Mrf
100,000 200,000 400,000 800,000 Accumulated production
If a downward-sloping experience curve exists, this is highly significant for the company. Not only will the company's unit production cost fall, but it will fall faster if the company makes and sells more during a given time period. But the market has to stand ready to buy the higher output. And to take advantage of the experience curve, TI must get a large market share early in the product's life cycle. This suggests the following pricing strategy: TI should price its calculators low; its sales will then increase, and its costs will decrease through gaining more experience, and then it can lower its prices further.
Some companies have built successful strategies around the experience curve. For example, Bausch & Lomb solidified its position in the soft contact lens market by using computerized lens design and steadily expanding its one SofLens plant. As a result, its market share climbed steadily, to 65 percent.
However, a single-minded focus on reducing costs and exploiting the experience curve will not always work. Experience-curve pricing carries some major risks. The aggressive pricing might give the product a cheap image. The strategy also assumes that competitors are weak and not willing to fight it out by meeting the company's price cuts. Finally, while the company is building volume under one technology, a competitor may find a lower-cost technology that lets it start at prices lower than those of the market leader, who still operates on the old experience curve.
Cost-Plus Pricing
The simplest pricing method is cost-plus pricing—adding a standard markup to the cost of the product. Construction companies, for example, submit job bids by estimating the total project cost and adding a standard markup for profit. Lawyers, accountants, and other professionals typically price by adding a standard markup to their costs. Some sellers tell their customers they will charge cost plus a specified markup; for example, aerospace companies price this way to the government.
To illustrate markup pricing, suppose a toaster manufacturer had the following costs and expected sales:
Variable cost $10
Fixed costs $300,000
Expected unit sales 50,000
Then the manufacturer's cost per toaster is given by the following:
Fixed Costs „„„ $300,000 Unit Cost = Variable Cost + TT . „ .— = $10 + = $16
Unit Sales 50,000
Now suppose the manufacturer wants to earn a 20 percent markup on sales. The manufacturer's markup price is given by the following:10
Unit Cost $16
Markup Price =
The manufacturer would charge dealers $20 per toaster and make a profit of $4 per unit. The dealers, in turn, will mark up the toaster. If dealers want to earn 50 percent on the sales price, they will mark up the toaster to $40 ($20 + 50% of $40). This number is equivalent to a markup on cost of 100 percent ($20/$20).
Break-even pricing (target profit pricing)
Setting price to break even on the costs of making and marketing a product, or setting price to make a target profit.
Break-Even Chart for Determining Target Price
Does using standard markups to set prices make sense? Generally, no. Any pricing method that ignores demand and competitor prices is not likely to lead to the best price. Still, markup pricing remains popular for many reasons. First, sellers are more certain about costs than about demand. By tying the price to cost, sellers simplify pricing—they do not need to make frequent adjustments as demand changes. Second, when all firms in the industry use this pricing method, prices tend to be similar and price competition is thus minimized. Third, many people feel that cost-plus pricing is fairer to both buyers and sellers. Sellers earn a fair return on their investment but do not take advantage of buyers when buyers' demand becomes great.
Still, markup pricing remains popular for many reasons. First, sellers are more certain about costs than about demand. By tying the price to cost, sellers simplify pricing—they do not have to make frequent adjustments as demand changes. Second, when all firms in the industry use this pricing method, prices tend to be similar and price competition is thus minimized. Third, many people feel that cost-plus pricing is fairer to both buyers and sellers. Sellers earn a fair return on their investment but do not take advantage of buyers when buyers' demand becomes great.
Break-Even Analysis and Target Profit Pricing
Another cost-oriented pricing approach is break-even pricing (or a variation called target profit pricing). The firm tries to determine the price at which it will break even or make the target profit it is seeking. Such pricing is used by General Motors, which prices its automobiles to achieve a 15 to 20 percent profit on its investment. This pricing method is also used by public utilities, which are constrained to make a fair return on their investment.
Target pricing uses the concept of a break-even chart, which shows the total cost and total revenue expected at different sales volume levels. & Figure 10.5 shows a break-even chart for the toaster manufacturer discussed here. Fixed costs are $300,000 regardless of sales volume. Variable costs are added to fixed costs to form total costs, which rise with volume. The total revenue curve starts at zero and rises with each unit sold. The slope of the total revenue curve reflects the price of $20 per unit.
The total revenue and total cost curves cross at 30,000 units. This is the break-even volume. At $20, the company must sell at least 30,000 units to break even, that is, for total revenue to cover total cost. Break-even volume can be calculated using the following formula:
$300,000
Break-Even Volume =
If the company wants to make a target profit, it must sell more than 30,000 units at $20 each. Suppose the toaster manufacturer has invested $1,000,000 in the business and wants to set price to earn a 20 percent return, or $200,000. In that case, it must sell at least 50,000 units at $20 each. If the company charges a higher price, it will not need to sell as many toasters to achieve its target return. But the market may not buy even this lower volume at the higher price. Much depends on the price elasticity and competitors' prices.
1,200
Continue reading here: Private Nonregulated Monopoly Example
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