a)  Distinguish between cost plus pricing and profit oriented pricing

Cost plus pricing is a management pricing tool where the pricing decision focuses totally on costs, ensuring that a selling price is set that covers the costs of running the business and will be sufficient to provide a profit. The selling price is arrived at by simply adding to costs a profit percentage to get the selling price. It is based on the following formula.

The percentage mark-up will generally be an industry norm and will vary depending on what actual costs (direct costs only or total costs) are taken into account. There are three main approaches to cost plus pricing.

1.   Gross margin pricing: This is where cost (C) represents just the materials cost or cost of sales. In this situation the mark-up percentage is quite high as it must be sufficient to cover both direct labour and direct expenses as well as overhead expenses and provide a profit.

2.   Direct cost pricing: This is where cost (C) represents the total direct costs. In this situation the mark-up percentage must be sufficient to cover both overhead expenses and provide a profit.

3.   Full cost pricing: This is where cost (C) represents total costs of the business. In this situation the mark-up percentage can be quite small as it represents clear profit.

Different business sectors will use different cost based methods. For example, the fast moving consumer goods (FMCG) end of the retail sector tends to use gross margin pricing, whereas other business sectors may use a full costing approach. It all depends on the business sector and the sophistication of the costing system used.

Profit oriented pricing focuses on profit and in particular the required level of profit for the amount of investment in the business. The focus is on the return on investment required of a business by its investors. The process involves calculating a total sales figure that should achieve a return on investment that will satisfy investors, assuming forecast costs and demand are accurate. The technique is an extension of the cost based and contribution pricing methods with an extra variable, profit or return, as part of the equation. The total estimated sales figure, divided by expected forecast demand will give a selling price which will ensure the required level of profitability for investors, provided costs and demand levels remain as forecast

Profit oriented methods are effectively cost based methods taking into account a required rate of return (profitability and investment). Thus their advantages include those of the cost based method with the added advantages that this method focuses on profit and investment.The main criticisms are, that as with cost based methods, it does not focus on the market, price elasticity of demand, competition and the economic environment and thus is considered quite insular. As with the cost based methods, it is considered a good point to start off in tackling the pricing question.

The American Hotel and Motel Association formalised a profit oriented pricing method for all hotel / motels. This method they called the 'Hubbard formula'. It starts with the required profit after tax on capital invested and then adds back taxation, financing costs and all fixed operating costs until total contribution required to achieve such a profit is calculated. The profit contributions of other revenue producing departments in a hotel such as restaurant, bar and banqueting are deducted from this total contribution, to leave the contribution required from accommodation. Adding on variable costs, a total accommodation sales figure is calculated which, when divided by an expected occupancy level, will give an average selling price. The Hubbard formula employs a process that is ultimately designed to set prices that will yield a specified return on capital for the hotel sector.

b) Explain and give examples of market oriented pricing

In any business sector where the level of competition is intense, most pricing strategies are market driven. This certainly is the case regarding the hospitality, tourism and retail sectors. The following are examples of some market based pricing strategies common to these sectors.

Going rate pricing / competition oriented pricing

This is quite common in the accommodation and travel sectors where price is set close to the level of your main competitor in the market. Competitors pricing quite often has the most significant influence on the price setting decision. This strategy is often called 'follow the leader' and it is essential that costs and profit are monitored under this strategy.

Perceived value /psychological pricing

This involves charging what, according to your own research, the market will accept based upon the consumers perception of the product. Thus understanding the consumer’s perceptions of your product or service can provide information regarding their ceiling in terms of what they are willing to pay. This approach recognises that consumers have a predetermined price range within which they are happy to purchase goods and services. Thus price is set within this range.

Loss leader / decoy pricing

An example of a loss leader would be where supermarkets reduce the price of one product to attract customers who will then buy other products. Examples of decoy pricing would be in the restaurant business where the business has high levels of beef in stock compared to chicken. The focus would be to increase the price of chicken to encourage customers to buy the beef.

Two-part pricing

This would be where some tourism organisations may charge a low basic price to gain access but then charge for additional services once the consumer has the basic product. For example in museums there may be a low or zero charge to gain access to the museum but then an extra charge to gain access to specific exhibitions.

Camouflage pricing

This is where businesses try to ensure that customers cannot compare their prices to competitors. This is done by advertising specific packages which include a number of products or services ensuring the consumer will find it hard to compare prices. For example, in the off-season, hotels can offer two nights B & B plus one evening meal or some ferry companies can charge based on one car while others can charge based on a per person rate.