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Pricing is defined as the process in which an organization or firm determines the exchange value in terms of monetary firms for its products and/or services (Bragg, 2007). Some of the factors that are associated with pricing include market place, market condition, manufacturing cost, and the quality of the product/service (Tracy & Tracy, 2008). Pricing is a taunting task for any account and manager since it involves numerous factors and elements (Coombs, Hobbs & Jenkins, 2005). Some of the reasons why pricing decision should be sound include maximisation on profits, gaining and maintaining the market share, championing organisational strategies, managing investment return and being customer-driven. Numerous pricing strategies exist but most of them are based on context and scenarios. For example, a marketer may utilise penetration and skimming pricing decision strategies while accountants may use gross-margin and cost plus in determining the price of their products. Thus, the aim of this paper is to analyse and discuss some pricing decisions for managers.
Types of Pricing Decisions
Gross margin also called gross profit margin is used by organisations to calculate the amount of revenues after subtraction of cost of selling products and manufacturing costs (Tracy & Tracy, 2008). The value can be obtained through taking the amount that an organisation has made within a specified period i.e. a year, and the finding the cost of the entire process especially manufacturing and selling within that period i.e. a year (Bragg, 2007). This value is then subtracted from the amount of money made, and thus the company or organisation has a rough estimate that indicates the amount the company within that period i.e. year. For example, an organisation that manufactures cars may take into consideration the cost of manufacturing cars plus the selling cost, then adding something small that generates the revenue to the organisation.
Numerous advantages and disadvantages exist for both the investors and company associated with calculating the gross margin. In the case of advantages, many investors aim at those organisations that had the highest gross margin (Coombs, Hobbs & Jenkins, 2005). Moreover, the organisation may utilise the ratio to determine the progression of the organisation while determining areas where it needs to be controlled (Young, 2003). For example, an organisation may determine that the cost of manufacturing certain product or service is higher that its worth and the organisation may either look for alternative way to produce the product or stop selling the production.
Nevertheless, some disadvantages are associated with gross profit ratios (Bragg, 2007). This is because some of products that are produced may not be variable since some analysts argue that the direct costs of materials should be included because it is the variable that changes in proportion to revenue (Hansen & Mowen, 2006). This generally means that if this approach (gross margin) is utilised, most of the costs are transferred to administrative and operational cost categories; if this approach is taken, it increase the gross margin and thus does not illustrate the real thing on the ground.
Return on Assets
Return on assets (ROA) is accounting ratio that is used to determine how profitable a company is relative to organisational total assets (Coombs, Hobbs & Jenkins, 2005). This means that the ratio tells an organisation how effective it is in maximising its asset base. Even though it is a standard measure, the number obtained varies depending on the industry involved since companies that requires initial huge investment may have lower return on assets (Hansen & Mowen, 2006). This value is commonly used to compare organisations within the same industry since the total assets of any organisation usually depends on the carrying value. This ratio is commonly utilised in banking institutions because the market value and carrying value are similar.
Some advantages associated with return on assets are that it is an internal management ratio since it is used to determine the amount of assets used to obtain certain profits (Bragg, 2007). Moreover, the return on assets can be used to determine whether to introduce a new system or expand on the way currently available (Tracy & Tracy, 2008). However, since the return on asset includes both the liabilities in case of assets, many investors do not see its benefit in determining the vehicle to invest in but this point is important for internal measure tool because it enables evaluating performance of sectors within the company (Coombs, Hobbs & Jenkins, 2005).
Transfer pricing is a pricing decision strategy that refers to analysis, setting, adjustment of charges and documentation made between related parties e.g. within the same organisation for use of property, product or even service (Bragg, 2007). For example, a department can transfer goods between departments with a cost plus profit basis, and the entire strategy can be based on variable cost, full cost or even standard cost (Hansen & Mowen, 2006). This type of pricing decision exists in large organisations since it encourages managers to make decisions that are goal-congruent, allows for evaluation of managerial effort continuously and managerial performance. Some of the reasons why transfer pricing is common include competition, profit for affiliates, market conditions, tax rates, custom duties and economic conditions to name some.
Transfer pricing is associated with numerous issues that either supports the idea or negates it. For example, incorrect prices may result in distortion of reported performance since some division may be made more profitable than others may (Coombs, Hobbs & Jenkins, 2005). Nevertheless, transfer-pricing offers an opportunity in an organisation may avoid taxes through shifting profits from high tax country to another country that has low taxes (Tracy & Tracy, 2008). Moreover, utilisation of artificial pricing can be used to control shareholders to profit rather than profiting the minority shareholders.
