Competitor profiling

Another common technique is to create detailed profiles on each of your major competitors. These profiles give an in-depth description of the competitor's background, finances, products, markets, facilities, personnel, and strategies. This involves:

•Background
1.location of offices, plants, and online presences
2.history - key personalities, dates, events, and trends
3.ownership, corporate governance, and organizational structure

•Financials
1.P-E ratios, dividend policy, and profitability
2.various financial ratios, liquidity, and cash flow

•Products
1.products offered, depth and breadth of product line, and product portfolio balance
2.new products developed, new product success rate, and R&D strengths
3.patents and licenses
4.quality control conformance
5.reverse engineering

•Marketing
1.segments served, market shares, customer base, growth rate, and customer loyalty
2.promotional mix, promotional budgets, advertising themes, ad agency used, and sales force success rate
3.distribution channels used, exclusivity agreements, alliances, and geographical coverage
4.pricing, discounts, and allowances

•Facilities
1.plant capacity, capacity utilization rate, age of plant, plant efficiency, capital investment
2.location, shipping logistics, and product mix by plant

•Personnel
1.number of employees, key employees, and skill sets
2.strength of management, and management style
3.compensation, benefits, and employee morale
•Corporate and marketing strategies
1.objectives, mission statement, growth plans, acquisitions, and divestitures
2.marketing strategies

Media Scanning

Scanning competitor's ads can reveal much about what that competitor believes about marketing and their target market. Changes in a competitor's advertising message can reveal new product offerings, new production processes, a new branding strategy, a new positioning strategy, a new segmentation strategy, line extensions and contractions, problems with previous positions, insights from recent marketing or product research, a new strategic direction, a new source of sustainable competitive advantage, or value migrations within the industry. It might also indicate a new pricing strategy such as penetration, price discrimination, price skimming, product bundling, joint product pricing, discounts, or loss leaders. It may also indicate a new promotion strategy such as push, pull, balanced, short term sales generation, long term image creation, informational, comparative, affective, reminder, new creative objectives, new unique selling proposition, new creative concepts, appeals, tone, and themes, or a new advertising agency. It might also indicate a new distribution strategy, new distribution partners, more extensive distribution, more intensive distribution, a change in geographical focus, or exclusive distribution. Little of this intelligence is definitive : additional information is needed before conclusions should be drawn.

A competitor's media strategy reveals budget allocation, segmentation and targeting strategy, and selectivity and focus. From a tactical perspective, it can also be used to help a manager implement his own media plan. By knowing the competitor's media buy, media selection, frequency, reach, continuity, schedules, and flights, the manager can arrange his own media plan so that they do not coincide.

Other sources of corporate intelligence include trade shows, patent filings, mutual customers, annual reports, and trade associations.

Some firms hire competitor intelligence professionals to obtain this information
New Competitors
In addition to analyzing current competitors, it is necessary to estimate future competitive threats. The most common sources of new competitors are:
•Companies competing in a related product/market
•Companies using related technologies
•Companies already targeting your prime market segment but with unrelated products
•Companies from other geographical areas and with similar products
•New start-up companies organized by former employees and/or managers of existing companies
The entrance of new competitors is likely when:
•There are high profit margins in the industry
•There is unmet demand (insufficient supply) in the industry
•There are no major barriers to entry
•There is future growth potential
•Competitive rivalry is not intense
•Gaining a competitive advantage over existing firms is feasible

Joint product pricing
Pricing for joint products is a little more complex that pricing for a single product. To begin with there are two demand curves. The characteristics of each demand curve could be different. Demand for one product could be greater than for the other product. Consumers of one product could be more price elastic than the consumers of the other product (and therefore more sensitive to changes in the product's price).
To complicate things further, both products, because they are produced jointly, share a common marginal cost curve. There are complexities in the production function also. Their production could be linked in the sense that they are bi-products (referred to as compliments in production), or they could be linked in the sense that they can be produced by the same inputs (referred to as substitutes in production). Also, production of the joint product could be in fixed proportions or in variable proportions.
When setting prices in a situation as complex as this, microeconomic marginal analysis is helpful. In a simple case of a single product, price is set at that quantity demanded where marginal cost exactly equals marginal revenue. This is exactly what is done when joint products are produced in variable proportions. Each product is treated separately. In fact, it might even be possible to construct separate cost functions. In the diagram below, to determine optimal pricing for joint products produced in variable proportions, you find the intersection point of marginal revenue (product A) with the joint marginal cost curve. You then extend that quantity, up to the demand curve for product A, and that gives you the profit maximizing price for product A (point Pa in the diagram). You do the same for product B, yielding price point Pb1.


Pricing of Joint Products
If the products are produced in fixed proportions (example: cow hides and cow steaks), then one of the products will very likely be produced in quantities different than the profit maximizing amount considered separately. In fact the profit maximizing quantity and price of the second half of the joint product, will be different than the profit maximizing amount considered separately. In the diagram, product B is produced in greater amounts than the profit maximizing amount considered separately, and sold at a lower price (point Pb2) than the profit maximizing price considered separately (point Pb1). Although price is lower and output is higher, marginal cost is also higher. Yet this is a profit maximizing solution to this situation. Quantity supplied of product B is increased to the point that marginal revenue becomes zero (i.e.: the point where the marginal revenue curve intersects the horizontal axis).

Transfer Pricing
Transfer pricing refers to the pricing of contributions (assets, tangible and intangible, services, and funds) transferred within an organization. For example, goods from the production division may be sold to the marketing division, or goods from a parent company may be sold to a foreign subsidiary. Since the prices are set within an organisation (i.e. controlled), the typical market mechanisms that establish prices for such transactions between third parties may not apply. The choice of the transfer price will affect the allocation of the total profit among the parts of the company. This is a major concern for fiscal authorities who worry that multi-national entities may set transfer prices on cross-border transactions to reduce taxable profits in their jurisdiction. This has led to the rise of transfer pricing regulations and enforcement, making transfer pricing a major tax compliance issue for multi-national companies.

Economic theory
The discussion in this section explains an economic theory behind optimal transfer pricing with optimal defined as transfer pricing that maximizes overall firm profits in a world with no taxes. In practice a great many factors influence the transfer prices that are used by multinationals, including performance measurement, capabilities of accounting systems, import quotas, customs duties, VAT, taxes on profits, and (in many cases) simple lack of attention to the pricing.
From marginal price determination theory, we know that generally the optimum level of output is that where marginal cost equals marginal revenue. That is to say, a firm should expand its output as long as the marginal revenue from additional sales is greater than their marginal costs. In the diagram that follows, this intersection is represented by point A, which will yield a price of P*, given the demand at point B.
When a firm is selling some of its product to itself, and only to itself (ie.: there is no external market for that particular transfer good), then the picture gets more complicated, but the outcome remains the same. The demand curve remains the same. The optimum price and quantity remain the same. But marginal cost of production can be separated from the firms total marginal costs. Likewise, the marginal revenue associated with the production division can be separated from the marginal revenue for the total firm. This is referred to as the Net Marginal Revenue in production (NMR), and is calculated as the marginal revenue from the firm minus the marginal costs of distribution.


Transfer Pricing with No External Market
It can be shown algebraically that the intersection of the firm's marginal cost curve and marginal revenue curve (point A) must occur at the same quantity as the intersection of the production division's marginal cost curve with the net marginal revenue from production (point C).
If the production division is able to sell the transfer good in a competitive market (as well as internally), then again both must operate where their marginal costs equal their marginal revenue, for profit maximization. Because the external market is competitive, the firm is a price taker and must accept the transfer price determined by market forces (their marginal revenue from transfer and demand for transfer products becomes the transfer price). If the market price is relatively high (as in Ptr1 in the next diagram), then the firm will experience an internal surplus (excess internal supply) equal to the amount Qt1 minus Qf1. The actual marginal cost curve is defined by points A,C,D.
If the firm is able to sell its transfer goods in an imperfect market, then it need not be a price taker. There are two markets each with its own price (Pf and Pt in the next diagram). The aggregate market is constructed from the first two. That is, point C is a horizontal summation of points A and B (and likewise for all other points on the Net Marginal Revenue curve (NMRa)). The total optimum quantity (Q) is the sum of Qf plus Qt.

Transfer Pricing with a Competitive External Market

Practical application
Role of Administrative Regulations and Guidelines
Although there is sound economic theory behind the selection of a transfer pricing method, the fact remains that it can be advantageous to arbitrarily select prices such that, in terms of bookkeeping, most of the profit is made in a country with low taxes, e.g. tax havens, thus shifting the profits to reduce overall taxes paid by a multinational group. However, most countries enforce tax laws based on the arm's length principle as defined in the OECD (Organisation for Economic Co-operation and Development) Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations, limiting how transfer prices can be set and ensuring that that country gets to tax its "fair" share. In the United States the pricing of transactions between related parties that are reported for tax purposes are governed by Section 482 of the Internal Revenue Code and the regulations there under.


