Pricing

The price (per unit) of 'primary commodities', such as, agricultural products and minerals is observed to be determined by the market forces of demand and supply, the price of' 'manufactures' is determined/ administered by firms based on the average/ marginal cost of production and the mark-up over and above the cost to accommodate profits. The margin of 'mark-up' in turn, depends on the degree of monopoly in the market. A monopolist is thus able to charge a higher margin of mark-up compared to a competitive firm.

If a public sector has a monopoly in supply, it may fix its price at the level that will maximize the mark-up as well as the gross profits. That may not, however, happen since the government may intervene to moderate the price in the interest of consumers or the user industries. In general, the governments fix/administer the price of goods (and services) being produced by public sector entities based on

(a) the true costs of goods and services,

(b) cross subsidization between one group and another or between one sector and another,

(c) below the costs if that can stimulate demand under conditions of excess/unutilized capacity,

(d) differential prices norm for peak and off-peak demand and

(e) different prices/ multi-tariffs to include discounts for purchase of larger volumes or for various other incentives. The public sector enterprises in India have had to work under the price regime, for goods and services produced by them, administered by the Government. Paradoxically, while these central public sector enterprises had to avail the government approval for fixing their prices, they have been price-takers for the inputs they utilized for their respective outputs. As such, if the output prices were not raised and the input costs went up, this led to losses to these enterprises. Better capacity utilization meant larger losses to the enterprises. This situation was reviewed in the wake of post- 1991 economic liberalization. With the dismantling of administered price mechanism thereafter, the price of products and services of these central public sector enterprises are now determined on economic grounds and by the market forces. The paragraphs below briefly discuss the evolution of pricing policies in respect of some of the major sectors covered by the public sector enterprises.

Pricing Basics:

To price products, you need to get familiar with pricing structures, especially the difference between margin and markup. As mentioned, every product must be priced to cover its production or wholesale cost, freight charges, a proportionate share of overhead (fixed and variable operating expenses), and a reasonable profit. Factors such as high overhead (particularly when renting in prime mall or shopping center locations), unpredictable insurance rates, shrinkage (shoplifting, employee or other theft, shippers' mistakes), seasonality, shifts in wholesale or raw material, increases in product costs and freight expenses, and sales or discounts will all affect the final pricing.

Overhead Expenses: Overhead refers to all non-labor expenses required to operate your business.

These expenses are either fixed or variable:

 Fixed expenses: No matter what the volume of sales is, these costs must be met every month. Fixed expenses include rent or mortgage payments, depreciation on fixed assets (such as cars and office equipment), salaries and associated payroll costs, liability and other insurance, utilities, membership dues and subscriptions (which can sometimes be affected by sales volume), and legal and accounting costs. These expenses do not change, regardless of whether a company's revenue goes up or down. 

Variable expenses: Most so-called variable expenses are really semivariable expenses that fluctuate from month to month in relation to sales and other factors, such as promotional efforts, change of season, and variations in the prices of supplies and services. Fitting into this category are expenses for telephone, office supplies (the more business, the greater the use of these items), printing, packaging, mailing, advertising, and promotion. When estimating variable expenses, use an average figure based on an estimate of the yearly total.

Cost of Goods Sold: Cost of goods sold, also known as cost of sales, refers to your cost to purchase products for resale or to your cost to manufacture products. Freight and delivery charges are customarily included in this figure. Accountants segregate cost of goods on an operating statement because it provides a measure of gross-profit margin when compared with sales, an important yardstick for measuring the business' profitability. Expressed as a percentage of total sales, cost of goods varies from one type of business to another.

Normally, the cost of goods sold bears a close relationship to sales. It will fluctuate, however, if increases in the prices paid for merchandise cannot be offset by increases in sales prices, or if special bargain purchases increase profit margins. These situations seldom make a large percentage change in the relationship between cost of goods sold and sales, making cost of goods sold a semi variable expense.

Price Determination:

Prices are generally established in one of four ways: 

Cost-Plus Pricing: Many manufacturers use cost-plus pricing. The key to being successful with this method is making sure that the "plus" figure not only covers all overhead but generates the percentage of profit you require as well. If your overhead figure is not accurate, you risk profits that are too low.

The following sample calculation should help you grasp the concept of cost-plus pricing:

Cost of materials (Rs.50.00) + Cost of labor (30.00) + Overhead (40.00) = Total cost (Rs.120.00) + Desired profit (20% on sales) (30.00) = Required sale price (Rs.150.00)

Demand Pricing:

Demand pricing is determined by the optimum combination of volume and profit. Products usually sold through different sources at different prices--retailers, discount chains, wholesalers, or direct mail marketers--are examples of goods whose price is determined by demand. A wholesaler might buy greater quantities than a retailer, which results in purchasing at a lower unit price. The wholesaler profits from a greater volume of sales of a product priced lower than that of the retailer. The retailer typically pays more per unit because he or she are unable to purchase, stock, and sell as great a quantity of product as a wholesaler does. This is why retailers charge higher prices to customers. Demand pricing is difficult to master because you must correctly calculate beforehand what price will generate the optimum relation of profit to volume.

