Part 2: Section C LOS
Explain how sensitivity analysis can be used in CVP analysis when there is uncertainty about sales
sensitivity analysis involves changing the value of a single variable while holding the values for all other vari-ables constant and observing the effect on operating profit. After this has been done for each of the variables, the analyst gets a sense as to which variables are the most important ones. Those important variables are then the ones deserving of getting the greatest attention in refining the estimates of their values in the future. When sales are uncertain, managers can focus on other variables which they can control with sensitivity analysis. They can set a high margin of safety for cushion. This can be achieved by increasing sales price, decreasing variable costs, or shift the sales to high-margin products.
Identify and describe qualitative factors in make-or-buy decisions, such as product quality and dependability of suppliers
- Supplier's reputation for dependability and quality [can the need the quality requirement] - Ability to reverse situation or alter the production process [supplier's flexibility] - Supplier's Management - Intellectual property rights [whether company is willing to expose intellectual property to suppliers] - Employee morale: Will extending suppliers improve our company morale. - Company's strategy [whether outsourcing will maintain, loose, or improve competitive position]
Identify different pricing methodologies, including market comparables, cost-based, and value-based approaches
> Market-based pricing is whereby the market prices of identical and substitutable products determine the market price. This is normally done in highly-competitive and commodity-type markets such as airlines, oils, gas, minerals and farm products. Two market methods help determine prices: demand-based pricing and competition-based pricing. - Demand-pricing: If the demand for the product is high, the price will be set high. If demand is low and/or there are numerous substitutes for the product, the price will be set low. [different methods include price skimming] Methods of demand-based pricing can include price skimming, price discrimination and yield management, price points, psychological pricing, bundle printing, penetration pricing, price lining, value-based pricing pricing, and geo and premium pricing. - Competition-based pricing: the selling price is set according to the price offered by competitors for identical and/or substitutable products > Cost-based Approach: looks at the costs to develop a product or service and sets a price to recoup those costs[markup] and make a desired profit. Cost-based pricing is appropriate when some level of product or service differentiation exists. > Value-based pricing, or value-optimized pricing is a business strategy. It sets prices primarily, but not exclusively, on the value, perceived or estimated, to the customer rather than on the cost of the product, the market price, competitors' prices, or historical prices. The goal of value-based pricing is to align a price with the value delivered.
Define value engineering
Also referred as value analysis, value engineering is a systematic, organized approach to providing necessary functions that adds value in a project at the lowest cost. It is used to solve problems and identify and eliminate unwanted costs, while improving function and quality. The aim is to increase the value of products, satisfying the product's performance requirements at the lowest possible cost. Value engineering can help close the gap between current cost and allowable cost by differentiating between value-added costs and non-value-added costs. The overall objective of this analysis is to balance the overall costs and benefits and increase the overall value of the product. It involves: 1. Identifying the main elements of a product, service or project. 2. Analysing the functions of those elements. 3. Developing alternative solutions for delivering those functions. 4. Assessing the alternative solutions. 5. Allocating costs to the alternative solutions. 6. Developing in more detail the alternatives with the highest likelihood of success.
