Pricing and Credit

After studying this chapter, you should be able to:

• Discuss the role of cost and demand factors in setting price.
• Apply break-even analysis and markup pricing.
• Identify specific pricing strategies.
• Explain the benefits of credit, factors that affect credit extension, and types of deals.
• Describe the activities involved in managing credit.

Very few business owners have any formal training in how to set prices for the products and services they sell. Most of the time, their prices are based on:

• What competitors are charging.
• Some percentage above their costs.
• Just an instinctive feel.

Pricing and credit decisions are vital to the success of a company because they influence the relationship between the business and its customers.

• Price: A specification of what a seller requires in exchange for transferring ownership or use of a product or service.
• Credit: An agreement between a buyer and a seller that provides for delayed payment for a product or service.

Setting a price – the entrepreneur decides on the most appropriate value for the product or service being offered for sale.

Total sales revenue depends on 2 components: sales volume and price. Even a small change in price can influence revenue.

Assuming no change in demand:

Quantity sold X Price per unit = Gross Revenue

• Pricing is important because it indirectly affects sales quantity.
• Setting a price too high may result in lower quantities sold, therefore reducing total revenue.
• Services are more difficult to price than products because of their intangible nature.

For a business to be successful, its pricing must cover total cost plus an appropriate profit margin.

• Total Cost: The sum of cost of goods sold, selling expenses, and overhead costs.
• Variable Costs: Costs that vary with the quantity produced or sold.
• Fixed Costs: Costs that remain constant as the quantity produced or sold varies.
• Average Pricing: An approach in which total cost for a given period is divided by the quantity sold in that period to set a price. It overlooks the reality of higher average costs at lower sales levels.

The Three Components of Total Cost:

1. Cost of Goods Offered: Example Costs: Cost of item, Freight Charges.
2. Selling Cost: Example Costs: Salesperson’s time, Advertising.
3. Overhead Cost: Example costs: Storage, Salaries, Taxes.

Break-Even Analysis

Phase 1: Examining cost-revenue relationships

The objective is to determine the sales volume level at which the product, at an assumed price, will generate enough revenue to start earning a profit.

• Break-even point: The sales volume at which total sales revenue equals total costs and expenses.
• Formula: Break-even point = Total fixed costs and expenses / (Unit selling price – Unit variable costs and expenses)
• Contribution margin: The difference between the unit selling price and the unit variable costs and expenses.

Phase 2: Incorporating sales forecasts into the analysis

Demand for a product decreases as price increases. An adjusted break-even chart can be developed by adding a demand curve.

Markup Pricing

An approach based on applying a percentage to a product’s cost to obtain its selling price. It is a manageable pricing system, especially in the retail industry.

Retailers add a markup percentage to cover: 1. operating expenses; 2. subsequent price reductions; 3. desired profit.

• Formula (based on selling price): (Markup / Selling Price) x 100
• Formula (based on cost): (Markup / Cost) x 100

Selecting a Pricing Strategy

Price determination must consider market characteristics and the firm’s current marketing strategy. Strategies include:

• Penetration pricing
• Skimming pricing
• Follow-the-leader pricing
• Variable pricing
• Price lining
• Pricing at what the market will bear

Offering Credit

There are two main types of credit:

1. Consumer Credit: Financing granted by retailers to individuals who purchase for personal or family use.
   • Open charge accounts: Allows a customer to obtain a product at the time of purchase, with payment due when billed.
   • Installment accounts: Requires a down payment, with the balance paid over a specified period.
   • Revolving charge accounts: A customer may charge purchases at any time, up to a pre-established limit.
   • Credit Cards & Debit Cards.
2. Trade Credit: Financing provided by a supplier of inventory to a client company. For example, terms of sale such as 2/10, net 30 (a 2% discount if the buyer pays within 10 days).

This process involves several key steps:

1. Evaluation of credit applicants:

   4 key 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.

2. Sources of credit information:
   • Trade-credit agencies: Privately owned organizations that collect credit information on businesses.
   • Credit bureaus: Privately owned organizations that summarize a number of firms’ credit experiences with particular individuals.
3. Aging of accounts receivable: A categorization of accounts receivable based on the length of time they have been outstanding.
4. Billing and Collection procedures: Timely notification to customers is crucial. Overdue accounts tie up a seller’s working capital and can lead to bad debt losses.
5. Credit Regulation: Fair Credit Billing Act, The Fair Credit Reporting Act, The Equal Credit Opportunity Act, The Fair Debt Collection Practices Act.

Discussion Questions

1. Explain the importance of fixed and variable costs to the pricing decision.
2. Elaborate on the difference between a penetration pricing strategy and a skimming price strategy. Under what circumstances would each be used?