Price Differentials in Financial Management
First let's understand the meaning of terms Price and Differential.
- Price : The literal meaning of the word 'PRICE' is the amount of money expected, required or given by one party to another party in return of some goods and / or services.
- Differential : Whereas, the word 'DIFFERENTIAL' means something pertaining to diversity (difference) between comparable things in terms of their price, quantity, quality, etc.
Pricing is an important factor in the financial management. Basically, the cost of production comprises a major share of the raw material pricing. The procurement of a raw material needs proper forecasting and analysis. This helps an organisation to quote a competitive price of the finished product.
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Price differentials may occur because of the terms of payment and the category of the customer. In this case, the same product is charged with different prices mainly because of the two factors discussed below.
A. Terms of Payment :-
Payment terms may change the price of the same product to the various customers. Broadly, the terms of payment are classified into CASH and CREDIT. This can be explained as follows.
- CASH payment will offer higher DISCOUNT to the customer; which will result in reduce price of the products.
- CREDIT payment will result in NO DISCOUNT to the customer. Further, the seller also recovers the interest cost of working capital with the increase in per unit cost of the product.
B. Customer's Category :-
Price differentials may occur with respect to the category of the end customer’s transaction with the organisation. Broadly, these can be categorized as a REGULAR CUSTOMER and IRREGULAR CUSTOMER. This can be explained as follows.
- Vendor companies usually charge REGULAR CUSTOMERS at an agreed or reduced price, to retain the customer with the organisation.
- Vendor companies usually charge IRREGULAR CUSTOMERS at the prevailing price in the market.
Price differentials may occur due to the quantity ordered and quality of the product. In this case, the price of the product varies because of the various factors discussed as follows:-
- Quantity is usually related to the size of order, which is being measured in terms of physical units of the particular commodity. If the ordered quantity is more, the price of the products may be reduced to compensate the storage cost and the fixed cost of the product.
- Quality : In this case, a slightly different product is charged at different price regardless of its cost-price relationship. The same product may be divided into different grades with some further processing or features, to quote relatively maximum and minimum price for the same products.
Price differentials may occur due to the place of acquisition of the goods and services. The price differentials occur due to the component of freight in addition to the cost of goods and services. This cost grows in importance as freight becomes a larger part of total variable cost.
- Purchase from Market : If the product or services are acquired directly from the market, the cost of the goods and services will be relatively low and vice-versa. This is because it does not include various components such as freight, labour, packaging, etc.
- Delivery of Goods : If the product is delivered at the buyer premises, the basic price of the goods may remain same but the other costs such as freight, labour, packaging, etc. will add to the price of the product.
Note:- However, this may not hold true for the bulk order of the goods and servicing of installed plant and machinery. But placing an order with the vendor who can provide you the same facilities with reduced cost will prove an added advantage for the organisation.
Price differentials may occur due to the placing of order of the goods and services not at the proper and planned time. Charging different prices on the basis of timing is frequently practiced in the market. The price differentials occur due to the urgent requirements of goods and services.
- Advanced Order : The cost of AMC (Annual Maintenance Contract) will always result in lower cost to the organisation, if compared with the urgent requirement to resolve the issues of failure. The advance or pre-planned order of booking with the airlines or another transport system will be charged at considerable reduced price.
- Immediate order : The immediate order may always result in a higher cost. The purchase order raised for immediate requirements of stock will result in a higher acquisition cost, as the review time for selecting the best quotation would be less and vice-versa.
Conclusion on Price Differentials
Thus, pricing differentials play a crucial role in financial management. A finance manager will always try all possible ways to curbs the ills of higher pricing differentials. Furthermore, higher pricing differentials will dilute the profit of the organisation.