Full Cost Plus
The full cost plus pricing decision approach is a method that is used to determine the sale price through calculating the full cost of a service or product by adding a percentage value that is make-up for profit. The full cost plus can take two forms either being a fully absorbed production cost or including distribution overhead, selling overhead and absorbed administration cost (Bragg, 2007). This approach is commonly used in those situations that an organisation has an idea for profits to be made and hence may decide on an average profit mark-up as a guideline for pricing decisions. This pricing decision is appropriate in those contractual works or jobbing work of which prices are required to be quoted (Tracy & Tracy, 2008).
Full cost pricing is associated with numerous shortcomings that hinder their success (Weygandt, Kimmel, & Kieso, 2009). Some of these shortcomings include lack of recognition of demand as price determination, need for adjustment of prices to demand and market conditions, establishment of budgeted output volume, and a selection of overhead absorption. Nevertheless, some advantages include easiness in estimating the profits while ensuring the entire process reflects the production overheads, and reflecting them clearly on the price of the product or service (Coombs, Hobbs & Jenkins, 2005).
In accounting, the break even pricing strategy is a technique that is commonly used by management accountants and production management. This means that the entire process is based on both the variable and fixed costs into determining the operations of management. Specifically, this is a point where the revenue and expenses or cost are equal meaning that there is neither no profit nor loss. It also means that the opportunity costs have been paid and other factors such as risk adjustment have been factored into consideration. Break even pricing decision is commonly utilised by manufacturing organisation such as a furniture shop (Bragg, 2007). For example, if the furniture shop sells less than a hundred chairs each month, it will translate to a loss but if they sell a hundred and one chairs in a month or more they make profits. Thus, from this analysis, it is evident that the accountant and managers will be forced to make and sell more than a hundred chairs monthly.
Break-even analysis is an important decision tool for accountants and managers but it has both its strengths and weaknesses (Weygandt, Kimmel, & Kieso, 2009). Some advantages associated with this pricing decision approach are it is easier and cheap to carry out, and can determine easily the profits or losses at varying outputs, and it easily summarises the organisational business. Nevertheless, some disadvantages of this process include the assumption that everything that is produced within certain period is sold, and it assumes that all sales are sold at the same price.
Minimum pricing is commonly associated with government legislations that try to set the lowest monetary value that a product can cost but sometimes can be used by accountants to set the price of products that they offer. Numerous reasons exist for setting minimum prices, which include protection of producers, guarantee specific level of earnings, and to create surplus (Weygandt, Kimmel, & Kieso, 2009). In the case of minimum price, an organisation that deals with alcohols may decide to set the minimum price in which it will shield the organisation against any risks associated with government legislations and any other legal changes in the environment.
This pricing decision has both strengths and weaknesses that shape its success within accountant view in accounting for an organisation (Bragg, 2007). Some of the disadvantages, in case of government legislations, associated with minimum prices include encouragement of inefficient and oversupply, higher tariffs, and higher prices for consumers. On the other hand, the advantages include producers are shielded, and products are not misused since some products such as alcohol can be controlled.
Absorption pricing is an approach that accountants shares the fixed cost between all the products that the organisation sales (Coombs, Hobbs & Jenkins, 2005). This means that the variable and fixed costs of a product plus the mark-up for profits are all included in the price. For example, an organisation such as a bank may include charges to some of its products and services ensuring that profitability are achieved.
Absorption pricing decision has numerous advantages and disadvantages. Some of the advantages include products and services are not undervalued, factors into consideration fixed costs, utilised commonly in preparation of financial accounts, and less fluctuation is evidenced especially in calculation of net profit when sales fluctuation is common. Nevertheless, some disadvantages include unreliability of the approach in decision making process, control, and planning, and the cost volume relationship is usually assumed because of emphasis on total cost.
Variable comes from the English term, vary, and in that something changes based on certain condition. Variable costing incorporates material, cost of labour, and overhead that fluctuates in volume of units that are produced (Bragg, 2007). Variable cost pays an important role in determining the total cost of production. For example, in production of chairs, the building rent will be the fixed cost while timber, nails, and labour will be variable costs (Hansen & Mowen, 2006).
Some advantages associated with variable costing includes data can be retrieved directly and can be used for cost volume profit analysis, profits cannot be affected by fluctuations in inventories, profits are championed, factors into consideration cost control method, and the pricing strategy can easily be used for cash flow. Some disadvantages of this approach includes many accountants are used to functional income statement, over-emphasis and broader significance may lead to improper decisions, and difficulty in separation of cost behaviours (Coombs, Hobbs & Jenkins, 2005).
Accountants have to face numerous challenges especially in determining the price of a product or service. Many pricing decision strategies are available but each of these strategies applies to different circumstances. Some of the pricing decisions that can be used by accountants include gross-margin, return on assets, transfer pricing, full cost plus, break even, minimum pricing, absorption pricing, and variable pricing. These decisions common with different benefits that can be championed by accountants into ensuring profitability and ensuring the organisation that they manage is successful.