MODULE 1: COSTING AND PRICING

INTRODUCTION

Setting a price for goods and services has always been difficult for new ventures in South Africa. Pricing is a critical marketing decision. The price you set for your goods and services is a key determinant in the final profit (or loss) that your business will make. Even though it is so obviously vital, there is evidence to suggest that the attention paid to pricing among some new ventures is scant. Problems that develop because of inattention to pricing, range from poor margins on products sold, through to losses on specific products/services due to cost inflation and failure to re-price. At worst it could mean the difference between making a profit or a loss It must be noted that, there are no firm rules; no ideal method for setting a price, but there are many indicators that can help entrepreneur when deciding on the price. It is a matter of discovering a reasonable price by careful consideration.

TRADING CYCLE

Every business follows a cycle from the point that it procures raw materials until it sales goods and services to the customers. This process is called the trading cycle. For a new venture to be able to cost and price its products, it must know this cycle. The diagram below shows a basic trading cycle for a business;

1. Procurement: It is the stage at which the business buys raw materials from suppliers. For example, raw materials
   to a company that manufactures furniture can be nails, wood, and boards. The procurement stage also covers the
   transportation of the raw material to the business.
2. Production: is that stage where the raw materials are converted into finished goods. Using the carpentry business
   as an example, this stage where products like chairs, tables, beds are produced.
3. Marketing: this is the stage where the business is informing and persuading the market to buy its products.
   Marketing includes advertising, and promotions.
4. Selling: This is the point where the business interacts with the buyer. That is, the business will exchange the
   finished goods or services for money.
5. After-sale support: This is the stage where the business provides technical assistance to customers who have
   bought goods and services.

THE CONCEPT OF COSTING

Costing is the process of determining and accumulating the cost of product or activity. It is a process of accounting for the incurrence and the control of cost. It also covers classification, analysis, and interpretation of cost. In essence, costing involves the classifying, recording and appropriate allocation of expenditure for the determination of costs of products or services; the relation of these costs to sales value; and the ascertainment of profitability.

OBJECTIVES OF COSTING
Costing has the following main objectives to serve:
– Determining selling price,
– Controlling cost
– Providing information for decision-making
– Ascertaining costing profit
– Facilitating preparation of financial and other statements.

Determining selling price
The objective of determining the cost of products is of main importance in costing. The total product cost and cost
per unit of product are important in deciding selling price of a product. Costing thus provides information regarding
the cost to make and sell product or services. Other factors such as the quality of product, the condition of the
market, the area of distribution, the quantity which can be supplied etc., are also to be given consideration by the
management before deciding the selling price, but the cost of product plays a major role.

Controlling cost
Costing helps in attaining aim of controlling cost by using various techniques such as Budgetary Control, Standard
costing, and inventory control.

Providing information for decision-making
Costing helps the management in providing information for managerial decisions for formulating operative policies.
These policies relate to the following matters:
– Determination of cost-volume-profit relationship.
– Make or buy a component
– Shut down or continue operation at a loss
– Continuing with the existing machinery or replacing them by improved and economical machines.

Ascertaining costing profit
Costing helps in ascertaining the costing profit or loss of any activity on an objective basis by matching cost with the
revenue of the activity.

Facilitating preparation of financial and other statements
Costing provides immediate information regarding stock of raw material, semi-finished and finished goods. This
helps in preparation of financial statements

CLASSIFICATION OF COSTS
At this point it is important to differentiate between fixed and variable costs;

FIXED COSTS
Fixed costs are those business costs that are not directly related to the level of production or output. In other words, even if the business has a zero output or high output, the level of fixed costs will remain broadly the same. In the long term fixed costs can alter – perhaps as a result of investment in production capacity
(e.g. adding a new factory unit) or through the growth in overheads required to support a larger, more complex business. Examples of fixed costs: Rent and rates, Depreciation, Research and development and Administration costs.

VARIABLE COSTS

Variable costs are those costs which vary directly with the level of output. They represent payment output-related inputs such as raw materials, direct labour, fuel and revenue-related costs such as commission. A distinction is often made between “Direct” variable costs and “Indirect” variable costs.

Direct variable costs are those which can be directly attributable to the production of a particular product or service and allocated to a particular cost centre. Raw materials and the wages those working on the production line are good examples.

Indirect variable costs cannot be directly attributable to production but they do vary with output. These include depreciation (where it is calculated related to output – e.g. machine hours), maintenance and certain labour costs.

