Decision making –

 Pricing
 Alternative manf options
 R&D
 Mktg
 Distribution
 Contract negotiations
 Outsourcing decisions
 Capital budgeting decisions

CVP analysis / breakeven analysis

used to calculate effect on profitability of changes in product mix and in quantities sold. It examines
relationship between costs, revenue and profits.

Assumptions –

 Costs are either variable or fixed

 Total costs and total rev are predictable and linear
 Fixed costs remain constant
 VC per unit remain constant
 Unit selling price and sales mix remain constant
 FG and WIP do not change
 Time value of money is ignored

CM = revenue – variable costs

amount that goes toward covering the fixed costs

CM ratio – CM / total rev

expressed as a percentage of the sales price

breakeven analysis – the operating income is always 0 at breakeven point

in units – FC / unit CM

in rev – FC / CM ratio

profit req

pre tax

 specific dollar amt - required pre-tax profit is treated as an additional fixed cost
in Units = Total Fixed Cost + Target Pre-Tax / Contribution Margin Per Unit
Revenue = Total Fixed Cost + Target Pre-Tax / Contribution Margin Ratio
  As a percentage of sales - pre-tax profit that each unit must generate is treated as an
additional variable cost, since it changes in total with changes in the sales level.
Fixed cost / cm – percentage of sales

After tax

 Special dollar amt

Target pre-tax income = Target after-tax income / (1 – tax rate)

 As a percentage of sales
target pre-tax net income needed per unit = Required after-tax percentage of revenue × Sale
price per unit / (1 – tax rate)
FC/ Sale price per unit – Variable cost per unit –Target pre-tax net income needed per unit

Breakeven analysis in decision making

Two main –

Increasing Fixed Marketing Costs to Increase Sales

Bep - Present Fixed Costs + Proposed Advertising Fixed Cost + Required Profit / Contribution Margin
Per Unit

Reducing Sales Price to Increase Sales

Fixed Costs + Required Profit / Contribution Margin Per Unit

Breakeven When more than one pdt is sold – assume constant sales mix

Sales qty mix

 Find cm of each pdt

 Multiple cm of each into percentage of mix and add it = weighted avg cm
 FC/ weighted avg cm
 Multiple percentage to get qty of each pdt to be produced

Sales rev mix

 Find cm ratio for each pdt

 Multiple cm ratio of each into percentage of mix and add it = weighted avg cm ratio
 FC/ weighted avg cm ratio
 Multiple percentage to get rev of each pdt

Effect of changes in sales mix

  If the company’s sales mix changes, operating income can change, even if total revenue does
not change, depending on the contribution margins of each of the individual
products/services in the mix
 If the products with higher contribution margins increase in proportion to those with lower,
operating income will increase and breakeven point in units and revenue will decrease. mix
becomes more beneficial.
 If the products with lower contribution margins increase in proportion operating income will
decrease and breakeven point in units and revenue will increase. mix becomes less
beneficial.

Sensitivity analysis

used to determine changes in operating income that take place if sales level, price or costs change

Margin of Safety = Planned Sales – Breakeven Sales

excess of budgeted sales over breakeven sale, it measures amount by which sales can fall without
company becoming unprofitable.

Margin of Safety Ratio = Margin of Safety ÷ Planned Sales

product with relatively low margin of safety is riskier than product with high margin of safety

expected value

sum of (prob * outcome)

deterministic approach - select the level of output or sales that is most likely

fixed vs variable costs

high fixed cost/low variable costs option is more attractive as volume increases

marginal analysis

analysis of how benefits and costs change in response to incremental changes in production.

Marginal costs revenues are addition to total cost or total revenue that results from one-unit
increase in production

Types of costs

 Relevant rev and costs can be –

- Incremental - incurred additionally as a result of an activity.
- Differential - differ between two alternatives.
 Avoidable cost – relevant costs, avoided if a particular option is selected
 Unavoidable – irrelevant costs cannot be eliminated
  Sunk costs – irrelevant, money already spent
 Explicit - identified and accounted for
 Implicit – not recorded in books
 Opportunity costs - contribution to income that is forgone by not using a limited resource in
its best alternative use

Marginal rev under different mkt structures

 Perfect competition – many buyers and sellers, customers are indifferent, pdt is
standardised

marginal revenue from sale of one more unit is equal to market price because sellers do not need to
reduce price to increase sales volume.

