UNIT – 3: PRICING METHODS IN PRACTICE, PROFIT

MANAGEMENT AND CAPITAL BUDGETING

CHAPTER – 7: PRICING METHODS IN PRACTICES
Meaning of Pricing:
Pricing is a process of fixing the value that a manufacturer will receive in
the exchange of services and goods. Pricing method is exercised to adjust the cost
of the producer’s offerings suitable to both the manufacturer and the customer.
The pricing depends on the company’s average prices, and the buyer’s
perceived value of an item, as compared to the perceived value of competitors
product.
While fixing the cost of a product and services the following point should be
considered:
 The identity of the goods and services
 The cost of similar goods and services in the market
 The target audience for whom the goods and services are produces
 The total cost of production (raw material, labour cost, machinery cost,
transit, inventory cost etc).
 External elements like government rules and regulations, policies,
economy, etc.,
Objectives of Pricing:
 Survival- The objective of pricing for any company is to fix a price that is
reasonable for the consumers and also for the producer to survive in the
market. Every company is in danger of getting ruled out from the market
because of rigorous competition, change in customer’s preferences and
taste. Therefore, while determining the cost of a product all the variables
and fixed cost should be taken into consideration. Once the survival phase
is over the company can strive for extra profits.
 Expansion of current profits-Most of the company tries to enlarge their
profit margin by evaluating the demand and supply of services and goods
 in the market. So the pricing is fixed according to the product’s demand
and the substitute for that product. If the demand is high, the price will also
be high.
 Ruling the market- Firm’s impose low figure for the goods and services
to get hold of large market size. The technique helps to increase the sale by
increasing the demand and leading to low production cost.
 A market for an innovative idea- Here, the company charge a high price
for their product and services that are highly innovative and use cutting-
edge technology. The price is high because of high production cost. Mobile
phone, electronic gadgets are a few examples.

SPECIFIC PRICING PROBLEMS

1. Product Pricing During Its Life Cycle
Every product has a life cycle—so sales and profitability fluctuate over
time. The product life cycle hypothesis was developed to recognize formally
distinct stages in the sales history of representative items.
The pricing strategies and problems must change as the product progresses
through each of these stages. There are four stages in a product’s life cycle—it
starts with the introduction stage, followed by the growth, then maturity, and
finally the decline stage.
The introduction phase is marked by low sales, moderate sales growth, and
negative or minimal earnings. The second growth phase is distinguished by two
characteristics: rapid sales and significant increases in product profitability.
The third stage entails a slowing of sales growth and a levelling off of
profits. The final stage is when both sales and profits begin to decline once more.
It should be emphasized that there is no clear-cut guideline for determining
where each stage starts or finishes, and the exact delineation of these stages must
be chosen subjectively.
2. The Market’s Growth Rate
Pricing policies, in turn, have a significant impact on this and some items
are intrinsically less likely than others to obtain a considerable market share. As
a result, these products are inappropriate for a penetration pricing strategy that
involves low or negative margins at first.

3. Distinctiveness Is Being Eroded

The rate at which distinctiveness erodes is determined by the quantity of
competing products that enter the market and their ability to replicate the
attributes of pioneer products.
An analysis of the initial producer’s strengths and weaknesses compared
to potential competitors regarding technology and access to distribution channels.
Moreover, you can also use financial stability to determine the possible lead time.
Skimming pricing can be reasonable if the lead time is extended. On the other
hand, a skimming price may be more appropriate where purchasers are more
interested in the product’s attributes, especially its cost, than with the source.
Woolen fabric manufacturers sometimes claim that they cannot maintain
the initial price of a new design for an extended period because purchasers soon
switch to a new, lower-cost source of supply.
There is also a negative factor: the firm may be more interested in boosting
its liquidity situation in the short term than reaping the long-term benefits of a
penetration policy.
Finally, although a pioneer product will not generally compete
aggressively with existing products, some substitution may occur.
If this substitution is likely to include the producer’s existing items, a penetration
price will be less appropriate once more.
4. The Significance of Cost
The cost of manufacturing a product directly impacts its pricing and profit
made from each sale. Price refers to a customer’s willingness to pay for a product
or service. The difference between the price paid and the costs incurred is referred
to as profit.

