Chapter 15 Pricing and Credit Decisions1

15Pricing and Credit Decisions

— / CHAPTER 15 LECTURE NOTES
1 / Discuss the role of cost and demand factors in setting a price.
PPT 15-1
Chapter 15
Pricing and Credit Decisions
PPT 15-2
Looking Ahead
PPT 15-3/TM 15-3
Setting a Price
PPT 15-4/TM 15-4
Price Changes
Affect Revenues
PPT 15-5
The Three Components of
Total Cost in Determining Price
[Acetate 15-5]
PPT 15-6
Cost Determination for Pricing
PPT 15-7
Cost Structure for a Hypothetical Firm, 2004
PPT 15-8
Cost Structure for a Hypothetical Firm, 2005
PPT 15-9
How Customer Demand Affects Pricing
PPT 15-10
Pricing and a Firm's Competitive Advantage /
  1. Setting a price
Definition of price: what the seller requires to transfer ownership or use of a product or service. Discuss credit and pricing.
Bring out the importance of pricing by explaining the following two points: (1) one-half of one side of the revenue equation is price! (Sales × Price = Revenue) and (2) price has an indirect impact on quantity sold.
  1. Cost determination for pricing
  • Emphasize that careful study of costs may keep a business from pricing too low.
  • Review the behavior of total fixed and total variable costs.
  • Explain the concept of average pricing and highlight its dangers.
  • How customer demand affects pricing
  1. The Elasticity of demand (the effect of a change in price on quantity demanded)
  • Elastic demand—an increase in price lowers total revenue.
  • Inelastic demand—an increase in price raises total revenue.
  • Ask the students to think of products or services to which they are price sensitive and some to which they are not.
  • Pricing and a firm’s competitive advantage
  • A product/service that will address unmet needs yields demand.
  • Most products/services are different, but similar products/services can be marketed differently.
  • Product price—using prestige pricing to signal quality, uniqueness.

2 / Apply break-even analysis and markup pricing.
PPT 15-11/TM 15-11
Applying a Pricing System
PPT 15-12
Break-Even Graphs for Pricing
[Acetate 5-12]
PPT 15-13/TM 15-13
Applying a Pricing System
PPT 15-14
A Break-Even Graph Adjusted for Estimated Demand
[Acetate 15-14]
PPT 15-15
Applying a Pricing System /
  1. Applying a pricing system
  2. Break-even analysis
  1. Examining cost and revenue relationships—cost break-even analysisis used to determine the quantity at which the product (with an assumed price) will generate enough revenue to start earning a profit.
  2. Incorporating sales forecasts—cost-adjusted break-even analysis is used to evaluate alternative prices by merging cost break-even analysis and the appropriate demand schedules for these alternative prices.
  1. Markup pricing—pricing effects from the involvement of intermediaries
  • Markup must cover (1) operating expenses, (2) subsequent price reductions, and (3) desired profit.
  • A markup on cost differs from a markup on selling price.
  • Converting from one type of markup to the other.

3 / Identify specific pricing strategies.
PPT 15-16/TM 15-16
Selecting a Pricing Strategy
PPT 15-17
Selecting a Pricing Strategy
PPT 15-18
Selecting a Pricing Strategy /
  1. Selecting a pricing strategy (seven alternatives):
  2. Penetration pricing—pricing below “normal” to gain mkt share, acceptance
  3. Skimming pricing—pricing above “normal” (esp. when competition is weak)
  4. Follow-the-leader pricing—setting the price at the prevailing level
  5. Variable pricing—making price concessions to different buyers
Dynamic pricing, a type of variable pricing—charge more after gauging a customer's financial means and desire for a product
  1. Price lining—having a range of distinct prices
  2. What the market will bear—maximizing price when competition is minor
  3. A final note on price strategies
  • Be sure to comply with local, state, and federal laws.
  • Pricing in one product line may affect sales in another.
  • Continually adjusting price may confuse customers.
  • Pricing is not an exact science—make adjustments and keep selling.

