The Fixation of the Pricing and Profitability - Case Study Example

The Fixation of the Pricing and Profitability Introduction Although market forces of demand and supply and other economic factors play more important role than the decisions of management in fixation of selling prices, the management while fixing the prices has to keep in view the profit desired. In the end, the selling prices of the products have to be higher than the total cost as otherwise the profits cannot be earned. However, invariably circumstances arise for management to consider special conditions and sell its regular products at a special price, which may be lower than the total cost. Accordingly, fixation of selling prices is a process to be considered both under a) normal circumstances and b) in times of competition and/ or trade depression. In the long run under normal circumstances, the selling price must cover cost (i.e., variable cost plus fixed cost) and give a reasonable amount of profit. This is essential for the survival of a business. In the short run due to adverse market conditions, the selling price may have to be fixed below total cost but it should be above variable cost. In other words, the selling price may be temporarily fixed at marginal cost plus contribution basis and the amount of contribution depends upon demand and supply, acuteness of competition, non cost factors etc. The important thing to consider is that fixation of selling price below total cost may be made only at on a short-term basis. Pricing of shoes via CVP technique Blimey Choo Shoe Company, a shoe manufacturing company, is contemplating to enter into a fierce competitive business venture to bid for its products to be used by the Chinese contingent participating in the upcoming Olympic Games, 2008. These are special circumstances, and therefore the company must put its costing structure under a systematized pricing technique to arrive at various suitable pricing options for bidding purposes. The pricing technique briefed in introduction above is technique based on Cost-Volume-Profit analysis (CVP) technique. CVP is a study of inter- relationship between sales, costs, and operating profits. Whenever there are changes in output, sale price, variable or fixed cost of the product, CVP analysis provide the resultant effects. This analysis is based on certain principles and underlying assumptions detailed as under: i) Reducing cost of goods sold and operating cost from total revenue of product sold calculate operating income. Non-operative revenue and non-operative expenditures do not exist for the purposes of CVP analysis. ii) The difference between revenue and variable cost is called contribution margin. Only variable cost is deducted from revenue to arrive at contribution margin. iii) Fixed costs remain constant at every level and do not increase or decrease with changes in output. Any change in total costs is the result of change in variable costs. iv) Variable costs fluctuate directly with output. In other words, variable costs vary in the same proportion in which volume of output or sales varies. v) All costs are capable of being bifurcated into fixed and variable elements. vi) Selling prices remain constant even with volume of production or sales changes. vii) The behavior of both sales revenue and expenses is linear throughout the entire range of activity. Sales and expenses are affected only by volume. viii) Production and sales remain identical. ix) Inventories do not change significantly from period to period. x) The analysis either covers a single product or assumes that sales mix, when a mix of products is sold, remains constant as the level of total quantity sold changes. Under CVP technique, the factors that play a decisive role in price fixation are Variable Costs, Contribution, and Fixed Costs (Overheads). An analysis of these factors is made hereunder in context of price fixation for Bilmey Choo Company: a) Variable Costs In the case of Blimey Choo Shoe Company special circumstances exists, as the company will be bidding the contract to supply 4,000 pairs each of Soccer Shoes (SS) and Athletic Shoes (AS). The competition is fierce and therefore matter is to be considered from a short-term point of view. The first step under such circumstances is to find the variable cost of producing 4000 pieces each of SS and AS, and that cost is calculated hereunder in table A. Table A b) Contribution Contribution is the difference between sales value and variable cost of sales. Also known as Gross Margin, it contributes towards meeting fixed costs and beyond that the resultant figure is profit of the business. Accordingly, Contribution margin is the key factor in taking crucial pricing decisions. It is not the maximization of total contribution that matters, but the contribution in terms of key factor that is important while comparing the relative profitability of different proposals. In case of Blimey Choo Shoe Company, the proposed selling prices are available and we have already calculated variable costs per pair of shoe (Table A) . Accordingly, the contribution to meet fixed cost is calculated as under: Table B c) Fixed Costs or Overhead Calculations of fixed cost or overheads in case of Bimey Choo Shoe Company present some tricky situations as overheads are being incurred on both production units and service units. Though absorption of overheads of service units has to be on basis as declared, the allocation of common overheads for all concerned units have been made on basis of reasonability as per the nature of the concerned overhead expenditure. Accordingly the under noted basis of allocation have been adopted for allocation of different fixed costs or overheads to respective production units : Overheads Basis of allocation Rent & Taxes Area covered by each unit Supervisory Salary No. Of employees in each unit Maintenance Department Salary Manufacturing hours available with each prod.unit Air Conditioning & lighting Area covered by each unit Depreciation of machinery Cost of Plant & Machinery installed in each unit Insurance of Machinery Cost of Plant & Machinery installed in each unit Building Insurance Area covered by each unit Further, the service units’ overheads have