20140829084556_topic 6 pricing and credit strategies

STUDY GUIDE BMSB5103 Small Business Management

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Topic 6: Pricing and Credit Strategies

Learning Outcomes

By the end of this topic, you should be able to:

1. Discuss the role of cost and demand factors in setting a price;

2. Apply break-even analysis and markup pricing;

3. Identify specific pricing strategies;

4. Explain the benefits of credit, factors that affect credit extension, and types of credit; and

5. Describe the activities involved in managing credit.

Topic Overview

Pricing and credit strategies are essential to small business. Setting a price is not an easy task. Setting a high price may not bring a sufficient sale volume to a small business, while setting a low price may lead to a high sale volume but not enough profit. Thus, price and credit directly influence the relationship between a small business and its customers, as well as directly affecting both revenue and sale of the small business. Customers do not like a high price or a price increase, so much so restrictive credit policies. As a value must be placed on a product and service by a producer or provider before it can be sold, undoubtedly pricing strategies are a critical issue in small business. It is always common that a seller provides credit to buyers or customer to make the exchange happen. An agreement between buyer and seller that payment for a product or service will be paid at some later date is known as credit. Giving too many credits to customers may loosen the cash flow and reduce the capacity of a small business to expand. Not providing a single credit facility may result in less revenue as customers may not like the products or services. Similar to pricing, credit represents another critical issue for small businesses.


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Focus Areas and Assigned Readings

Focus Areas Assigned Readings

6.1 Define what is price and credit Discuss the role of cost and demand factors in setting a price.

6.2 Setting a PriceApply break-even analysis and markup pricing.

6.3 Applying a Pricing System Identify specific pricing strategies.

6.4 Selecting a Pricing Strategy Explain the benefits of credit, factors that affect credit extension and types of credit.

6.5 Offering Credit Describe the Credit Process.

6.6 Managing the Credit process 6.6.1 Evaluation of Credit Applicants 6.6.2 Sources of Credit Information 6.6.3 Aging of Accounts Receivable 6.6.4 Billing and Collection

Procedures 6.6.5 Credit Regulation 6.6.6 Pricing and credit decisions

Moore et al. (2010), Chapter 16, p 419

Extra Readings:

Scarborough (2012), Chapter 11, p 361.

Moore et al. (2010), Chapter 16, pp 419-420

Extra Readings: Scarborough (2012), Chapter 11, pp 362-365.



Moore et al. (2010), Chapter 16, pp 423-426 Extra Readings: Scarborough (2012), Chapter 11, pp 370-382.


Extra Readings: Scarborough (2012), Chapter 11, pp 382-383-384.






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Other Sources

1. Small Business School video; company website: Glidden Point Oysters - http://www.oysterfarm.com

2. A.G.A Correa & Son http://www.agacorrea.com/aga/cgi

bin/aga.pl

3. Hardy Boat Cruises http://www.hardyboat.com. Maine Gold http://www.mainegold.com

4. Gulf of Maine Visionary Awards http://www.gulfofmaine.org/mediaroom/documents/2006Visionaryawards.pdf

Content Summary

6.1 Setting a Price

Cost Determination for Pricing

(a) Cost of goods offered for sale

(b) Selling cost

(c) Overhead cost applicable to the given product

How Customer Demand Affects Pricing Cost analysis can identify a level below which a price should not be set under normal circumstances, but does not show how much the final price might exceed that minimum figure and still be acceptable to customers

Elasticity of Demand

(a) Customer demand for a product is often sensitive to the price level

(b) Inelastic demand for a product means a lower total revenue when the price is raised

(c) Pricing and a firm’s competitive advantage

(d) When customers perceive the product/service as an important solution to their unsatisfied needs, they are likely to demand more


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(e) If competing firms offer identical products and services, then the services offered by the companies generally differ

(f) Prestige pricing is setting a high price to convey an image of high quality or uniqueness

6.2 Applying a Pricing System

Break-Even Analysis

(a) Examining cost and revenue relationships

(b) First phase of break-even analysis is to determine the sales volume level at which the product, at an assumed price, will generate enough revenue to start earning a profit

(c) Contribution margin difference between the unit selling price and the unit variable costs and expenses

(d) Unrealistic to assume that quantity sold can increase continually

(e) Incorporates sales forecasts

(f) Indirect impact of price on the quantity that can be sold complicates pricing decisions

Markup Pricing

(a) Applying a percentage to a product’s cost to obtain its selling price

(b) Manageable pricing system that allows quick pricing of many products

(c) Must cover operating expenses, subsequent price reductions (i.e. such things as markdowns and employee discounts) and desired profit


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6.3 Selecting a Pricing Strategy

Figure 6.1: Pricing strategies

Penetration Pricing

(a) Prices a product or service at less than its normal, long-range market price to gain more rapid market acceptance or to increase existing market share

(b) Strategy can sometimes discourage new competitors from entering the market niche

Skimming Pricing

(a) Sets prices for products/services at high levels for a limited period before reducing prices to lower, more competitive levels

