Note by James R. Martin, Ph.D., CMA
Professor
Emeritus, University of South Florida
Pricing Decisions Main Page |
Surveys
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This article begins with two conflicting statements found in economics textbooks related to the pricing decision. A statement in Joel Dean's 1951 Managerial Economics reveals that surveys of actual business practice have indicated that the most pervasive pricing method is based on a cost estimate plus a margin for profit. On the other hand, a contradictory statement in William Baumol's 1977 Economic Theory and Operations Analysis indicates that pricing and output in a competitive industry are determined by the intersection of the industry's supply and demand curves. The purpose of this article is to clear up some of the confusion by examining the pricing decision from the market structure perspective, i.e., perfect competition, monopoly, monopolistic competition, and oligopoly.
Interrelationships: Market Structure and Cost Concepts
Perfect competition
In a perfectly competitive market the individual producer has no control over the price of their product and therefore no direct need for cost information for this purpose. Of course cost data is still important for determining the viability of the business.
Monopoly
This type of market structure mainly includes regulated monopolies such as public utilities. The costs that are relevant in this case are full costs since regulating agencies allow the firm to recoup full cost plus a certain amount to cover the cost of capital as a competitive return on investment. Although this approach makes no distinction between product and period costs, accountants must develop an acceptable rational for allocating period costs to products.
Monopolistic competition
Monopolistic competition with product differentiation represents one type of imperfect competition. Each firm in this type of market structure produces products that are different in some way, e.g., packaging, location, or special sales features such as better service or gift coupons. In this type of economic environment the relationship between possible prices and the demand for the product should be established. In addition, cost information is needed to support pricing decisions including an analysis of variable and fixed product and distribution cost as well as the expected cost behavior in response to changes in volume.
Oligopoly
Oligopoly includes situations where a few large suppliers produce most of the industry's relatively uniform output. Since price wars tend to have disastrous effects in this type of economic environment, one firm usually assumes the role of price leadership. Typically market share is determined by secret price concessions and by non-price competition such as cost minimization. Therefore an analysis of the firm's and competitor's cost structures becomes important particularly in regard to improving productivity and avoiding idle capacity costs.
Other Approaches to Full Cost Determination
Full cost is determined in different ways. For example full cost for government contracting includes direct material, direct labor, production overhead costs, and relevant period costs referred to as general and administrative costs. Since the distinction between fixed and variable costs is ignored in such allocations, changes in the volume of output can have significant effects on unit cost. Therefore capacity costs should be allocated on the basis of anticipated capacity utilization rather than actual production volume, assuming the potential customers can be identified.
Conclusion
Examining pricing decisions from a market structure perspective helps explain why surveys show that many firms use cost-plus pricing, while many others base their prices on the established market prices for similar competitive products. It also supports the author's view that adequate professional training for pricing decisions (university curricula and professional continuing education programs) requires an understanding of traditional cost accounting, and the relevant areas of managerial economics.
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Related summaries:
Bertini, M. and O. Koenigsberg. 2021. The pitfalls of pricing algorithms. Harvard Business Review (September/October): 74-83. (Summary).
Govindarajan, V. and R. N. Anthony. 1983. How firms use cost data in price decisions. Management Accounting (July): 30-31, 34-36. (Summary).
Hinterhuber, A. 2008. Customer value-based pricing strategies: Why companies resist. Journal of Business Strategy 29(4): 41-50. (Summary).
Hinterhuber, A. and S. Liozu. 2012. Is it time to rethink your pricing strategy? MIT Sloan Management Review (Summer): 69-77. (Summary).
Hughes, S. B. and K. A. Paulson Gjerde. 2003. Do different cost systems make a difference? Management Accounting Quarterly (Fall): 22-30. (Summary).
Martin, J. R. Not dated. Chapter 11: Conventional Linear Cost-Volume-Profit Analysis. Management Accounting: Concepts, Techniques & Controversial Issues. Management And Accounting Web. Chapter11.
Oser, J. 1963. The Evolution of Economic Thought. Chapter 20: The Departure from Pure Competition. Harcourt, Brace & World, Inc. (Summary).
Porter, M. E. 1980. Competitive Strategy: Techniques for Analyzing Industries and Competitors. The Free Press. (Summary).
Shim, E. and E. F. Sudit. 1995. How manufacturers price products. Management Accounting (February): 37-39. (Note).
Shim, E. D. and R. Lim. 2022. A survey of U.S. firms' pricing strategies and costing methods. Cost Management (May/June): 15-19. (Note).
Thurston, K. L. D. M. Keleman and J. B. MacAarthur. 2000. Providing strategic activity cost information: Cost for pricing at Blue Cross and Blue Shield of Florida. Management Accounting Quarterly (Spring): 4-13. (Summary).