Module 2 - Profits Sensitivity to Price PDF

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MODULE Flexible Learning A.Y. 2020-2021 DISTANCE EDUCATION COURSE STUDY GUIDE

2

v.3

6 hours Course instructor: Liza Mae P. Nismal Contact details: FB messenger: Liza Mae Nismal | Email: [email protected] | Phone: +63 9231133807, 446-1281 Consultation schedule: Class hour (Asynchronous)

Profits Sensitivity to Price

In this module, we explore the rational approaches to setting prices and managing price decisions. Economic price optimization is useful in some markets. Unlike the broad range of prices developed from exchange value models, economic price optimization can provide price guidance down to a fraction of a cent. In markets for mature, commonly purchase products customers will switch suppliers to capture even the slightest price break. To capture and retain customers, executives need the higher level of accuracy provided through economic price optimization than that provided through exchange value models. Economic price optimization requires a highly accurate understanding of the relationship between prices and demand. Despite the apparent ability of economic price optimization to pinpoint a price, it is not appropriate for pricing decisions. One of the key differences between revolutionary products and more mature products is the availability of relevant information regarding the customer’s response to price changes. In revolutionary markets, the product will have very little track record from which to quantify the customer response to price changes. In more mature markets, research and statistical approaches may reveal an accurate relationship between prices and demand.

Learning Outcomes At the end of the lesson, you must have: 1. Recognized the influence of price changes to capture customers 2. Differentiated the relationship between the price cuts, to sales volume and the firm’s profit 3. Computed the elasticity of demand to optimize profit.

Match the different levels of price sensitivity in Column A to the products found in Column B. 1. Price sensitivity is high

A. 2. Price sensitivity is almost null

B. MRKT102: Pricing Strategies

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3. Price sensitivity is lower

C.

Price changes have both direct and indirect effects on profits. The direct effect is seen in linear relationship between profits and prices. The indirect effect derives from the influence of price changes on customer demand.

From the profit sensitivity analysis, volume hurdles can be uncovered. In strategic decisions to attack a specific market at a new price point, volume hurdles enable executives to quantify the required selling goals and compare them against their expectations of potential demand. In tactical pricing decisions, volume hurdles are a routine procedure in setting sales target for price promotions and discount practices and for evaluating the profitability of price concessions at the end of the promotions.

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The profit sensitivity analysis also lays the foundation for conducting economic price optimization. A profit sensitivity analysis is conducted to construct volume hurdles. We highlight the importance of understanding the relationship between prices and demand leading to an exploration of elasticity of demand.

Profit Sensitivity Analysis A profit sensitivity analysis evaluates the impact of a small price change on profitability. It is a straightforward analysis of the expected profits earned at two different prices. With a profit sensitivity analysis, we compare the expected profits to be earned at the current price against those which may be earned at a different price.

Volume Hurdles result from the requirement for price changes to leave the firm better off, if not at least as well off, after the price change than it was before. Based on the profit motive of the firm, we can state that the requirement of price changes to improve profits as 𝜋𝑓 ≥ 𝜋𝚤

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Graphical Analysis With a graphical analysis, we can see that the volume hurdle results from requiring profit contributions gained through increases in volume at a lower price to be greater than those lost be price reduction. The revenue gained at a given price is the area of a rectangle given by 𝒫 x 𝒬. The profit contribution at a given price is the area of a smaller rectangle given by (𝒫 − 𝒱)x 𝒬. As before, a price change should be executed only if, at a minimum, the new price improves profits. If G is the profit contribution gained through volume increases at a reduced price, and L is the profit contribution lost through the price reduction, the profit motive of the firm requires gains to be greater than losses or G  L. The profit contribution gained, G, is the area of the rectangle defined by the change in volume multiplied by the new contribution margin. The profit lost, L, is the area of the rectangle defined by the change price multiplies by the old volume.

Larger CM yields smaller volume hurdles, smaller CM yields larger volume hurdles. On the case of fixed cost (FC), firms must cover fixed costs to stay in the business but fixed costs do not affect the optimal price. As an issue, FC affects the investment decision to enter, stay or exit a business, but they should have no impact on pricing. Put crudely, the firm’s fixed cost are the firm’s problem, not the customers’. The volume hurdle is a necessary condition for pricing actions to improve the profitability of the firm, but it is not a sufficient condition. Every time a price change is contemplated, volume hurdles should be the first line of analysis. No pricing action should be taken if the volume hurdle is unlikely to be achieved. Volume hurdle provide an important first check on the pricing decisions, but not the final word....