Pricing Decisions
Decision Making
Pricing Decisions
Syllabus tag: KASNEB CPA | Intermediate Level | CA25 Management Accounting | Topic 10 Pricing Decisions
Lesson objectives
By the end of this topic, you will be able to:
- Price on a cost-plus basis and distinguish mark-up from margin
- Compute a price that delivers a target return on capital
- Find the profit-maximising price from a demand function
- Explain price elasticity and its effect on a pricing decision
- Compare penetration, skimming and other pricing strategies
Why this matters
Every earlier topic in this paper produced a cost. This one asks what to charge — which is a different question, because cost tells you the floor and the market decides the ceiling.
One product throughout
Direct materials 180, direct labour 140, variable production overhead 60, variable selling overhead 30. Fixed production overhead absorbed at 90 per unit. Capital employed KES 24,000,000, output 30,000 units.
| Cost measure | KES |
|---|---|
| Marginal cost (180 + 140 + 60) | 380 |
| Absorption cost (+ 90) | 470 |
| Full cost including selling (+ 30) | 500 |
Which cost you start from changes the answer, so an examiner will always say which one to use.
Cost-plus pricing
Mark-up on cost: 500 × 1.40 = KES 700
Margin on selling price: 500 / 0.60 = KES 833.33
Both are described as "40%". They are not the same, and the gap is large. A 40% margin needs a mark-up of (833.33 − 500) / 500 = 66.67%.
Cost-plus is simple, defensible in negotiation, and ensures costs are covered. Its weakness is that it ignores demand entirely — it sets the same price whether customers would happily pay double or refuse to buy at all. It is also circular under absorption costing: the fixed cost per unit depends on volume, and volume depends on price.
Target return on capital
Work backwards from the return the business needs.
Target profit = 18% × 24,000,000 = KES 4,320,000 Profit per unit = 4,320,000 / 30,000 = KES 144 Price = 500 + 144 = KES 644
Useful for a board that thinks in terms of return on capital, and it carries the same weakness: it assumes 30,000 units will sell at whatever price the arithmetic produces.
Demand-based pricing
Where demand responds to price, the profit-maximising price can be found directly.
Demand function: P = 1,200 − 0.02Q Marginal revenue: MR = 1,200 − 0.04Q Marginal cost: MC = 380
Profit is maximised where MR = MC:
1,200 − 0.04Q = 380, so Q = 820 / 0.04 = 20,500 units
P = 1,200 − (0.02 × 20,500) = KES 790
Contribution = (790 − 380) × 20,500 = KES 8,405,000
Compare a higher price. At KES 900, demand falls to (1,200 − 900) / 0.02 = 15,000 units, and contribution = (900 − 380) × 15,000 = KES 7,800,000.
The higher price earns 520 on each unit rather than 410 — and 605,000 less in total, because 5,500 sales were lost to get it. Margin per unit and total profit are not the same objective.
Note that MR falls twice as fast as price. Selling one more unit means accepting a lower price on every unit, not just the last one.
:::checkpoint A sales director argues for raising the price to KES 900 because "our margin improves by 110 shillings a unit". Using the figures above, explain precisely what is wrong with the argument. :::
Price elasticity
Elasticity = percentage change in quantity / percentage change in price
- Elastic (greater than 1): quantity moves more than price. Cutting price raises total revenue.
- Inelastic (less than 1): quantity moves less than price. Raising price raises total revenue.
Demand tends to be elastic where substitutes are plentiful, the item is a large share of the buyer's budget, or the purchase can be postponed. It tends to be inelastic for necessities, for habitual purchases, and where a strong brand has removed the sense of substitutes.
Pricing strategies
Penetration pricing. Launch low to build volume and market share quickly. Suits elastic demand, an easily copied product, and a business with the capacity to serve the volume. It also discourages competitors from entering.
Market skimming. Launch high to earn from the customers least sensitive to price, then lower it in stages. Suits a genuinely novel product with a segment willing to pay for being first, and it recovers development cost quickly.
Price discrimination. The same product at different prices to different segments — student fares, off-peak tariffs. It requires the segments to be separable and resale between them to be impossible.
Loss leaders. One item priced below cost to draw customers who buy other things at normal margins.
Product line pricing. Prices set across a range rather than item by item, so a basic model can be priced thinly to make the mid-range look good value.
Cost as the floor, market as the ceiling
The practical summary of this topic:
- In the long run, price must cover full cost or the business fails.
- In the short run, any price above marginal cost adds contribution, which is why the special order in Relevant Costing was worth accepting at 620 against a full cost of 620.
- Between those two, the market decides.
:::checkpoint A company launches a genuinely new product with no close substitute, and expects competitors within eighteen months. Recommend penetration or skimming, and give the main risk of the strategy you choose. :::