Session 9

1. Session 9 Pricing Policies and Practices & Capital Budgeting

2. PRICING • Pricing denotes revenue to seller • Perceived Value to buyer • Pricing strategy Important for new product, modified product, new market, new market segment, objective of firm • Basic determinants are supply and demand

3. PRICING PRACTICES General Considerations To Be Kept In Mind While Formulating A Pricing Policy: • Objectives of business- Notwithout considering its impact on all objectives • Market structure • Competitor’s strategy • Price Sensitivity/ elasticity(even for monopolist) • Conflicting Interests of Manufacturers and Middlemen, consumers

4. General Considerations • Routinisation of Pricing- Speed required in decision-making, quality of data available, competitive market • Role of Non Business Groups in pricing Decisions- Government, political considerations , farmers and business lobbies, Trade Unions etc

5. Types of Pricing • Cost Based Pricing • Based on Firm’s Objective • Competition Based Pricing • Product Life Cycle Pricing • Cyclical Pricing • MULTIPRODUCT PRICING • Administered Pricing

6. I. Cost Based Pricing • Cost Based Pricing • Cost Plus or Mark Up • Marginal Cost pricing • Target Return pricing

7. Cost Based Pricing i. Cost Plus / Full Cost/Average Cost/ Mark-up Pricing Price set to cover cost plus a percentage for predetermined profits. P= AC+ m where, m =mark-up percentage

8. Mark up depends on target rate of return, degree of competition, price elastiicty, substitutes etc • Most common • Simple to fix the price • More defensible on moral grounds

9. Cost Based Pricing Drawbacks: -Historical cost rather than current cost data is used, which may lead to over/under pricing -Inappropriate if variable cost fluctuates frequently -Some critics say it ignores demand side (But firm determines mark up on the basis of ‘what the market can bear’) • Ignores marginal cost as it uses average cost • Not suitable if competition is tough or when entering new market

10. Marginal Cost Pricing ii. Marginal Cost Pricing/ Incremental cot pricing: Price of product = Variable cost plus a profit margin. Only those costs which are directly attributable to the output of a specified product Here price will be lower than the full cost pricing. :WHY?

11. Marginal Cost Pricing • All past outlays are historical and a firm should deal solely with anticipated revenuesand outlays • Firm is more interested in future changes in cost due to changing decisions • Unlike fixed costs , MCs are controllable in the short run • Total costs can not be of use in case of multi- product/ markets/ process situations

12. Marginal Cost Pricing Useful to beat competition Also, to enter the market Used for pricing public utility where profit is not the motive Weaknesses: • Can only be a short term strategy (as it omits fixed costs) • Can be only restricted to pricing of specific orders

13. Cost Based Pricing Iii) Target Return Pricing • Producer rationally decides the minimum rate of return which must be earned by the product • Methodology similar to the above, but margin is decided on the basis of target rate of return, on the basis of experience, consumer’s paying capacity, risk involved etc

14. II. Based on Firm’s Objective • Pricing Based on Firm’s objective -Profit Maximisation- considers total cost -Sales Maximisation- should adopt competitive pricing, say marginal pricing

15. III. Competition Based Pricing i. Penetration Pricing : Low price when entering new market dominated by existing players (Nirma, Deccan Air) ii. Entry Deterring- Price kept low to make market unattractive for competitors (Common in oligopoly)

16. Competition Based Pricing iii. Going Rate Price: Why? Firms do not want price wars Small/ new firms may not be sure of the effect of charging a different price Products are close substitutes with high cross elasticity

17. Competition Based Pricing Popular in monopolistic and oligopoly markets because a) of low product differentiation and b) for consumer the cost of switching is minimal • Uniform price of packaged water or fruit juice

18. IV. PRICE DISCRIMINATION First degree Price Discrimination • Each unit of output • is sold at a different price • or each consumer is charged • a different price . • Entire consumer’s surplus wiped out Price Quantity