4 / Explain the benefits of credit, factors that affect credit extension, and types of credit.
PPT 15-19
Offering Credit
PPT 15-20
Offering Credit
PPT 15-21
Offering Credit
PPT 15-22/TM 15-22
Types of Credit
PPT 15-23/TM 15-23
Types of Consumer
Credit Accounts
PPT 15-24
Types of Credit Cards
[Acetate 15-24] /
  1. Offering credit
Remind students of the definition of a market used in Chapter 7 (that is, people with unsatisfied needs and purchasing power).
Describe credit as a means of boosting market purchasing power.
  1. Benefits of credit
  • To borrowers:
Satisfies needs now, while not requiring payment until later
Provides better purchase records
Provides better service and greater convenience in productexchange
Establishes of a credit history
  • To sellers:
Provide working capital to the firm
Can create a closer association with customers
Can provide a marketing tool (e.g., for selling over the Internet)
Tends to smooth out sales fluctuation (consistent purchasing power)
Provides a tool for competitiveness
  1. Factors that affect selling on credit
  2. Type of business (online selling and the problem of credit card fraud)
  3. Credit policies of competitors
  4. Income level of customers
  5. Availability of working capital
  6. Types of credit
  7. Consumer credit—extended to final consumers
(1)Open charge accounts—indefinite repayment period
(2)Installment accounts—for larger purchases
(3)Revolving charge accounts—installment accounts with credit limit
  1. Credit cards
(1)Bank credit cards (e.g., Visa, MasterCard)
(2)Entertainment credit cards (e.g., American Express, Diner’s Club)
(3)Retailer credit cards (issued directly by the firm)
Poll students to find out which types of credit cards they have. What do they believe are the advantages and disadvantages of each?
  1. Trade credit
  • Explain the role of trade credit.
  • Terms are established by tradition—difficult for small businesses to implement a unique policy.

5 / Describe the activities involved in managing credit.
PPT 15-25
Managing the Credit Process
PPT 15-26
Sources of Credit Information
PPT 15-27/TM 15-27
Hypothetical Aging Schedule for Accounts Receivable
PPT 15-28
Managing the Credit Process
PPT 15-29/TM 15-29
Credit Regulation
[Acetate 15-29] /
  1. Managing the credit process
  2. Evaluation of credit applicants
  1. The four credit questions
  2. Can the buyer pas as promised?
  3. Will the buyer pay?
  4. If so, when will the buyer pay?
  5. If not, can the buyer be forced to pay?
  6. Ask students to evaluate the statement: “Every applicant is creditworthy to some degree.” What is the point of the statement? Do they agree with it?
  7. The traditional five C’s of credit (character, capital, capacity,conditions, collateral)
  1. Sources of credit information
  2. The use of credit histories
  3. A firm’s financial statements as a source
  4. Pertinent data from outsiders (e.g., other sellers)
  5. The customer’s banker as a source
  6. Trade-credit agencies (credit information on businesses, not customers)
  7. Credit bureaus (credit information on individuals, even on-line)
  8. Ask students what they believe to be the responsibilities of small businesses when they use data from credit sources ( privacy, correcting inaccuracies, etc).
  9. Aging of accounts receivable
  10. Billing and collection procedures—discuss bad-debt ratio
  11. Credit regulation
Review the federal legislation related to credit management. Ask students to comment on which of these laws they think has had the greatest impact on credit management practices.
— / SOURCES OF AUDIO, VIDEO, AND OTHER INSTRUCTIONAL MATERIALS

Something Ventured is a comprehensive video series produced to parallel this textbook. The video titled What the Market Will Bear: Pricing Products and Services investigates how cost, demand, and competitive forces influence the price a small firm can charge for a product or service. For more information, contact your South-Western/ITP sales rep or ITP Faculty Support (fax (415) 592-9081 or E-mail ).

Two videotapes on the subject of pricing are available through Nimco, P. O. Box 9, 102 Highway 81N, Calhoun, KY 42327. Their toll-free telephone number is (800) 962-6662. The tape Pricing Goods and Services discusses elasticity and the break-even concept. The other tape, entitled Pricing Strategies, investigates the role of price in the marketing mix and intermediary price markups.