5. Post-Skimming Strategies
It’s not enough to choose a low price. The timing and size of subsequent
price reductions from the original price will have to be decided later.
Competitors’ conduct may, in some cases, bind the producer’s hand. Producers
may have more leeway in other cases.
If it is determined that the market’s “peak” has been saturated, it is
necessary to cut the price to attract new clients.
Another thing to think about is how much the product has developed an
image of exclusivity or status. A significant price cut can result in a drop in status,
and it might be better to make a series of small price decreases.

6. Mixed Strategies
Many businesses choose a strategy that lies somewhere between the two
extremes of skimming and penetration prices. In the case of a large number of
new items, many large corporations adhere to this philosophy—Du Pont, for
instance, used a hybrid technique for nylon and cellophane.
However, cellophane was closer to the penetration end of the spectrum than
nylon, presumably because the cost elasticity of volume output and the price
elasticity of expanding demand were both high enough to allow a faster pace of
expansion.
In the pricing of a significant piece of farm machinery like the cotton
picker, the decision arrived on was a middle ground between the predicted
maximum economic value as a substitute for hand labour, and a sufficiently low
price to assure widespread adoption,
7. Pricing in Maturity
It keeps companies from becoming comfortable after introducing
successful items by reminding them that they need to have additional products
ready to market when their current products begin to decline.
Another weakness in the product-life-cycle idea is that it implies a decline
stage that will automatically follow maturity. However, maturity can be extended
for many years in some markets by a succession of product innovations.
Even though the market elasticity of demand may be low, it is vital to
consider cost conditions. If cost continues to reduce with an increase of output
owing to the learning effect, there will be pressure for a price reduction.
When there are considerable cost differences but little room for cost cuts,
lowering prices puts further pressure on the margins of high-cost companies,
which may be forced out of the market.
Besides, if the low-cost firm decides to take a wait-and-see approach, it
will keep its prices the same, maybe using the higher short-run earnings to invest
in product differentiation activities.
8. Pricing Products in Decline
At this stage of decline, there are three additional techniques to consider:
 Product Reformulation Strategy
First, the product must be radically reformulated and sold at a considerably lower
price. This is a regular procedure in the book business when a hard-bound
edition’s market saturation signals the arrival of a paperback edition.
 Price Reduction Strategy
The second technique entails significantly lowering prices to stimulate a brief
sales rebound. This occurred in the instance of the Ford Anglia in the United
Kingdom, whose popularity had declined due to improvements in appearance and
performance in competing models.
POPULAR PRICING PRACTICES: COST-ORIENTED PRICING,
COST-PLUS PRICING AND OTHER PRICE DETERMINANTS
Pricing method is a technique that a company apply to evaluate the cost of
their products. This process is the most challenging challenge encountered by a
company, as the price should match the current market structure and also
compliment the expenses of a company and gain profits. Also, it has to take the
competitor’s product pricing into consideration so, choosing the correct pricing
method is essential.
Types of Pricing Method:
The pricing method is divided into two parts:
 Cost Oriented Pricing Method– It is the base for evaluating the price of
the finished goods, and most of the company apply this method to calculate
the cost of the product. This method is divided further into the following
ways.
o Cost-Plus Pricing- In this pricing, the manufacturer calculates the
cost of production sustained and includes a fixed percentage (also
known as mark up) to obtain the selling price. The mark up of profit
is evaluated on the total cost (fixed and variable cost).
o Markup Pricing- Here, the fixed number or a percentage of the total
cost of a product is added to the product’s end price to get the selling
price of a product.
o Target-Returning Pricing- The company or a firm fix the cost of
the product to achieve the Rate of Return on Investment.
 Market-Oriented Pricing Method- Under this category, the is
determined on the base of market research
o Perceived-Value Pricing- In this method, the producer establish the
cost taking into consideration the customer’s approach towards the
goods and services, including other elements such as product
 quality, advertisement, promotion, distribution, etc. that impacts the
customer’s point of view.
o Value pricing- Here, the company produces a product that is high
in quality but low in price.
o Going-Rate Pricing- In this method, the company reviews the
competitor’s rate as a foundation in deciding the rate of their
product. Usually, the cost of the product will be more or less the
same as the competitors.
o Auction Type Pricing- With more usage of internet, this
contemporary pricing method is blooming day by day. Many online
platforms like OLX, Quickr, eBay, etc. use online sites to buy and
sell the product to the customer.
o Differential Pricing- This method is applied when the pricing has
to be different for different groups or customers. Here, the pricing
might differ according to the region, area, product, time etc.