Competitive Pricing:

Competitive pricing is generally used when there's an established market price for a particular product or service. If all your competitors are charging Rs.100 for a replacement windshield, for example, that's what you should charge. Competitive pricing is used most often within markets with commodity products, those that are difficult to differentiate from another. If there's a major market player, commonly referred to as the market leader, that company will often set the price that other, smaller companies within that same market will be compelled to follow. 

To use competitive pricing effectively, know the prices each competitor has established. Then figure out your optimum price and decide, based on direct comparison, whether you can defend the prices you've set. Should you wish to charge more than your competitors, be able to make a case for a higher price, such as providing a superior customer service or warranty policy. Before making a final commitment to your prices, make sure you know the level of price awareness within the market.

If you use competitive pricing to set the fees for a service business, be aware that unlike a situation in which several companies are selling essentially the same products, services vary widely from one firm to another. As a result, you can charge a higher fee for a superior service and still be considered competitive within your market.

Markup Pricing:

Used by manufacturers, wholesalers, and retailers, a markup is calculated by adding a set amount to the cost of a product, which results in the price charged to the customer. For example, if the cost of the product is Rs.100 and your selling price is Rs.140, the markup would be Rs.40. To find the percentage of markup on cost, divide the dollar amount of markup by the dollar amount of product cost: 

Rs.40 of the Rs.100 = 40%

This pricing method often generates confusion--not to mention lost profits--among many first-time small-business owners because markup (expressed as a percentage of cost) is often confused with gross margin (expressed as a percentage of selling price). The next section discusses the difference in markup and margin in greater depth. 

The main considerations in the formulation of a proper pricing policy for public sector consist of:

(1) rational allocation of resources,

(2) attainment of the optimum level of operations,

(3) generation of surpluses for reinvestment,

(4) making products available to consumers as widely as possible,

(5) coping with competition from private sector and foreign markets.

The pricing policy to be adopted by a particular public enterprise depends upon several factors, e.g.,

(a) nature of the enterprise-industrial,

(b) public utility,

(c) promotional,

(d) regulatory, etc,

Pricing policies of the Public enterprises:

In India different public enterprise has been found to follow alternative pricing policies:

1) No-Profit-no-Loss Pricing: Under their Memorandum of Association, Hindustan Insecticides and Hindustan Antibiotics follow this price policy. Break-even pricing is a strategy that yields zero profit on a transaction. At break-even pricing the sales revenue equals expenses and is calculated by totalling the fixed and variable costs. This happens when the Gross Profit that you earn from a business is exactly equal to the Fixed Expenses of the business.

2) Profit Pricing: Indian Railways, Sindri Fertilisers, Hindustan Machine Tools adopt this policy to contribute to public exchequer and to plough back their earnings.

3) Subsidized Pricing: The prices of the products of public enterprises charged by the government are blow their cost of the production, the subsidy being paid by the government. Subsidies, by means of creating a wedge between consumer prices and producer costs, lead to changes in demand/ supply decisions.

Subsidies are often aimed at :

1. inducing higher consumption/ production

2. offsetting market imperfections including internalisation of externalities;

3. achievement of social policy objectives including redistribution of income, population control, etc

Enterprises running schemes for public welfare follow this policy, e.g., the State Bank of India, Rural Branch Expansion Scheme, State Electricity Boards, Food Corporation of India 

4) Parity Pricing:

Parity price is commonly used in the context of convertible securities and often referred to as "conversion parity price" or "market conversion price". It is the price an investor effectively pays to exchange or convert a convertible security into common stock and is equal to the price of the convertible security divided by the conversion ratio (the number of shares that the convertible can be converted into). Conversely, in the case of common stock, it is calculated by dividing market value by the conversion ratio.

In agricultural commodities, you can think of parity price as the purchasing power of a particular commodity relative to a farmer's expenses such as wages, interest on debt, equipment, taxes and so forth. The Agricultural Adjustment Act of 1938 states that the parity price formula is "average prices received by farmers for agricultural commodities during the last 10 years and is designed to gradually adjust relative parity prices of specific commodities". If the parity price for a commodity is not sufficient enough for a farm operator to support his or her family and operate the business then the government could step in and support prices through direct purchases, or the issuance of non-recourse loans to farmers.