Application of the Arm's Length Principle
Although there are discrepancies in the specifics of each country's laws concerning the application of the arm's length principle, the fact that they are primarily based in the OECD Guidelines means that, although such a strategy carries a greater taxation risk than solutions tailored to each country, global transfer pricing policies can be effectively used to determine an appropriate range representing the arm's length price for transactions carried out across a global enterprise.
However, different countries may accept different methods of calculating the transfer prices (i.e. Japan requires that the three "traditional" methods, outlined below, be systematically discounted before allowing the use of alternative methods, while the United States accepts the most appropriate method regardless), so care must be taken in such circumstances. In addition, some countries may have immature transfer pricing regimes or apply the arm's length principle in different ways—Brazil, for example, does not apply the arm's length principle despite the existence of transfer pricing legislation.
The following definitions are thus based on the OECD Guidelines.

Traditional Transaction Methods
The OECD Guidelines refer to the following methods as 'traditional transaction method':
Comparable Uncontrolled Price method (CUP);
Resale Price Method (RPM); and
Cost Plus Method (CP method or C+);
These are described below and are different from the transactional profit methods:
Profit split method; and
Transactional Net Margin Method (TNMM).
The OECD Guidelines prefer the use of the traditional transaction methods, whereby the other methods should be used as methods of last resort (for example when there is no data available or available data cannot be used reliably). However, the Guidelines stress there is no best-method rule: a taxpayer is only required to show that the method used delivers a reasonable (at arm's length) result and is not required to disprove the use of each other method than the method used. Regarding the 'reasonable outcome', the Guidelines note that transfer pricing is not an exact science

Comparable Uncontrolled Price method
The Comparable Uncontrolled Price (CUP) method compares the price at which a controlled transaction is conducted to the price at which a comparable uncontrolled transaction is conducted. Comparability between a controlled and uncontrolled transaction exists when there are no differences between these transactions or, if there are differences, when such differences do not have a material effect or for which reasonable adjustments can be made. Hence, an at arm's length transfer price can be determined through a comparison with the sales price between two unrelated corporations executing a (comparable) transaction. However, the fact that virtually any minor difference in the circumstances of trade (billing period, amount of trade, branding, etc.) may have a significant effect on the price makes it exceedingly difficult to find a transaction--much less transactions--that are sufficiently comparable.
Should they exist, such comparable transactions fall into two categories: external comparables and internal comparables. The former is a comparable uncontrolled transaction in the purest sense of the term--if Company A, in France, sells widgets to its subsidiary A(sub) in Turkey, then an external comparable transaction would be the sale of widgets from an unrelated French Company B to an unrelated Turkish Company C on comparable terms as the trade between Company A and its subsidiary A(sub). An internal comparable transaction, then, would be either the trade of widgets between Company A and an unrelated Company C, or the trade of widgets between an unrelated Company B and Company A's subsidiary, with the term "internal" referring to the fact that one of the parties involved in the tested transaction is also involved in the comparable uncontrolled transaction.

Cost Plus Method
The Cost Plus (CP) method, generally used for the trade of finished goods, is determined by adding an appropriate markup to the costs incurred by the selling party in manufacturing/purchasing the goods or services provided, with the appropriate markup being based on the profits of other companies comparable to the tested party. For example, the arm's length price for a transaction involving the sale of finished clothing to a related distributor would be determined by adding an appropriate markup to the cost of materials, labour, manufacturing, and so on. Cost-based method calculates transfer price on the cost of the goods or services available as per the cost accounting records of the company. The method is generally accepted by the tax customs authorities, since it provides some indication that the transfer price approximates the real cost of item. Cost-based approaches are, however, not as transparent as they appear. A company can easily manipulate its cost accounts to alter the magnitude of the transfer price. Companies that adopt the cost-based transfer pricing method have to choose between alternative approaches which are listed below :
Actual cost approach
Standard cost approach
Variable cost approach
Marginal cost approach

Apart from this, companies also have to decide on the treatment of fixed cost and research and development cost. These issues can prove problematic for the company that adopts a cost-based transfer pricing method. Cost-based method usually creates difficulties for the selling profit centre. As their incentives to be cost effective may fall, if they know that they can recover increased cost simply by raising the transfer price without an incentive. To produce efficiently the transfer price may erode the competitiveness of the final product in the market place.

Resale Price Method
The Resale Price (RP), while similar to the CP method, is found by working backwards from transactions taking place at the next stage in the supply chain, and is determined by subtracting an appropriate gross markup from the sale price to an unrelated third party, with the appropriate gross margin being determined by examining the conditions under which the goods or services are sold and comparing said transaction to other, third-party transactions. In our clothing example, then, the arm's length price would be determined by subtracting an appropriate gross margin from the price at which the distributor sold the products received from the manufacturer to third-party retailers--department stores, boutiques, etc.
In this example, both the CP and RP methods are being used to examine the same transaction--the one between the manufacturer and the distributor--meaning that the selection of one for use is ultimately dependent on the availability of data and comparable transactions. This flexibility is not available in other transactions, particularly those involving intangible goods (i.e. it is exceedingly difficult to determine the costs involved in developing technological know-how, and so the arm's length price for the payment of royalties from one company to another is best determined by working backwards from the profits gained based on the usage of the know-how--in other words, the RP method).

Transactional Profit Methods
The OECD Guidelines consider the following transactional profit methods: the Profit Split (PS) method and the Transactional Net Margin Method (TNMM). In principle, application of any other method which would deliver a reasonable at arm's length transfer price should not be disallowed.

Profit Split Method (PSM)
The PS method (and its derivatives, including the Comparative and Residual Profit Split methods) is applied when the businesses involved in the examined transaction are too integrated to allow for separate evaluation, and so the ultimate profit derived from the endeavor is split-based on the level of contribution--itself often determined by some measurable factor such as employee compensation, payment of administration expenses, etc.--of each of the participants in the project.
To present a highly simplified example, if Company A above sent three researchers to Company A(sub) to aid in the development of widgets tailored for the Turkish market while Company A(sub) allocated seven identically-compensated researchers to aid in the development, we would expect that Company A(sub) would pay Company A 30% of the royalty fee portion of the ultimate profits for the technical knowledge provided by Company A's researchers.

The residual profit split method initially focuses on the company in a controlled transaction which performs the most routine functions, for example toll-manufacturing or (limited risk) distributing services. Routine functions are functions which are low value-added compared to the overall profitability. Such company is generally referred to as 'least-complex entity'. The residual profit split method seeks to set the appropriate arm's length remuneration for such least-complex entity, whereby the remaining profit is allocated to the other company of the controlled transaction.
An example: Company A sells widgets through its subsidiary, a limited-risk distributor, in the Turkish market. Assume that an overall profit of 100 is made on the sale. The limited-risk distributor should receive an at arm's length return of 5. Then, the residual profit of 95 would be allocated to Company A, being the complex entity or entrepreneur. In case of an overall loss, the Turkish subsidiary should, in principle, continue to receive the arm's length return of 5.

Transactional Net Margin Method (TNMM)

TNMM, meanwhile, is a method that focuses on the arm's length operating profit (earnings after all operating expenses, including overhead, but before interest and taxes) earned by one of the entities (the tested party) in the transaction. It stipulates that relative operating profit (relative to sales, costs, or assets to allow comparisons between different companies or transactions) may be a more robust measure of an arm's length result when close comparables, as required for the traditional methods, are not available. For example, two distributors may sell different products that require different sales efforts per unit sold. This may lead to very different gross margins (and hence the resale price method may not be easily applicable). However, the operating margins would not be expected to be materially different since the margins reflects a competitive return only.
The margin is measured pre-interest since the level of interest expense is a function of how a company decides to finance its operations and unrelated to the transfer pricing.
Although not one of the traditional three methods, the TNMM and its counterpart under the U.S. transfer pricing regulations, the Comparable Profits Method or CPM is one of the most-widely used transfer pricing methods. See for example, the IRS' annual APA report which publishes details on the transfer pricing methods used in APAs.

Advance Pricing Agreement (APA)

An Advance Pricing Agreement/Arrangement (the specific terminology varies by country), or APA, is an agreement between the taxpayer and the competent taxation authorities that a future transaction will be conducted at the agreed-upon price, which is recognized as the arm's length price for the period designated. Although retroactive APAs can be used to reduce tax exposure in past years, APAs are primarily used to avoid the risk of future income assessment adjustments which, as in the case of GlaxoSmithKline, could lead to hefty payments in the future.

There are two types of APAs: unilateral and bilateral/multilateral APAs. A unilateral APA is, as its name suggests, an agreement between a corporation and the authority of the country where it is subject to taxation. Although simpler to implement than a bilateral/multilateral APA, a unilateral APA will not be recognized by a foreign tax authority, meaning that a U.S. company securing a unilateral APA for trade with its British subsidiary would still run the risk of being assessed should the foreign tax authorities not agree with the method of calculating the arm's length price, resulting in double taxation.