Skimming Pricing
Skimming pricing is another popular method that marketers use to elevate
their product sales. Here, the firm charges the maximum price of the product in
the initial stages and reduces the price with time.
Premium Pricing
Premium pricing is a pricing strategy where the product price is set higher
than the prices of similar products.
Psychological Pricing
Psychological pricing is a practice where the price of the product is set
slightly lower than that of the whole number. For example – 999, 599, and so on.
Factors Affecting Pricing Decisions
The pricing of products is influenced by a multitude of factors that
businesses must carefully consider to determine an appropriate and effective
pricing strategy. These factors can vary across industries, markets, and
individual businesses. Some of the key factors affecting product pricing include:
1. Customer’s Perception of Value: The customers’ expectation of the price
of the product plays an important role in deciding the price of the product.
Customers only bear the cost of a product that they can afford. If a business
keeps the price of its product/service very high, it will have a very small
customer base. Customer-oriented price approach is generally followed in order
to cover the customers’ perception of value. In a customer-oriented price
approach, the customer is considered as the ‘king’ and all the decisions relating
to pricing are taken from the viewpoint of the customer.
2. Competitors: Competitors’ pricing strategies, market share, and positioning
can significantly impact how a product is priced. Businesses may choose to price
their products at a premium, match competitors’ prices, or use other strategies
to differentiate themselves.
3. Government Law and Regulations: Pricing decisions are also affected by
federal and state regulations. Some laws prevail in order to protect the customers
from getting exploited at the hands of manufacturers, promotion of ethical
behaviours from the end of manufacturers, etc. For example, Firms coming
together and joining hands, agreeing on charging higher prices for a particular
type of product, is illegal.
4. Economy: Economic environment like fluctuations in the general price level,
interest rates, and unemployment level also affects the pricing strategy of firms.
5. Product Costs: The total cost that the manufacturer incurred in the
production of the product affects the pricing decision. Production costs can be
of several types, like fixed costs, variable costs, semi-variable costs, etc. Also,
promotional costs, distribution channel costs, packing costs, etc., are considered
while deciding the price.
6. Market Demand: The level of demand for the product at different price
points affects pricing decisions. High demand might allow for higher prices,
while low demand could require competitive pricing to attract customers.
7. Elasticity of Demand: Price elasticity measures how sensitive demand is to
price changes. Inelastic demand allows for price increases without significant
drops in demand, while elastic demand requires more cautious pricing
adjustments.
8. Market Segmentation: Different customer segments may have varying
willingness to pay. Businesses can tailor pricing strategies to target specific
segments and maximize revenue from each.
9. Branding and Positioning: Premium brands can command higher prices due
to their reputation and perceived quality. Pricing can be used to reinforce the
brand’s image as luxury, value-oriented, or innovative.
10. Distribution Channels: The chosen distribution channels can impact
pricing. Direct-to-consumer sales might allow for more flexibility in pricing
compared to working through intermediaries.

