Pricing and Credit Decisions

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1 CHAPTER OUTLINE Spotlight: Dynamic Network Services (http://www.dyn.com) 1 Setting a Price Discuss the role of cost and demand factors in setting a price. Cost Determination for Pricing Total cost includes (Exhibit 16-1 The Three Components of Total Cost in Determining Price) Cost of goods offered for sale Selling cost Overhead cost applicable to the given product Variable costs increase in total as the quantity of product increases Fixed costs remain constant at different levels of quantity sold Average pricing is an approach in which total cost for a given period is divided by quantity sold in that period to set a price How Customer Demand Affects Pricing Cost analysis can identify a level below which a price should not be set under normal circumstances, but does not show how much the final price might exceed that minimum figure and still be acceptable to customers Elasticity of Demand the degree to which a change in price affects the quantity demanded. Elastic demand demand that changes significantly when there is a change in the price of the product or service. Inelastic demand - demand that does notchange significantly when there is a change in the price of the product or service Pricing and a Firm s Competitive Advantage When customers perceive the product/service an important solution to their unsatisfied needs, they are likely to demand more If competing firms offer identical products and services, then the services offered by the companies generally differ Prestige pricing is setting a high price to convey an image of high quality or uniqueness 2 Applying a Pricing System Apply break-even analysis and markup pricing. Break-Even Analysis Examining Cost and Revenue Relationships First phase of break-even analysis is to determine the sales volume level at which the product, at an assumed price, will generate enough revenue to start earning a profit (Exhibit 16-4[a] Break-Even Graphs for Pricing) Contribution margin is the difference between the unit selling price and the unit variable costs and expenses Unrealistic to assume that quantity sold can increase continually Incorporating Sales Forecasts 169

2 Indirect impact of price on the quantity that can be sold complicates pricing decisions Markup Pricing Retailing Applying a percentage to a product s cost to obtain its selling price Manageable pricing system that allows quick pricing of many products Must cover operating expenses, subsequent price reductions (i.e., such things as markdowns and employee discounts) and desired profit 3 Selecting a Pricing Strategy Identify specific pricing strategies. Penetration Pricing a technique based on setting lower than normal prices to hasten market acceptance of a product or service or to increase market share Strategy can sometimes discourage new competitors from entering the market niche Skimming Pricing Sets prices for products/services at high levels for a limited period before reducing prices to lower, more competitive levels Assumes certain customers will pay the higher price due to perception it is a prestige item Follow-the-Leader Pricing Uses a particular competitor as a model in setting a price for a product/service Price differential options may not work with different size competitors Variable Pricing a technique based on setting more than one price for a product or service in order to offer price concessions to certain customers Dynamic (personalized) a technique based on charging more than the standard price when a customer s profice suggest that the higher price will be accepted. Price Lining a technique based on setting a range of several distinct merchandise price levels Amount of inventory stocked at different quality levels depends on the income levels and buying desires of a store s customers Pricing at What the Market Will Bear - can only be used when the seller has little or no competition Some Final Notes on Pricing Strategies Local, state, and federal laws may affect setting prices (Sherman Antitrust Act prohibits price fixing) Sometimes a line of products may have items which compete with each other in which case the effects of a single product must be considered when setting prices Adjusting a price to meet changing marketing conditions Can be costly to the seller and confusing to buyers Alternative may be a system of discounting design to reflect a variety of needs Pricing errors can be corrected 4 Offering Credit Explain the benefits of credit, factors that affect credit extension and types of credit. Benefits of Credit 170

