PRICING AND SALES PROMOTION:THE ROLE OF COSTS IN PRICING

4. THE ROLE OF COSTS IN PRICING

As indicated earlier, demand provides an upper limit on the pricing discretion the firm has. This limit is the willingness of buyers to purchase at a stated price. On the other hand, the other variable directly affecting profits—costs—sets a floor to a firm’s pricing discretion. If prices are too low in comparison with costs, volume may be high but profitless. By determining the difference between costs and the price under consideration and then balancing that margin against the estimated sales volume, the seller can determine whether the product or service will contribute sufficient money to enable the firm to recover its initial investment. In considering the cost aspect of a pricing decision, a crucial question is what costs are relevant to the decision.

It is important for the seller to know the causes and behavior of product costs in order to know when to accelerate cost recovery, how to evaluate a change in selling price, how to profitably segment a market, and when to add or eliminate products. Even so, costs play a limited role in pricing. They indicate whether the product or service can be provided and sold profitably at any price, but they do not indicate the actual prices that buyers will accept. Proper costs serve to guide management in the selection of a profitable product mix and determine how much cost can be incurred without sacrificing profits.

Cost Concepts

To determine profit at any volume, price level, product mix, or time, proper cost classification is required. Some costs vary directly with the rate of activity, while others do not. If the cost data are classified into their fixed and variable components and properly attributed to the activity causing the cost, the effect of volume becomes apparent and sources of profit are revealed.

In addition to classifying costs according to ability to attribute a cost to a product or service, it is also important to classify costs according to variation with the rate of activity (Ness and Cucuzza 1995). Some costs vary directly with the activity level, while other costs, although fixed, are directly attributable to the activity level. Hence, it is important to clarify specifically what is meant by the terms direct and indirect. The directly traceable or attributable costs are those costs that we can readily determine as contributing to the product or service’s cost. However, whether a direct cost is variable, fixed, or semivariable depends on properly determining the cause of that cost. Perhaps more than anything else, managers need to exert the will to understand how costs are incurred and how they behave as activity levels change in their organizations.

Profitability Analysis

Virtually every planned action or decision in an organization affects costs and therefore profits. Profit analysis attempts to determine the effect of costs, prices, and volume on profits. The goal of this analysis is to provide accurate information about the profit contributions made by each product, thereby giving management a sound basis for managing its product lines.

One of the most important pieces of data resulting from a profit analysis is the contribution ratio, which is usually referred to as the profit-volume ratio (PV). The PV ratio is the proportion of sales dollars available to cover fixed costs and profits after deducting variable costs:

This PV ratio is an important piece of information for analyzing the profit impact of changes in sales volume, changes in the cost structure of the firm (i.e., the relative amount of fixed costs to total costs), as well as changes in price.

For a single product situation, the elements of profitability that the firm must consider are price per unit, sales volume per period, variable costs per unit, and the direct and objectively assignable fixed costs per period. However, typically firms sell multiple products or offer multiple services, and the cost-classification requirements noted above become more difficult. Further, many companies now recognize that it is important to avoid arbitrary formulas for allocating overhead (common costs) so that each product carries its fair share of the burden. In part, these companies understand that the concept of variable costs extends beyond the production part of the business. That is why we have stressed the notion of activity levels when defining variable costs. These companies have found out that using the old formula approach to cost allocation has meant that some products that were believed to be losing money were actually profitable and that other so-called profitable products were actually losing money.

A key lesson from the above discussion and the experiences of companies that use this approach to developing the relevant costs for pricing is that profits must be expressed in monetary units, not units of volume or percentages of market share. Profitability is affected by monetary price, unit volume, and monetary costs.

Profit Analysis for Multiple Products

In multiproduct firms, it is important to place emphasis on achieving the maximum amount of con- tribution revenue for each product instead of attempting to maximize sales revenues. Each product offering faces different competition, has a different demand elasticity, and perhaps depends for its sales, at least in part, on the sales of the other products in the line.

Within a multiproduct firm, each offering generates a different amount of volume, a different cost structure, including variable and fixed costs, different unit prices, and, of course, different revenues. Not only are these important factors different, but they are changing. The PV ratio can be used to analyze the relative profit contributions of each product in the line. Each product has a different PV value and different expected dollar sales volume as a percentage of the line’s total dollar volume. In multiple-product situations, the PV is determined by weighting the PV of each product by the per- centage of the total dollar volume for all products in the line.

This issue of managing the prices and profitability of the firm’s product line is extremely impor- tant. For example, consider the prices of a major hotel chain. For the same room in a given hotel, there will be multiple rates: the regular rate (commonly referred to as the rack rate), a corporate rate that represents a discount for business travelers, a senior citizen rate, a weekend rate, single vs. double rates, group rate, and conference rate, to name just a few. Over time, the hotel’s occupancy rate expressed as a percentage of rooms sold per night had increased from about 68% to 75%. Yet despite increasing prices that more than covered increases in costs, and increasing sales volume, profitability was declining.

After a careful examination of this problem, it was discovered that they were selling fewer and fewer rooms at the full rack rate while increasing sales, and therefore occupancy, of rooms at dis- counted rates that were as much as 50% off the full rack rate. As a result, the composite weighted PV ratio had significantly declined, indicating this demise in relative profitability. Further, to illustrate the importance of considering buyers’ perceptions of prices, the price increases had primarily been at the full rack rate, creating a greater and more perceptible difference between, for example, the full rate and the corporate rate. More and more guests were noticing this widening price difference and were requesting and receiving the lower rates.

When there are differences in the PVs among products in a line, a revision in the product selling mix may be more effective than an increase in prices. That is, a firm, by shifting emphasis to those products with relatively higher PVs, has a good opportunity to recover some or all of its profit position. Hence, profit at any sales level is a function of prices, volume, costs and the product dollar sales mix (Monroe and Mentzer 1994).