19. Second Degree Price Discrimination Seller gets part of consumer’s surplus. Highest price of OP1 for OQ1 units. Price is OP2 for Q1Q2 units Lowest price of OP3 for the next Q2Q3 units. Monopolist maximises revenue at TR= (OQ1*AQ1)+ (Q1Q2*BQ2)+ (Q2Q3*CQ3) D A P1 P2 B Price C P3 D O Q1 Q2 Q3 Demand

20. Third Degree Price Discrimination MC B Cost & Revenue A T AR=D Da Db MRa MR MRb o Qb O Q O Qa Quantity Demanded

21. Third Degree Price Discrimination • Monopolist has 2 markets, A and B. • For market A, Da is the average revenue (demand) curve and MRa is the marginal revenue curve. • For market B, Db is the average revenue (demand) curve and MRb is the marginal revenue curve. • Horizontal summation of the two markets give the aggregate AR=D and MR curves for the monopolist.

22. Third Degree Price Discrimination • Firm’s MC intersects MR curve at T. • Drawing a perpendicular from T we get the optimum level of the firm’s aggregate output at OQ. • At this level of output, MR=MC.

23. Third Degree Price Discrimination • OQ is divided between the two markets in such a way that the profit maximisation condition (i-e., MC (=TQ ) is equal to MR) is satisfied in both the markets. • This is achieved by drawing a line from point T parallel to X axis , through MRa and MRb. • Optimum share for market A is OQa (at price AQa) and for market B the share is OQb (at price BQb).

24. V. Product Life Cycle Pricing • Refers to different pricing strategies for a product depending on the different stages of its life cycle • Each phase is unique- different demand patterns and competition • So setting same price will mean less than optimum revenue

25. V. Product Life Cycle Pricing Sales revenue Curve 1.Introduction 2.Growth 3.Maturity 4.Saturation 5. Decline 5 2 3 4 1

26. Product Life Cycle Pricing • New Product: a)Skimming Policy : Charging very high initial price and super normal profits-Lower price during maturity • The first ball pens introduced in 1945 cost 80 cents to produce but were priced at $12.50. • Initial high prices of computers • 1st day movie tickets

27. Product Life Cycle Pricing Why? • Demand is likely to be less price-elastic in initial stages • If life ofproduct is likely to be short, the producer can get as much as possible as fast as possible • The policy can lead to introduction of product for lower segments later. • High initial price may finance the heavy initial costs of introducing a new product when other sources of finance may not be available

28. Product Life Cycle Pricing Benefits of lower cost due to growing volumes and technological development allows for lowering of prices at a later stage.

29. Product Life Cycle Pricing b) Low Penetration Price: Close to customary price- only minor adjustments required eventually. • Objective of low penetration pricing is to keep off competition Appropriate where: • Sales respond strongly to lower prices • High volumes lead to lower costs • Product acceptable for mass consumption • To capture a large share of market quickly where there is a threat ofpotential competition

30. Product Life Cycle Pricing High Skimming price Low penetration Price

31. Product Life Cycle Pricing ii) Rapid Growth- Stable price policyfor sustained growth iii) Maturity: Growth occurs at diminishing rate- firm may introduce minor quality changes with higher prices iv) Saturation- Lower prices and discounts to clear stocks v) Decline- Wind up

32. Product Life Cycle Pricing Product Bundling- Two or more products bundled together for a single price Strategy for both new and mature/ declining product Saves cost of spreading awareness Captures part of consumer surplus Regain customers during decline phase TOI and ET

33. Product Life Cycle Pricing Perceived Value pricing: Psychological pricing depending on consumer’s perception of utility- Tanishq jewelry, Parker pens etc-by creating a hype about high quality Value pricing- variant of iv. Try to create high value and charge a low price ie., price charged is lower than perceived value e.g., heavy discounts

34. Product Life Cycle Pricing Loss Leader Pricing: Here, multi product firms sell one product at a low price and compensate the loss by another product Charge lower price for a good that is durable and has a high value but high price for the complementary, low value consumable (HP printers and cartridges)