3 Provides small firms with working capital, often allowing marginal businesses to continue operations Retail Customers (borrowers) Ability to satisfy immediate needs and pay for them later Better records of purchases on credit billing statements Better service and greater convenience when exchanging purchased items Establishment of a credit history Suppliers Facilitate increased sales volume Suppliers earn money on unpaid balances Closer association with customers because of implied trust Easier selling through telephone- and mail-order systems and over the Internet Smoother sales peaks and valleys, since purchasing power is always available Easy access to a tool with which to stay competitive Factors That Affect Selling on Credit Credit sales should increase profits, but this is not a risk-free practice May shift or share credit risk by accepting credit cards Cost of accepting credit cards includes fraud protection, chargebacks Variety of reasons why small business may decide not to sell on credit including the type of business, credit policies of competitors, customers income levels, and the availability of working capital Type of Business Retailers of durable goods typically grant credit more freely than those that sell perishables or primarily serve local customers Big ticket items often must be sold on an installment basis Credit Policies of Competitors Age and Income Level of Customers Availability of Working Capital Economic conditions Types of Credit Consumer credit financing granted by retailers to individuals who purchase for personal or family use Trade credit financing provided by a supplier of inventory to a client company Open Charge Accounts a line of credit that allows the customer to obtain a product or service at the time of purchase, with payment due when billed Installment Accounts a line of credit that requires a down payment, with the balance paid over a specified period of time Revolving Charge Accounts a line of credit on which the customer may charge purchases at any time, up to a pre-established limit Credit Cards Bank Credit Cards Entertainment Credit Cards Retailer Credit Cards Debit cards 171

4 Trade Credit Terms may be specified (such as 2/10, net 30) Depends on product sold and the buyer s and the seller s circumstances Affected by tradition within industries 5 Managing the Credit Process Describe the activities involved in managing credit. Evaluation of Credit Applicants The Four Credit Questions Can the buyer pay as promised? Will the buyer pay? If so, when will the buyer pay? If not, can the buyer be forced to pay? The Traditional Five C s of Credit Character Capacity Capital Conditions Collateral Sources of Credit Information Customer s previous credit history Trade credit agencies collect credit information on businesses Credit bureaus summarize a number of firms credit experiences with particular individuals Aging of Accounts Receivable Aging schedule (see Exhibit 16-6 Hypothetical Aging Schedule for Accounts Receivable) Billing and Collection Procedures Timely notification of customers indicating the status of their accounts is most effective method of keeping credit accounts current Overdue credit accounts time seller s working capital Effective weapon in collecting past-due accounts is reminding the debtors that their credit standing may be impaired Bad-debt ratio is the ratio of bad debts to credit sales Credit Regulation Variety of federal and state laws that vary from state to state Federal legislation includes: The Fair Credit Billing The Fair Credit Reporting Act The Equal Credit Opportunity Act The Fair Debt Collection Practices Act Pricing and credit decisions have a direct impact on the firm s financial health 172

5 ANSWERS TO END-OF-CHAPTER DISCUSSION QUESTIONS 1. Why does average pricing sometimes result in a pricing mistake? Average pricing (or average-cost pricing) is the approach that involves dividing total cost over a previous period by the quantity sold in that period. The resulting average cost is then used to set the current price. Such a procedure overlooks the fact that there is a higher average cost at a lower sales level. This higher average cost is due to a constant fixed cost, which must be spread over fewer units. Small businesses that use the average pricing method are totally disregarding differences between fixed and variable costs. 2. Explain the importance of total fixed and variable costs to the pricing decision. The major problem with average-cost pricing (or average pricing) explains why an understanding of fixed and variable costs is important. Remember that average-cost pricing treats all costs as variable. It ignores costs that are fixed and therefore not the same per unit at different levels of production. Average fixed costs decrease as production increases, while average variable costs remain the same. Since their behavior is different, they should not be grouped together in determining price. 3. How does the concept of elasticity of demand relate to prestige pricing? Give an example. Elasticity of demand relates to prestige pricing in that prestige pricing is appropriate when a product or service is characterized by inelastic demand. A product or service is said to have inelastic demand if an increase in its price raises total revenue. Prestige pricing is the setting of a higher price to convey an image of high quality and uniqueness, which are two product or service characteristics that generate inelastic demand. 4. If a firm has fixed costs of $100,000 and variable costs per unit of $1, what is the break-even point in units, assuming a selling price of $5 per unit? Each item sold at $5 will contribute $4 to fixed costs, after $1 is allocated to variable costs. This means that 25,000 units will have to be sold ($100,000 $4) to reach the break-even point. At this level, the total cost of $125,000 ($100,000 fixed + $25,000 variable) will equal the total sales of $125,000 (25,000 units $5 selling price). 5. What is the difference between a penetration pricing strategy and a skimming pricing strategy? Under what circumstances would each be used? Penetration pricing involves pricing products or services lower than a normal, longrange market price in order to gain more rapid market acceptance or to increase market share. This strategy may discourage new competitors from entering the market if they view the penetration price as a long-term price. 173