Bilateral/multilateral APAs, however, do provide such coverage, although their implementation requires a more lengthy application process, including consultation between and the agreement of all competent authorities involved.
Mutual agreement procedures
A mutual agreement procedure is an instrument used for relieving international tax grievances, including double taxation. Although the specifics vary based on the laws of each country, they are only carried out between authorities of countries or principalities with existing tax treaties--for example, it is impossible to relieve double taxation by holding mutual agreement procedures between the authorities of China and Taiwan.

Although most conventions require that each party to put forth all reasonable effort to resolve such disputes, they are generally not required to come to any sort of agreement. This means that although mutual agreement procedures can be an effective tool for the relief of taxation grievances, they are not fail-safes.
Some countries are beginning to insert into their tax treaties provisions for the mandatory arbitration of mutual agreement procedures that do not reach resolution after a period of time. Such arbitration provisions, for example Article 25 of the OECD model tax treaty as at 2008, are intended to ensure that double taxation disputes under tax treaties reach a final and relatively independent resolution within a fixed period of time.

Break-Even Point

What is Break-Even Point?
The Break-Even Point for a product is the point where total revenue received equals the total costs associated with the sale of the product (TR=TC). A break-even point is typically calculated in order for businesses to determine if it would be profitable to sell a proposed product, as opposed to attempting to modify an existing product instead so it can be made lucrative. Break even analysis can also be used to analyse the potential profitability of an expenditure in a sales-based business

Introduction

Break-even analysis is a technique widely used by production management and management accountants. It is based on categorizing production costs between those which are "variable" (costs that change when the production output changes) and those that are "fixed" (costs not directly related to the volume of production).
Total variable and fixed costs are compared with sales revenue in order to determine the level of sales volume, sales value or production at which the business makes neither a profit nor a loss (the "break-even point").

Graphing the Break-Even Point
Break-even point can also be indicated by graphing. Figure 1 below is a sample graph for a business. To draw the graph, we should follow these steps:
1.Number of units produced is marked along the horizontal axis and the total revenue expressed in dollars is set on the vertical axis.
2.The sales line is drawn to indicate the sales at each level of production.
3.A horizontal line is drawn at the $12,000 level of sales to represent the fixed costs for our sample business.
4.A total cost line is drawn from the point of intersection of the fixed cost line and the vertical axis to the point of total costs as full capacity --$28,000.
5.The intersection of the total cost line with the sales line represents the break-even point, in this case $20,000. The dotted lines represent the level of production and the total costs at this level of operation.
6.Areas of net loss and of net profit are marked.

The break-even point graph helps the business owner determine the levels of production that will create profits for every level of sales. The business owner then works to increase profits without investing extra funds. To do this, he/she should study the following important points:
1.A possible increase in utilization of existing capacity through reduction of idle time.
2.Better repair and maintenance of equipment to reduce down time --time elapsed from the moment the machine breaks down to the time it gets back in service.
3.Improved working schedules and inventory levels.
4.Longer business hours.
5.Improved production control.
6.Markup policy.

Let us take a closer look at two of these points.

Markup Policy
Another item to study when considering ways to improve profit without increasing investment is the company's markup policy. Markup is the amount above cost that the business charges for an item. Too many business owners believe that the only way to larger profits is through higher markups. As a result, they tend to use either a fixed percentage of cost markup or some vague and arbitrary "rule of thumb" which multiples costs by some mystical figure in the manager's head to arrive at the selling price.

Actually, markup should be flexible. Break-even analysis allows studies to be made of volumes of sales at various price levels. It is often discovered that a lover markup will produce a higher volume of sales and increased profits.
If a customer feels costs are too high he/she will take their business elsewhere. Reduced turnover means slow sales. It also means that the business owner may have to raise prices to cover its inventory investment. This will drive more customers away.
An appreciation of the meanings of break-even analysis can prevent such a vicious cycle from even starting.

Margin of Safety
Margin of safety represents the strength of the business. It enables a business to know that what is the exact amount he/ she has gained or lost over or below the breakeven point).
Margin of safety = (sales - break-even sales) / sales) x 100% If P/V ratio is given then sales/pv ratio

Fixed Costs
Fixed costs are those business costs that are not directly related to the level of production or output. In other words, even if the business has a zero output or high output, the level of fixed costs will remain broadly the same. In the long term fixed costs can alter - perhaps as a result of investment in production capacity (e.g. adding a new factory unit) or through the growth in overheads required to support a larger, more complex business.
Examples of fixed costs:
- Rent and rates
- Depreciation
- Research and development
- Marketing costs (non- revenue related)
- Administration costs

Variable Costs
Variable costs are those costs which vary directly with the level of output. They represent payment output-related inputs such as raw materials, direct labour, fuel and revenue-related costs such as commission.
A distinction is often made between "Direct" variable costs and "Indirect" variable costs.
Direct variable costs are those which can be directly attributable to the production of a particular product or service and allocated to a particular cost centre. Raw materials and the wages those working on the production line are good examples.
Indirect variable costs cannot be directly attributable to production but they do vary with output. These include depreciation (where it is calculated related to output - e.g. machine hours), maintenance and certain labour costs.

Semi-Variable Costs
Whilst the distinction between fixed and variable costs is a convenient way of categorizing business costs, in reality there are some costs which are fixed in nature but which increase when output reaches certain levels. These are largely related to the overall "scale" and/or complexity of the business. For example, when a business has relatively low levels of output or sales, it may not require costs associated with functions such as human resource management or a fully-resourced finance department. However, as the scale of the business grows (e.g. output, number people employed, number and complexity of transactions) then more resources are required. If production rises suddenly then some short-term increase in warehousing and/or transport may be required. In these circumstances, we say that part of the cost is variable and part fixed.

In Capital Budgeting
Break even analysis is a special application of sensitivity analysis. It aims at finding the value of individual variables which the project’s NPV is zero. In common with sensitivity analysis, variables selected for the break even analysis can be tested only one at a time.
The break even analysis results can be used to decide abandon of the project if forecasts show that below break even values are likely to occur.
In using break even analysis, it is important to remember the problem associated with sensitivity analysis as well as some extension specific to the method:
Variables are often interdependent, which makes examining them each individually unrealistic.
Often the assumptions upon which the analysis is based are made by using past experience / data which may not hold in the future.
Variables have been adjusted one by one; however it is unlikely that in the life of the project only one variable will change until reaching the breakeven point. Management decisions made by observing the behaviour of only one variable are most likely to be invalid.
Break even analysis is a pessimistic approach by essence. The figures shall be used only as a line of defence in the project analysis

Break-Even Point Calculation( BEP)
Calculation of the BEP can be done using the following formula:

BEP = TFC / (SUP - VCUP)

Where:
BEP = break-even point (units of production)
TFC = total fixed costs,
VCUP = variable costs per unit of production,
SUP = selling price per unit of production.

Benefits of Break-Even Analysis

The main advantage of break-even analysis is that it explains the relationship between cost, production volume and returns. It can be extended to show how changes in fixed cost-variable cost relationships, in commodity prices, or in revenues, will affect profit levels and break-even points. Break-even analysis is most useful when used with partial budgeting or capital budgeting techniques. The major benefit to using break-even analysis is that it indicates the lowest amount of business activity necessary to prevent losses.

Limitation of Break-Even Analysis

It is best suited to the analysis of one product at a time;
It may be difficult to classify a cost as all variable or all fixed; and
There may be a tendency to continue to use a break-even analysis after the cost and income functions have changed.

Summary
Break-even analysis and techniques are the tools that finally tell the business owner or manager when he/she is making a profit. Break-even charts and analysis will be part of every budget the business owner put out. They enable he/she to gauge the business' production rate accurately. They will tell whether an increase or a slowdown in production is called for. They are a vital part of the business owner's life

Markup (business)

What is Markup?

•Markup is the determination of a retail selling price, based on some percentage increase in the wholesale cost; also called margin. For example, a 20% markup on an item wholesaling at $100 would be $20, resulting in a retail selling price of $120. Typical markups are 28% for cameras, 41% for dresses, 46% for costume jewelry, and so forth. The size of retail markups tends to vary inversely with the wholesale cost and with turnover (the rate at which a quantity is sold).
•Markup is the amount by which the price of a product exceeds the cost of producing and distributing the product.

Initial Markup
The initial markup is the average markup required on all products to cover the cost of all items, incidental expenses, and to obtain a reasonable profit. The initial dollar markup is expressed as a percentage. Initial Dollar Markup = (Operating Expenses + Price Reductions + Profit) / (Forecasted Net Sales + Price Reductions)
Example:
Forecasted Sales = $380
Operating Expenses = $140
Anticipated Price Reductions = $24
Expected Profit = $38
($140 + $24 + $38) / ($380 + $24) = 50%
Thus the initial dollar markup on the product should be 50%. Price reductions, or markdowns, are reductions in the retail selling price when the item cannot be sold at its intended price and erode into profit. Operating expenses are costs incurred in addition to the total product cost and can vary depending on the product and service being sold. In reviewing operating expenses, annualized figures should be used since any individual month may not properly reflect the expenses incurred over a full year.
Initial pricing of a product is an important step in merchandising. The Keystone Method doubles cost of an individual product to arrive at its selling price (2 x total product cost ). The Dollar Markup Method takes into account the total amount of operating expenses and desired profit. These are then broke down on a per product unit basis, which is then added on to the total product cost. This addition onto the total cost is the dollar markup. This dollar markup is either expressed as a percentage of the total cost per unit or the selling price.