(b) Assumes certain customers will pay the higher price due to perception of the product as a prestige item

Follow-the-Leader Pricing

(a) Uses a particular competitor as a model in setting a price for a product/service


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(b) Price differential options may not work with different size competitors

Variable Pricing

(a) Offers price concessions to certain customers

(b) Dynamic (personalised) pricing strategy charges more than the standard price after gauging a customer’s financial means and desire for the product

Price Lining

(a) Establishes distinct price categories

(b) Amount of inventory stocked at different quality levels depends on the income levels and buying desires of a store’s customers

Pricing at What the Market Will Bear Uses when the seller has little or no competition

Final Notes on Pricing Strategies

(a) Local, state, and federal laws may affect setting prices (Sherman Antitrust Act prohibits price fixing)

(b) Sometimes a line of products may have items which compete with each other in which case the effects of a single product must be considered when setting prices

(c) Adjusting a price to meet changing marketing conditions

(d) Can be costly to the seller and confusing to buyers

(e) Alternative may be a system of discounting design to reflect a variety of needs

(f) Pricing errors can be corrected

6.4 Offering Credit Explain the benefits of credit, factors that affect credit extension and types of credit.

Benefits of Credit

(a) Provides small firms with working capital, often allowing marginal businesses to continue operations

(b) Retail Customers (borrowers)

(i) Ability to satisfy immediate needs and pay for them later

(ii) Better records of purchases on credit billing statements

(iii) Better service and greater convenience when exchanging purchased items


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(iv) Establishment of a credit history

(c) Suppliers

(i) Facilitate increased sales volume

(ii) Suppliers earn money on unpaid balances

(iii) Closer association with customers because of implied trust

(iv) Easier selling through telephone, mail-order systems and the Internet

(v) Smoother sales peaks and valleys, since purchasing power is always available

(vi) Easy access to a tool with which to stay competitive

Factors That Affect Selling on Credit

(a) Credit sales should increase profits but this is not a risk-free practice

(b) May shift or share credit risk by accepting credit cards

(c) Cost of accepting credit cards includes fraud protection, “chargebacks”

(d) Variety of reasons why small businesses may decide not to sell on credit including the type of business, credit policies of competitors, customers’ income levels and the availability of working capital

Type of Business

(a) Retailers of durable goods typically grant credit more freely than those that sell perishables or primarily serve local customers

(b) Big ticket items often must be sold on an instalment basis

Types of Credit

(a) Consumer credit including open charge accounts, instalment accounts, revolving charge accounts

(b) Credit cards including bank credit cards, entertainment credit cards. retailer credit cards

(c) Trade Credit (depends on product sold and circumstances of the buyer and the seller)


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Managing the Credit Process

(a) Describe the credit process.

(b) Evaluation of Credit Applicants with Four Credit Questions

(i) Can the buyer pay as promised?

(ii) Will the buyer pay?

(iii) If so, when will the buyer pay?

(iv) If not, can the buyer be forced to pay?

The traditional five C’s of credit (character, capital, capacity, conditions, collateral) are relevant.

Sources of Credit Information

(a) Customer’s previous credit history

(b) Trade credit agencies collect credit information on businesses

(c) Credit bureaus summarise a number of firms’ credit experiences with particular individuals

Aging of Accounts Receivable Aging schedule (see Exhibit 16-6 Hypothetical Aging Schedule for Accounts Receivable)

Billing and Collection Procedures

(a) Timely notification of customers indicating the status of their accounts is the most effective method of keeping credit accounts current

(b) Overdue credit accounts time seller’s working capital

(c) Effective weapon in collecting past-due accounts is reminding debtors that their credit standing may be impaired

(d) Bad-debt ratio is the ratio of bad debts to credit sales

Credit Regulation

(a) Variety of federal and state laws that vary from state to state

(b) Federal legislation includes: The Fair Credit Billing; The Fair Credit Reporting Act; The Equal Credit Opportunity Act; The Fair Debt Collection Practices Act

Pricing and credit decisions have a direct impact on a firm’s financial health.


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Study Questions

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

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

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

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

5. Based on this case study, answer the questions that follow.

(a) What advice would you give Mat Junid regarding the screening of new credit customers?

(b) What action should Mat Junid take to encourage current credit customers to pay their debts? Be specific.

(c) Mat Junid has considered eliminating credit sales. What are the possible consequences of this decision?

SUPPLIES TEMPORARY OFFICE HELP

Mat Junid is the 35-year-old owner of a highly competitive small business that supplies temporary office help. Like most businesspeople, he is always looking for ways to increase profit. However, the nature of his competition makes it very difficult to raise prices for the temps’ services, while reducing their wages makes recruiting difficult. Mat Junid has, nevertheless, found an area – bad debts – in which improvement should increase profits. A friend and business consultant met Mat Junid to advise him on credit management policies. Mat Junid was pleased to get his friend’s advice, as bad debts were costing him about two percent of sales. Currently, Mat Junid has no system for managing credit.

Adapted from Moore et al. (2010)

20140829084556_topic 6 pricing and credit strategies

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