PEAK - LOAD PRICING

The Peak Load Pricing is the pricing strategy wherein the high price is
charged for the goods and services during times when their demand is at peak. In
other words, the high price charged during the high demand period is called as
the peak load pricing.
This type of price discrimination is based on the efficiency, i.e. a firm
discriminates on the basis of high usage, high-traffic, high demand times and
low demand times. The consumer who purchases the commodity during the high
demand period has to pay more as compared to the one who buys during low
demand periods.
The peak load pricing is widely used in the case of non-storable
goods such as electricity, transport, telephone, security services, etc. These are
the goods which cannot be stored and hence their production is required to be
increased to meet the increased demand. Thus, the marginal cost is also high
during the peak periods as the capacity to produce these goods is limited. And,
hence, the price is set at its highest level with an aim to shift the demand or at
least the consumption of goods and services to attain a balance between demand
and supply.
For example, during summers, the electricity consumption is highest
during the daytime as several offices and educational institutes are operational
during the day time, called as a peak-load time. While the electricity
consumption is lowest during the night as all the office establishments and
educational institutes are closed by this time, called as off-peak time. Thus, a
firm will charge a relatively higher price during the daytime as compared to the
price charged at night.
Essential Principles in Peak Load Pricing
From the definition, you might now have a sense of the primary principles
that drive Peak Load Pricing.
1. Maximising Profit: This is the underlying drive for most businesses
implementing Peak Load Pricing. By levying higher prices during peak demand,
revenue generated is increased.
2. Managing Demand: As mentioned before, fluctuating prices can direct
consumer behaviour. Higher peak period prices deter excessive use, thus
managing demand better.
3. Efficient Resource Allocation: This strategy aids in optimal allocation of
resources, reducing the likelihood of surplus or shortage.
4. Fairness: This principle endeavours to balance cost distribution among
consumers. Those using services at peak times, causing high demand, are charged
more. Here's a simple representation of the Peak Load Pricing Model using a
mathematical formula. Let us assume the price P is determined by the demand D
and the peak load L during a time t. That could be represented as:
[ P = f(D,L,t) \]
Where f is a function that calculates the price based on demand, the peak
load, and time.
Application of Peak Load Pricing in Managerial Economics
When it comes to managerial economics, peak load pricing becomes an
essential tool in the arsenal of a firm. This strategy is not only beneficial in
balancing supply and demand but it also assists in achieving the goal of profit
maximisation. By adjusting prices depending on the demand and supply
condition, a firm can achieve better revenue collection and cost management.
The Role of Peak Load Pricing in Managerial Economics
In the realm of managerial economics, peak load pricing holds a significant
position. Here are some ways in which peak load pricing aids managerial
decision-making:
1. Resource Allocation: By applying peak load pricing, managers are better
able to allocate resources effectively. This prevents situations where
resources either fall short or are left unused
2. Cost Management: Balancing supply and demand also helps in managing
costs effectively. Avoiding overproduction or underproduction can save a
large amount of capital for the firm.
3. Consumer Satisfaction: Peak load pricing, to an extent, ensures fairness
in cost distribution, leading to increased customer satisfaction.
Peak Load Pricing Advantages
There are several advantages of making use of peak load pricing. Here's a
detailed discussion about how you, as a consumer or a business entity, can benefit
from this approach:
1. Managing and Predicting Demand: By fluctuating prices according to
demand, this strategy helps manage and predict consumer behaviour. Consumers
are likely to reduce their consumption during peak periods to avoid high costs,
thereby assisting in demand and resource management.
2. Spreading the Demand: Peak load pricing not only manages the existing
demand but helps spread it over a longer period. It discourages usage during peak
periods and encourages off-peak usage. Consequently, it reduces intensity during
peak periods and mitigates resultant pressure on resources.
3. Optimal Utilisation of Resources: Resources, especially scarce ones, need to
be judiciously used. By controlling the surge in demand during peak times using
pricing as a deterrent, businesses can ensure optimal utilisation of resources. This,
in turn, helps prevent wastage or overuse of resources.
4. Enhanced Revenue Generation: Businesses can maximise their profits by
levying higher prices when demand is high. The high prices offset the cost of
managing peak loads — effectively, an example of net revenue gain derived from
demand-based pricing.
Peak Load Pricing Disadvantages
1. The Elasticity Issue: The effectiveness of peak load pricing largely depends
on the elasticity of demand. If the demand is inelastic, consumers will continue
to purchase products or services irrespective of the price hike during peak periods,
which might not reduce the peak demand as anticipated.
2. Lack of Fairness: Critics argue that peak load pricing might be unfair to those
who have no choice but to use certain services during peak periods. For instance,
consider a commuter who must travel during the rush hour - the peak pricing can
impose higher costs on such individuals.
3. Implementation Challenges: Implementing this strategy might be
complicated, as it requires a thorough understanding of demand trends and an
efficient mechanism to modify prices during variable demand. This could be
logistically challenging and costly for some providers. Peak load pricing shines
as a strategy aiming to achieve a balance between demand and availability of
resources. However, it's equally important to be aware of the potential backlashes
that could arise. Fully understanding the advantages and disadvantages enables
you to evaluate whether or not this form of pricing strategy is suitable for your
economic representation.
PRICE OVER THE LIFE CYCLE OF THE PRODUCT
Product life cycle pricing is an important pricing strategy that allows
companies to forecast and improve sales. The life cycle has several stages, from
launch to declination, in which the product may behave differently in the market.
If you're a sales or marketing professional, you may want to learn more about
product life cycle pricing and how it works. In this article, we discuss product life
cycle pricing, including the four stages within it, its benefits and how businesses
use it.
Product life cycle pricing is a strategy for selling products in which pricing
correlates with a product's location in its life cycle. There are four phases within
the life cycle, including launch, growth, maturity and declination. Businesses use
product life cycle pricing to better understand how discounts, clearance prices,
new versions and marketing can affect their sales in each phase. A company may
choose to strategize differently depending on the market and how its product sells.