Hindustan Shipyard and such other enterprises follow this policy whose products have to compete with the foreign products. The landed price of imported products is considered. 

5) Discriminatory Price:

It leads to lower prices for some consumers and higher prices for others. Output can be expanded when price discrimination is very efficient, but output can also decline when discrimination is more effective at extracting surplus from highvalued users than expanding sales to low valued users. Even if output remains constant, price discrimination can reduce efficiency by misallocating output among consumers. 

6) Concessional Pricing for long-term contract or bulk purchases:

Hindustan Steel Ltd. Charges concessional prices on bulk purchases and Chittranjan Locomotives for longterm contract for the supply of locomotives.

7) Cost plus Pricing:

Cost-plus pricing is the simplest pricing method. The firm calculates the cost of producing the product and adds on a percentage (profit) to that price to give the selling price. This method although simple has two flaws; it takes no account of demand and there is no way of determining if potential customers will purchase the product at the calculated price. This appears in 2 forms, Full cost pricing which takes into consideration both variable and fixed costs and adds a % markup. The other is direct cost pricing which are variable costs plus a % markup, the latter is only used in periods of high competition as this method usually leads to a loss in the long run.

Hindustan Aeronautics, Indian telephone industries, Hindustan Cables and the Posts and Telegraphs Department fix prices by adding a certain margin (often 10%) of the cost of production. 

8. Dual Pricing:

Under this policy higher prices are charged from rich buyers an lower prices from poor buyers. The practice of setting prices at different levels depending on the currency used to make the purchase. Dual pricing may be used to accomplish a variety of goals, such as to gain entry into a foreign market by offering unusually low prices to buyers using the foreign currency, or as a method of price discrimination. 

Dual pricing can also take place in different markets that use the same currency. This is closer to price discrimination than when dual pricing is implemented in foreign markets and different currencies. Dual pricing is not necessarily an illegal pricing tactic; in fact, it is a legitimate pricing option in some industries. However, dual pricing, if done with the intent of dumping in a foreign market, can be considered illegal.

(9) Following the Leader:

An observation made of oligopic business behavior in which one company, usually the dominant competitor among several, leads the way in determining prices, the others soon following. In this case price are fix by the public enterpriser’s taking in to consideration the price of similar goods fixed by a leading undertaking in the same line of production. For example While Fixing the price Kerala Sop and oils company tale in to consideration the prices of Godreg Sop, Hindustan liver and Mysore Sop etc.

(10) Pooled Pricing:

Prices of fertilizers are fixed on the basis of the fertilizer pool. This pool comprises of retention prices paid to public sector fertilizer units and the price paid for imported fertilizers.

11. Other practices: Some other pricing practices followed by public enterprises are as follows:

(a) Enterprises like Air India, Shipping Corporation of India fix their rates as per trends in the international market. Similarly petrol prices depend on international prices of oil.

(b) Enterprises with a captive market charge prices so as to generate surplus for expansion, e.g., public sector hotels.

(c) STC, MMTC, etc. operate on the basis of the certain percent service charge on foreign operations.

The pricing in private and public enterprise differs primarily on the supply side. In the long run, private enterprises must cover total costs and provide an adequate return necessary to attract venture capital. In contrast, extra-commercial considerations may influence pricing in public enterprises. They may incur losses in the public interest under explicit directives from the government.

A number of theories of pricing in public enterprises have been put forward.

Most important of these are:

(1) marginal cost of production theory;

(2) no profit, no loss theory;

(3) average cost of production theory;

(4) theory of making profits.

All these theories suffer from a number of weaknesses and none of them taken individually is a satisfactory guide for determining the prices of the products of public enterprises. 

There however exists a strong case for public enterprises, particularly in developing countries, to earn reasonable profits in pricing their products. Public enterprises fostered on public revenues must yield surpluses which can be used either for their own expansion or for financing the general development plans of the country. The profits which a public enterprise can earn are an important indication of the justification for the use of economic resources in that economic activity. Upholding the test of profit not only lessens possibilities of the investment decisions being subjected to political pressures but also safeguards against inefficiency in management. A policy of profits is essential for attaining the goal of building a socialist society. The amount of profits expected from different enterprises, however, cannot be uniform because of diverse objectives sought in the setting up of public enterprises, degree of essentiality of their products, nature of the services provided by them, size of their market, class of their consumers and their paying capacity, conditions of market under which they operate, their role in stimulating growth and social benefits conferred by them.

ADMINISTERED PRICING:

The price of a good or service as dictated by a governmental or other governing agency, administered prices are not determined by regular market forces of supply and demand. 

