The question of pricing strategy is one of the most important in any business. Prices in one hand defining a competitive market position, and on the other hand – they determine the level of profits. Feature of the market economy is that prices for any product formed on the basis of supply and demand, and the particular company may not always act on them.
This post is about how to effectively form a competitive price of goods on the basis of cost estimates and taking into account the situation at the market.
Let’s start with a definition.
Price is the monetary valuation of the goods.
In my previous article about revenue planning I mentioned that one of the main types of revenue is operating revenue from selling goods, services or works. I wrote that at the operating revenue level affects the production capacity, the percentage of sales and prices.
Production capacity is a constant, it depends on the capabilities of equipment and human resources. Therefore, to adjust the operating income of the company management can affect the percentage of sales of goods and their prices.
Here you can specify such an interesting relationship: increase in prices reduces the percentage of sales of products and vice versa – a decline in the price level increases the percentage of sales.
This dependence is due to the influence of competition and supply and demand. At higher prices demand decreases at lower prices – demand grows.
The main of management task is to identify the conditions under which the company will receive the maximum possible percentage of sales and the best possible prices.
To do this we must first determine the total cost of production or cost of services.
The structure of total costs of production include direct and indirect costs.
Direct costs can be directly associated with the production of products. Direct costs include the following costs:
- Material costs. Material costs – the costs of raw materials.
- Labor costs. Total costs for employees engaged in the manufacture of products.
- Social taxes, which are charged on the salary of employees.
- Depreciation of equipment.
- Other direct costs. They include the costs of repairs, spare parts, electricity, fuel and municipal services.
Indirect costs are the costs that are not directly related to the production of products.
Indirect costs include the following costs:
- The cost of maintenance of management.
- The cost of banking (cash management services, interest on loans or other financial services).
- Legal and other services from other companies.
- The cost of marketing and product sales.
- Other indirect costs.
Planned direct costs may be based on standard expenses of raw materials, the number of employees and their average salaries, depreciation rates and social taxes and fees rates.
Planned indirect costs can be determined by using the average percentage of indirect costs.
Average planned percentage of indirect costs is defined as the ratio of the average actual amount of indirect costs for prior periods to the average amount of actual direct costs for these periods.
The actual direct and indirect costs are determined on the basis of accounting.
So the planned production costs can be determined using the following formulas:
- Average planned percentage of indirect costs (PIC)
PIC = AaIC / AaDC x 100%AaIC – Average actual indirect costs sumAaDC – Average actual direct cost sum
- Planned direct cost (PDC)PDC = SErm x PPQ + NE x AWE + ST + RV x DR + ODCSErm – standard expenses of raw materials per production unitPPQ – planned production quantity
NE – number of employees
AWE – average wage of employees
ST – social taxes, which are calculated based on the wages of workers
RV – residual value of production facilities and equipment’s
DR – depreciation rate
ODC – other direct costs
- Planned indirect cost (PIDC)PIDC = PDC x PIC
Total planned production costs (TPC)
TPC = PDC + PIDC
Planned production unit cost (PPUC)
PPUC = TPC / PPQ
After determining of planned cost we can determine the price of goods.
The composition of the price of goods includes planned production unit cost, expected rate of profit and indirect taxes (if any).
Expected rate of profit is calculated as a percentage of the total cost of the products.
Indirect taxes are determined as a prescribed percentage of the total amount of cost and profit.
So price can be determined by the formula:
Price of product (PP)
PP = PPUC + EPR + IT
EPR – expected rate of profit
IT – indirect taxes
To ensure profitable company product price must not be lower than the sum of the total costs and indirect taxes.
We conclude that marketing pricing strategy should be based on economic calculations of prices.
Manager can adjust prices only by regulation of the rate of profit.
That is, if a company wants to raise the price of products – it can increase rate of profit, if the company wants to reduce the price of the product – it should reduce the profitability down to 0%.
If the price drops to a level that will return less than 0, the company will receive damages.
Negative profitability may be allowed only when a company seeks to capture the market by dumping prices, but in this case, the company must have other sources to compensate its losses.
Also, good manager must consider that lower prices may stimulate demand and increase the percentage of sales, and therefore the amount of profit.
For example, if company will sell 10 units of goods at a price of $ 1,000 (PPUC – 790.51 dollars, EPR- 10%, IT -15%), it will get the same profit as it will sell 20 units of goods at a price of 954.54 dollars. (PPUC – 790.51 dollars, EPR – 5%, IT – 15%).
It is possible because with lower prices demand for the company’s products may be greater and the percentage of sales will increase.
Marketing department must determine which strategy is more attractive for the company: to keep higher prices and receive the planned amount of profit at a lower level of sales, or reduce the price and increase the level of sales.