 Monopoly – only one efficient supplier, pdt is unique, high barriers of entry, control over
price, downward facing dd curve I,e demand is negatively related to price.

marginal revenue received from producing an additional unit will be less than price received as it will
have to lower price for all units it sells in order to get consumers to buy additional output. Marginal
rev curve is below dd curve.

 Monopolistic competition - many firms operate in the market and do not collude with one
another in setting prices, products are similar but not identical.

Marginal rev curve is below dd curve, must drop price to sell additional units.

 Oligopoly - few firms operating, each firm affected by what others do, pdt can be
standardized or differentiated, participants exhibit strategic behaviour - consider impact of
actions on competitors

price decrease is matched by competitors, but price increase is usually not be followed

point where MR = MC is the point of production and sales that will maximize profit

avg cost – total cost / total units produced

cost and cost objects

 cost object is any item or activity for which we can measure the costs.
 Cost assignment is a term that refers to both tracing costs and allocating costs to a cost
object

Cost behaviour (when prodn increases)

 Fixed – fixed in total but decreases in total

 Variable – increases in total but fixed per unit
 Mixed
 Semi fixed - fixed over a given range of activity, and above that it suddenly jumps, moves
upward in a step fashion

Semi variable - basic fixed amount must be paid regardless of activity and added to it is
amount that varies with activity. Exp – utilities

Tax effects

 net incremental revenue should be reduced by resulting tax liability and net incremental
expense reduced by tax benefit that results from the tax-deductible expense
 Depreciation expense is a tax-deductible expense. The amount of tax savings is called
depreciation tax shield which is amount of the depreciation multiplied by the company’s tax
rate.

Make vs buy

Relevant costs – purchasing costs and avoidable variable costs and fixed costs of in house prodn

Maximum Price willing to Pay outsider = Total Internal Production Costs – Unavoidable Costs

Special order decisions

Factors to be considered –

 Direct costs of prodn - costs that would be avoidable if the company did not produce this
order.
 Level of operating capacity – if operating at full capacity, must also recover contribution
(selling price - variable costs) lost on units that are not going to be produced and sold
because of producing this order.

Sell or process further decisions

Joint prodn

 place in the production process where products become individually identifiable is called
splitoff point. Costs incurred up to the splitoff point are joint costs. Costs incurred after
splitoff point are separable costs.
 increased revenues attainable by processing further should be balanced against the
increased costs to process further

disinvestment decisions

If revenue from division is less than avoidable costs of division, division should be terminated

Change in existing level of output

Marginal product

 Law of Diminishing Returns - states that as more and more of a resource is put into
production process, increase in total production that will result from each additional unit of
input decreases. Therefore, increase in total revenue from addition of more and more
resources also declines.
 adding additional workers will cause output to rise up to a certain point. However,
eventually additional output and revenue derived from adding more workers will reduce as
more workers crowd around a fixed workspace to use fixed quantity of capital.
 profit-maximizing firm should add units of a specific resource only as long as each successive
unit of the resource added adds more to the firm’s total revenue than it adds to total cost

marginal cost

change in total cost that results from using one additional unit of a resource

Pricing

If price too high – not sell enough – lose money

If too low – not earn enough

Influencers –

 Customers – high dd, low supply, price increases

 Competitors – if their price is low, price decreases
 Costs – lower cost, more supply

Demand

Law of demand - price of product is inversely related to quantity demanded

Elasticity of dd - percentage change in quantity demanded divided by the percentage change in

price.