Examples of administered prices included price controls and rent controls. Administered prices are often imposed to maintain the affordability of certain goods and to prevent price gouging during periods of shortages (such as gas prices). Rent controls are intended to stabilize rent in certain cities, where rents are reviewed by a standard of reasonableness.

The two basic types of price controls are price ceilings and price floors. Price ceilings are maximum prices set below the equilibrium price. Price floors are minimum prices set above the equilibrium price. Price controls imposed on an otherwise efficient and competitive market create imbalances (shortages or surpluses) which cause inefficiency. However, imposing price controls on a market that fails to achieve efficiency (due to market control, externalities, or imperfect information) can actual improve efficiency. Price controls have also be used economy-wide in an attempt to reduce inflation.

The proposed rationalisation/relaxation of entry and exit policy should enhance the competitiveness of the industrial sector. These benefits will he somewhat reduced if the Government continues to administer prices and the distribution of various industrial products. At present, the prices of industrial products such as natural gas, petroleum, petroleum products, coal, electricity, fertilizer, sugar and various non-ferrous metals are being administered by the Government. A thorough review of the usefulness of these price controls needs to be carried out. Wherever the product concerned is internationally tradable, the Government should decontrol the prices. In order to ensure that such price decontrols do not allow the existing producers to hike prices and hence enjoy "rents", the tariff rates on the import of these products should be suitably adjusted downwards, as had recently been done in the case of steel. Without such a supportive tariff adjustment, decontrol of hitherto administered prices may lead to unreasonable increase in the prices, thereby hurting the consumers. 

Causes of Administered Prices:

There are various causes behind government intervention and controlling the prices. The most important in the farm sector is to give the farmer stable and assured income .In the non farm sector important reason behind fixing the prices is to avoid the alternative of high prices resulting from the profit maximisation motive which inspires production for the market. 

1) Price must cover cost plus:

In the case of non agricultural prices, particularly of the goods produce by the public sector, there has been a long history since start of the public sector in the early fifteen till the mid seventeen when the purpose was maintaining the low price by following the principles of no profit no loss. The purpose was the socialist goal.

2) To strengthen weaker section of the society:

The second reason of administered price is to favour the weaker section of the society to get benefited. The price of the goods produce by the public enterprises is fixing below its production cost so that the weaker section get benefited. For example Janta cloth, Levy sugar or in the case of iron and steel used by the small scale industries

3) To avoided inflation:

The third reason to fixing prices is to avoid inflation or what is possibly more appropriate to this country, Stag inflation that is the phenomenon of high and rising prices along with stagnant or declining productivity and production. This latter purpose of countering stag inflation is never mentioned overtly and all emphasize is usually on the dumping down the inflation process.

4) To rise resource for the government:

The fourth purpose of pricing is to raise the resources for the government. The public visaged in the plans or financing the public sector enterprises outlay and then there is resort to rising administered prices. Even more frequently the rising of administered prices is the soft option chosen by the government in the place of increasing of taxes.

5) It may be to discourage or encourage the consumption:

The fifth cause for the administered pricing is to encourage or discourage the consumption of the commodities to make available the commodity at lower price for the weaker section of society and at the same time to avoid the state’s subsidizing the lowered pricing, the system of double pricing is introduce , wherein the well to do pay a higher price called the free market price which pay for the lower price of the commodity available to the poor called the levy price, as in case of cement sugar , paper etc.

6) Efficient allocation of the resources:

Finally an important purpose of the pricing is to ensure efficient allocation of the resources. Administered prices have given more offend than not to the wrong signals and resulted in the imbalance and distortion in the investment sector of the economy.

ADMINISTERED PRICING FOR PETROLEUM PRODUCTS:

As an example the country has traditionally operated under an Administered Pricing Mechanism for petroleum products. This system is based on the retention price concept under which the oil refineries, oil marketing companies and the pipelines are compensated for operating costs and are assured a return of 12% post-tax on networth. Under this concept, a fixed level of profitability for the oil companies is ensured subject to their achieving their specified capacity utilisation. Upstream companies, namely ONGC,oil and GAIL, are also under retention price concept and are assured a fixed return.

The administered pricing policy of petroleum products ensures that products used by the vulnerable sections of the society, like kerosene, or products used as feed stocks for production of fertilizer, like naphtha, may be sold at subsidized prices.

Gradually, the Government of India is moving away from the administered pricing regime to market-determined, tariff-based pricing. Free imports are permitted for almost all petroleum products except petrol and diesel. Free imports are permitted for almost all petroleum products except petrol and diesel. Free marketing of imported kerosene, LPG and lubricants by private parties is permitted. It is contemplated that in a phased manner, all administered price products will be taken out of the administered pricing regime and the system will be replaced by a progressive tariff regime in order to provide a level playing field for new investments in a free and competitive market.