35. VI.CYCLICAL PRICING Rigid or flexible? • Rigid price means Firms selling a stable price irrespective of the business cycle phase (Flexible pricing is meaningless for eatables etc where demand does not change with cycles; dangerous in case of durables as consumers will wait for the next recession to buy durables)

36. VII. MULTIPRODUCT PRICING • Tata Sons produces steel as well as trucks and cars where steel is used as input • Demand Interdependence: A firm can produce goods which are substitutes(Zen and wagon R) or complements. • If substitutes, either price them the same(coke and Thums Up) or resort to perceived value pricing; or even, going price strategy • One firm’s output may be another’s input

37. MULTIPRODUCT PRICING Ramsay pricing • A firm should fix the price close to the marginal cost for product which has high elasticity and charge substantial margins for products which have low elasticity. Price deviations from marginal cost should be inversely proportional to the price elasticity of the product,

38. Transfer Pricing Transfer Prices are the charges made when a company supplies goods, services, or financial services to its subsidiary or sister concern. Globally, 60% of transactions are between associated companies. MNCs are required to set Transfer Prices for supply of goods, technical know-how, marketing rights etc from parent to subsidiary or one subsidiary to another.

39. Transfer Pricing Govts keep strict watch on this in order to check tax evasion as companies try to reduce tax incidence globally by transferring higher income to low tax jurisdiction and higher expenditure to high tax countries • In general regulatory authorities agree on “arms length price”- i.e., same price should be charged whether the transaction is between related or unrelated parties

40. VIII. Peak Load Pricing Peak Load Pricing • Higher price at peak level of use and lower at slack time Examples- Electricity, telephone charges, air fares

41. IX. Administered Price Administered Price Originally associated with monopoly - Now understood as Fixed by authorities - Specific social objectives- social justice, correcting imbalances, price stability -Conflict between ‘public utility approach’ and ‘rate of return’ approach

42. Guidelines for Price Fixing Bates and Parkinson’s Guidelines for Price Fixing: • Find out how your costscompare with your competitors’. • Keep an eye on the market-if orders are difficult to come by, drop prices; if easy, raise. • Goodwill of customers is probably gained more through advertising than keeping price low

43. If you can sell all your output at prices that give you substantial profit, consider expanding production. • If you find that your sales vary over seasons, adjust prices • If your prices seem to be higher than those of your competitors although they scarcely cover costs, you may need to take a re-look at your production methods and organisational process

44. If you are one of very few producers in the industry, what your competitors are likely to do may be a more important consideration in fixing prices rather than your costs. • If you are a monopolist and follow a pricing policy that is seen as being against public interest, beware of government action and potential competition…

46. Capital Budgeting Process of conceiving, analysing, evaluating, and selecting the most profitable project for investment. Significant because i) capital expenditure is generally irreversible ii) survival of firm depends on how well planned the capital expenditure is.

47. Prerequisites/Steps in Capital Budgeting • Defining Capital Expenditure Expenditure on acquiring assets which yield returns over a number of years -Only long term expenditure involving a commitment of at least one year is taken into consideration.

48. Defining Capital Expenditure Examples: • Expenditure on new capital equipment • Expenditure on long term assets by a new firm • Expenditure on expansion or diversification of assets and addition to stock by old firms • Expenditure on replacement of depreciated capital • Expenditure on R&D and innovation

49. Deciding the Project Period 2. Deciding the Project Period Determining the span of the project A clear vision is required for- • Effective planning, execution and control; • For possible dovetailing of old plan with the new • Assessment of economies of scale and determination of plant size • Timely arranging of finances

50. Appraisal Criteria 3. Choice of Decision Rules/ Appraisal Criteria -Criteria for accepting or rejecting a project The first step is to clearly define the objective of investment. Objective may be profit maximization, asset building, regular cash flow or maximization of short term or long term gains etc. Normally, criteria for accepting or rejecting is chosen on the basis of the objective of the firm. .