Chapter 8 - Revision Notes

Chapter 8 - Revision Notes - Chapter 8 Cost Approaches to...

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Chapter 8 Cost Approaches to Pricing I. Introduction Prices influence the profitability of a firm. Four main factors are essential for price determination: 1. Demand Demand sets the upper limit or ceiling of price. It determines what customers are willing to pay. Elasticity of demand to changes in price is an important issue in setting prices. The price elasticity of demand is measured as the change in quantity demanded per unit change in price. In numerical terms, Price elasticity of demand = (% change in Quantity Demanded)/ (% change in Price) For instance, a budget hotel increases its room price from 20$ to 22$ per room night (10%). Consequent to this price increase, the demand declined from 100 to 950 rooms (5%). The price elasticity of demand for this motel would be (5%/10%) or 0.5. The airline and lodging industry recognize seasonal fluctuations in demand and price their products accordingly. Such demand-based approach to pricing is called yield management . 2. Costs Another important factor to consider in pricing is cost. Costs set the lower limit or floor of price. 3. Objectives Business objectives or goals of a firm constitute the third price setting factor. Objectives or goals provide the overall environment for setting prices. A 10% profit objective annually, for instance, provides a price- setting environment for a business firm. Such environment differs significantly if a firm happens to be a non-profit organization.
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4. Competition Competition provides the fourth important price-setting factor. A firm’s competition sets the benchmark for comparing its various pricing alternatives. Skimming and penetrating price policies are examples substantiating this fact. Two other modifying factors must also be remembered in setting prices. First is the historical trend of prices. Dramatic price changes should be avoided if possible as they affect demand adversely. Second, the final price must be set after incorporating policies such as odd and even pricing (e.g., $9.99 instead of
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