Pricing Decisions

Dilip M. SarwateProfessor Emeritus & Certified

Management Consultant

What is price?It is the amount a consumer is willing to pay for fulfilling needs & wants through

acquiring products & services

Everything has a pricePrice goes by many namesRent for an apartment, Tuition for educationFare for a train, Interest for a loanTariff for MSEB, Fee for a lawyerToll on highway, Wage for a workerPremium for insurance, Commission to a sales personBribe by a government official, Salary for the executiveHonorarium for faculty, Income tax for making moneyDowry for marriage, Khandani for extortionMatch fixing by a bookie, Donation to a politicianElecting scoundrels is the price, we pay for democracy,Without it, life would be nice

Pricing will have to be worked out for,

a. Manufactured goodsb. Traded goods

c. Servicesd. Others like agriculture produce etc.

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COST ANALYSIS

Cost terminologies

• Prime cost: Material cost + labor cost + direct expenses

• Works cost: Prime cost + production overheads

• Cost of production: Works costs + admin overheads

• Cost of goods sold: Cost of production + selling & distribution costs

• Marginal cost: Variable cost

• Contribution: Sales – variable cost

• Profit: Contribution – fixed cost

• Sales – variable cost = Fixed cost + profit

Cost terminologies (Cont.)

• Opportunity cost: Economic benefit obtained or lost by accepting one alternative over another.

• Sunk cost: Economic resources already committed and spent. Cannot be recovered if there are no results.

• Differential costs: Additional out of pocket costs on account of a result of specific decisions. Cost implications on account of changes in 4 P’s.

• Replacement costs: Investments in assets at old costs to be replaced at today’s or tomorrow’s price.

Cost terminologies (Cont.)

• Batch costing: Different costs added for a certain batch of production.

• Activity based costing: Costs allotted on the basis of various activities performed.

• Process costing: Different business processes and their costs till the final product is ready.

Pricing for other than manufactured goods

• Traded goods: Discount versus mark up• Services: Per hour basis, percentage of cost of

project basis, seniority basis and others• Agriculture produce: Supply & demand basis

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DEFINITIONS• Fixed costs: (Those costs which are not related

to volume of production) Salaries, electricity for admin office, administrative cost, overhead costs, interest on term loan, annual maintenance cost, depreciation

• Variable costs: (Those costs which are directly related to volume of production) Raw materials, packaging, wages, utilities used in manufacturing, interest on working capital, sundry expenses

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Cost breakdown analysis

(Engineering, FMCG, Service

Companies)

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Cost breakdown as a percentage of Sale

EngineeringCompany

100

Mktg5 - 7W & S7 - 8

RM50 - 60

ConsumerCompany

100

Mktg25 - 30

W & S7 - 8

RM25 - 30

ServiceOrganization

Establishment30 - 40

Mktg10 - 15

RM10 - 15

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Breakeven AnalysisDefinition - Breakeven point is a level of production volume or the capacity utilization where a company breaks even without getting any profit or incurring any loss. Typically, this point is called - “No Profit No Loss Point”

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1. Breakeven Point = Fixed Cost / Contribution per Unit = Fixed Cost / (Selling Price - Variable Cost PU)2. Breakeven Sales = (FC \ Sales) / (Sales - VC)3. Margin of Safety = Present Sales Value - Breakeven Sales Value4. Profit / Volume Ratio…………Profit means ContributionVolume means Sales Value5. Profit = (P/V) \ Margin of Safety

Sensitivity analysis

• Price• Fixed cost• Variable cost By making assumptions with respect to say realizing

10% less Price and/or increase in Fixed cost and Variable cost say by 10%, what happens to Break Even Volume?

The most sensitive is the one resulting in highest volume needed for break even.

The power of analyticsDeveloping winning strategies

By Professor Davenport

To identify the most profitable products, territories, customers

and so on

Cost analysis

• By products• Bu customers• By territories• By operating divisions• By sales force• By order size• By channels of distribution• By method of selling• By mode of transportation • By terms of sale (Advance, credit and instalment)

Pricing Decisions

Price setting in Theorya. Market penetration pricingb.Market skimming pricingc. Multi brand pricingd.Multi level pricing

Pricing decisions

Price setting in practice• Cost plus method• Target return• Competitive parity• Demand oriented wrt to product quality,

customer, quantity, payment terms and seasonality

• Sealed bid pricing

International pricing

Market Imperatives

• Country/Region/Type of customer (AU/OEM/Jobber/Reseller/ Government)

• Entry barriers• Custom duties• Volume• Payment terms• Competition (Local/overseas)• Seasonality• Any other

Export Incentives

• Duty drawback(Excise/ Customs)• Import entitlement (Premium prevailing at the

time on import license)• Tax advantage• Preferential allotment of raw materials,

electricity• Assistance in doing overseas market research• Any others

Export objectives

• Utilization of capacity• Import entitlement• Market penetration• Quality improvement• Employment generation• Earning foreign exchange• Ego building

Inco Terms

• Ex factory price• FOR• FAS• FOB• C & F• CIF• FRANCO

Cost elements• Cost of goods manufactured• Inspection costs• Inbound transportation• Loading/unloading costs• Port charges• Transit insurance• Risk insurance (ECGC)• Banking charges• Freight• Demurrage• Loading/unloading at port of destination• Custom duties• Landed cost• Wastage costs

Proforma Invoice

• Name of the consignee• Description and specification of goods• Volume• Delivery period• Price (FOB, CIF) and currency• Mode of payment• Transportation• Insurance

• Other terms & conditions (Inspection, warrantee, force majeure, jurisdiction and others)

Transfer pricing This is the price charged by a MNC in a country. To minimize group profit,

they artificially raise profit in low tax countries and reduce profit in high tax countries.