Define product life cycle; identify and explain the four stages of the product life cycle;
Analyze the life cycle: INTRODUCTION STAGE - Pricing tactic: Penetration Pricing to build brand and market share[customer-based] - Cost: Investment costs and production costs are high and inefficiencies are being worked out. - Competition: Market Competition is low [Few competitors], which makes demand inelastic to price - Customers: Type of customers are innovators[who do not care about spending] - Company is operating usually at a loss with low sales and high cost per customer. GROWTH STAGE - Pricing tactic: Premium Pricing to emphasize additional service features. [competition-based pricing] - Cost: Production costs are improving, but continue to be high - Competition: Beginning, but demand is still relatively price inelastic - Customers: Type of customers are early adopters - Profits are rising, with rapidly rising sales and lowing cost per customer. SHAKEOFF STAGE MATURITY STAGE - Pricing Tactic: Variable cost-based pricing is available to target profit margin, but investments are made in additional features and marketing campaign to keep the market focused on premium features of the services. [cost-based pricing] - Cost: Production costs are leveled out and efficient as the facility are operating near or at full capacity. Initial investments are recouped. - Competition: Strong - an oligopoly market is formed with 3 main competitors, which creates price elasticity[with elastic price it is not ideal to increase price because revenues will decrease - differentiation is ideal] - Customers: Middle Majority - Profits are high, with the sales at its peak and cost per customer at its trough. DECLINE STAGE - 3 choices: Recreate, Harvest, Discontinue a. Recreate the product to restart the life cycle b. Harvest the product with high close-out prices c. Discontinue the product with low close-out prices to extend sales volume - Cost: Excess production capacity is emerging, resulting cost inefficiencies - Competition: Very Strong and alternative services are disrupting the market, leading to significant price elasticity. [monopolistic competition] - Customer: Laggards - Profits: Declining, with the loosing sales and dropping demand
Evaluate and recommend pricing strategies under specific market conditions. Explain why pricing decisions might differ over the life of a product
Business firms need to consider how to cost and price a product over a multiyear product life cycle. The product life cycle considers the time from initial research and development on a product to when customer servicing and support is no longer offered for that product. Life cycle costing tracks costs attributable to each product from start to finish. Life cycle costs provide important information for pricing. Over the life cycle of the product, customer, competition and cost will vary. These 3 components affects the pricing decision of a manager. Take for example: > Introduction stage: Costs are very high at this stage, competition is low with less entrants and sales are slow for consumers might not have an instant demand for it. With this mix, we need to make sales in order to capture the market. Pricing strategy in this stage, businesses either price their products low or high, depending on their industry and financial projections. To price product low helps a business penetrate the market and gain market competition. Pricing products high will yield quick profits, and this is especially good if there a demand for a product and lack for competition. With the low competition, products are inelastic at this - so it can be considered to increase the price, resulting an increase in revenue. >
Demonstrate an understanding of the impact of income taxes on CVP analysis
Companies that will incur taxes will consider its effects when firms have target profit instead to operate at break-even. As firms increase the total contribution margin by either increasing the contribution margin per unit or shifting the product mix to high-margin product greater than the fixed cost, the result is an increase in taxes. Likely, the net income will decrease.
Define and demonstrate an understanding of target pricing and target costing and identify the main steps in developing target prices and target costs
Define: It is where the anticipated selling price[target price] and the desired profit are determined beforehand.Target price is the maximum allowable price that can be charged for the product or service. Steps: 1. Determine the target price 2. Determine the target profit margin 3. Determination and achieving the target cost. Techniques: 1. Determination of target price: - Market Assessment tools. [know the market and customers] - Reverse engineering. The acquisition and disassembly of competitors' products to investigate their design, material(s), likely manufacturing processes, attributes, quality, and costs 2. Determination of target profit margin: - Industry and competitive analysis [know your competitors to gain competitive advantage] - Financial Planning and Statement Analysis. 3. Determination of target cost: - Internal Cost Analysis - Cost tables How to achieve the target/allowable costs: 1. Concurrent engineering. Process where the product design as early in the process. 2. Value engineering. [Principal way]: Systematic analysis of the product/service design, materials, specifications, and process in the context of customer requirements. 3. Quality function deployment. structured approach to defining customer needs or requirements"voice of the customer" and translating them into specific plans to produce products to meet those needs. 4. Life-cycle costing. Tracks and accumulates all actual costs associated with a product or service throughout its life cycle.
Differentiate between costs that are fixed and costs that are variable with respect to levels of output
Fixed cost includes expenses that remain constant for a period of time "irrespective of the level of outputs", like rent, salaries, and loan payments, while variable costs are expenses that change "directly and proportionally" to the changes in business activity level or volume, like direct labor, taxes, and operational expenses. Moreover, fixed costs per unit decreases as the level of business activity increases. variable cost per unit is fixed even the volume of activity changes. However, when stated on a per unit basis, variable costs and the total fixed cost remain constant across all production levels within the relevant range
Explain why there is no unique breakeven point in multiple-product situations
For multiple-product situations, each product has varying contribution margin. In order to operate at break-even, company needs only to achieve a total contribution margin equal to the fixed cost. Hence, a company can create multiple different sales mix as as long as the contribution margin can be achieved. As the sales mix differ, the break-even point changes as well. This creates multiple possibilities and unique mix of products to operate at break-even. Hence, for simplicity, under CVP analysis, sales mix is constant over the period of analysis.
