Determining Pricing for Products or Services

When products or services are developed and ready to be provided to customers, an entrepreneur still needs to make a pricing decision. Entrepreneurs need to be careful to ensure that the appropriate price is determined since customers generally do not like increases in prices.

Price is one of the four Ps of the marketing mix, which are product, place (distribution), promotion and price. Price, further, is interrelated with other Ps of the marketing mix.

Price of the product or service directly affects the revenue of the business. It also indirectly affects demand for the product or service (level of sales). This refers to the fact that generally as price of the product or service decreases demand tend to increase and as price increases demand tend to decrease. Both of this influences of price needed to be taken into account when an entrepreneur decides on appropriate price for the product or service.

Sales revenue

Total sales revenue of the business depends on quantity sold and price. If we ignore the affect of changes in price on demand than we can assume that as price increases revenue will also increase and vice versa.

For example, if a small business owner increases its price from $6.5 to $7 and the demand stays the same at 150,000 units per year than the following changes in revenue will take place:

Sales revenue at $6.5 per unit: $6.5 * 150,000 = $975,000

Sales revenue at $7 per unit: $7 * 150,000 = $1,050,000

As we can see from the above, an entrepreneur can lose a $75,000 annually in sales revenue by charging just $0.5 less.

A price of the unit of product or service is the cost per unit sold plus profit per unit. To determine pricing, entrepreneurs firstly need to understand the total cost of providing product and service. This includes all costs involved in getting the product or service to customers and after sales service, and includes manufacturing, advertising, storage, delivery, taxes, salaries, et cetera. When considering costs, it is important to divide total costs into fixed costs and variable costs.

Fixed costs refer to costs which do not change as volume of sales changes. For example, assume that enterprise is renting a building. The rent paid is a fixed cost since it does not fluctuate with changes in sales volume. Even if company will not sell any products over a certain period, the rent must still be paid.

Variable costs, on the other hand, refer to costs which fluctuate with changes in sales volume. An example of variable cost is commission paid to sales personnel. For example, assume that the business sells product at $100 per unit and pays sales commission of $5 to its sales personnel. The sales commission is a variable cost since it will fluctuate with changes in sales volume.

Many entrepreneurs treat fixed and variable costs the same. An average pricing approach which is often used by entrepreneurs is a manifestation of this. To find average price, entrepreneurs take total cost from the last period and divide it by total number of units sold from the last period. This gives them an average cost per unit.

This approach is very risky. The problem with this approach is that it does not account for the difference in fixed and variable costs. For example, if sales of the business will be lower than last year than fixed cost will increase the average cost per unit. This can decrease or eliminate the profit margin of the business. What is even worse is that this can even lead to business making a loss.

For example, imagine that ABC Company in the last financial period had fixed costs of $750,000 and variable costs of $250,000. Over last period 150,000 units were sold. To determine the average cost per unit, ABC will divide $1,000,000 ($750,000 + $250,000) by 150,000 units. This results in average cost per unit of $6.7. Assume that on the basis of this ABC decided to charge $9 per unit.

However, the slowdown of the economy led to decrease in number of units that ABC could sell to 90,000 units. This decreased the variable cost to $150,000. However, the fixed cost of ABC was left unchanged at $750,000. The new average cost per unit of ABC is ($750,000+$150,000)/90,000=$10 per unit. Since company charges customers $9 per unit, which is less than its average cost per unit of $10, it is making a loss.

The above example illustrates very clearly how risky an average pricing is, especially for the small business.

Pricing changes and demand

When entrepreneurs determine pricing, it is important to consider how demand is affected by pricing. The response of demand to price changes depends on whether the goods or services is demand elastic or demand inelastic.

Elastic demand refers to demand for products and services when increase in price will result in decrease in quantity purchased and decrease in price will result in increase in quantity purchased. For example, a decrease in price of certain brand of chocolate may result in increase in quantity of this brand of chocolate that is purchased.

Inelastic demand refers to demand for products and services which do not respond much to changes in price. For example, if the price of sugar will increase, the quantity of sugar purchased will likely remain unchanged. This is because sugar is seen as necessity and the amount of sugar that is used is usually more or less fixed in quantity.

To determine whether demand is elastic or inelastic it is helpful to start from a desktop research. Desktop research refers to research that can be done at one’s desk, such as with the use of the internet. The product or service that the entrepreneur makes available is provided by other companies as well and information on their prices and volumes will be available. After some research you should be able to see if demand for the product or service that you want to provide is elastic or not.

The degree of elasticity will determine barriers that entrepreneur has to consider when increasing the price of the product or service. To decrease elasticity of demand for product or service, an entrepreneur can take steps towards making product or service more unique and more value adding compared to that offered by competitors. In other words, an entrepreneur needs to establish a sustainable competitive advantage.