 Elastic - quantity demanded changes by larger percentage than associated change in price.
price decrease will result in an increase in total revenue and vice versa. Perfectly elastic has
horizontal line
 Inelastic - quantity demanded changes by a smaller percentage than the associated change
in the product’s price. price increase will result in increased total revenue. Perfectly inelastic
has vertical line

Mid point / arc method to calculate eod

= (Q2 – Q1) / [(Q2 + Q1) / 2] / (P2 – P1) / [(P2 + P1) / 2]

 Ed = 0 – perfectly inelastic
  Ed = 1 - unitary elastic
 Ed < 1 – inelastic
 Ed > 1 – elastic

Supply

Law of supply – positive relationship b/w price and supply of good

Factors that have direct relationship with the supply curve (rightward shift)
 Number of producers - Increase in the number of producers generally causes an increase in
the quantity of products supplied at any particular price point.
 Government subsidies - Availability of subsidy reduces the production cost. This causes an
increase in the quantity of products supplied at any particular price point.
 Expectations of price increases - Expectation that prices are likely to increase in the future
causes an increase in production / supply. However, there may be an inverse relationship if
suppliers hoard.
 Technological advancement - This reduces the production cost and will cause an increase in
the quantity of products supplied at any particular price point.

Equilibrium

point where the demand curve intersects with the supply curve

Short-Run Equilibrium Pricing

 if equilibrium price is greater than firm’s average variable cost, any profit-maximizing firm
will produce at the point where marginal revenue = marginal cost
 if equilibrium price is lower than firm’s average variable cost, firm will shut down.
 The price at which firm’s production is just covering its average variable cost but there is
nothing extra to put toward covering fixed costs is called shut-down price.

In pure competition -

 Many buyers and sellers, pdt is standardised, customers are indifferent, no barriers to entry
or exit, no non price competition, perfect info available, price taker
 Dd curve is perfectly elastic
 equilibrium price is the market price. Demand=AR=MR=P.
 firm adjusts level of output in response to changes in market price to maximize its profit.
 output decisions that individual firms make have no effect on the market price

In monopoly –

 Single firm, unique pdt, barrier to entry, price maker

 Monopoly quantity is determined at the point where MR=MC.
  highest price is point on demand curve directly above desired quantity. It will earn an
economic profit equal to the difference between price and average total cost at desired
quantity

in monopolistic competition

 many non-collusive firms, pdt can be differentiated, minimal barriers, limited control over
price
 higly elastic dd curve
 In the short run, maximizes profit by producing where marginal revenue equals marginal
cost
 in the long run, other firms will enter the industry because of the economic profits to be
earned. As new firms enter the market, the demand curve and the marginal revenue curve
of each of the older firms shift to the left.

In oligopoly

 Few firms, standardized or differentiated products, prices may be rigid, barriers, Demand is
static in the short term
 relatively elastic curve when prices increase because other firms will not follow price
increase and the firm will lose sales. Therefore, a small increase in price will lead to a large
decrease in demand.
 relatively inelastic, when price decreases because the other firms will match price decrease.
Therefore, the firm will need to make a large price decrease in order to gain any sales.

Pricing strategy

Internal factors

 Mktg obj – pdt quality leadership, mkt share leadership, survival, profit maximisation, low to
discourage competition
 Mktg mix strategy - Decisions made about quality, promotion and distribution will affect
pricing decision
 Costs - Costs include not only production costs but also distribution and selling costs, both
fixed and variable, and give it a fair profit
 Organisational considerations – who sets the price

External factors

 Mkt and dd - set the upper limit for prices.

 Competitors
 Others - inflation, recession, and interest rates

Pricing approaches
Cost based - figures out total costs and sets a price that covers its cost plus a factor for profit. If the
market decides that price is too high, company has to reduce its price and settle for lower profits or
leave the price high and settle for lower sales. product – cost - price - value – customer

Types

 Cost plus pricing

 Markup pricing –
- Markup on cost - Price = Item Cost + (Item Cost × Markup Percentage)
- Markup on selling price - Item Cost / 1 – Markup Percentage
 Break even and target profit pricing

Value based - target price is based on customer perceptions of the value of the product

customer - value - price - cost – product

types

 everyday low pricing

 high low pricing

Competition based – types

 Going rate pricing – if homogeneous good firms normally all charge the same price.
However, if a company is a market leader, it can elect to maintain its price while raising
perceived value or quality of its product, or perhaps launch a lower-priced “fighter” line.
 Bidding - sealed-bid pricing is when each company submits a bid that is based more on how
it thinks its competitors will bid rather than on its costs. The winning bid will be the lowest
price
 Target pricing - begins with selling price, based on customer demand and prices charged by
the competition and then figures out how to produce product at a cost that permits an
adequate profit

