Chapter 8 – Price

# 8.2 Estimate Demand, Costs and Profit

LEARNING OBJECTIVES

• Estimate demand.
• Determine costs.
• Establish Profit Level.

Having a pricing objective isn’t enough. A company also has to look at a myriad of other factors before setting its prices.

## Estimate Demand

How will buyers respond? Three important factors are: whether the buyers believe that the product offers value, how many buyers there are, and how sensitive they are to changes in price. In addition to gathering data on the size of markets, companies must try to determine how price sensitive customers are. Will customers buy the product, given its price? Or will they believe the value (benefit of the product is less than the cost and effort) and choose an alternative or decide they can do without the product or service? Equally important is how much buyers are willing to pay for the offering. Figuring out how consumers will respond to prices involves judgment as well as research.

Price elasticity, or people’s sensitivity to price changes, affects the demand for products. Elasticity refers to the change in demand as a result of a change in price. Imagine that the price of a twelve-pack of bottled water changing from \$4.5 a pack to \$1.50 a pack. Many people will become more likely to buy more bottled water at \$1.50 than they are at \$4.50. An example of price inelasticity is city bus fare. If you are not interested or willing to take the price, dropping the price will not influence your decision to take the bus over your bike or car.

When consumers are very sensitive to the price change of a product, that is, they buy more of it at low prices and less of it at high prices, the demand for it is price elastic. Durable goods such as computers, cars, and stoves are more price elastic than necessities. More people are likely to buy them when their prices drop and fewer consumers are likely to buy them when their prices rise. Demand for essential products such as many basic food and first-aid products is not as affected by price changes as many nonessential goods.

The number of competing products and available substitutes affects the elasticity of demand. Whether a person considers a product a necessity or a luxury, and the percentage of a person’s budget allocated to different products and services also affect price elasticity. Some products, such as cigarettes, tend to be relatively price inelastic since most smokers keep purchasing them regardless of price increases and non-smokers will not buy regardless of the price. Service providers, such as utility companies in markets in which they have a monopoly (only one provider), face an inelastic demand since no substitutes are available.

However, in most markets, even monopolies need to be monitoring the landscape for new indirect competitors. Canada Post continues to be the only company who can charge the price it does for first class Lettermail (Canada Post, n.d.). However, beginning over 30 years ago with the introduction of the internet, email, and then mobile phones, the inelastic demand provides no protection to the negative impact to its Lettermail business.

### Competitors

How competitors price and sell their products will have a tremendous effect on a company’s pricing decisions. If you wanted to buy a certain pair of shoes, but the price was 30% less at one store than another, what would you do? Because companies want to establish and maintain loyal customers, they will often match their competitors’ prices. Some retailers, such as Home Depot have a price-matching guarantee where they will give you a 10% discount if you find the same product for less somewhere else (Home Depot, n.d.). Similarly if one company offers you free shipping, then other competitors will offer it as well. With so many products sold online, consumers can compare the prices of many merchants before making a purchase decision. Recall from the Five Forces Model that companies must look at substitutes and potential entrants as well as direct competitors.

### The Economy and Government Laws and Regulations

The economy has an effect on pricing decisions. When the economy is weak and many people are unemployed, companies often lower their prices. In international markets, currency exchange rates also affect pricing decisions. Pricing decisions are affected by federal, provincial and municipal regulations. Regulations are designed to protect consumers, promote competition, and encourage ethical and fair behavior by businesses. For example, in Canada the Competition Act contains pricing provisions about a misleading ordinary selling price; bait and switch selling; or sale above advertised price (Competition Bureau Canada, 2018b). The intent is to protect consumers and businesses and create a fair market.

## Determine Costs

The costs of the product and its inputs including the amount spent on product development, testing, and packaging have to be taken into account when the company makes their pricing decision. So do the costs related to promotion and distribution. For example, when a new product is launched, its promotion costs can be very high because people need to be made aware that it exists and potentially be taught how to use it. These high costs that relate to the stage of the product’s life cycle can affect its price. Furthermore, the country where the product is sold may have an impact. For example, while sales of iPhone remain fairly constant in North America, people in other countries have felt that the phone was too expensive compared to the average income of the country, did not function as well as the networks in their countries, or their functionality was restricted by the government. Thus, Apple offers a cheaper, less featured iPhone in some countries (Mickle, 2020). Similarly, if a company opens brick-and-mortar storefronts to distribute and sell their offering, these costs must be built into the price of the product. Recently Microsoft closed its bricks and mortar stores because the cost of running them could not be make up in the price of the products sold (Microsoft, 2020).

## Establish Profit Level

The point at which total costs equal total revenue is known as the breakeven point (BEP). For a company to be profitable, a company’s revenue must be greater than its total costs. If total costs exceed total revenue, the company suffers a loss.

Total costs include both fixed costs and variable costs. Fixed costs, or overhead expenses, are costs that a company must pay regardless of its level of production or level of sales. A company’s fixed costs include items such as rent, leasing fees for equipment, contracted advertising costs, and insurance. As a student, you may also incur fixed costs such as the rent you pay for an apartment. You must pay your rent whether you stay there for the weekend or not. Variable costs are costs that change with a company’s level of production and sales. Raw materials, labor, and commissions on units sold are examples of variable costs. You, too, have variable costs, such as the cost of gasoline for your car or your utility bills, which vary depending on how much you use.

Consider a small company that publishes specialty print books and sells them through different brick and mortar stores and online retail stores. The publisher’s selling price is \$15, which is what the retailer pays for the books. The retailer then sells the books to consumers for an additional charge. The manufacturer has the following costs:

Fixed Costs

 Copyright and distribution charges for the titles \$150,000 Package and label designs for the books \$10,000 Advertising and promotion costs \$40,000

Variable Costs

 Reproduction of books \$5 per unit Labels and packaging \$1 per unit Royalties \$1 per unit

In order to determine the breakeven point, you must first calculate the fixed and variable costs. To make sure all costs are included, you may want to note the fixed costs and the variable costs. Then, using the formulas below, calculate how many units the manufacturer must sell to break even.

The formula for BEP is as follows:

BEP = total fixed costs (FC) ÷ contribution margin per unit (CU)

Contribution margin per unit = MSP – variable costs (VC)

BEP = \$200,000 ÷ (\$15 – \$7) = \$200,000 ÷ \$8 = 25,000 units to break even

To determine the breakeven point in dollars, you simply multiply the number of units to break even by the MSP. In this case, the BEP in dollars would be 25,000 units times \$15, or \$375,000.