 

Operating leverage

Operating leverage is the relationship between sales and revenue (Price*Quantity of units sold) and operating profit (which is also called EBIT (earnings before interest and taxes)). It is a measure of how the potential use of fixed costs can enlarge the effect that change in sales volume has on operating profit (EBIT).

We can represent the calculation of operating leverage as follows:

Sales (P * Q)

Less: Fixed operating costs (FC)

Less: Variable operating costs (VC*Q)

= EBIT

Or

EBIT = (P*Q)-FC-(VC*Q)

This simplifies into:

EBIT = Q * (P-VC) – FC

When do firms have operating leverage?

If a firm has fixed costs, it has operating leverage. Because fixed cost (FC) is unchanged, an increase in sales revenue (P*Q) results in a proportionally bigger increase in EBIT (earnings before interest and taxes, which is also called operating profit). However, decrease in sales revenue (P*Q) will result in a proportionally bigger decrease in EBIT.

Increase in operating leverage increases business risk, which is a chance that the business will not be able to cover its operating costs.

How to calculate the degree of operating leverage (DOL) of the firm?

To calculate degree of operating leverage, which is just a way to measure operating leverage of the firm, we can use the following formula:

DOL =% change in EBIT/% change in sales

Therefore, if the degree of operating leverage is greater than 1, than operating leverage exists (which is the case as long as the company has fixed operating costs).

Businesses can increase their operating leverage by substituting variable costs for fixed costs, where possible. For example, salaries to sales personnel could be fixed instead of variable of units sold. Of course, many other variables need to be taken into account to make such a decision, such as consideration of how such changes would affect motivation levels of sales personnel.

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Degree of total leverage (DTL)

The degree of total leverage, which is a way to measure the total leverage of the firm, refers to the relationship between sales revenue and EPS. It (financial and operating leverage) is a measure of how potential total fixed costs (fixed operating costs and fixed financial costs) can enlarge the effect that change in sales (P*Q) has on EPS (earnings per share).

When does a firm have total leverage?

If the (DTL) is greater than 1, than total leverage exists (which is the case as long as the company has fixed operating or/and financial costs). Due to total leverage (existence of fixed operating or/and financial costs), any increase in sales will result in an even larger increase in EPS and any decrease in sales will result in an even larger decrease in EPS. The higher the fixed financial and operating costs, the higher the (DTL). There are three approaches to calculate the (DTL):

1st approach to calculate the (DTL)


To calculate the (DTL), we can utilize the following formula:

(DTL) =% change in EPS / % change in sales

Test yourself

ABC has a change in operating profit of 70%, change in EPS of 310% and change in sales of 60%.

Required:

Find the degree of operating leverage, the degree of financial leverage and the degree of total leverage.

Solution:

Degree of operating leverage:

DOL =% change in EBIT / % change in sales DOL =70%/60% DOL =1.17

Degree of financial leverage:

DFL =% change in EPS / % change in EBIT DFL =310%/70% DFL =4.43

(DTL):

DTL =% change in EPS / % change in sales DTL =310%/60% DTL =5.17

2nd approach to calculate the (DTL)


If we have data on the degree of operating leverage and degree of financial leverage, then the (DTL) can be calculated as follows:

(DTL) = DOL * DFL

Test yourself:

ABC has a change in operating profit of 70%, change in EPS of 310% and change in sales of 60%.

Required:

Find the (DTL) using the second approach.

Solution:

Firstly, we need to find the degree of operating leverage and the degree of financial leverage.

Degree of operating leverage:

DOL =% change in EBIT / % change in sales DOL =70%/60% DOL =1.17

Degree of financial leverage:

DFL =% change in EPS / % change in EBIT DFL =310%/70% DFL =4.43

Now, we can calculate the degree of total leverage.

(DTL):

DTL=DOL*DFL

DTL=1.17*4.43

DTL=5.18

Note that this is aligned with the answer that we obtained while using 1st approach above for calculation of the degree of total leverage.

3rd approach to calculate the (DTL)


There is another formula that can be used to calculate the (DTL). A third approach to calculate the (DTL) is a more direct technique. The formula is as follows:

(DTL) at base sales level Q =

Q*(P-VC)/Q*(P-VC)-FC-I-(PD*1/1-T)

WHERE:

Q – sale quantity in units

P – sale price per unit

VC – variable operating cost per unit

FC – fixed operating cost per unit

I – interest

PD – preferred stock dividends

T – tax rate

Test yourself:

ABC Corporation ascertained that Q=1800, P=$8, VC=$3, FC=$1300, I=$1,800, PD=$3,000 and the tax rate is 40%.

Required:

Find the (DTL) using a more direct formula for calculation.

Solution:

The calculation of the (DTL) of ABC Corporation will be as follows:

Degree of total leverage at base sales level Q = 1800*(8-3)/1800*(8-3)-1300-1800-(3000*1/1-.4)

Degree of total leverage at base sales level Q = 9000/900

Degree of total leverage at base sales level Q = 10

Since the result is greater than 1, ABC Corporation has total leverage.

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