6 A skimming price strategy sets prices for products or services at high levels for a limited period before reducing them to a lower level. This strategy is most practical when there is little threat of short-term competition or when startup costs must be recovered rapidly. 6. If a small business conducts its break-even analysis properly and finds the breakeven volume at a price of $10 to be 10,000 units, should it price its product at $10? Why or why not? Most students will probably say, Yes, if the business can produce more than 10,000 units. This is correct, but more can be said. The yes answer assumes that (1) demand at $10 is equal to or greater than 10,000 units; (2) another, higher price will not provide greater profits, or this price-and-demand level will reach a profit goal; and (3) price lining and similar policies are not appropriately implemented in this case. 7. What are the major benefits of credit to buyers? What are its major benefits to sellers? For buyers, credit Satisfies needs now, while not requiring payment until later Provides better purchase records Provides better service and greater convenience in product exchange Builds a credit history For sellers, credit Provide working capital to the firm Can create a closer association with customers Can provide a marketing tool Tends to smooth out sales fluctuation Provides a tool for competitiveness 8. How does an open charge account differ from a revolving charge account? With an open charge account, a customer incurs a debt, and payment is due when the customer is billed. There is usually no finance charge if the customer pays in full when billed. Also, customers are not generally required to make a down A revolving charge account is an installment charge account under the terms of which the seller grants a line of credit that may be used by customers for credit purchases. A specified percentage of the outstanding balance must be paid monthly. 9. What is meant by the term 2/10, net 30? Does it pay to take discounts when they are offered? The credit term 2/10, net 30 means that the seller offers the buyer 2 percent discount on the agreed-upon price if the account is paid within 10 days of the invoice date. The full account is due 30 days from the invoice date. It pays to take discounts if 174

7 the cash is available and is not earning interest or if the money can be obtained at an interest charge lower than what can be earned by taking the discount. 10. What is the major purpose of aging accounts receivable? At what point in credit management should this activity be performed? Why? Aging of accounts receivable is the process of dividing credit customer charges into age categories based on the length of time they have been outstanding. The purpose of aging is to identify the status of each credit charge in order to plan credit management strategies. There is no particular time when the aging should be done. In some cases, weekly or monthly aging may be sufficient. At other times, a daily report may be needed. COMMENTS ON CHAPTER YOU MAKE THE CALL SITUATIONS Situation 1 1. What advice would you give Jones regarding the screening of new credit customers? Jones should investigate clients, when possible, prior to supplying them with temporary help. If a new client s needs are immediate, help could be supplied and the credit investigation begun concurrently. Banks and trade-credit agencies would be possible sources of credit information. Jones must be careful not to offend new clients, but at the same time he must realize that the credit check is simply a good business practice. A client application form could be used to obtain relevant information for the credit evaluation. Jones might also offer a discount for services paid for in cash. 2. What action should Jones take to encourage current credit customers to pay their debts? Be specific. The most important step is to provide timely billing. Most credit customers will pay their bills on time if they receive proper notification and verification. Jones could offer a higher discount for credit customers who pay early and/or on time. He could also devise a formal procedure with timely step-by-step collection actions. 3. Jones has considered eliminating credit sales. What are the possible consequences of this decision? The loss of business is the most obvious consequence of eliminating credit. Many businesses are set up to make payments on credit, and requiring payment in cash is an inconvenience to them. 175