TOTAL COSTS

If we combine variable and fixed costs, we get the total cost. That is, total cost (TC) describes the total cost of production and is made up of variable costs, which vary according to the quantity of a good produced and include inputs such as labour and raw materials, plus fixed costs, which are independent of the quantity of a good produced and include inputs that cannot be varied in the short term, such as buildings and machinery. The total cost of producing a specific level of output is the cost of all the factors of input used.

THE CONCEPT OF PRICING

All organisations always want to make sure that their products and services are priced appropriately. Prices should be consistent with the business strategy and also linked to the cost of producing the product or service.

Pricing is the process of determining what a business will receive in exchange for its products. Pricing is based on factors like total cost, market place, competition, market condition, and quality of product. Pricing is a fundamental aspect of the four Ps of the marketing mix. The other three aspects are product, promotion, and place. Price is the only revenue generating element amongst the four Ps, the rest being cost centers.

OBJECTIVES OF PRICING

The following are some of the common pricing objectives.

Partial cost recovery

A company that has sources of income other than from the sale of products may decide to implement this pricing objective, which has the benefit of providing customers with a quality product at a cost lower than expected.

Competitors without other revenue streams to offset lower prices will likely not appreciate using this objective for products in direct competition with one another. Therefore, this pricing objective is best reserved for special situations or products.

Profit margin maximisation

Seeks to maximise the per-unit profit margin of a product. This objective is typically applied when the total number of units sold is expected to be low.

Profit maximisation

Seeks to garner the greatest dollar amount in profits. This objective is not necessarily tied to the objective of profit margin maximisation.

Revenue maximisation

Seeks to maximise revenue from the sale of products without regard to profit. This objective can be useful when introducing a new product into the market with the goals of growing market share and establishing long-term customer base.

Quality Leadership

Used to signal product quality to the consumer by placing prices on products that convey their quality.

Quantity Maximisation

Seeks to maximise the number of items sold. This objective may be chosen if you have an underlying goal of taking advantage of economies of scale that may be realised in the production or sales arenas.

Status Quo

Seeks to keep your product prices in line with the same or similar products offered by your competitors to avoid starting a price war or to maintain a stable level of profit generated from a particular product.

Survival

Put into place in situations where a business needs to price at a level that will just allow it to stay in business and cover essential costs. For a short time, the goal of making a profit is set aside for the goal of survival. Survival pricing is meant only to be used on a short-term or temporary basis. Once the situation that initiated the survival pricing has passed, product prices are returned to previous or more appropriate levels.

TYPES OF PRICING
The following are the 6 main types of pricing.

1. Profit mark-up pricing
   Set the price at your production cost, including both cost of goods and fixed costs at your current volume, plus a
   certain profit margin.
   For example:
   You are a manufacturer of candles; the cost of raw materials and production costs is R20, fixed costs come to R30
   per unit. Your total cost is R50 per unit.
   You decide that you want to operate at a 20% mark up, so you add R10 (20% x R50) to the cost and come up with
   a price of R60 per unit.
   NOTE: So long as you have your costs calculated correctly and have accurately predicted your sales volume, you
   will always be operating at a profit.

2. Target return pricing
   Set your price to achieve a target return-on-investment (ROI).
   For example:
   We assume that you have R10, 000 invested in the company. Your expected sales volume is 1,000 units in the first
   year.
   You want to recoup all your investment in the first year, so you need to make R10, 000 profit on 1,000 units, or
   R10 profit per unit, giving you again a price of R60 per unit.

3. Value-based pricing
   Price your product based on the value it creates for the customer. This is usually the most profitable form of
   pricing, if you can achieve it. The most extreme variation on this is “pay for performance” pricing for services, in
   which you charge on a variable scale according to the results you achieve
   For example:
   Let’s say that your candles save the typical customer R1, 000 a year in, say, energy costs. In that case, R60 seems
   like a bargain – maybe even too cheap.
   If your product reliably produced that kind of cost savings, you could easily charge R200, R300 or more for it, and
   customers would gladly pay it, since they would get their money back in a matter of months.

4. Psychological pricing
   Ultimately, you must take into consideration the consumer’s perception of your price, figuring things like:
   a. Positioning
   If you want to be the “low-cost leader”, you must be priced lower than your competition. If you want to signal
   high quality, you should probably be priced higher than most of your competition.
   b. Popular price points
   There are certain “price points” (specific prices) at which people become much more willing to buy a certain
   type of product.
   For example;
   Under R100″ is a popular price point. “Enough under R20 to be under R20 with sales tax” is another popular
   price point, because it’s “one bill” that people commonly carry.
   Meals under R50 are still a popular price point, as are entree or snack items under R1 (notice how many fast food places have a R0.99 “value menu”).
   Dropping your price to a popular price point might mean a lower margin, but more than enough increase in
   sales to offset it.