Price determination
1 As a fixed Amount
Assume:
retail list price = $1.99 and the product cost is $1.40
MARKUP = price − cost
1.99 − 1.40 = 0.59

assume the actual selling price was $1.60
MARKDOWN = List price − selling price
1.99 − 1.60 = 0.39

INITIAL MARKUP = list price − cost
1.99 − 1.40 = 0.59

MAINTAINED MARKUP = sale price - cost
1.60 − 1.40 = 0.20
2 As a percentage
INITIAL MARKUP % = initial markup / sale price
0.59 / 1.99 = 29%

MAINTAINED MARKUP % = maintained markup / sale price
0.20 / 1.60 = 13%

MARKUP % ON COST = markup / cost
0.59 / 1.40 = 42%

MARKUP % ON PRICE = markup / price
0.59 / 1.99 = 29%

To convert from markup on price to markup on cost:
MARKUP ON COST = markup % on price / (1 − markup % on price)
0.29 / (1 − 0.29) = 42%

To convert from markup on cost to markup on price:
MARKUP ON PRICE = markup % on cost / (1 + markup % on cost)
0.42 / (1 + 0.42 ) = 0.29

PRICE = cost / (1 − markup % on price)
1.40 / (1 − 0.29) = 1.99

COST = price / (1 + markup % on cost)
1.99 / (1 + 0.42) = 1.40

PRICE = markup / markup % on price
0.59 / 0.29 = 1.99
Cost-Plus Pricing with Elasticity Considerations
One of the most common pricing methods used by firms is cost-plus pricing. In spite of its ubiquity, economists rightly point out that it has serious methodological flaws. It takes no account of demand. There is no way of determining if potential customers will purchase the product at the calculated price. To compensate for this, some economists have tried to apply the principles of price elasticity to cost-plus pricing.
We know that:
MR = P + ((dP / dQ) * Q)
where:
MR = marginal revenue
P = price
(dP / dQ) = the derivative of price with respect to quantity
Q = quantity
Since we know that a profit maximizer, sets quantity at the point that marginal revenue is equal to marginal cost (MR = MC), the formula can be written as:
MC = P + ((dP / dQ) * Q)
Dividing by P and rearranging yields:
MC / P = 1 +((dP / dQ) * (Q / P))
And since (P / MC) is a form of markup, we can calculate the appropriate markup for any given market elasticity by:
(P / MC) = (1 / (1 - (1/E)))
where:
(P / MC) = markup on marginal costs
E = price elasticity of demand
In the extreme case where elasticity is infinite:
(P / MC) = (1 / (1 - (1/999999999999999))
(P / MC) = (1 / 1)
Price is equal to marginal cost. There is no markup. At the other extreme, where elasticity is equal to unity:
(P /MC) = (1 / (1 - (1/1)))
(P / MC) = (1 / 0)
The markup is infinite. Most business people do not do marginal cost calculations, but one can arrive at the same conclusion using average variable costs (AVC):
(P / AVC) = (1 / (1 - (1/E)))
Technically, AVC is a valid substitute for MC only in situations of constant returns to scale (LVC = LAC = LMC).
When business people choose the markup that they apply to costs when doing cost-plus pricing, they should be, and often are, considering the price elasticity of demand, whether consciously or not.

Geographical Pricing

Geographical Pricing is the practice of modifying a basic list price based on the geographical location of the buyer. It is intended to reflect the costs of shipping to different locations.

There are several types of geographic pricing:
•FOB origin (Free on Board origin) - The shipping cost from the factory or warehouse is paid by the purchaser. Ownership of the goods is transferred to the buyer as soon as it leaves the point of origin. It can be either the buyer or seller that arranges for the transportation.
•Uniform delivery pricing - (also called postage stamp pricing) - The same price is charged to all.
•Zone pricing - Prices increase as shipping distances increase. This is sometimes done by drawing concentric circles on a map with the plant or warehouse at the center and each circle defining the boundary of a price zone. Instead of using circles, irregularly shaped price boundaries can be drawn that reflect geography, population density, transportation infrastructure, and shipping cost. (The term "zone pricing" can also refer to the practice of setting prices that reflect local competitive conditions, i.e., the market forces of supply and demand, rather than actual cost of transportation.)
Zone pricing, as practiced in the gasoline industry in the United States, is the pricing of gasoline based on a complex and secret weighting of factors, such as the number of competing stations, number of vehicles, average traffic flow, population density, and geographic characteristics. This can result in two branded gas stations only a few miles apart selling gasoline at a price differential of as much as $0.50 per gallon.

Many businesspeople and economists state that gasoline zone pricing merely reflects the costs of doing business in a complex and volatile marketplace. Critics contend that industry monopoly and the ability to control not only industry-owned "corporate" stations, but locally owned or franchise stations, make zone pricing into an excuse to raise gasoline prices virtually at will. Oil industry representatives contend that while they set wholesale and dealer tank wagon prices, individual dealers are free to see whatever prices they wish and that this practice in itself causes widespread price variations outside industry control.

•Basing point pricing - Certain cities are designated as basing points. All goods shipped from a given basis point are charged the same amount.
•Freight-absorption pricing - The seller absorbs all or part of the cost of transportation. This amounts to a price discount, and is used as a promotional tactic

Cost-Plus Pricing
Cost-plus pricing is a strategy that is used to determine the retail and/or wholesale price of goods and services offered for consumption. Businesses of all sizes tend to use this simplistic pricing model as a guideline for arriving at sale prices that will allow the company to cover all costs associated with the production and sale of the products, and still make a reasonable profit from the effort. The basic formula for cost-plus pricing works as well for calculating pricing goods such as the cost of a meal in a café as it does for pricing services such as utilities or courier services.
The ultimate goal of cost-plus pricing is to allow the originator of a good or service to price goods and services in a manner that helps to ensure all costs associated with the effort are covered. At the same time, cost-plus pricing helps to promote the creation of a situation where the originator makes a profit and remains competitive with companies that offer similar goods and services. Fortunately, only a few simple pieces of information are required to establish a solid cost-plus pricing model for any business.

The first key component to calculating cost-plus pricing is to establish what it costs to actually produce the end product or service. This involves considering all expenses that go into the production process, such as raw materials, labor and production costs, packaging, transport, and sales and marketing expenses. By dividing the cumulative expenses associated with producing the products by the number of units produced, it is possible to arrive at what is sometimes referred to as the unit cost. The unit cost represents the minimum price that must be charged in order for the producer to recoup his or her investment into the creation of the unit.

Calculating price using the cost-plus method
There are several ways of determining cost, and the profit can be added as either a percentage markup or an absolute amount. One example is:
P = (AVC + FC%) * (1 + MK%)
Where:
P = price
AVC = average variable cost
FC% = percentage apportionment of fixed costs
MK% = percentage markup
For example: If variable costs are 30 dollars, the allocation to cover fixed costs is 10 dollars, and you feel you need a 50% markup then you would charge a price of 60 dollars:
P = (30 + 10) * (1 + 0.50)
P = 40 * 1.5
P = 60
**This equation states that 50% of the Total costs will be added on top of the total costs to get the selling price

An alternative way of doing a similar calculation is:
P = (AVC + FC%) / (1 − MK%)
** This equation states the total costs are 50% of the selling price**
These two mark up equations are slightly different, and yield different results. The first equation (40*1.5=60) The second equation (40/(1-.5)=80
If you are in the USA, it should be noted carefully that any pricing on a cost-plus contract can be audited by the government. How to do this pricing, what items can be included, and how the calculations are to be made is governed by the FAR (or Federal Acquisition Regulations). Failure to follow the precepts of FAR can lead to decreased contractor revenue or, in extreme cases, claims of penalties against the contractor under the False Claims Act and Contract Disputes Act.
To make things simpler, some firms, particularly retailers, ignore fixed costs and just use the purchase price paid to their suppliers as the cost term. They indirectly incorporate the fixed cost allocation into the markup percentage. To simplify things even further, sometimes a fixed amount is applied rather than a percentage. This fixed amount is usually determined by head-office to make it easy for franchisees and store managers. This is sometimes referred to as turnkey pricing.
Another variant of cost plus pricing is activity based pricing. This involves being more careful in determining costs. Instead of using arbitrary expense categories when allocating overhead, every activity is linked to the resources it uses.
Cost will need to be recalculated and the percentage markup wills likely need to be adjusted as the product goes through its life cycle. This is sometimes referred to as product life cycle pricing, although it is seldom done deliberately or in a planned and organized manner. Price skimming and penetration pricing are also types of product life cycle pricing but they are demand based pricing methods rather than cost based.