Price adjustment strategies

 Cash discounts for early payment

 Volume discounts
 Seasonal discounts - for purchasing products or services out of season, when sales are
generally low.
 Trade discounts - to trade channel members
 Allowances – promotional, upgrade, trade in

New pdt pricing –

 Penetration - set a low initial price with the expectation that high sales volume will result.
The goal is to win market share, stimulate market growth, and discourage competition.
market must be price-sensitive and demand for product elastic.
  Skimming - initial high price to “skim” market by attracting early purchasers. When sales
slowdown, and competitors enter, company lowers price to attract the next group of price-
sensitive customers.

Pdt mix pricing

 Pdt line pricing - Price points are set

 Optional pdt pricing – option to buy another at low price
 Captive pdt pricing – requires use of additional, more costly pdt
 By pdt pricing - manufacturer should accept any price that is higher than cost of storing and
delivering. Proceeds from the sale of by-product reduces cost of the main product
 Pdt bundle pricing - seller bundles products, features or services together and offers it at a
price that is lower than the price of the items if purchased individually. If the customer has
only one option to purchase entire bundle, it’s called pure bundling. However, if consumer
has choice between buying bundle or buying items individually that is called mixed bundling.

Short run vs long run

in the long run, all costs are variable.

Profit margins in long-run are set to earn a return on investment. In the short run, prices are based
on dd

Short run –

 Availability of production capacity plays an important, If a manufacturing company has

excess capacity, it will be more likely to price its products lower than it would be if it were
operating at 100% capacity
 fixed costs are frequently irrelevant
 competitor’s price plays an imp role

long run –

 mkt based - focuses on what the customers want and how competitors will react, no
influence over price. Types –

target pricing – first establish target price, then target cost per unit must be determined.

Target Price – Target Operating Income Per Unit = Target Cost Per Unit

Can cut costs by – value engineering - evaluation of all business functions in value chain with the
objective of reducing costs while satisfying customer needs. Eliminate non value adding costs

 cost based – used when pdt differentiation, calculates cost of production and then adds a
markup of an amount that will result in a target rate of return on investment.

Must not include cost of unused assets, as it results in a figure higher than the actual “cost” of
production, leading to a decreased demand and further idle fixed assets. This continued decrease in
demand is called the downward demand spiral.
Lifecycle costing

tracks and accumulates all costs of each product all the way through the value chain.

Lifecycle of pdt – development

 Introduction - Promotion spending needs to be high, Pricing is usually the highest as early
adopters buy the product and the company has goal of recovering development costs
quickly. Sometimes, set low to gain large mkt share
 Growth - Prices are usually decreased to be competitive in the market, though if the product
is extremely popular, prices may be maintained at a high level. Profits increase because
promotion and fixed manufacturing costs are spread over a larger volume. Continuously
improve quality and gain mkt share.
 Maturity - sales peak, but sales growth slows down. prices begin to decrease while
promotion costs increase, leading to lower profits. mktg obj is to maximize profit while
defending market share. look for ways to modify market, product, and mktg mix to extend
product’s life cycle
 Decline - marketing objective is to reduce expenditures and make the most of the brand.
Decision must be made whether to maintain, harvest, or drop

Price discrimination is the practice of charging different prices for the same product to different
customers.

Peak-load pricing involves charging a higher price for the same product or service at times when
demand is the greatest and a lower price at times when demand is lowest

Illegal pricing –

 Predatory prices – reducing prices too low to wipe out competition and then increase later
to recover
 Robinson patman act - makes it illegal for manufacturers to discriminate between customers
in the U.S. based on prices
 Collusive prices - two or more companies act together to either restrict output or to set
prices at an artificially high level.
 Dumping - occurs when company sets price of product artificially low and sells it in another
country.
 Cartel - group of firms that create formal, written agreement that governs how much each
member will produce and charge. The objective is to limit competitive forces

High low method