Ch.11Using Leverage for Developing Pricing Strategies

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

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

Operating Leverage

http://youtu.be/T6OrW-Z27V4

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.

LeveragePrice- Demand- Operating Profit – Earning

Price changes can affect sales volume, revenue, cost, contribution and operating profit

Leverage

DOL = % change in operating profits % change in sales volume

Year 2011 2010 changeSales 120,000 100,000 20%Operating profits 70,000 50,00040%Leverage 2

(for every 1 percent change in sales, it brings 2 % in operating profits)

Sample of Income statement

0.06

0.29

0.5

0.1

In PricingLeverage can be applied to increase the

operating profit (EBIT) through:-Operating Leverage-Financial Leverage-Combined Leverage

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 volumeIt is not easy to know the price elasticity prior

making price changes decision.

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

Financial Leverage Amplifying the effect of change in operating

profits on earning per shareUse of debt in financing the firm.Interest is fixed financial charge that must be

paidGreater 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

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

= =

Pricing Single Product With Fixed Cost Structure

No change Decrease price

6.2% Increase price 7%

Price per unit ($) 20.00 18.76 21.40

Variable cost per unit ($) 15.00 15.00 15.00

Contribution per unit ($) 5.00 3.76 6.40

PV 0.25 0.20 0.30

Fixed cost ($) 2,000,000.00 2,000,000.00 2,000,000.00

Desired profits ($) 10,000,000.00 10,000,000.00 10,000,000.00 Required sales revenue ($) 48,000,000.00 60,000,000.00 40,000,000.00

Required unit volume (unit) 2,400,000.00 3,200,000.00 1,870,000.00

33% -22%

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.

Leverage

It depends on the price elasticity alsoPrice elasticity of demand good for price

reductionPrice inelasticity of demand good for price

increase

To calculate price elasticity of demand for a certain PV ratio:Price elasticity of demand ( Ed) =

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

Pricing With Different Cost Structure

Change in variable cost = Net change in margin__________

Original margin +net change in margin

Change in fixed costSales = FC/PV

Competitive price decrease

Pricing In Multi Product MixDifferent product could have different cost

structure, price, sales volume, and revenuesDifferent product produces different profit

volume ratioProduct 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.

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

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

A0.4 40 0.4 0.16 20 0.2 0.08

B0.2 30 0.3 0.06 50 0.5 0.1

C0.1 30 0.3 0.03 30 0.3 0.03

Composite 0.25 0.21

Pricing With Scarce ResourcesFirm’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

A B C TotalPrice ($) 2.20 3.00 4.00 Variable Cost Direct Labor ($) 1.20 0.70 0.60 Direct Material 0.41 1.54 2.40 Total ($) 1.61 2.24 3.00 Contribution ($) 0.59 0.76 1.00 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 12.40 3.24 2,063.00 Tons per unit 0.08 0.31 0.48

Mat

eria

l

need

ed p

er

unit

Max. contribution

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

Criterion Resource UnitsUnit Produced Total Contribution

Contribution per unitA - - - B 600 1,944 1,477 C 2,400 5,000 5,000

6,477 Total ContributionA - - - B 2,500 8,100 6,156 C 500 1,041 1,041

7,197 Proportion of Resouces neededA 270 3,348 1,975 B 1,410 4,588 3,472 C 1,320 2,750 2,750

8,197

Contribution per Resource Unit (CPRU)A B C

Contribution ($) 3,658 6,156 5,000

Resource Units 500 2,500 2,400 CPRU ($) 7.32 2.46 2.08

A B C Price ($) 5.00 5.00 6.00 Variable Cost ($) 1.61 2.24 3.00 Contribution ($) 3.39 2.76 3.00 Demand 3,340.00 4,900.00 3,000.00 Units produced 3,400.00 4,900.00 2,528.00 Resource required 274.19 1,512.34 1,213.47 contributions ($) 11,526.00 13,524.00 7,584.00 CPRU ($) 42.04 8.94 6.25

Optimum price solution