Advantages of Cost-Plus Pricing
1.Easy to calculate
2.Minimal information requirements
3.Easy to administer
4.Tends to stabilize markets - insulated from demand variations and competitive factors
5.Insures seller against unpredictable, or unexpected later costs
6.Ethical advantages

Disadvantages of Cost-Plus Pricing
1.Provides no incentive for efficiency
2.Tends to ignore the role of consumers
3.Tends to ignore the role of competitors
4.Use of historical accounting costs rather than replacement value
5.Use of “normal” or “standard” output level to allocate fixed costs
6.Inclusion of sunk costs rather than just using incremental costs
7.Ignores opportunity costs
8.Contractors may not focus on performance because the cost is always covered by the client

Price Elasticity of Demand

What is Price Elasticity of Demand?

•Price elasticity of demand (PED) is defined as the measure of responsiveness in the quantity demanded for a commodity as a result of change in price of the same commodity. It is a measure of how consumers react to a change in price. In other words, it is percentage change in quantity demanded by the percentage change in price of the same commodity. In economics and business studies, the price elasticity of demand is a measure of the sensitivity of quantity demanded to changes in price. It is measured as elasticity that is it measures the relationship as the ratio of percentage changes between quantity demanded of a good and changes in its price.
•Price elasticity of demand refers to the way prices change in relationship to the demand, or the way demand changes in relationship to pricing. Price elasticity can also reference the amount of money each individual consumer is willing to pay for something. People with lower incomes tend to have lower price elasticity, because they have less money to spend. A person with a higher income is thought to have higher price elasticity, since he can afford to spend more. In both cases, ability to pay is negotiated by the intrinsic value of what is being sold. If the thing being sold is in high demand, even a consumer with low price elasticity is usually willing to pay higher prices.
Elasticity implies stretch and flexibility. The flexibility or the price elasticity of demand will change based on each item. Changing nature of both price and demand are affected by a number of factors.
Generally, goods or services offered at a lower price lead to a demand for greater quantity. If you can get socks on sale you might buy several pairs or several packages, instead of just a pair. This means that though the seller offers the socks at a lower price, he usually ends up making more money, because demand for the product has increased. However if the price is set too low, the retailer may lose money by selling too many pairs of socks at a reduced rate.

Price elasticity of demand evaluates how change in price influences demand. In certain circumstances, demand remains inelastic, despite higher prices. This is true of a number of medications that are available to treat certain conditions, where there is no substitute. Demand remains constant in spite of high prices.

In simpler words, demand for a product can be said to be very inelastic if consumers will pay almost any price for the product, and very elastic if consumers will only pay a certain price, or a narrow range of prices, for the product. Inelastic demand means a producer can raise prices without much hurting demand for its product, and elastic demand means that consumers are sensitive to the price at which a product is sold and will not buy it if the price rises by what they consider too much.

Drinking water is a good example of a good that has inelastic characteristics in that people will pay anything for it (high or low prices with relatively equivalent quantity demanded), so it is not elastic. On the other hand, demand for sugar is very elastic because as the price of sugar increases, there are many substitutions which consumers may switch to.

A price fall usually results in an increase in the quantity demanded by consumers. The demand for a good is relatively inelastic when the change in quantity demanded is less than change in price. Goods and services for which no substitutes exist are generally inelastic. Demand for an antibiotic, for example, becomes highly inelastic when it alone can kill an infection resistant to all other antibiotics. Rather than die of an infection, patients will generally be willing to pay whatever is necessary to acquire enough of the antibiotic to kill the infection.
Various research methods are used to calculate price elasticity:
Test markets
Analysis of historical sales data
Conjoint analysis

Price Elasticity of Demand
Elasticity of demand (Ped) = % change in demand of good X / % change in price of good X
•If the PED is greater than one, the good is price elastic. Demand is responsive to a change in price. If for example a 15% fall in price leads to a 30% increase in quantity demanded, the price elasticity = 2.0
•If the PED is less than one, the good is inelastic. Demand is not very responsive to changes in price. If for example a 20% increase in price leads to a 5% fall in quantity demanded, the price elasticity = 0.25
•If the PED is equal to one, the good has unit elasticity. The percentage change in quantity demanded is equal to the percentage change in price. Demand changes proportionately to a price change.
•If the PED is equal to zero, the good is perfectly inelastic. A change in price will have no influence on quantity demanded. The demand curve for such a product will be vertical.
•If the PED is infinity, the good is perfectly elastic. Any change in price will see quantity demanded fall to zero. This demand curve is associated with firms operating in perfectly competitive markets

Factors that determine the value of price elasticity of demand
1. Number of close substitutes within the market - The more (and closer) substitutes available in the market the more elastic demand will be in response to a change in price. In this case, the substitution effect will be quite strong.
2. Luxuries and necessities - Necessities tend to have a more inelastic demand curve, whereas luxury goods and services tend to be more elastic. For example, the demand for opera tickets is more elastic than the demand for urban rail travel. The demand for vacation air travel is more elastic than the demand for business air travel.
3. Percentage of income spent on a good - It may be the case that the smaller the proportion of income spent taken up with purchasing the good or service the more inelastic demand will be.
4. Habit forming goods - Goods such as cigarettes and drugs tend to be inelastic in demand. Preferences are such that habitual consumers of certain products become de-sensitised to price changes.
5. Time period under consideration - Demand tends to be more elastic in the long run rather than in the short run. For example, after the two world oil price shocks of the 1970s - the "response" to higher oil prices was modest in the immediate period after price increases, but as time passed, people found ways to consume less petroleum and other oil products. This included measures to get better mileage from their cars; higher spending on insulation in homes and car pooling for commuters. The demand for oil became more elastic in the long-run
Mathematical Definition
The formula used to calculate coefficients of price elasticity of demand for a given product is

Conventions differ regarding the minus sign, considering remarks like "price elasticity of demand is usually negative". (The sign of the coefficient should actually be determined by the directions in which price and quantity change; i.e. if the price increases by 5% and quantity demanded decreases by 5%, then the elasticity at the initial price and quantity = −5%/5% = −1. Note, however, that many economists will refer to price-elasticity of demand as a positive value although it is generally negative due to the negative relationship between price and quantity demanded.)
This simple formula has a problem, however. It yields different values for Ed depending on whether Qd and Pd are the original or final values for quantity and price. This formula is usually valid either way as long as you are consistent and choose only original values or only final values. (note that a percentage change is always calculated with the initial value in the denominator; if you are to use your final value in the denominator then you must treat that value as the initial value in the numerator. i.e. if price increases from $5 to $10, then the percentage increase is calculated as: ((10 − 5)/5)*100 = 100%. If price decreases from 10 to 5, the percent decrease = ((5 − 10)/10))*100 = −50%. If you throw 10 into the denominator without switching the terms in the numerator your product's price will appear to increase by 50% which is simply not true.)
Or, using the differential calculus form:

This can be rewritten in the form:

On the graduate level, Mas-Colell, Winston, and Green (1995) defines elasticity of demand with respect to price as follows. Let be the demand of goods as a function of parameters price and wealth, and let be the demand for good . The elasticity of demand with respect to price pk is

Point-price elasticity
Point Elasticity = (% change in Quantity) / (% change in Price)
Point Elasticity = (∆Q/Q)/(∆P/P)
Point Elasticity = (P ∆Q) / (Q ∆P)
Point Elasticity = (P/Q)(∆Q/∆P) Note: In the limit (or "at the margin"), "(∆Q/∆P)" is the derivative of the demand function with respect to P. "Q" means 'Quantity' and "P" means 'Price'.
Example
Suppose a certain good (say, laserjet printers) has a demand curve Q = 1,000 − 0.6P. We wish to determine the point-price elasticity of demand at P = 80 and P = 40. First, we take the derivative of the demand function Q with respect to P:

Next we apply the equation for point-price elasticity, namely

to the ordered pairs (40, 976) and (80, 952). We have
at P=40, point-price elasticity e = −0.6(40/976) = −0.02.
at P=80, point-price elasticity e = −0.6(80/952) = −0.05.

Price Skimming

Definition
•A pricing technique designed to allow a business to charge each potential customer the most that he or she would be willing pay for a given product or service. The product or service is first offered at the highest price that customers will pay, and the price is incrementally dropped until it reaches a level designed to be viable for the long term

•Price skimming is a business technique which involves charging a high price for a product when it is released initially, and gradually lowering the price over time. The goal of this practice is to ensure that the price matches consumer willingness to pay, generating profits for the company both over time and in the short term. The “skimming” is a reference to a stage in milk processing in which the cream is repeatedly skimmed from the top, yielding milk with a steadily lower butterfat content, much as price skimming creates a steadily cheaper product.
There are a number of reasons for companies to utilize price skimming, beyond the simple desire for profits. One of the most basic motivations is the desire to recoup the investment involved in product development before competitors hit the market and make high prices unsustainable. For example, if a company develops a totally new and innovative product, it may spend a great deal of money in the process of designing and marketing the product, and it wants to recover this money quickly to make the product profitable.