PSI Research/Oasis Press, 300 North Valley Drive, Grants Pass, OR 97526, offers a how-to workbook entitled Collection Techniques for Small Business, which provides worksheets, checklists, and practical advice on dealing with debt collection. Contact PSI Research/Oasis Press at (800) 228-2275.

— / Answers to end-of-chapter
discussion questions
  1. Why does average pricing sometimes result in a pricing mistake?

p. 333Average pricing (or average-cost pricing) is the approach that involves dividing total cost over a previous period by the quantity sold in that period. The resulting average cost is then used to set the current price. Such a procedure overlooks the fact that there is a higher average cost at a lower sales level. This higher average cost is due to a constant fixed cost, which must be spread over fewer units. Small businesses that use the average pricing method are totally disregarding differences between fixed and variable costs.

  1. Explain the importance of total fixed and variable costs to the pricing decision.

p. 333The major problem with average-cost pricing (or average pricing) explains why an understanding of fixed and variable costs is important. Remember that average-cost pricing treats all costs as variable. It ignores costs that are fixed and therefore not the same per unit at different levels of production. Average fixed costs decrease as production increases, while average variable costs remain the same. Since their behavior is different, they should not be grouped together in determining price.

  1. How does the concept of elasticity of demand relate to prestige pricing? Give an example.

p. 333-334Elasticity of demand relates to prestige pricing in that prestige pricing is appropriate when a product or service is characterized by inelastic demand. A product or service is said to have inelastic demand if an increase in its price raises total revenue. Prestige pricing is the setting of a higher price to convey an image of high quality and uniqueness, which are two product or service characteristics that generate inelastic demand.

  1. If a firm has fixed costs of $100,000 and variable costs per unit of $1, what is the break-even point in units, assuming a selling price of $5 per unit?

p. 335Each item sold at $5 will contribute $4 to fixed costs, after $1 is allocated to variable costs. This means that 25,000 units will have to be sold ($100,000 ÷ $4) to reach the break-even point. At this level, the total cost of $125,000 ($100,000 fixed + $25,000 variable) will equal the total sales of $125,000 (25,000 units × $5 selling price).

  1. What is the difference between a penetration pricing strategy and a skimming pricing strategy? Under what circumstances would each be used?

p. 338Penetration pricing involves pricing products or services lower than a normal, long-range market price in order to gain more rapid market acceptance or to increase market share. This strategy may discourage new competitors from entering the market if they view the penetration price as a long-term price.

A skimming price strategy sets prices for products or services at high levels for a limited period before reducing them to a lower level. This strategy is most practical when there is little threat of short-term competition or when startup costs must be recovered rapidly.

  1. If a small business conducts its break-even analysis properly and finds the break-even volume at a price of $10 to be 10,000 units, should it price its product at $10? Why or why not?

Most students will probably say, “Yes, if the business can produce more than 10,000 units.” This is correct, but more can be said. The yes answer assumes that (1)demand at $10 is equal to or greater than 10,000 units; (2)another, higher price will not provide greater profits, or this price-and-demand level will reach a profit goal; and (3)price lining and similar policies are not appropriately implemented in this case.

  1. What are the major benefits of credit to buyers? What are its major benefits to sellers?

p. 340For buyers, credit

  • Satisfies needs now, while not requiring payment until later
  • Provides better purchase records
  • Provides better service and greater convenience in product exchange
  • Builds a credit history

For sellers, credit

  • Provide working capital to the firm
  • Can create a closer association with customers
  • Can provide a marketing tool
  • Tends to smooth out sales fluctuation
  • Provides a tool for competitiveness
  • How does an open charge account differ from a revolving charge account?

p. 342With an open charge account, a customer incurs a debt, and payment is due when the customer is billed. There is usually no finance charge if the customer pays in full when billed. Also, customers are not generally required to make a down payment.

A revolving charge account is an installment charge account under the terms of which the seller grants a line of credit that may be used by customers for credit purchases. A specified percentage of the outstanding balance must be paid monthly.