Launch or development stage

The launch phase, or development portion of the life cycle, is when the
company first introduces the product to the market. During this time, the business
may record few sales, as the consumers within the market may be reluctant to
purchase a new product. This can be especially true when a product is unique,
resulting in lower competition but slower market acceptance.
Early or growth stage
The early stage within the product life cycle comes after the launch and is
when demand for the product or service rises. Experts may call this stage the
promotional stage, and it can be when marketing efforts may show positive
results. During this stage of the cycle, competitors may release their own products
to compete with yours.
Mid or maturity stage
The maturity stage, or the regular pricing phase, represents a plateau in the
product's sales and awareness. This is the time in the product life cycle where the
product shows acceptable sales and profits. This may be the phase of the cycle
where there is the highest level of competition.
Late or declination stage
Experts may also call the last stage in the product life cycle the clearance
phase. It's during this phase that consumers may choose an alternative product.
Many companies plan to remove the product from production during this stage,
as there is less demand for the product. In this stage, businesses may even lose
money by continuing to produce the product.
Benefits of life cycle pricing
Here are some benefits of using life cycle pricing for new products:
 Improved marketing strategies: Understanding life cycle pricing can aid
marketing teams in correctly pricing and marketing products to achieve
optimal sales.
 Enhanced customer loyalty: By offering discounts or clearance at the
best time during the product life cycle, companies can increase customer
loyalty.
 Increased profits: Knowing how to price a product at each phase of its
life allows businesses to correctly predict when and how much consumers
may pay for their products, increasing their total profits.
 A more reputable brand: When businesses follow life cycle pricing,
consumers may rely on them for sales or discounts and consider them to be
reputable and reliable for pricing.
 Reliable sales forecasting: Understanding how consumers view your
product at each phase of the cycle can allow you to better calculate what
sales projections may be throughout the product's life.
  Improved decision-making: Companies can use life cycle pricing to
support their decision-making for altering, discontinuing or decreasing the
price for their items.

PENETRATION PRICE
Penetration pricing is a pricing strategy that is used to quickly gain market
share by setting an initially low price to entice customers to purchase. This
pricing strategy is generally used by new entrants into a market. An extreme form
of penetration pricing is called predatory pricing.
Rationale Behind Penetration Pricing
It is common for a new entrant to use a penetration pricing strategy to quickly
obtain a substantial amount of market share. Price is one of the easiest ways to
differentiate new entrants from existing market players. The overarching goal of
this pricing strategy is to:
 Capture market share
 Create brand loyalty
 Switch customers from competitors
 Generate significant demand, looking to utilize economies of scale
 Drive competitors out of the market

Situations where penetration pricing works effectively:

 When there is little product differentiation
 Demand is price-elastic
 Where the product is suitable for a mass market (and, therefore, for
utilizing economies of scale)

Illustration and Example of Penetration Pricing

A current small-sized player in the marketplace where laundry detergent
sells at around $15. Company A is an international company with a large amount
of excess production capacity and is, therefore, able to produce laundry detergents
at a significantly lower cost.
Company A decides to enter the market, employ a penetration pricing
strategy, and sell laundry detergent at a sale price of $6.05. The company’s cost
to produce laundry detergent is $6.