Discuss how pricing decisions can differ in the short run and in the long run
It is having a time horizon of less than one year and include decisions such as pricing a one-time Special order with no long-run implications[unused capacity is for only a short period and will be release for more profitable opportunities], and adjusting product mix and output volume in the competitive market. In here variable-cost information are taken into account. Long run pricing decisions is having time horizon of one year or longer and include decision such as: pricing a product in a major market[cost-plus, target costing]. In the long-run, firms can adjust the supply of virtually all of their activity resources. Therefore, a product or service should be priced to cover all of the resources that are committed to it - full-cost information. They differ because cost that are often irrelevant for short-policy decision[e.g. fixed costs] are generally relevant in the long-run because costs can be altered in the long-run. Profit margins in long run pricing decisions are often set to earn a reasonable return on investment.
Demonstrate an understanding of how cost/volume/profit (CVP) analysis (breakeven analysis) is used to examine the behavior of total revenues, total costs, and operating income as changes occur in output levels, selling prices, variable costs per unit, or fixed costs
It is method for analyzing the interrelationships among total cost, volume, and profits in an organization. It analyze the interactions among the selling prices, sale volume, variable costs, fixed costs, and sales mix. Allows decision making for - raising/lowering prices - introducing a new product/service - expanding a product - to replace an existing equipment[fixed costs] - deciding whether to make or buy a product or service Assumptions 1. Linearity: Revenue and cost functions are linear over the relevant range. 2. Certainty: the parameters [sales price, sales volume, unit variable costs and fixed costs] are known or can be reasonably estimated 3. Consistent single product/product mix: 4. Production equal sales!!!!
identify the effects of changes in capacity on production decisions
Low utilization: If some of your production capacity is idle, your investment in the facilities and equipment is not generating any income and reducing your potential profit. Since additional production volume does not increase fixed costs, higher capacity utilization may result in lower per-unit product costs and higher potential profits. Example, with capacity of 1,000, a facility produces 500 units with a VC of $20 and fixed cost of 10,000. A production of 500 will result a total cost of $ 20,000 or a unit cost of $40 [20,000 / 500]. If the facilities decide to utilize the production to another 300 units, the total cost is $ 26,000 or a unit cost of $32.5. Full utilization: When your product is successful, you can reach full capacity utilization, leading to high profitability and a streamlined manufacturing plant that turns out high-quality products. But a decision to expand to take over the new demand will decrease the total capacity utilization, drawing the profitability down but the increasing demand will compensate and increase the profit as it approaches full utilization. Over utilization: When capacity utilization passes its maximum due to demand that exceeds your ability to supply the products, your costs rise and product quality decreases. To meet excess demand, you have to schedule overtime that results in higher costs and stressed workers who make more mistakes. There is less time for equipment maintenance, and employees cut corners to maintain high excess levels of demand over actual capacity.
Define, calculate, and interpret the margin of safety and the margin of safety ratio
Margin of Safety is the allowable amount before the company will result a break-even at a given volume of sales/production. It defines how far the firm is beyond its break-even point at the current volume level. A high safety margin is preferred, as it indicates sound business performance with a wide buffer to absorb sales volatility. On the other hand, a low safety margin indicates a not so good position and must be improved by increasing the selling price, increasing sales volume, improving contribution margin via reduction of variable cost, or adopting a more profitable product mix. A low percentage of margin of safety might cause a business to cut expenses while a high spread of margin assures a company that it is protected from sales variability. MOS = MSR x Sales MOS = Sales - Breakeven Sales MOSR = 1 / DOL MOSR = EBIT / DOL MOSR = MS / Sales
Differentiate between a cost-based approach (cost-plus pricing, mark-up pricing) and a market-based approach to setting prices
Market-based pricing sets the product price based on customer expectations and demand. Companies that face high levels of competition use market-based pricing. Cost plus pricing involves adding a certain percentage to cost in order to fix the price. This method is simpler and use mostly on differentiated products.
Demonstrate an understanding of how changes in unit sales mix affect operating income in multiple-product situations
Organization normally sells not only on products. Sales mix shows the ratio of sold units for each sale transaction is made. When the resulting sales mix change, the sales mix contribution margin also change. The change would then affect the operating income for the period. Say, shifting the sales mix and focusing on selling more on high contribution margin product. As we sell less low contribution margin product, the over all contribution margin for the period increases. This means that we have enough earnings to cover the fixed costs. In effect, the overall operating income increases for that period.
