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Pricing is a significant element for the organizations in accomplishing the goal of maximization. A good pricing decision helps the organizations to become the long-run survivals of businesses as ability of gaining incremental or marginal revenues from sales is possessed by such organizations. This is because pricing of a product is the impression that attracts consumers to make buying decisions. Over-charging or under-pricing a product will lead to adverse impact on consumers' perception and eventually decrease in sales. The right price also reflects the ability of the product to maintain higher status among its substitutes because comparison is made by consumers. Essentially, the price derives from consumers' expectation is considered as reasonable when it exceeds the organizations' costs to deliver the particular products. Therefore, a mutually beneficial exchange exists where prices are set between consumers' willingness to pay and the organizations' costs.
Pricing Decisions and Approaches
Basically, there are two types of pricing decisions, namely, internal and external pricing. Internal pricing is where all of the information relating to prices used for internal transfers and is used to set prices for transfers among an organization's divisions, for instance, negotiated pricing and transfer pricing. While the application of external pricing takes place where prices are set externally, for example, based on the overall market and supply forces, i.e. market-based pricing (Crosson & Needles, 2011).
According to different situations, different pricing approaches will be appropriated and adopted by the organizations. Accounting information is often an important input to pricing decisions. The pricing decision of the organizations is never a stand-alone issue yet must be considered with a combination of other factors such as marketing strategies, organizational goals, costs of the product etc. For instance, costs are interrelated to pricing as there is a need for pricing to cover not only the costs but also to earn a profit margin. Based on different circumstances, pricing approaches are mainly categorized into market-based pricing, cost-plus pricing and negotiated pricing. Thus, it is undeniable that pricing is a device of maximizing profits that cannot be ignored because the capabilities of management to make and inform pricing decisions as well as the abilities of selecting pricing approaches used will have serious consequences on organizations' profitability.
From the macroeconomic view, price plays a role of facilitator to direct the overall economic system as the organizations attempt to set the price at a level where profits are maximized (Drury, 2004). Price is directly influenced by the different kinds of competition and product offered in the market.
Market-based pricing can be defined as an approach that evaluates prices of similar products that are being offer and on the market. Apart from this, it deals with the three key issues that influence the pricing decisions, to wit, customers, competitors and costs. In terms of customer perspective, organizations attempt to satisfy the customers' need and the price that they are willing to pay. For the competitor perspective, competitors' reactions affect the pricing decisions and this is why organizations endeavor to identify rival's actions that are taken to challenge the strategies which the organizations are taking. For example, a rival's prices and products may force a business to lower its prices to be competitive. While in the cost perspective, organizations strive to charge the reasonable price for the purpose of matching the customers' price sensitivities.
It is logical where the market-based pricing approach is used in a highly competitive market. This is because goods produced and services provided by the organizations are similar to other producing companies and those products and services can be substituted for another due to the problem of there are homogeneous products and services. Hence, such condition causes the organizations have no influence over the prices to charge and therefore fulfills the formulated definition. However, in the market with monopolistic or imperfect competition, organizations have some discretion over prices. This is because most of the goods produced and services provided are differentiated from one another because products are not perfect substitutes. As a result, market-based pricing model cannot be used in such industry because of the differentiated goods which lead to the market-based pricing approach becomes illogical (Bhimani, Horngren, Datar & Foster, 2008).
Basically, market based pricing has its own advantages because it is based on the demand of market that is able to reflect the willingness of individual to pay cost for the use of benefits of a product. Thus, price of the market are normally easy to be obtained especially for established market and these data can be used as observation for consumer consumption patterns. However, the market based pricing method is not flexible in a sense that it is difficult to manipulate prices even when the particular product is making a loss and market price must still be used. Due to market imperfection or policy failures, market price may not reflect the true value of products while seasonal variations and other factors must not be neglected.
Smith & Hilton (2009) stated that cost-plus pricing is considered as an approach that price is charged based on the different measures of cost and adding a mark-up to the cost. Generally, such pricing approach assists the organizations to set the selling price according to the purpose at hand rather than based on a reaction to demand fluctuations (Lavoie, 2005). This is because different cost bases such as marginal or full cost based can be used for cost-plus pricing model. In addition, different percentage profit margins are also allowed and added depending on the cost based that is used.
