accounting

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Importance of costs in pricing strategy of organisations

Price of a product is a major element of the marketing mix. Pricing is one of the most important strategic issue because it is related to the product positioning. The price goes in hand with the other marketing mix elements such as product promotion, channel decisions and its features.

For a developing the pricing of a new product, there can be a general sequence of steps that can be followed by the organisation which may vary from other organisations. The main area of focus will however be same for all the organisations. The different steps can be as follows.

Develop marketing strategy - perform marketing analysis, segmentation, targeting, and positioning.

Make marketing mix decisions - define the product, distribution, and promotional tactics.

Estimate the demand curve - understand how quantity demanded varies with price.

Calculate cost - include fixed and variable costs associated with the product.

Understand environmental factors - evaluate likely competitor actions, understand legal constraints, etc.

Set pricing objectives - for example, profit maximization, revenue maximization, or price stabilization.

Determine pricing - using information collected in the above steps, select a pricing method, develop the pricing structure, and define discounts.

The various pricing strategies for products include, competition based pricing, cost-plus pricing, creaming or skimming, limit pricing, loss leader, market oriented pricing, penetration pricing, price discrimination, premium pricing, predatory pricing, contribution margin based pricing, psychological pricing, dynamic pricing, price leadership, target pricing, absorption pricing, high-low pricing, premium decoy pricing, marginal cost pricing, value based pricing. For each and every pricing strategies has its own reasons and market reach.

At the end of the assignment, we can observe the various methodologies and techniques an organisation adopts in managing the finances using the pricing centric point of view.

The factors that influence how a consumer perceives a given price and how price-sensitive a consumer is likely to be with respect to different purchase decisions[1]

Reference Price Effect Buyer’s price sensitivity for a given product increases the higher the product’s price relative to perceived alternatives. Perceived alternatives can vary by buyer segment, by occasion, and other factors.

Difficult Comparison Effect Buyers are less sensitive to the price of a known / more reputable product when they have difficulty comparing it to potential alternatives.

Switching Costs Effect The higher the product-specific investment a buyer must make to switch suppliers, the less price sensitive that buyer is when choosing between alternatives.

Price-Quality Effect Buyers are less sensitive to price the more that higher prices signal higher quality. Products for which this effect is particularly relevant include: image products, exclusive products, and products with minimal cues for quality.

Expenditure Effect Buyers are more price sensitive when the expense accounts for a large percentage of buyers’ available income or budget.

End-Benefit Effect The effect refers to the relationship a given purchase has to a larger overall benefit, and is divided into two parts: Derived demand: The more sensitive buyers are to the price of the end benefit, the more sensitive they will be to the prices of those products that contribute to that benefit. Price proportion cost: The price proportion cost refers to the percent of the total cost of the end benefit accounted for by a given component that helps to produce the end benefit (e.g., think CPU and PCs). The smaller the given components share of the total cost of the end benefit, the less sensitive buyers will be to the component's price.

Shared-cost Effect The smaller the portion of the purchase price buyers must pay for themselves, the less price sensitive they will be.

Fairness Effect Buyers are more sensitive to the price of a product when the price is outside the range they perceive as “fair” or “reasonable” given the purchase context.

The Framing Effect Buyers are more price sensitive when they perceive the price as a loss rather than a forgone gain, and they have greater price sensitivity when the price is paid separately rather than as part of a bundle.

The Activity-based costing (ABC)

The Activity-based costing (ABC) is a type costing model that identifies activities in an organization which assigns the cost of each activity resource to all products and services according to the actual consumption by each. The main concept of this model is to assign more of the indirect costs into direct costs. Indirect costs are costs that are not directly accountable to a cost object, such as a particular function or product. Indirect costs may be either fixed or variable. Indirect costs include taxes, administration, personnel and security costs, and are also known as overhead, which is nothing but the cost incurred for operating any kind of business.

So in this costing model an organisation can precisely estimate the cost of individual products and services so they can identify and eliminate those that are unprofitable and lower the prices of those that are overpriced. In a business organization, the ABC methodology assigns an organization's resource costs through activities to the products and services provided to its customers. It is generally used as a tool for understanding product and customer cost and profitability. As such, ABC has predominantly been used to support strategic decisions such as pricing, outsourcing, identification and measurement of process improvement initiatives.

The different uses of the ABC model is as follows

It helps to identify inefficient products, departments and activities

It helps to allocate more resources on profitable products, departments and activities

It helps to control the costs at an individual level and on a departmental level

It helps to find unnecessary costs

It helps fixing the price of a product or service scientifically

Yes, the ABC model does has it's limitations. Even in activity-based costing, some overhead costs are difficult to assign to products and customers, such as the chief executive's salary. These costs are termed 'business sustaining' and are not assigned to products and customers because there is no meaningful method. This lump of unallocated overhead costs must nevertheless be met by contributions from each of the products, but it is not as large as the overhead costs before ABC is employed.

Although some may argue that costs untraceable to activities should be "arbitrarily allocated" to products, it is important to realize that the only purpose of ABC is to provide information to management. Therefore, there is no reason to assign any cost in an arbitrary manner.

Be able to apply forecasting techniques to obtain information for decision making

Apply forecasting techniques to make cost and revenue decisions in an organisation

Assess the sources of funds available to an organisation for a specific project

Be able to participate in the budgetary process of an organisation

Select appropriate budgetary targets for an organisation

Participate in the creation of a master budget for an organisation

Compare actual expenditure and income to the master budget of an organisation

Evaluate budgetary monitoring processes in an organisation

Be able to recommend cost reduction and management processes for an organisation

Recommend processes that could manage cost reduction in an organisation

Evaluate the potential for the use of activity-based costing

Be able to use financial appraisal techniques to make strategic investment decisions for an organisation

Apply financial appraisal methods to analyse competing investment projects in the public and private sector

Make an justified strategic investment decision for an organisation using relevant financial information

Report on the appropriateness of a strategic investment decision using information from a post-audit appraisal

Be able to interpret financial statements for planning and decision making

Analyse financial statements to assess the financial viability of an organisation

Apply financial ratios to improve the quality of financial information in an organisation's financial statements

Make recommendations on the strategic portfolio of an organisation based on its financial information


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