Demonstrate an understanding of the short-run equilibrium price for the firm in (i) pure competition; (ii) monopolistic competition; (iii) oligopoly; and (iv) monopoly using the concepts of marginal revenue and marginal cost
Perfect Competition: Price Takers P = MC Monopolistic Competition: Price Makers Max profits: MR = MC P > MC Oligopoly: Price Makers P > MC Monopoly: Price Makers P > MC - Price takers are those firms that have little control over the prices of their products or services. For price takers cost information is of vital importance in deciding on the OUTPUT and MIX of products and services. - Price setters are those firms that have some discretion over the setting of selling prices for their products or services. Cost information is of vital importance to price setters in making PRICING DECISION.
Identify techniques used to set prices based on understanding customers' perceptions of value and competitors' technologies, products, and costs
Price skimming - a pricing strategy in which marketer sets a relatively high price for a product, the lowers it over time. It is a temporal version of price discrimination - which targets consumers that are less price conscious. Price skimming is sometimes referred to as riding down the demand curve. The objective of a price skimming strategy is to capture the consumer surplus. Price discrimination/Price differentiation exist when sales of identical goods of services are transaction at different prices from the same provider. (identical goods + same provider + different prices = discrimination). This is in violation of Robinson-Patman Act of 1936. Yield Management. The process of understanding, anticipating, and influencing consumer behavior in order to maximize yield or profits from a fixed, perishable source such as airline seats or hotel room reservation. As a specific, inventory-focused means of revenue management, yield management involves strategic control of inventory to sell it to the right customer at the right time for the right price. This process can result in price discrimination. Price points are prices at which demand for a given product is supposed to stay relatively high. It is the point where you are making the most - the point at which customer are still attracted to a product. Psychological pricing or price ending is a marketing practice based on the theory that certain prices have a psychological impact. Psychological pricing is one cause of price points. Product bundling is a marketing strategy that involves offering several products for sale as one combined product Penetration pricing is the pricing technique of setting a relatively low initial entry price, often lower than the eventual market price, to attract new customers. The strategy works on the expectation that customers will switch to the new brand because of the lower price. Value-based pricing, or value-optimized pricing is a business strategy. It sets prices primarily, but not exclusively, on the value, perceived or estimated, to the customer rather than on the cost of the product, the market price, competitors' prices, or historical prices. The goal of value-based pricing is to align a price with the value delivered. Product-mix pricing, the price is set low for some products or segments in the hope that it will attract others. If it is found that adults are usually accompanied by students, attempts could be made to find the mix of adult/student prices that brings in the most patrons. Off-peak pricing is used to encourage purchases during slower periods. A discounted pricing could be set on days when volume is expected to be low (e.g., cloudy days) or during slower times of the day (e.g., evening admission). Volume discount pricing could be used by allowing for discounts based on an individual patron's usage (e.g., season pass) or allowing for group discounts (e.g., clubs, church groups). Breakeven pricing is used to establish a frame of reference; it is not a stand-alone method for setting a price. Breakeven pricing determines the number of units that must be sold at a set price to cover all fixed and variable costs. Once the breakeven value is known, a firm can assess the feasibility of exceeding the breakeven price and generating a profit.
Define the pricing technique of cost plus target rate of return
Rate of return pricing is a method by which a company fixes the price of the product in such a way that it ultimately helps organisations in achieving the ultimate goal or return on the capital employed. The rate of return pricing helps the company in achieving a certain level of profit which is required to keep the liquidity intact. Pricing the product by rate of return can also have some short comings. It does not take into the account the price elasticity and the pricing of the competition which are two important things to consider before the final pricing is set.
Identify and define relevant costs (incremental, marginal, or differential costs), sunk costs, avoidable costs, explicit and implicit costs, split-off point, joint production costs, separable processing costs, and relevant revenues
Relevant Cost: Or also referred as incremental, marginal, or differential cost. These are costs that are affected by the decisions to be made. Costs that differs between a alternatives being considered. Sunk Costs: These are cost that are unchanged by decisions and are never relevant. Typically, past cost made prior to the decision are sunk cost. Future cost can also be "sunk" if these costs are unavoidable and unchanged by the decisions. For example, cost committed to be paid due to a contract signed are sunk cost. [depreciation are relevant cost] Avoidable Cost or also referred relevant cost. These are cost which can be avoided or terminated when making an alternative. Explicit costs are out-of-pocket costs, that is, actual payments. Examples of which are rents and salaries. Implicit cost represent the opportunity cost - the potential gain from other alternatives when one alternative is chosen. Split-off point: the location in a production process where jointly manufactured products are manufactured separately. It is the point after which their cost can be individually identified. Joint production cost: these are cost prior to split-off point allocated to jointly manufactured product. Normally, joint production cost are irrelevant. Separable Processing cost: These are cost incurred after the split-off point and are traceable to separately manufactured. Relevant Revenues: these are revenues what will change depending on a decision make.