With a marginal cost of $6 and a sale price of $6.05, Company A is making

nominal profits per sale. However, the company is comfortable with this decision
as its overarching goal is to switch customers over, capture as much market share
as possible, and utilize economies of scale with their high production capacity.
Company A believes that its competitor will not be able to sustain itself in the
long-term and will eventually exit the market. When the competitor exits the
marketplace, Company A will become the only seller of laundry detergent and
therefore be able to establish a monopoly over the market and raise prices to a
level that will provide a high profit margin.

Advantages of Penetration Pricing

 High adoption and diffusion: Penetration pricing enables a company to
get its product or service quickly accepted and adopted by customers.
  Marketplace dominance: Competitors are typically caught off guard by a
penetration pricing strategy and are afforded little time to react. The
company is able to utilize the opportunity to switch over as many
customers as possible.
 Economies of scale: The pricing strategy generates a high sales quantity
that enables a firm to realize economies of scale and lower its marginal
cost.
 Increased goodwill: Customers that are able to find a bargain in a product
or service are likely to return to the firm in the future. In addition, this
increased goodwill creates positive word of mouth.
 High inventory turnover: Penetration pricing results in an increased
inventory turnover rate, making vertical supply chain partners, such as
retailers and distributors, happy.

Disadvantages of Penetration Pricing

 Pricing expectation: When a firm uses a penetration pricing strategy,
customers often expect permanently low prices. If prices gradually
increase, customers may become dissatisfied and may stop purchasing the
product or service.
 Low customer loyalty: Penetration pricing typically attracts bargain
hunters or those with low customer loyalty. Said customers are likely to
switch to competitors if they find a better deal. Price cutting, while
effective for making some immediate sales, rarely engenders customer
loyalty.
 Damage brand image: Low prices may affect the brand image, causing
customers to perceive the brand as cheap or poor quality.
 Price war: A price penetration strategy may trigger a price war. This
decreases overall profitability in the market, and the only companies strong
 enough to survive a protracted price war are usually not the new entrant
who triggered the war.
 Inefficient long-term strategy: Price penetration is not a viable long-term
pricing strategy. It is usually a better idea to approach the marketplace with
a pricing strategy that your company can live with, long-term. While it may
then take longer to acquire a sizeable market share, such a patient, long-
term strategy is more likely to serve your company better overall, and less
likely to expose you to severe financial risks.

PRICING OF MULTIPLE PRODUCTS

Generally, organizations produce more than one product in their line of
production. Even a single product of an organization can differ in styles and
sizes. For example, a refrigerator manufacturing organization produces
refrigerators in different colors, sizes, and features. Similarly, an automobile
organization manufactures vehicles in different colors, sizes, and mileage.
The pricing in case of multiple products is called multiple product pricing.
The demand curve for multiple products would be different. However,
the MC curve of these products is same as these are produced under
interchangeable production facilities. Therefore, AR and MR curves are
different for each product. On the other hand, AC and MC are inseparable.
Therefore, the condition of MR=MC cannot be applied directly to fix the
prices of each product.
The solution of this problem was provided by E.W. Clemens who stated how
the multi-product organizations fix prices of their products. Suppose there are
four differentiated products. A, B, C, and D produced by an organization.
Figure-6 shows multiple product pricing:
As shown in Figure-6, the AR (price) and MR curves for four products are
shown as four different curves and MC curve is shown as the total of MC of
all the products. Suppose the aggregate MR curve, which is the total of all
individual MR curves, passes through point E on the MC curve.
From point E, a parallel line, equal marginal revenue (EMR) is drawn towards
Y- axis (parallel to X-axis). This parallel line passes through the M Rs of A,
B, C, and D. The output and prices of these four products are determined at
the points where their respective MC and MR curves intersect each other.
As shown in Figure-6, OQa, QaQb, QbQc, QcQd are the output levels of
products A, B, C, and D and PaQa, PbQb, PcQc, PdQd are the prices of the
products respectively. These are the maximum price and output levels of an
organization.
CHAPTER – 8: PROFIT ANALYSIS: MEANING OF PROFIT
In general, the profit is defined as the amount gained by selling a product,
which should be more than the cost price of the product. It is the gain amount
from any kind of business activity.
In short, if the selling price (SP) of the product is more than the cost
price (CP) of a product, then it is considered as a gain or profit.
Profit or Gain = Selling Price – Cost Price

