Ch.11 Using Leverage for Developing Pricing Strategies

1. Ch.11Using Leverage for Developing Pricing Strategies

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

3. Break-Even Analysis 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

4. Operating Leverage • http://youtu.be/T6OrW-Z27V4

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 2011 2010 change Sales 120,000 100,000 20% Operating profits 70,000 50,000 40% Leverage 2 (for every 1 percent change in sales, it brings 2 % in operating profits)

8. Sample of Income statement 0.06 0.1 0.29 0.5

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 • If Financial Leverage is combined with operating leverage, the effect of change in sales volume on earning per share is magnified. • DCL = DOL X DFL • = • =

14. Pricing Single Product With Fixed Cost Structure

15. Testing Pricing alternatives • Necessary volume changes: For price decrease, minimum volume increase can be calculated: • Volume increase (%) = ) 100 For price increase maximum volume decrease can be calculated: • Volume decrease (%) = ) 100 X = is the price change in percentage.

16. Leverage • It depends on the price elasticity also • Price elasticity of demand  good for price reduction • Price inelasticity of demand  good for price increase To calculate price elasticity of demand for a certain PV ratio: • Price elasticity of demand ( Ed) =

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 • Change in variable cost = Net change in margin__________ Original margin +net change in margin • Change in fixed cost Sales = FC/PV • Competitive price decrease

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

22. Pricing With Scarce Resources • Firm’s 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. Max. contribution Material needed per unit

24. Assumption: only 3000 tons of material is available for production process

25. Optimum price solution