8 On the other hand, by eliminating credit sales, Jones can eliminate the loss of 2 percent of sales revenue, which could amount to more than the gross revenue lost as a result of the new policy. Situation 2 1. What do you think makes selling works of art different from selling other kinds of products? What makes it the same? Students answers will vary but may include discussion about the subjective nature of art. Value can be inflated due to perception or hype as this is market is rather unconventional. This is not a typical product where you add the cost of materials, labor, overhead and tack on a profit. With art, the material cost is low, the labor cost is high but the value is mostly perceived. Pricing is completely subjective based on what the market will bear. What makes it the same is packaging, branding, and perception. These conventional methods of marketing translate to any product. 2. Have you bought anything on ebay? If so, do you feel you received good value for the price you paid? If not, ask someone who has shopped successfully on ebay for advice on how to shop on that site, and report what you were told. Student answers will vary on this. 3. How would you price a work of art? What do you think the advantages and disadvantages of using an auction would be? Student answers will vary on this. Situation 3 1. What would the nature of this industry suggest about the elasticity of demand affecting Bowlin s pricing? The nature of this industry is such that service is not standardized. There are large differences in the services that can be provided. In other words, this service can be distinguished from other tree removal and pruning businesses. This means that demand can be very inelastic within a certain range. There is the opportunity to distinguish the services in such a way that small price increases will cause little resistance from customers and thereby result in increasing total revenues. 2. What types of costs should Bowlin evaluate when he is determining his breakeven point? 176

9 The types of costs Bowlin must evaluate are the same as in any other business fixed and variable costs. For Bowlin, fixed costs may include such items as chain saws, tools, pick-up trucks, and insurance. Variable costs would include gasoline and labor costs. 3. What pricing strategies could Bowlin adopt to further his long-term success in this market? A variable pricing strategy will be required in this type of business because no two jobs will be exactly the same. Bowlin may also want to consider flexible pricing to reflect special market conditions such as distant locations and adverse weather conditions. 4. How can the high quality of Bowlin s work be used to justify somewhat higher price quotes? Bowlin might consider some degree of prestige pricing for certain high-income customers, which could successfully convey an image of high quality or uniqueness. This approach could work well if certain customers associate quality with price. SUGGESTED SOLUTION TO CASE 16: DYNAMIC NETWORK SERVICES, INC. 1. Explain the importance of fixed and variable costs to Dyn s pricing decisions. Since the bulk of Dyn s costs are fixed, they need to have accurately defined which of their costs are fixed and which are variable. A miscalculation here could mean they either overstate or understate their price. Cost and profits would similarly be affected. Also, should the market change and demand decrease for their product, Dyn would have to look at reducing their overhead (fixed) costs and would again, need to rely on accurate data. 2. Basing your answer on the discussion of prestige pricing in Chapter 16 and on the Dyn Inc. video, how does the concept of elasticity of demand relate to Dyn s pricing structure? Or does it? Because customer demand for a product or service is often sensitive to the price level, Dyn has to be careful about how it structures its pricing. So far, Dyn has experienced inelastic demand for as they have increased their pricing, demand has risen. However, they need to be more careful now. Since they each customer requires different pricing strategies, Dyn must be careful to appropriate the correct variable costs to these customers. They also need to appropriate the correct amount of sales force cost- some of these costs will be fixed (i.e. salary) and some will be variable (i.e. commission). 177

10 Should they utilize the concept of prestige pricing, an approach based on setting a high price to convey an image of high quality or uniqueness, they need to ensure that their product is superior over their competitors. With more competitors entering their market, they have to absolutely deliver on their ability to handle the rate of traffic and the consistency of their software. To achieve this superb level of quality they may have to increase their fixed cost. This in turn will affect their pricing and consequently may affect their pricing elasticity. If customers are price sensitive in this down economy, Dyn wants to be sure they don t price themselves out of the market. 3. Do you think Dyn would benefit from offering credit to its customers? Offering credit to their customers provides several benefits, such as: The ability to satisfy immediate needs and pay for them later Better records of purchases on credit billing statements Establishment of a credit history Closer association with customers because of implied trust Easier selling through telephone- and mail-order systems and over the internet Smoother sales peaks and valleys, since purchasing power is always available East access to a tool with which to stay competitive. Selling on credit though is not a risk-free business. Dyn will incur some extra administrative cost in establishing credit with credit card companies. Dyn will also have to pay a service fee to these companies. There s also the issue of internet fraud. There s also the issue of charegebacks whenever a buyer disputes a transaction. It s probably best if Dyn do a thorough analysis to see if the use of credit would be of benefit to its existing customers and see if this benefit would be a deciding factor for new customers. 178

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