5. Fair pricing
   Sometimes it simply doesn’t matter what the value of the product is, even if you don’t have any direct
   competition. There is simply a limit to what consumers perceive as “fair”. If it’s obvious that your product only
   cost R20 to manufacture, even if it delivered R10,000 in value, you’d have a hard time charging two or three
   thousand Rands for it — people would just feel like they were being gouged. A little market testing will help you
   determine the maximum price consumers will perceive as fair. Now, how do you combine all of these calculations
   to come up with a price?

6. Marginal cost pricing
   Marginal cost pricing is the practice of setting the price of a product at or slightly above the variable to produce it.
   This situation usually arises in one of two circumstances:
   – A company has a small amount of remaining unused production capacity available that it wishes to use;
   or
   – A company is unable to sell at a higher price
   The first scenario is one in which a company is more likely to be financially healthy – it simply wishes to maximise
   its profitability with a few more unit sales. The second scenario is one of desperation, where a company can
   achieve sales by no other means. In either case, the sales are intended to be on an incremental basis; they are not
   intended to be a long-term pricing strategy.
   The variable cost of a product is usually only the direct materials required to build it. Direct labour is rarely
   completely variable, since a minimum number of people are required to crew a production line, irrespective of
   the number of units produced.
   For example:
   ABC International has designed a product that contains R5.00 of variable expenses and R3.50 of
   allocated expenses. ABC has sold all possible units at its normal price point of R10.00, and still has residual
   production capacity available. A customer offers to buy 6,000 units at the company’s best price. To obtain the
   sale, the sales manager sets the price of R6.00, which will generate an incremental profit of R1.00 on each unit
   sold, or R6,000 in total. The sales manager ignores the allocated overhead of R3.50 per unit, since it is not a
   variable cost.

PRICING STRATEGIES

After selecting a pricing objective, an entrepreneur needs to determine a pricing strategy. This will assist you when it comes time to actually price your products. As with the pricing objectives, numerous pricing strategies are available from which to choose. Certain strategies work well with certain objectives, so make sure you have taken your time selecting an objective.

1. Competitive Pricing
   This entails pricing your product(s) based on the prices your competitors have on the same product(s). This pricing strategy can be useful when differentiating your product from other products is difficult. So, let’s say you produce fruit jams such as blueberry, strawberry, blackberry, and raspberry. You may consider using competitive pricing since there are many other jams on the market and you are unable to differentiate your jams to an extent that customers may be willing to pay more for yours. Thus, if the price range for jams currently on the market is R14.50 to R18.50 per jar, you may price your jams at R16.50 per jar to fall in line with the competition.
   The strategy of competitive pricing can be used when the pricing objective is either survival or status quo. When the objective for pricing products is to allow the business to either maintain status quo or simply survive a difficult period, competitive pricing will allow the business to maintain profit by avoiding price wars (from pricing below the competition) or falling sales (from pricing above the competition).

2. Good, Better, Best Pricing
   It charges more for products that have received more attention (for example, in packaging or sorting). The same product is offered in three different formats, with the price for each level rising above that of the previous level. For example, the manager of a farm market that sells fresh apples may place some portion of apples available for sale in a large container through which the customers have to sort to choose the apples they wish to purchase. These apples would be priced at the “good” price. Another portion of apples could also be placed in a container from which customers can gather, but these apples would have been pre-sorted to remove less desirable apples, such as those with soft spots. These would be priced at the “better” price. The “best” apples those priced higher than the rest may have been pre-sorted, just as the “better” apples, but have also been pre-packaged for customer convenience. As demonstrated in this example, the “better” and “best” levels require more attention by management or labour but, if priced appropriately, may be worth the extra effort. This pricing strategy should be used when pursuing revenue maximisation and quantity maximisation objectives. Revenue maximisation should occur as a result of quantity maximisation. Quantity maximisation should occur from the use of this pricing strategy because product is available to customers in three prices ranges.

3. Loss Leader
   Loss leader refers to products having low prices placed on them in an attempt to lure customers to the business and to make further purchases. For example, grocery stores might use bread as a loss leader product. It you come to their store to purchase your bread, you are very likely to purchase other grocery items at their store rather than going to another store. The goal of using a loss leader pricing strategy is to lure customers to your business with a low price on one product with the expectation that the customer will purchase other products with larger profit margins. The loss leader pricing strategy should be paired with either the quantity maximisation or partial cost recovery pricing objectives. The low price placed on the product should result in greater quantities of the product being sold while still recovering a portion of the production cost.

