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1. Decisions that convert costs from variable to fixed or vice versa. 2. Decision that reduce or increase costs. 3. Decision that increase sales volume.

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Presentation on theme: "1. Decisions that convert costs from variable to fixed or vice versa. 2. Decision that reduce or increase costs. 3. Decision that increase sales volume."— Presentation transcript:

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2 1. Decisions that convert costs from variable to fixed or vice versa. 2. Decision that reduce or increase costs. 3. Decision that increase sales volume or revenue. 4. Decision to change selling price. Break-Even Analysis

3 BEQ = FC / (P-VC) 1 BEQ = Break even sales quantity FC = Fixed cost per period P = Price VC = direct variable cost per unit. BES = FC/PV 2 BES = Break even in sales revenue PV = profit volume or PV ratio PV = (P-VC)/P 3 Profit = (sales revenue x PV) – Fixed cost 4 PV = (Target profit +Fixed expense)/Sales revenue 5 Break-Even Analysis

4 Operating Leverage

5 Leverage for Developing Price Strategy Application of small amount of force to one end of rigid mechanism on a fulcrum to raise a heavy object on the other end Small change in sales volume leads to larger change in operating profits.

6 Leverage Price- Demand- Operating Profit – Earning Price changes can affect sales volume, revenue, cost, contribution and operating profit

7 Leverage DOL = % change in operating profits % change in sales volume Year change Sales120,000100,00020% Operating profits 70,000 50,00040% Leverage2 (for every 1 percent change in sales, it brings 2 % in operating profits)

8 Sample of Income statement

9 In Pricing Leverage can be applied to increase the operating profit (EBIT) through: - Operating Leverage - Financial Leverage - Combined Leverage

10 Operating Leverage Amplifying the effect of sales volume on operating profits Fixed operating costs as one component of the costs born by company (Profit target can be treated as fixed expense) Changing price (increase/ decrease) produces market reaction (reduce /increase) sales volume It is not easy to know the price elasticity prior making price changes decision.

11 Operating Leverage Amplifying the effect of sales volume on operating profits Price reduction initial loss in revenue and contribution How many additional units need to be sold to achieve equal profit achieved prior the price reduction? Price increase initial gain in revenue and contributions How many units can the firm afford not to sell to achieve equal profit achieved prior the price increase? DOL = (OP/OP)÷(Q/Q) DOL = degree of operating leverage; OP = Operating Profit (before I and T) in previous period; Q = Sales volume in the previous period; = Change

12 Financial Leverage Amplifying the effect of change in operating profits on earning per share Use of debt in financing the firm. Interest is fixed financial charge that must be paid Greater debt greater leverage the more fixed financial costs in fixed operating costs to enhance the impact of changes in sales volume. DFL is the ratio of change in operating profits before interest and taxes. DFL = % change in operating profits BIT______ % change in operating profits before tax = DFL = __OP_ OP- iD

13 Combined Leverage

14 Pricing Single Product With Fixed Cost Structure No change Decrease price 6.2%Increase price 7% Price per unit ($) Variable cost per unit ($) Contribution per unit ($) PV Fixed cost ($) 2,000, Desired profits ($) 10,000, Required sales revenue ($) 48,000, ,000, ,000, Required unit volume (unit) 2,400, ,200, ,870, %-22%

15 Testing Pricing alternatives

16 Leverage

17 Prerequisite for Successful Price Reductions Product has large contribution margin prior price reduction. Product- market must be in growth situations (has elastic demand) Combined leverage should be greater than its competitors. For any price change: - required sales volume = minimum amount necessary to meet the contribution target the elasticity boundary that still provides the profits when the price changes

18 Pricing With Different Cost Structure

19 Pricing In Multi Product Mix Different product could have different cost structure, price, sales volume, and revenues Different product produces different profit volume ratio Product sales mix could produce: - Greater profits for fewer sales - Smaller profits for more sales It is more important to achieve maximum contributions revenues for each product than maximize sales revenues Example: hotel room.

20 Pricing In Multi Product Mix Each product has different PV, different sales volume and contribution to the total sales volume For multiple products mix, we should adapt the PV by weighting each product PV with the percentage of the total monetary volume for all product in the line

21 Pricing in multi product Product PV % of total monetary volume Proportion of total monetary volume Weighted PV % of total monetary volume Proportion of total monetary volume Weighted PV A B C Composite

22 Pricing With Scarce Resources Firms resources (machine, labors, material, times, cash etc.) are always limited. Not all products produced use similar amount of resources per dollar of revenues. Resources can be allocated based on a). unit contribution, b). total contributions, or c). proportionately based on resource requirement. But to decide the pricing based on the margin contributions may not effectively help the company to achieve its profits goals better to use CPRU

23 ABCTotal Price ($) Variable Cost Direct Labor ($) Direct Material Total ($) Contribution ($) Data For Planning Period Demand 6,200 8,100 5,000 Revenue ($) 13,640 24,300 20,000 57,940 Direct Labor ($) 7,440 5,670 3,000 16,110 Direct Material ($) 2,542 12,474 12,000 27,016 Contribution ($) 3,658 6,156 5,000 14,814 Material required (ton) 500 2,500 2,400 5,400 Units per ton , Tons per unit Material needed per unit Max. contribu tion

24 Assumption: only 3000 tons of material is available for production process CriterionResource Units Unit ProducedTotal Contribution Contribution per unit A B 600 1,944 1,477 C 2,400 5,000 6,477 Total Contribution A B 2,500 8,100 6,156 C 500 1,041 7,197 Proportion of Resouces needed A 270 3,348 1,975 B 1,410 4,588 3,472 C 1,320 2,750 8,197

25 Contribution per Resource Unit (CPRU) ABC Contribution ($) 3,658 6,156 5,000 Resource Units 500 2,500 2,400 CPRU ($) A B C Price ($) Variable Cost ($) Contribution ($) Demand 3, , , Units produced 3, , , Resource required , , contributions ($) 11, , , CPRU ($) Optimum price solution


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