Pricing Decisions

Dilip M. Sarwate
Professor 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 price

Price goes by many names Rent for an apartment, Tuition for education Fare for a train, Interest for a loan Tariff for MSEB, Fee for a lawyer Toll on highway, Wage for a worker Premium for insurance, Commission to a sales person Bribe by a government official, Salary for the executive Honorarium for faculty, Income tax for making money Dowry for marriage, Khandani for extortion Match fixing by a bookie, Donation to a politician Electing scoundrels is the price, we pay for democracy, Without it, life would be nice

Pricing will have to be worked out for,

a. Manufactured goods b. Traded goods c. Services d. Others like agriculture produce etc.

COST ANALYSIS

Dilip M. Sarwate

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 Ps.

Replacement costs: Investments in assets at old costs

to be replaced at todays or tomorrows price.

Cost terminologies (Cont.)

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

Activity based costing: Costs allotted

various activities performed. costs till the final product is ready.

on the basis of

Process costing: Different business processes and their

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

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

100
Mktg 5-7 W&S 7-8 RM 50 - 60 100

Mktg 25 - 30
W&S 7-8 RM 25 - 30 Consumer Company
Dilip M. Sarwate

Mktg 10 - 15
Establishment 30 - 40 RM 10 - 15 Service Organization
12

Engineering Company

Breakeven Analysis
Definition - 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 Value 4. Profit / Volume Ratio Profit means Contribution Volume means Sales Value 5. Profit = (P/V) \ Margin of Safety
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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 analytics Developing 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 Theory a. Market penetration pricing b. Market skimming pricing c. Multi brand pricing d. 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. 2. 3. 4. 5. Use of netting or matching Leading or lagging Sifting risk to customers/suppliers Invoices for purchases in domestic currency 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. MNCs 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 finance

Balance sheet analysis

PROFIT & LOSS STATEMENT

Income
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
Dilip M. Sarwate 37

BALANCE SHEET
Sources 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 Ratio A. Fixed Assets / Net Worth B. Debt / Equity 2. Liquidity Ratio A. Current Ratio = Current Assets / Current Liabilities B. Quick Ratio = (Current Assets Inventory)/ Current Liabilities 3. 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 100 B. Return on Total = (PAT) / Total Capital Employed 5. 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 PLAYERS

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Case studies

Thank you