## Pricing Models

Category: Financial Control Management

The most popular and traditional pricing strategy in Moldova is price setting based on Total Cost. Since resources were spent on manufacturing, the producer considers that price should include incurred costs plus a standard profit margin. The traditional pricing approach consists of adding a standard fixed extra charge (e.g. +20% + 25%), determined in accordance with the desired profitability level, to costs corresponding to the planned level of output.

Setting a price by including a Profit Margin does not guarantee Profit at all. The main flaw of cost-plus pricing is the disregard for the relationship between price and sales volume. A given price does not guarantee sales volume.

The situation becomes dangerous if the price is limiting sales volume. In this case usually, company’s management increases the price to secure profit at the same level and if the market demand is elastic, rising price results in further reduction of the sales volume. At the same time, fixed costs are distributed over a smaller amount of products, and if the company it trying to retain a certain profitability level it looks like it is necessary to increase prices again.

As a conclusion, if a company implements this pricing strategy and is trying to achieve the desired output, planned costs and profitability, it can lead to wrong decisions. There are some other reasons that express the reduced adequacy or even the fact that this method of pricing is a wrong one, such as:

— When setting prices, the allocation of fixed costs per unit of product is a suspect one as the total unit cost calculated on this manner is correct only for particular output volumes. The only case it could be applicable is when the company is producing stable quantities over a long period of time. If there are changes in output the total cost will be different from the one calculated in advance;

— The process of fixed costs allocation per product is significantly influenced by the subjectivism of the entitled persons to perform the assignment as well as by the level of detailed information in respect of a particular fixed costs component. There are many possible ways of how to assign fixed costs to the specific range of products;

— The allocation methods in place can not ever be fully justified;

— Often the Total Unit Costs lead to misunderstandings or wrong interpretation of such information due to the deficiencies of splitting costs into fixed and variable, which again lead to wrong managerial decisions.

Market Oriented Pricing. Cost analysis allows the company to examine consequences of different pricing strategies. With these results, it is much easier to follow the aspects of pricing, which are related to demand elasticity, and the reaction of competitors. The concept of Price Elasticity of Demand is very important in demand analysis: it is percentage change of sales changes as result of a 1% price change. As a rule, price elasticity of demand is negative, which means that price increase results in demand decrease and vice versa. Information regarding the behavior of demand for different products might be gathered through marketing researches or summarization reports developed by specialized bodies.

Microeconomics offers a possibility to set prices which maximize revenues of the company in combination with marketing information. The starting point is the description of the Linear Demand Curve, an example of which is:

If one multiplies Price by Quantity the result is Revenue.

In order to know which price-volume relationship maximizes revenues, it needs to know how total revenue behaves when changing volume by a small amount. Using calculations, this change in revenues can be captured by a derivative of the revenue function. The derivative is called the Marginal Revenue.

The last equation is telling that the marginal revenue curve will have the same intercept with the Y axis as the demand curve, and will cross the X axis half way between the origin and the point where the demand curve meets the X axis. It follows that for the volume-price combination where MR = 0 (where the MR curve intercepts the X axis) revenue is maximized. As a conclusion, the Revenue-Maximizing Price lies in the middle point of the demand curve, and Profits are maximized at the point where marginal revenue equals marginal cost as.

When a company strives for a strong position on the market, price policy becomes a key factor in accomplishing the goal. Price is the tool to stimulate the demand. At the same time, pricing determines the long-term Profitability of a company. For the development of a pricing strategy, it is necessary to consider other profit-related goals such as, sales volume potential and marketing competition. Price determines overall profitability of a company as well as sales volume by implying sales volume at the level above the break-even point for which Cost-Volume-Profit relation is optimal. Price setting directly determines demand level, and consequently, Sales Volume for output with demand elastics. Incorrect pricing (too high or too low) may undermine the position of a given product on the market.

There is a category of businesses that are the only suppliers of a particular product on the market. They face no competition at least in for a visible time span in respect of the particular product or service. The advantage of such a business is the freedom in setting the price and at the same time it is its major danger, expressed by a spoiled image on the market.

These kinds of businesses have to find a balance between the assurance of a sufficient product profitability and simultaneously to not provoke the other companies offering the same «demanded» product through own production or imports.

Another important issue is price setting for the «cannibalized» products, which is the increasing of share of a particular product, implies the shrinkage of the share of other products that is the result of devoting the production capacities to more efficient units from the manufacturer point of view.

There is a practical methodology how to proceed in the establishment of prices for such businesses, which is based on the following steps:

1. Estimation of the satisfactory amount of Profit per annum, deriving from the ROI or from other profitability perspectives. For example the target Income is 3 000 000 MDL/year.

2. Knowing the Fixed Costs of the business, the target Contribution Margin, is calculated by adding up the Income and Fixed Costs. For example the target Contribution Margin is 5 500 000 MDL/year.

3. Deriving from the market research and other possibilities, the approximate product mix for the year is determined in terms of the share of each product in the total product mix.

4. The Productivity and the Contribution Margin per Unit for all products included in the product mix.

5. The Contribution Margin Statement produced, which comprises the following items:

a. Quantity of each product

b. The annual production capacity for each product

c. Unit price per products

d. Contribution margin per unit

e. Total contribution margin per product

6. The Capacity Utilization Ratio for the initial production program is calculated, and based on it, the Target Contribution Margin per 1% of Production Capacity Used.

In order to reach the target Contribution Margin, one must observe the level of production capacities utilization. If the capacity is already used in a high proportion, then the adjustment procedure for prices is required. The prices for those products that have the lowest Contribution Margin per 1% of Production Capacity Used must be increased until 1% of Production Capacity would result in at least 1% of Contribution Margin.

This procedure is followed until the target Contribution Margin (Profit) is reached. If the initial Contribution Margin is already higher than the targeted one, then some price reduction could be applied. The core issue in this context is the actual level of Production Capacity Utilization. It should be appropriately analyzed. The minimum PCU which is acceptable for price setting using this methodology is 75%. At the same time, higher than 95% capacity utilization is not advised. The normal range used for this purposes must fall within 75-90%. In any case, the use of existing output capacities are the second indicator taken into account in the pricing after the demand requirements.