The variables include:• Volume of business and over all profit expected• Restrictions on repatriation• Competition• Differential in income tax rates• Performance evaluation of foreign units• Import restrictions and customs duties• Restrictions on royalty• Availability of local funds and cash flow to be maintained• Fluctuating currency and rate of inflation• Anti dumping laws• Risk factors

Complexity of International Finance

• Accounting practices• Forex fluctuations• Tax laws• Interest rates• Inflation rates• Working capital norms• Liquidity

Complexity of International Finance (cont.)

Exchange rates• Fixed • Floating• Current ( Mix of fixed and floating)

Forex market: The banks, dealers, brokers and users are involved in this market. The RBI keeps a track of change staking place and decides the rates.Spot transactions: Actual physical exchange of currency takes place after

the deal is done.

Forward transaction: Payment received after some days. Hence, there are spot and forward rates.

Complexity of International Finance (cont.)

Exchange rate quotation• Direct: Number of units of home currency that are paid

for a single unit of foreign currency• Indirect: Number of unit of foreign currency one would

pay for a unit of home currency• % Change = ( Beginning rate – Ending rate)x

100/(Ending rate)• % Change= (Ending rate – Beginning rate) x 100/

(Beginning rate)

Foreign exchange risks

• Translation exposure: Affects financial statements

• Transaction exposure: Due to time lag, forex fluctuations

• Economic exposure: Cash flow affected due to effects of exchange rate changes

International cash management• Transaction cost: Commercial cost, bank charges etc• Institutional barriers: Differing tax system, exchange control

etc.• Local liquidity needs• Organizational considerations

Risk management techniques

• Hedging: Delays

• External: Adopting positions in financial markets like forward contract, currency swaps, future/options, government insurance schemes (ECGC)

• Internal: Modifications to exposures within company like,1. Use of netting or matching2. Leading or lagging3. Sifting risk to customers/suppliers4. Invoices for purchases in domestic currency5. Invoice prices directly to exchange rates

Tax havens

These are the countries who offer zero or low tax rates like Monaco, St. Kitts. Isle of Man etc.MNC’s defer taxes by channeling income through such countries and creating paper subsidiaries.

International taxation: Tax earned in home country on income earned on,• Dividends• Interest from foreign branch subsidiary• Double tax avoidance treaty

Entry barriers

Tariff barriers• Customs duties• Any other

Non-tariff barriers • Banned items• Restricted quota• Barter system• Local procurement• Investments in local country

Understanding basic financeBalance sheet analysis

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PROFIT & LOSS STATEMENTIncome• From sales• From other sources

Expenses• Raw materials and other consumables• Wages & salaries• Utilities• Administrative & other overhead costs• Maintenance• Operating profit (EBIDT)• Interest • Cash profit• Depreciation• Book profit• Income tax• Net profit

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BALANCE SHEETSources of funds• Equity• Loans• Reserves & surplus

Application of funds• Fixed assets (Land, Building, Plant & machinery, sundry assets)• Current assets (Raw materials, GIP, finished goods, sundry debtors, cash)

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Analysis of Financial Performance

Stability - Financial Strength, Relative Stake of Shareholders

Liquidity - Availability of liquid resources to meet commitments

Turnover - Efficient handling of stocks, debtors & creditors

Profitability - Operational profit, profit before & after tax, return on investments

Coverage - Servicing of debt & equity

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Financial Ratios

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1. Stability RatioA. Fixed Assets / Net WorthB. Debt / Equity

2. Liquidity RatioA. Current Ratio = Current Assets /

Current LiabilitiesB. Quick Ratio = (Current Assets – Inventory)/

Current Liabilities3. Turnover Ratio/

A. Stock Turnover Ratio = Cost of Sales / Average Stock

B. Debtors Turnover Ratio = (Debtors x 365)/ Annual Credit Sales

C. Creditors Turnover Ratio = (Creditors x365) / Annual Credit Purchases

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4. Profitability Ratio.A. Profit before tax ratio = (PB / Sales) X 100B. Return on Total = (PAT) / Total

Capital Employed5. Coverage.

A. Interest Cover = PBIT / Interest charges

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APPLICATIONS OF RATIO ANALYSIS

• TREND ANALYSIS• BUDGETING• COMPARISON WITH MAJOR COMPETITORS• COMPARISON WITH OTHER INDUSTRY

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Case studies

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