been absorbed on following declared basis and priority: Unit Priority Basis of absorption Canteen First No. of employees Stores Second value of material consumed Maintenance Third Manufacturing hours Based on the above stated criteria the fixed cost or overheads per unit have been calculated as shown in the table C below. Table C At this stage, it is important to refer to the concept of ‘Break Even Analysis’. The break-even point is the volume of output or sales at which total cost is exactly equal to sales. It is a point of no profits no loss. This is the minimum point of business activity at which total cost is recovered and after this revenue contributes to profitability. That means to achieve break even the company’s revenue must cover both its variable and fixed costs. Profitability and its impact on price fixation When variable cost technique is used for fixation of prices, the price should be higher than the variable cost so that it contributes towards fixed cost and help reduce the loss. When price is equal to variable cost, the amount of loss will be equal to the amount of fixed cost because in such situations the selling prices do not contribute towards fixed cost. In circumstances of competition, like the one faced by Bilmey, if selling price is higher than variable cost, the production should not be stopped. This is because fixed cost will have to be incurred irrespective of whether production is continued or not, and continuing the production will help reducing the amount of loss. The unit is under profit when contribution exceeds the fixed costs or overheads. Contributions, as calculated in table B, on basis of the proposed pricing of $55 per pair of Soccer Shoes (SS) and $65 per pair of Athletic Shoes (AS) result into profits shown below: At proposed sales prices, total Contribution per pair is 18.125% of the total sale value. This ratio is known as Profit- Volume ratio or P/V Ratio. P/V ratio is one of the most important ratios to watch in business. It is an indicator at which point profit is being earned. A high P/V ratio indicates high profitability and a low ratio indicates low profitability in the business. The profitability of different sections of the business such as sales area, classes of customers, product lines, methods of production, etc., may also be compared with the help of profit- volume ratio. In case of Blimey Choo Shoe Company, profitability of two types of shoes it is producing can be compared on basis P/V ratio of each of production line. The P/v ratio of Soccer Shoes (SS) and Athletic shoes activity lines are calculated hereunder: The P/V ratio is the function of sales and variable cost (as contribution is sales minus variable cost). Thus, it can be improved by widening the gap between sales and variable cost. Blimey Choo Shoe company can increase P/V ratio by: a) Increasing the selling prices of SS and/ or AS b) Reducing the variable cost, e.g., purchasing the material in larger quantity and taking the advantage of reduced material cost if available on large quantity purchases. c) Changing sales mix, i.e., selling more of Soccer shoes (SS) than Athletic Shoes (AS) as the P/V ratio of AS is much higher than SS. Blimey Choo Shoe Company can also make use of P/V ratio technique for the following: i) For calculating Break Even point ii) For calculating profit at given level of sales of SS and SS separately and in a mix. iii) Calculation of the volume of sales earning a given profit. Sensitivity Analysis Sensitivity analysis is a technique to assess the effects of input changes on the output of model developed to solve certain business issues. In the computing techniques, spreadsheets are used for sensitivity analysis. Excel is such spreadsheet that is widely used for such analysis. ‘Most formulation in Excel are in the form of a computational flow from one input cell (or range) to another till we reach one (or more) result or output cell’ (Akram, 2006) Using Excel spreadsheet and the technique of Cost- volume-profit analysis, various pricing and profitability options at disposal of Bimey Choo Shoe Company are analyzed hereunder: a) When production and sale in each of two components is 1000 units more than original forecast P/V ratio is assumed to be 20% of selling price. Effects on profitability using CVP technique are depicted below under three different scenarios, namely, when other factors remain the same, when profits on sales, i.e., P/V ratio increases by 5%, and when P/V ratio decreases by 5%: b) When production and sale in each two components is 1000 units more than original forecast and direct material cost increases/ decreases by 10% P/V ratio is assumed to be 20% of selling price. Effects of increase/ decrease in direct material cost increases by 10%, on pricing and profitability are depicted in the following model: Increase in the material cost will spur the variable cost and in order to maintain the same level of profit margin or P/V ratio, the prices have to be increased to cover the shortfall in contribution. Decrease in material cost will reduce the variable cost and the company will get the liberty to reduce prices if the same profit margin or P/V ratio is required. This is true in both cases whether there is increase or decrease in production and sale of pair of shoes in each category as shown in c) below where there is decrease of pairs in production and sale. c) When production and sale in each two components is 1000 units less than original forecast P/V ratio is assumed to be 20% of selling price. Effects of increase/ decrease in direct material cost increases by 10%, on pricing and profitability are depicted in the following model: Sensitivity analysis has opened a number of options for the Blimey Choo Company in order to make a selection of pricing and profitability in the face of fierce competition. The bidding process prefer lowest bid along with qualitative options. Sometime quality overpowers the criteria of lowest bid offered. The range of options calculated under CVP technique above provide different pricing strategies for the purpose. References Akram, December 2006, What is Sensitivity Analysis, http://www.lockergnome.com/nexus/akramnajjar/2006/12/16/sensitivity-analysis/ Read More