Another reason involves consumer psychology. Many people attach certain values to high priced products, including luxury, exclusivity, and quality. By releasing a product with a high price, the manufacturer sends a message to prestige-conscious consumers, ensuring that they will flock to buy their product. Even as the price drops, people will continue to associate these values with the product, creating a steady demand for it.
Price skimming relies heavily on early adopters who are willing to pay a high price to be the first to have a new product. As the product spreads among these early adopters, the producer can slowly lower the price as people become less willing to pay top dollar for the product. Ideally, the producer will remain competitive with the inevitable rival products released by other companies. Supply and demand for the product will also remain stable over time.

Manipulation of pricing is a delicate business, because a company must be able to balance evidence about consumer psychology and the direction of the market when they set a price for a new product. Companies must also comply with laws which generally restrict price manipulation for reason of consumer protection. However, many nations recognize that companies have a right to attempt to recoup investments, and therefore price skimming may be tolerated as a legitimate business practice.

Limitations of Price Skimming

There are several potential problems with this strategy.
•It is effective only when the firm is facing an inelastic demand curve. If the long run demand schedule is elastic (as in the diagram to the right), market equilibrium will be achieved by quantity changes rather than price changes. Penetration pricing is a more suitable strategy in this case. Price changes by any one firm will be matched by other firms resulting in a rapid growth in industry volume. Dominant market share will typically be obtained by a low cost producer that pursues a penetration strategy.
•A price skimmer must be careful with the law. Price discrimination is illegal in many jurisdictions, but yield management is not. Price skimming can be considered either a form of price discrimination or a form of yield management. Price discrimination uses market characteristics (such as price elasticity) to adjust prices, whereas yield management uses product characteristics. Marketers see this legal distinction as quaint since in almost all cases market characteristics correlate highly with product characteristics. If using a skimming strategy, a marketer must speak and think in terms of product characteristics in order to stay on the right side of the law.
•The inventory turn rate can be very low for skimmed products. This could cause problems for the manufacturer's distribution chain. It may be necessary to give retailers higher margins to convince them to enthusiastically handle the product.
•Skimming encourages the entry of competitors. When other firms see the high margins available in the industry, they will quickly enter.
•Skimming results in a slow rate of stuff diffusion and adaptation. This results in a high level of untapped demand. This gives competitors time to either imitate the product or leap frog it with a new innovation. If competitors do this, the window of opportunity will have been lost.
•The manufacturer could develop negative publicity if they lower the price too fast and without significant product changes. Some early purchasers will feel they have been ripped-off. They will feel it would have been better to wait and purchase the product at a much lower price. This negative sentiment will be transferred to the brand and the company as a whole.
•High margins may make the firm inefficient. There will be less incentive to keep costs under control. Inefficient practices will become established making it difficult to compete on value or price.

Two- Part Tariffs

Definition of Two-Part Tariffs

A Two-Part Tariff is a pricing technique in which the price of a product or service is composed of two parts. Examples of two-part tariffs include:
1."membership discount retailers" such as shopping clubs that charge an annual fee for admission to the point of sale and also charge for your purchases
2.amusement parks where there are admission fees and also per-ride fees
3.cover charge for bars combined with per drink fees
4.credit cards which charge an annual fee plus a per-transaction fee
5.loyalty cards or clubs

The Economics of Two Part Tariffs

Economists view two part tariffs as a means to the end of price discrimination in partially or fully monopolistic markets. The way it works is the producer charges the consumer surplus as a 'cover charge' and then has a per unit charge that is the marginal cost of the unit.
For example, imagine a restaurant that can produce spaghetti for a marginal cost of $1 a plate. A customer comes in who is willing to pay $3 for the first plate, $2 for the second plate, $1 for the next plate and $0 for the fourth plate. If the restaurant charges $1 for a plate of spaghetti, then the customer will buy three plates of spaghetti for $3 and will get a consumer surplus of $3 (since they get a consumer surplus of $3-$1 = $2 for the first plate and $2-$1 = $1 for the second plate and $1-$1 = $0 for the third). If the restaurant charges $2 for a plate of spaghetti, then the customer will buy two plates at $2 for a consumer surplus of $1. The producer will get $2 of producer surplus (2*($2 - $1) or amount sold * (price - marginal cost)). That is the best the producer can do with a single price. However, if they can charge a two part tariff, then the restaurant can charge $3 to enter the restaurant and $1 per plate of spaghetti. The customer will pay the $3 to enter the restaurant (since they get $3 of consumer surplus from buying spaghetti at $1 a plate) and then buy three plates of spaghetti, for a net consumer surplus of $0. The restaurant gets $3 of producer surplus from the entrance fee, which is better than they can do with a single price.
In short, the way two-part tariff's work is the producer charges the consumer surplus as an entrance fee or cover charge, and then just charges the marginal cost for each unit of the good. This theoretically allows the producer to capture all of the consumer surplus.
In reality, the producer does not know the consumer's demand curve (a.k.a. their willingness to pay) and there is a transaction cost associated with collecting the money twice. Also, each consumer will have a different individual demand curve, so if there is just one cover charge or entrance fee, some of the customers will get some consumer surplus and some will decline to enter even though they would have been willing to pay some lesser entrance fee (since the entrance fee can be above their consumer surplus for getting the good at its marginal cost) so the producer cannot capture all of the consumer surplus.

A two-Part Tariff when Consumer Demand is Homogeneous

When consumers have homogeneous demand, any one consumer is representative of the market (the market being n identical consumers). For purposes of demonstration, consider just one consumer who interacts with one firm which experiences no fixed costs and constant costs per unit - hence the horizontal marginal cost (MC) line.
Recall that the demand curve represents our consumer’s maximum willingness to pay for any given output. Thus, as long as he receives an appropriate amount of goods, such as Qc, then he will be willing to pay his entire surplus (ABC) in addition to the cost per unit under perfect competition (Pc by Qc) - i.e. the entire area under the demand curve up to point Qc.
If the firm is perfectly competitive, it would charge price Pc and supply Qc to our consumer, making no economic profit but producing an allocatively efficient output. If the firm is a non-price discriminating monopolist, it would charge price Pm per unit and supply Qm, maximizing profit but producing below the allocatively efficient level of output Qc. This situation yields economic profit for the firm equal to the green area B, consumer surplus equal to the light blue area A, and a deadweight loss equal to the purple area C.
If the firm is a price discriminating monopolist, then it has the capacity to extract more resources from the consumer. It charges a lump sum fee, as well as a per unit cost. In order to sell the maximum number of units, the firm must charge the perfectly competitive price per unit, Pc, because this is the only price at which Qc units can be sold (note this is also the marginal cost per unit). To make up for the lower cost per unit, the firm then imposes a fee upon our consumer equal to her consumer surplus, ABC.
The lump-sum fee enables the firm to capture all the consumer surplus and deadweight loss areas, resulting in higher profit than a non-price discriminating monopolist could manage. The result is a firm which is in a sense allocatively efficient (price per unit is equal to marginal cost, but total price is not) - one of the redeeming qualities of price discrimination. If there are multiple consumers with homogeneous demand, then profit will equal n times the area ABC, where n is the number of consumers.

A two-part tariff when consumer demand is different
We now consider the case where there are two consumers, X and Y. Consumer Y's demand is exactly twice consumer X's demand, and each of these consumers is represented by a separate demand curve, and their combined demand (D market). The firm is the same as in the previous example. We assume that the firm cannot separately identify each consumer - it cannot therefore price discriminate against each of them individually.
The firm would like to follow the same logic as before and charge a per-unit price of Pc while imposing a lump-sum fee equal to area ABCD - the largest consumer surplus of the two consumers. In so doing, however, the firm will be pricing consumer X out of the market, because the lump-sum fee far exceeds his own consumer surplus of area AC.
Nevertheless, this would still yield profit equal ABCD. A solution to pricing consumer X out of the market is to thus charge a lump-sum fee equal to area AC, and continue to charge Pc per unit. Profit in this instance equals twice the area AC (two consumers): since consumer Y's demand is twice consumer X's, then 2 x AC = ABCD. As it turns out, the producer is indifferent to either of these pricing possibilities.
However, it is possible for the firm to earn even greater profits. Assume it sets the unit price equal to Pm, and imposes a lump-sum fee equal to area A. Both consumers again remain in the market, except now the firm is making a profit on each unit sold - total market profit from the sale of Qm units at price Pm is equal to area CDE. Profit from the lump-sum fee is 2 x A = AB. Total profit is therefore area ABCDE.
Thus, by charging a higher per unit price and a lower lump-sum fee, the firm has generated area E more profit than if it had charged a lower per-unit price and a higher lump-sum fee. Note that the firm is no longer producing the allocatively efficient output, and there is a deadweight loss experienced by society equal to area F - this is a result of the exercise of monopoly power.
Consumer X is left with no consumer surplus, while Consumer Y is left with area B.