4. Multiple Pricing
   This strategy seeks to get customers to purchase a product in greater quantities by offering a slight discount on the greater quantity. In the display of prices, a price for the purchase of just one item is displayed along with the price for a larger quantity. For example, a farm market may price one melon at R16.90 and two at R30.00. Pricing in this way offers the customer an apparent discount (in this example R0.38) for purchasing the greater quantity. Customers feel like they’re getting a discount since R15 (R30.00 ÷ 2) is less than the R16.90 price for one melon. However, R15 is the price you would typically charge if you were not employing a multiple pricing strategy. If you think the majority of your customers will purchase the greater quantity, you will want to price the quantity so that
   your costs are covered, and your profit margin is maintained. A customer purchasing just one item will pay more for the item than what you would typically charge if you were not using a multiple pricing strategy. The multiple pricing strategies works well with the profit maximisation and quantity maximisation objectives. By
   enticing your customer to purchase more than one item you are generating more profit since you have set the price for just one item so that you receive a greater profit margin than for which you would typically price. Essentially, the customer is being penalised for purchasing just one item. In addition, multiple pricing should increase the quantity of items being sold, hopefully resulting in less product loss or fewer unsold items.

5. Optional Product Pricing
   It is used to attempt to get customers to spend a little extra on the product by purchasing options or extra features. For example, some customers may be willing to spend a little extra to be assured that they receive product as soon as it becomes available. This can be an excellent strategy for custom operators. Optional product pricing is best used when the pricing objective is revenue maximisation or quality leadership. By enticing customers to purchase one or more of the options offered to them, you will be increasing your revenue since the customers may not have purchased the option if it were not offered or may have gone elsewhere to
   purchase it. By offering optional products to complement your base product or service, you are projecting an image of quality to your customers. They will likely recognise your offer of additional products or services as awareness of and sensitivity to their needs.

6. Penetration pricing
   This strategy is used to gain entry into a new market. The objective for employing penetration pricing is to attract and grow market share. Once desired levels for these objectives are reached, product prices are typically increased. Penetration prices will not garner the profit that you may want; therefore, this pricing strategy must be used strategically.
   The strategy of penetration pricing can be used when your pricing objective is either revenue or quantity maximisation. The lower price set on products by using penetration pricing is done to entice the maximum number of customers possible to purchase your product. Large numbers of customers purchasing your product should maximise your revenue and the quantity of product sold. If the price were higher, you would expect fewer purchases, thus leading to lower revenues.

7. Premium Pricing
   This strategy is employed when the product you are selling is unique and of very high quality, but you only expect to sell a small amount. These attributes demand that a high, or premium, price be attached to the product. Buyers of such products typically view them as luxuries and have little or no price sensitivity. The advantage of this pricing strategy is that you can price high to recoup a large profit to make up for the small number of items being sold.
   Premium pricing can be employed with the profit margin maximisation or quality leadership pricing objectives. The premium price charged for the uniqueness and quality of your product allows you to generate large profit margins on each item sold. Your product will also demonstrate your commitment to quality, and customers will think of you when they desire such quality.

8. Product Bundle Pricing
   This strategy can be used to group several items together for sale. This is a useful pricing strategy for complementary, overstock, or older products. Customers purchase the product they really want, but for a little extra they also receive one or more additional items. The advantage of this pricing strategy is the ability to get rid of overstock items.
   Product bundle pricing can be employed with revenue maximisation or quantity maximisation objectives since bundling products may result in the sale of products that may have gone unsold. Quality leadership can be achieved since some customers will appreciate having the opportunity to purchase a group of items at a discount. The partial cost recovery or survival objectives can be fulfilled from a product bundling pricing strategy when products likely would have gone unsold otherwise and selling the products at a discount.

9. Skim Pricing
   It is similar to premium pricing, calling for a high price to be placed on the product you are selling. However, with this strategy the price eventually will be lowered as competitors enter the market. This strategy is mostly used on products that are new and have few, if any, direct competitors when first entering the market.
   The skim pricing strategy should be reserved for when your pricing objective is profit maximisation, revenue maximisation, or profit margin maximisation.

INTERNAL FACTORS

The main internal factors affecting pricing are marketing objectives and cost.