In fact, cost-plus pricing approach is widely used by organizations nowadays as the formula provides a fairly simple base for setting price. Furthermore, organizations are able to gain the most important advantage, that is, price cannot be charged below the cost of a good or service, by implementing the cost-plus pricing model (Smith & Hilton, 2009). For instance, a product's price should usually cover its cost in the long-term even though a product may be given away at a price below cost during the initially launching activity (Arnold & Turley, 2006). Basically, two major elements, relevant costs and profits, are concerned by the organizations where the cost-plus pricing system is adopted. It is noted that there is a need to determine the size of the unit whose products are to be cost and priced in order to derive the relevant cost of production. Moreover, the size of the mark-up depends on the target rate of return on invested capital or the desired operating return on investment (ROI) for the product or service (2). The determination of normal capacity is necessary taken into consideration for the aim of framing a price policy (1). The cost-based pricing formula is expressed as follow:
Price = Cost + (Mark-up Percentage Ã- Cost)
Marginal (Variable) Cost Based Pricing
Under cost plus-pricing method, variable cost based pricing refers to the pricing formulas that are based on either variable manufacturing costs or total variable costs (Smith & Hilton, 2009). It is an application of cost-volume-profit (CVP) analysis to pricing decisions or is a contribution method of pricing. By adopting marginal cost based pricing, organizations are able to maximize contribution towards fixed cost and profit.
Advantages and Disadvantages of Marginal (Variable) Cost Based Pricing
Three primary advantages are attributed to the marginal cost based pricing approach. Firstly, variable cost data do not obscure the cost behaviour pattern by unitizing fixed costs and making them appear variable. Thus, variable cost information is consistent with CVP analysis, which may be used by managers to assess the profit implications of changes in price and volume. Secondly, variable cost data do not require allocation of fixed costs to individual product lines. For example, the annual salary of a company's manufacturing director is a cost that must be borne by all of the company's product lines. Arbitrarily allocating a portion of the salary of such company's manufacturing director to the individual product is not meaningful. Thirdly, variable cost data are exactly the type of information managers need when facing certain tactical short-term pricing decisions, for instance, whether to accept a special order. This is because the decision on a special order often requires an analysis that separates fixed and variable costs in order to determine the incremental costs of the special order. Where there is spare capacity, the price of the special order may be set just above the variable cost of producing the order.
On the other hand, marginal cost based pricing approach is able to remove the effect of inventory changes on profit in terms of timing and disclosure. This is because the exclusion of fixed costs in such pricing model would reduce the distortion in profit for short-term or long-term as it disregards the fluctuations of stock levels that will significantly affect the amount of fixed overheads. In relation to disclosure, managers with performance measured by profit tend to manipulate inventory levels to reduce fixed costs and present better profit outcomes. Hence, marginal cost based pricing method avoids this situation because inventory changes effect on profit is removed and through internal reporting will be disclosed without manipulation of managers. Besides, fixed overheads can be avoided to be capitalized in unsaleable stocks if variable costing approach is used. This is because the variable costs are excluded in such pricing model. As a result, fixed costs will not be deferred to later accounting periods and profit calculations for the current period will not be misleading if the surplus stocks exist.
In terms of its disadvantage, that is, prices must be set to cover all costs and a normal profit margin in the long-term. If managers perceive the variable cost of a product to be the floor for the price, they may tend to set the price too low for the firm to cover its fixed costs. Ultimately, such a practice could result in the failure of the business. If variable cost data are used as the basis for cost-plus pricing, managers must understand the need for higher mark-ups in order to ensure that all costs are covered.
Absorption (Full) Cost Based Pricing
Full cost based pricing approach uses either absorption manufacturing cost, or product cost that includes product-related upstream and downstream costs, as the basis for pricing products or services. In other words, it uses conventional cost accounting principles to establish the total cost for a product to which is added a mark-up to arrive at a selling price.
Advantages and Disadvantages of Absorption (Full) Cost Based Pricing
Basically, absorption cost based pricing formula provides a justifiable price that tends to be perceived as equitable to all parties. Consumers generally understand a company must make a profit on its product to remain in business. Basing a price on the total cost of production and other product-related costs that occur outside production, plus a reasonable profit margin, seems fair to many customers. Apart from this, absorption cost information is usually provided by a firm's costing system because it is required for external financial reporting under accounting standards. Since absorption cost information already exists, it is cost-effective to use it for pricing. The alternative would involve preparing special product cost data specifically for the pricing decision. In a firm with hundreds of products, such data could be expensive to produce.
Nevertheless, the primary disadvantage of absorption cost based pricing is that the cost behaviour pattern of the firm is obscured. Since allocated fixed costs are included, it is not clear from these data how the firm's total costs will change as production and sales volumes change. In addition, absorption cost data are not consistent with CVP analysis. CVP analysis emphasizes the distinction between fixed and variable costs. Therefore, it enables managers to predict the effects of changes in prices and sales volume on profit. Absorption cost information obscures the distinction between variable and fixed costs. Furthermore, absorption costing will not ensure that fixed costs will be recovered if actual sales volume is less than the estimate used to calculate the fixed overhead rate. Thus, it is obvious that it does not understate the importance of fixed costs. Moreover, absorption costing avoids fictitious losses being reported. This is because fixed overheads will be deferred and included in the closing inventory valuation, and will be recorded as an expense only in the periods when the goods are sold. Losses are therefore unlikely to be reported in the periods when stocks are being built up. By adopting absorption costing system, internal profit reporting system is consistent with the external financial accounting system and thus it will be congruent with the measures used by financial markets to appraise overall company performance.