Price Discrimination

Most businesses charge different prices to different groups of consumers for what is more or less the same good or service! This is price discrimination and it has become widespread in nearly every market. This note looks at variations of price discrimination and evaluates who gains and who loses?

What is price discrimination?

•Price Discrimination is charging a different price for a different product or to a different buyer without any true cost differential to justify the different price. An agreement to charge a better price for the same product to one buyer versus another may constitute a violation of antitrust laws. A marketer may charge more for one model of a product than for another in order to add perceived value to the product. For example, makers of designer jeans charge a premium price for a product that costs no more to manufacture than no-name jean
•Practice of selling goods or services at different prices to different buyers, even though sales costs are the same for all the transactions. Buyers may be discriminated against on the basis of income, ethnicity, age, or geographic location. For price discrimination to succeed, other entrepreneurs must be unable to purchase goods at the lower price and resell them at a higher one
•Price discrimination or yield management occurs when a firm charges a different price to different groups of consumers for an identical good or service, for reasons not associated with costs.
It is important to stress that charging different prices for similar goods is not pure price discrimination.
We must be careful to distinguish between price discrimination and product differentiation – differentiation of the product gives the supplier greater control over price and the potential to charge consumers a premium price because of actual or perceived differences in the quality / performance of a good or service.

Conditions necessary for price discrimination to work

Essentially there are two main conditions required for discriminatory pricing

1.Differences in price elasticity of demand between markets: There must be a different price elasticity of demand from each group of consumers. The firm is then able to charge a higher price to the group with a more price inelastic demand and a relatively lower price to the group with a more elastic demand. By adopting such a strategy, the firm can increase its total revenue and profits (i.e. achieve a higher level of producer surplus). To profit maximise, the firm will seek to set marginal revenue = to marginal cost in each separate (segmented) market.

2.Barriers to prevent consumers switching from one supplier to another: The firm must be able to prevent “market seepage” or “consumer switching” – defined as a process whereby consumers who have purchased a good or service at a lower price are able to re-sell it to those consumers who would have normally paid the expensive price. This can be done in a number of ways, – and is probably easier to achieve with the provision of a unique service such as a haircut rather than with the exchange of tangible goods. Seepage might be prevented by selling a product to consumers at unique and different points in time – for example with the use of time specific airline tickets that cannot be resold under any circumstances.

Examples of Price Discrimination

Price discrimination is an extremely common type of pricing strategy operated by virtually every business with some discretionary pricing power. It is a classic part of price competition between firms seeking a market advantage or to protect an established market position.

Perfect Price Discrimination

Sometimes known as optimal pricing, with perfect price discrimination, the firm separates the whole market into each individual consumer and charges them the price they are willing and able to pay. If successful, the firm can extract all consumer surplus that lies beneath the demand curve and turn it into extra producer revenue (or producer surplus). This is impossible to achieve unless the firm knows every consumer’s preferences and, as a result, is unlikely to occur in the real world. The transactions costs involved in finding out through market research what each buyer is prepared to pay is the main block or barrier to a business’s engaging in this form of price discrimination.
If the monopolist is able to perfectly segment the market, then the average revenue curve effectively becomes the marginal revenue curve for the firm. The monopolist will continue to see extra units as long as the extra revenue exceeds the marginal cost of production.
The reality is that, although optimal pricing can and does take place in the real world, most suppliers and consumers prefer to work with price lists and price menus from which trade can take place rather than having to negotiate a price for each unit of a product bought and sold.

Second Degree Price Discrimination

This type of price discrimination involves businesses selling off packages of a product deemed to besurplus capacity at lower prices than the previously published/advertised price.
Examples of this can often be found in the hotel and airline industries where spare rooms and seats are sold on a last minute standby basis. In these types of industry, the fixed costs of production are high. At the same time the marginal or variable costs are small and predictable. If there are unsold airline tickets or hotel rooms, it is often in the businesses best interest to offload any spare capacity at a discount prices, always providing that the cheaper price that adds to revenue at least covers the marginal cost of each unit.
There is nearly always some supplementary profit to be made from this strategy. And, it can also be an effective way of securing additional market share within an oligopoly as the main suppliers’ battle for market dominance. Firms may be quite happy to accept a smaller profit margin if it means that they manage to steal an advantage on their rival firms.
The expansion of e-commerce by both well established businesses and new entrants to online retailing has seen a further growth in second degree price discrimination.

Early-Bird Discounts – Extra Cash-Flow

The low cost airlines follow a different pricing strategy to the one outlined above. Customers booking early with carriers such as Easy Jet will normally find lower prices if they are prepared to commit themselves to a flight by booking early. This gives the airline the advantage of knowing how full their flights are likely to be and a source of cash-flow in the weeks and months prior to the service being provided. Closer to the date and time of the scheduled service, the price rises, on the simple justification that consumer’s demand for a flight becomes more inelastic the nearer to the time of the service. People who book late often regard travel to their intended destination as a necessity and they are therefore likely to be willing and able to pay a much higher price very close to departure.
Airlines call this price discrimination yield management – but despite the fancy name, at the heart of this pricing strategy is the simple but important concept – price elasticity of demand!


Peak and Off-Peak Pricing

Peak and off-peak pricing and is common in the telecommunications industry, leisure retailing and in the travel sector. Telephone and electricity companies separate markets by time: There are three rates for telephone calls: a daytime peak rate, and an off peak evening rate and a cheaper weekend rate. Electricity suppliers also offer cheaper off-peak electricity during the night.
At off-peak times, there is plenty of spare capacity and marginal costs of production are low (the supply curve is elastic) whereas at peak times when demand is high, we expect that short run supply becomes relatively inelastic as the supplier reaches capacity constraints. A combination of higher demand and rising costs forces up the profit maximising price.

Third Degree (Multi-Market) Price Discrimination

This is the most frequently found form of price discrimination and involves charging different prices for the same product in different segments of the market. The key is that third degree discrimination is linked directly to consumers’ willingness and ability to pay for a good or service. It means that the prices charged may bear little or no relation to the cost of production.
The market is usually separated in two ways: by time or by geography. For example, exporters may charge a higher price in overseas markets if demand is estimated to be more inelastic than it is in home markets.
MC=AC

Suppose that a firm has separated a market by time into a peak market with inelastic demand, and an off-peak market with elastic demand. The demand and marginal revenue curves for the peak market and off peak markets are labeled A and B respectively. This is illustrated in the diagram above. Assuming a constant marginal cost for supplying to each group of consumers, the firm aims to charge a profit maximising price to each group.
In the peak market the firm will produce where MRa = MC and charge price Pa, and in the off-peak market the firm will produce where MRb = MC and charge price Pb. Consumers with an inelastic demand for the product will pay a higher price (Pa) than those with an elastic demand who will be charged Pb.

The Internet and Price Discrimination

A number of recent research papers have argued that the rapid expansion of e-commerce using the internet is giving manufacturers unprecedented opportunities to experiment with different forms of price discrimination. Consumers on the net often provide suppliers with a huge amount of information about themselves and their buying habits that then give sellers scope for discriminatory pricing. For example Dell Computer charges different prices for the same computer on its web pages, depending on whether the buyer is a state or local government, or a small business.

Two Part Pricing Tariffs

Another pricing policy common to industries with pricing power is to set a two-part tariff for consumers. A fixed fee is charged (often with the justification of it contributing to the fixed costs of supply) and then a supplementary “variable” charge based on the number of units consumed. There are plenty of examples of this including taxi fares, amusement park entrance charges and the fixed charges set by the utilities (gas, water and electricity). Price discrimination can come from varying the fixed charge to different segments of the market and in varying the charges on marginal units consumed (e.g. discrimination by time).



Product-line Pricing

Product line pricing is also becoming an increasingly common feature of many markets, particularly manufactured products where there are many closely connected complementary products that consumers may be enticed to buy. It is frequently observed that a producer may manufacture many related products. They may choose to charge one low price for the core product (accepting a lower mark-up or profit on cost) as a means of attracting customers to the components / accessories that have a much higher mark-up or profit margin.


Good examples include manufacturers of cars, cameras, razors and games consoles. Indeed discriminatory pricing techniques may take the form of offering the core product as a “loss-leader” (i.e. priced below average cost) to induce consumers to then buy the complementary products once they have been “captured”. Consider the cost of computer games consoles or Mach3 Razors contrasted with the prices of the games software and the replacement blades!

The Consequences of Price Discrimination - Welfare and Efficiency Arguments

To what extent does price discrimination help to achieve a more efficient allocation of resources? There are arguments on both sides of the coin – indeed the impact of price discrimination on welfare seems bound to be ambiguous.

