leijon, 2017). It is by understanding the cost of producing the products that companies can set product prices so that they (the prices) appeal to consumers and at the same time serve to maximize operating income (Tarjomefa, 2015). Continue reading …