ACCOUNTING PROFIT & ECONOMIC PROFIT

Accounting profit is the profit after subtracting explicit costs (such as

wages and rents). Economic profit includes explicit costs as well as implicit
costs.
As such, accounting profit represents a company's true profitability
while economic profit is indicative of its efficiency.

Accounting profit reflects how well your business is performing financially.

The accounting profit formula

Elements of the formula

 Total revenue is the sum of all the money you earn by selling goods
and services. You can calculate it by multiplying the number of
products sold by the price of each product. So, for example, if your
business sells 100 pens for ₹ 5 each, your total revenue would be 100
x ₹5 = ₹500.
  Explicit costs are the operational costs you pay for running a
business. These appear on the business ledger and directly affect your
profit. Common examples include equipment, rent, cost of goods
sold, and insurance.
An accounting profit example
Let’s assume you own a T-shirt business. Your explicit costs include:
 ₹ 70,000 for raw material costs
 ₹ 10,000 in payroll
 ₹ 8,000 for factory rent per year
Your total explicit costs equal ₹ 88,000 (70,000 + 10,000 + 8,000).
Assuming, for the year, you sold 5,000 units of T-shirts for ₹30 each. Your
Total revenue would be ₹ 150,000 (5,000 x ₹30).
Accounting profit = ₹ 150,000 - ₹ 88,000 = ₹ 62,000
So, your business has a net income of ₹ 62,000.
Economic profit:
Economic profit is similar to accounting profit. It subtracts explicit
costs from total revenue; however, it also factors in implicit costs, which are
the costs of your business’s resources.
Economic profit subtracts the economic costs for choosing one decision
over another—measuring how efficiently your company allocates its assets
to maximize revenue.

How to calculate economic profit

1. Determine your business’s expected total revenue or income on sales
of goods and services, which is essentially the quantity sold
multiplied by the price per product.
2. Define your total explicit costs, including raw materials, payroll, rent,
etc.
3. Identify your implicit costs (or total opportunity cost).
 4. Subtract the sum of explicit and implicit costs from the total revenue;
the resulting amount is your economic profit for each alternative.
The economic profit formula

Elements of the formula

The calculations for revenue and explicit costs are the same for
accounting and economic profit, but economic profit also considers implicit
costs.
Your implicit or opportunity cost is the revenue lost from other
alternatives when you choose one option over another. Your implicit cost
won’t appear on any financial statements since it is a theoretical estimate
used to compare alternatives. So, for example, an implicit cost could be the
amount of money you could earn if your business invested in stocks instead
of putting that money toward equipment for business operations.
An economic profit example
Let’s say a company XYZ has the option of making products A and B
with its raw materials. For some reason, though, it can’t do both. Upon
choosing to make product A, the business makes an accounting profit of
$50,000 for the financial year. If it had chosen B, it would make an
accounting profit of $62,000 instead.
The economic profit for manufacturing and selling product A or B is:
Economic profit (A) = $50,000 - $62,000 = -$12,000
Economic profit (B) = $62,000 - $50,000 = $12,000
This means that choosing to make product B—in other words, capitalizing on
opportunity B instead of A—would have helped the business make $12,000
more.
In this example, we calculated the actual cost of choosing to adopt
business operation A over other available options, as opposed to just the cost
of running operation A.