The Impact on Consumer Welfare

Consumer surplus is reduced in most cases - representing a loss of consumer welfare. For the majority of consumers, the price charged is significantly above marginal cost of production. Those consumers in segments of the market where demand is inelastic would probably prefer a return to uniform pricing by firms with monopoly power! Their welfare is reduced and monopoly pricing power is being exploited.
However some consumers who can buy the product at a lower price may benefit. Previously they may have been excluded from consuming it. Low-income consumers may be “priced into the market” if the supplier is willing and able to charge them a lower price. Good examples to use here might include legal and medical services where charges are dependent on income levels. Greater access to these services may yield external benefits (positive externalities) which then have implications for the overall level of social welfare and the equity with which scarce resources are allocated.

Producer Surplus and the use of Profit

Price discrimination is clearly in the interests of businesses who achieve higher profits. A discriminating monopoly is extracting consumer surplus and turning it into extra supernormal profit. Of course businesses may not be driven solely by the aim of maximising profit. A company will maximise its revenues if it can extract from each customer the maximum amount that person is willing to pay.
Price discrimination also might be used as a predatory pricing tactic – i.e. setting prices below cost to certain customers in order to harm competition at the supplier’s level and thereby increase a firm’s market power. This type of anti-competitive practice is difficult to prove, but would certainly come under the scrutiny of the UK and European Union competition authorities.
A converse argument to this is that price discrimination may be a way of making a market more contestable in the long run. The low cost airlines have been hugely successful partly on the back of extensive use of price discrimination among consumers.

The profits made in one market may allow firms to cross-subsidies loss-making activities/services that have important social benefits. For example profits made on commuter rail or bus services may allow transport companies to support loss making rural or night-time services. Without the ability to price discriminate these services may have to be withdrawn and employment might suffer. In many cases, aggressive price discrimination is seen as inimical to business survival during a recession or sudden market downturn.
An increase in total output resulting from selling extra units at a lower price might help a monopoly supplier to exploit economies of scale thereby reducing long run average costs.

Variable Pricing

What is Variable Pricing?

Variable Pricing is a marketing strategy that allows a different price to be charged to different customers or at different times. This type of pricing is common among street vendors, antique dealers, and other small, independently owned businesses but is not practical for direct marketers, who rely upon preprinted promotion forms. Variable pricing risks the loss of customer goodwill when one customer discovers another paid less. Federal and state laws protect competing retailers from discriminatory pricing that gives competitors an unfair advantage
Most firms use a Fixed price policy. That is, they examine the situation, determine an appropriate price, and leave the price fixed at that amount until the situation changes, at which point they go through the process again. The alternative has been variable pricing, a form of first degree price discrimination, characterized by individual bargaining and negotiation, and typically used for highly differentiated, high value items (like real estate).

Two variants of variable pricing are price shading (in which sales people are given the authority to vary the price by a certain amount or percentage), and auctions (in which potential buyers have the option of bidding on a product and thereby varying the price). Consumers generally prefer fixed prices because they don’t need to worry about being out-negotiated by a professional with expert knowledge and skills. The exceptions are people that enjoy the social aspect of negotiating, and people that think they might have an advantage due to their product knowledge or negotiating skills.

Due to advances in technology, another variant of variable pricing, called real time pricing, has arisen. In some markets events occur so fast that there is insufficient time to either set a fixed price or engage in lengthy negotiations. By the time you have all the information to determine a price, everything has changed. Examples include Airline tickets, equity markets and currency markets. In each case prices can change in less than a second. By linking all the market participants through internet connections, price changes are disseminated instantly as they occur.
A variant of real time pricing is online auction business model (such as eBay). All participants can view the price changes soon after they occur (technically this is not quite real time pricing because there is a delay built into the eBay system). Traditional auctions are inefficient because they require bidders (or their representatives) to be physically present. By solving this problem, online auctions reduce the transaction costs for bidders, increase the number of bidders, and increase the average bid price.

In addition to these examples of variable pricing in the short term, there are long term pricing practices that could be considered instances of variable pricing. They are price skimming, penetration pricing, and seasonal discounts.
This kind of price discrimination is largely and widely used by rental car companies. Usually those firms need to know what your country of residence is so they can adjust the price. Depending on the answer you can get significantly different quotes for the same vehicle, date and time of rental. It is also true when accessing the rental car site through the .com main site


Profit Maximization

Definition
•A process that companies undergo to determine the best output and price levels in order to maximize its return. The company will usually adjust influential factors such as production costs, sale prices, and output levels as a way of reaching its profit goal. There are two main profit maximization methods used, and they are Marginal Cost-Marginal Revenue Method and Total Cost-Total Revenue Method. Profit maximization is a good thing for a company, but can be a bad thing for consumers if the company starts to use cheaper products or decides to raise prices.

Basic Definitions

Any costs incurred by a firm may be classed into two groups: fixed cost and variable cost. Fixed costs are incurred by the business at any level of output, including zero output. These may include equipment maintenance, rent, wages, and general upkeep. Variable costs change with the level of output, increasing as more product is generated. Materials consumed during production often have the largest impact on this category. Fixed cost and variable cost, combined, equal total cost.
Revenue is the total amount of money that flows into the firm. This can be from any source, including product sales, government subsidies, venture capital and personal funds.

Marginal cost and revenue, depending on whether the calculus approach is taken or not, are defined as either the change in cost or revenue as each additional unit is produced, or the derivative of cost or revenue with respect to quantity output. It may also be defined as the addition to total cost as output increase by a single unit. For instance, taking the first definition, if it costs a firm 400 USD to produce 5 units and 480 USD to produce 6, the marginal cost of the sixth unit is approximately 80 dollars, although this is more accurately stated as the marginal cost of the 5.5th unit due to linear interpolation. Calculus is capable of providing more accurate answers if regression equations can be provided.


Total Cost-Total Revenue Method

To obtain the profit maximizing output quantity, we start by recognizing that profit is equal to total revenue (TR) minus total cost (TC). Given a table of costs and revenues at each quantity, we can either compute equations or plot the data directly on a graph. Finding the profit-maximizing output is as simple as finding the output at which profit reaches its maximum. That is represented by output Q in the diagram.
There are two graphical ways of determining that Q is optimal. Firstly, we see that the profit curve is at its maximum at this point (A). Secondly, we see that at the point (B) that the tangent on the total cost curve (TC) is parallel to the total revenue curve (TR), the surplus of revenue net of costs (B,C) is the greatest. Because total revenue minus total costs is equal to profit, the line segment C,B is equal in length to the line segment A,Q.

Computing the price at which to sell the product requires knowledge of the firm's demand curve. The price at which quantity demanded equals profit-maximizing output is the optimum price to sell the product

Marginal Cost-Marginal Revenue Method

If total revenue and total cost figures are difficult to procure, this method may also be used. For each unit sold, marginal profit equals marginal revenue minus marginal cost. Then, if marginal revenue is greater than marginal cost, marginal profit is positive, and if marginal revenue is less than marginal cost, marginal profit is negative. When marginal revenue equals marginal cost, marginal profit is zero. Since total profit increases when marginal profit is positive and total profit decreases when marginal profit is negative, it must reach a maximum where marginal profit is zero - or where marginal cost equals marginal revenue. This is because the producer has collected positive profit up until the intersection of MR and MC (where zero profit is collected and any further production will result in negative marginal profit, because MC will be larger than MR). The intersection of marginal revenue (MR) with marginal cost (MC) is shown in the next diagram as point A. If the industry is competitive (as is assumed in the diagram), the firm faces a demand curve (D) that is identical to its Marginal revenue curve (MR), and this is a horizontal line at a price determined by industry supply and demand. Average total costs are represented by curve ATC. Total economic profits are represented by area P,A,B,C. The optimum quantity (Q) is the same as the optimum quantity (Q) in the first diagram.
If the firm is operating in a non-competitive market, minor changes would have to be made to the diagrams. For example, the Marginal Revenue would have a negative gradient, due to the overall market demand curve. In a non-competitive environment, more complicated profit maximisation solutions involve the use of Game Theory.


Suppose that a firm is Competitive Market

A competitive market is one in which there are many buyers and sellers trading homogeneous goods so that each buyer and seller is a price taker. Firms can freely enter or exit this type of market.
Marginal revenue is the change in revenue from an additional unit sold.


For a competitive firm, the demand curve is perfectly elastic.

The marginal cost curve is also the firm’s supply curve because the marginal cost curve determines the quantity of the good the firm is willing to supply at any price.

Short-Run Decision to Shut Down

Shut down if…



The competitive firm’s short-run supply curve is the portion of its marginal-cost curve that lies above average variable cost.
Sunk cost is a cost that has already been committed and cannot be recovered.

Long-Run Decision to Exit/Enter a Market

Exit if…

TR < TC
TR/Q < TC/Q
P < ATC

Enter if…

P < ATC

Measuring Profit

At the end of enter/exit, firms that remain in the market must be making zero economic profit.
Entry and exit ends only when P and ATC are driven to equality.