  1. What is meant by the term 2/10, net 30? Does it pay to take discounts when they are offered?

p. 343The credit term 2/10, net 30 means that the seller offers the buyer 2 percent discount on the agreed-upon price if the account is paid within 10 days of the invoice date. The full account is due 30 days from the invoice date. It pays to take discounts if the cash is available and is not earning interest or if the money can be obtained at an interest charge lower than what can be earned by taking the discount.

  1. What is the major purpose of aging accounts receivable? At what point in credit management should this activity be performed? Why?

p. 345-346Aging of accounts receivable is the process of dividing credit customer charges into age categories based on the length of time they have been outstanding. The purpose of aging is to identify the status of each credit charge in order to plan credit management strategies. There is no particular time when the aging should be done. In some cases, weekly or monthly aging may be sufficient. At other times, a daily report may be needed.

— /

COMMENTS ON CHAPTER “YOU MAKE THE CALL” SITUATIONS

Situation 1

  1. What advice would you give Jones regarding the screening of new credit customers?

Jones should investigate clients, when possible, prior to supplying them with temporary help. If a new client’s needs are immediate, help could be supplied and the credit investigation begun concurrently. Banks and trade-credit agencies would be possible sources of credit information. Jones must be careful not to offend new clients, but at the same time he must realize that the credit check is simply a good business practice.

A client application form could be used to obtain relevant information for the credit evaluation. Jones might also offer a discount for services paid for in cash.

  1. What action should Jones take to encourage current credit customers to pay their debts? Be specific.

The most important step is to provide timely billing. Most credit customers will pay their bills on time if they receive proper notification and verification. Jones could offer a higher discount for credit customers who pay early and/or on time. He could also devise a formal procedure with timely step-by-step collection actions.

  1. Jones has considered eliminating credit sales. What are the possible consequences of this decision?

The loss of business is the most obvious consequence of eliminating credit. Many businesses are set up to make payments on credit, and requiring payment in cash is an inconvenience to them.

On the other hand, by eliminating credit sales, Jones can eliminate the loss of 2 percent of sales revenue, which could amount to more than the gross revenue lost as a result of the new policy.

Situation 2

  1. What do you think Anderson means when he asks, "Is my business storage or real estate?" Why do you think he feels a need to ask this question prior to developing a pricing strategy?

Anderson is probably asking whether he should be pricing the space (a real estate view) or is he pricing the service (a storage company). The answer to this question may impact his promotion and other elements of his marketing effort, but it is not really an issue right now. He needs to evaluate his costs, both fixed and variable, and equate these relationships to what demand levels he believes he can achieve.

  1. What pricing strategy would be effective in combating the existing contractual relationships between potential customers and competitors?

Anderson should consider a combination of a penetration and variable pricing strategy. Some of his customers need a concession on price to reflect the removal fee they would have to pay to switch to Anderson’s storage business. The penetration pricing strategy will enable him to price lower than he normally will to gain more rapid market acceptance.

  1. Assuming that business costs would allow Anderson to lower prices, what problems do you see with this approach?

The main problem with lowing prices is the expectation that the strategy creates in the minds of consumers. That is why a temporary reduction has to be clearly communicated as a discounted price, not a price expected to last forever.

  1. Do you believe his business could benefit from offering credit to consumers? Why or why not?

Every firm should evaluate a credit system to decide if the benefits discussed in this chapter will apply to their situation. It may be a standard practice in his industry and therefore difficult to avoid. There is a cost associated with credit, and this must be balanced against the potential increase in sales revenue related to offering credit.

Situation 3

  1. What would the nature of this industry suggest about the elasticity of demand affecting Bowlin’s pricing?

The nature of this industry is such that service is not standardized. There are large differences in the services that can be provided. In other words, this service can be distinguished from other tree removal and pruning businesses. This means that demand can be very inelastic within a certain range. There is the opportunity to distinguish the services in such a way that small price increases will cause little resistance from customers and thereby result in increasing total revenues.

  1. What types of costs should Bowlin evaluate when he is determining his break-even point?

The types of costs Bowlin must evaluate are the same as in any other business—fixed and variable costs. For Bowlin, fixed costs may include such items as chain saws, tools, pick-up trucks, and insurance. Variable costs would include gasoline and labor costs.