Explain why the classification of fixed vs. variable costs is affected by the time frame being consideredThe relevant range is the range of activity (e.g., production or sales) over which these relationships are valid
The concept that a unit variable cost and the total fixed cost is constant only applies within the relevant range. The relevant range is the range of activity (e.g., production or sales) over which these relationships are valid. Moreover, these cost behave differently depending on the time horizon. Generally, these principles apply to fixed and variable cost classifications over time: • The shorter the time period, the higher the percentage of total costs that can be viewed as fixed. • The longer the time horizon, the more costs that can be viewed as variable. Example, you have a fixed cost for the month with a single equipment, clearly it behave as a fixed cost. But if we increase the relevant range and the time horizon to the point more equipment are purchased, it may behave like a variable cost. In the long-term all production factors are variable depending on the production level. Fixed costs turn into opportunity costs, i.e. the cost of alternatively employing production factors, such as rent and equity.
Define and explain elastic and inelastic demand
The elasticity of demand, or demand elasticity, refers to how sensitive demand for a good is compared to changes in other economic factors like price or income. When demand for a good or service is static when its price or other factor changes, it is said to be inelastic. So when the price goes up, consumers will not change their buying habits. So if there is a 1 percent change in the price of a good, then the amount demanded or supplied will have less than a 1 percent change. While many elastic goods have substitutes, inelastic goods do not. A common example of an elastic product is gasoline. The most common goods with inelastic demand are food, prescription drugs, and tobacco products. Another common example of a product with inelastic demand is salt Increasing the price of an elastic product will decrease the quantity and a decreasing revenue. But increasing the price of an inelastic product will remain the quantity demanded and increase the revenue.
Demonstrate an understanding of how the pricing of a product or service is affected by the demand for and supply of the product or service, as well as the market structure within which it operates
The four basic laws of supply and demand are: > If demand increases and supply remains unchanged, then it leads to higher equilibrium price and higher quantity. > If demand decreases and supply remains unchanged, then it leads to lower equilibrium price and lower quantity. > If supply increases and demand remains unchanged, then it leads to lower equilibrium price and higher quantity. > If supply decreases and demand remains unchanged, then it leads to higher equilibrium price and lower quantity. If a price for a particular product goes up and the customer is aware of all relevant information, demand will be reduced for that product. Should price decline, demand would increase.
Define and distinguish between a value-added cost and a nonvalue-added cost
Value-added costs are those costs that convert resources into products or services consistent with customer requirements. They are costs that cus-tomers perceive as adding value or utility to a product or service. Conversely, non-value-added costs are not critical to customer preferences, that adds to the total cost of a product or service but does not outwardly enhance its value from a consumer perspective. Examples VA: R&D to develop technology for voice command NVA: Cost to secure patent,
Explain why sunk costs are not relevant in the decision-making process
When making decision, we only need to focus on cost that relevant - those that differ between alternatives. Sunk cost are those that is indifferent between alternatives. These are cost that already incurred or to be paid but is the same on all alternatives. Hence, sunk cost are not relevant in the decision-making process.
demonstrate an understanding of the impact of income taxes on marginal analysis
When pretax operating income is maximized, net operating profit after tax (NOPAT) also is maximized. Therefore, income taxes are typically irrelevant in marginal analysis.
Define marginal analysis, marginal cost and marginal revenue
a.k.a Incremental analysis or differential analysis. Is a method of analyzing short-term decisions, emphasizing incremental cost increase or decrease rather than total costs and benefit associate with an action. Examples: - Specials Orders - Make or Buy - Sell or Process further - Add/drop a segment - Maximize contribution per unit of the limiting factor Marginal Revenue - the amount of revenue one could gain from selling one additional unit. Marginal Cost - the cost of selling one more unit MR = MC: Profit Maximizing Rule
Demonstrate an understanding of the impact of cartels on pricing
• Higher prices[which reduces the elasticity of demand] • Lack of transparency • Restricted output • Carving up a market - [less competition] !: cartels are most powerful when there are high barriers to entry.