January 10th, 2018
Making Pricing Decisions
Information from costing systems is not only important for external reporting purposes but also for internal reporting purposes. Internal reports help managers make both short-term decisions such as special order, pricing and product mix decisions; and long-term decisions such as decisions on capital investments (Bamber, Braun & Harrison 2008). This paper focuses on short-term decisions specifically decisions about pricing. First the paper assesses the validity of the statement that maximizing profits requires selling the entity’s output at the highest price, and then evaluates how marginal costs should be considered for price determination.
Does Maximizing Profits Imply Selling Output at the highest Price?
Selling output at the highest price may not lead to profit maximization. The statement advanced that “to maximise profit, you need to sell your output at the highest price”, is thus invalid. This can be explained by the factors that determine product pricing. For regular pricing decisions (i.e. decisions that do not involve setting a price for a special order), the price set for a product is determined by three aspects – the target profit, the customers’ paying ability and whether the entity is a price-taker or price-setter for that specific product (Bamber, Braun & Harrison 2008). Price-takers are those entities with no control over the price of their products or services since such products do not possess any unique quality or there exist strong competition in the market for that product e.g. food commodities (Bamber, Braun & Harrison 2008, p. 422). Companies with unique products or differentiated products that limit direct competition have some level of control over their prices hence referred to as price-setters (Bamber, Braun & Harrison 2008, p. 422).
With these factors, selling the output at the highest price could drive the customers away thus making the sales volumes decline. The prices that customers are willing to pay are dependent on such other factors as existing competition, unique characteristics of the product, how effective the marketing programs of the entity are, and prevailing economic conditions (Drury 2006; Bamber, Braun & Harrison 2008, p. 422). If selling the output at the highest price will result into a reduction in volumes purchased, then the strategy would only maximize profits where the contribution generated by the increased price outweighs the contribution reduced by declined sales volumes. A better strategy in this case would be to sell the output at a considerable price that drives the sales volumes thus increasing the operating income since some costs will remain unchanged even at higher volumes of sales (Drury 2006; Bamber, Braun & Harrison 2008). Go to part 2 here.