Profit analysis in Managerial Economics:

In managerial economics, profit analysis is a form of cost accounting used
for elementary instruction and short run decisions. A profit analysis widens the
use of info provided by breakeven analysis. An important part of profit analysis
is the point where total revenues and total costs are equal. At this breakeven point,
the company does not experience any income or any loss.

Components of Profit Analysis

The key components involved in profit analysis include:
 Selling price per unit
 Level or volume of activity
 Total fixed costs
 Per unit variable cost
 Sales mix
Applications of Profit Analysis:
The profit analysis is helpful in simplifying the calculation of breakeven in
breakeven analysis. Besides, it is generally helpful in simple calculation of Target
Income Sales. Moreover, it also simplifies the process of analysing short run
trade-offs in operational decisions.

BREAK-EVEN ANALYSIS
Break-even analysis is the effort of comparing income from sales to the
fixed costs of doing business. The analysis seeks to identify how much in sales
will be required to cover all fixed costs so that the business can begin
generating a profit.
This activity also leads to calculating and examining the margin of
safety for an entity based on the revenues collected and associated costs. A
demand-side analysis would give a seller significant insight into selling
capabilities.
Calculations for Break-Even Analysis
The calculation of break-even analysis may use two equations. In the first
calculation, divide the total fixed costs by the unit contribution margin. In the
example above, assume the value of the entire fixed costs is $20,000. With a
contribution margin of $40, the break-even point is 500 units ($20,000 divided
by $40). Upon the sale of 500 units, the payment of all fixed costs are
complete, and the company will report a net profit or loss of $0.
Alternatively, the calculation for a break-even point in sales dollars
happens by dividing the total fixed costs by the contribution margin ratio. The
contribution margin ratio is the contribution margin per unit divided by the sale
price.
Returning to the example above, the contribution margin ratio is 40% ($40
contribution margin per item divided by $100 sale price per item). Therefore, the
break-even point in sales dollars is $50,000 ($20,000 total fixed costs divided by
40%). Confirm this figured by multiplying the break-even in units (500) by the
sale price ($100), which equals $50,000.
Users of Break-Even Analysis
Break-even analysis is used by a wide range of entities, from entrepreneurs,
financial analysts, businesses and government agencies.
 Entrepreneurs: Break-Even analysis is useful for entrepreneurs and
founders because it helps determine the minimum level of sales needed to
cover costs. This is critical for the early stage of a business.
 Financial Analysts: These professionals use break-even analysis as a
profitability and risk metric. Financial Analysts tie break-even analysis
into their valuations and recommendations on a business.
 Investors: Investors conduct break-even analysis to determine the
financial performance of companies. With this information they make
more informed decisions on their asset selections.
 Stock and Option Traders: Break-even analysis is crucial for stock and
option traders because they need to know how much money is needed to
cover their expenses for each transaction they make. This analysis help
them determine how much money to allocate a transaction and which
assets would generate the higher profits for them.
 Businesses: A broad range of businesses use break-even analysis to paint
a better picture of their cost structure, pricing, as well as their operational
efficiencies.
 Government Agencies: Government agencies need to understand the
financial viability of projects and programs and they use break-even
 analysis to determine this. It answers the question: What is the minimum
level of sales or revenue required to cover costs?
The Importance of Break-Even Analysis to Businesses
There are several reasons why break-even analysis is important to businesses.
They are as follows:
 Pricing: Businesses get a comprehensible perspective on their cost
structure with break-even analysis. With that understanding, businesses
can set prices for their products that not only cover their fixed and variable
costs but provide a reasonable profit margin as well.
 Decision-Making: When it comes to new products and services,
operational expansion or increase production, businesses use break-even
analysis to help them make informed decisions surrounding those
activities.
 Cost Reduction: Break-even analysis helps businesses find areas where
they can reduce costs to increase profitability.
 Performance Metric: Break-even analysis is a financial performance tool
and helps businesses ascertain where they are when it comes to achieving
their short, medium and long term goals.
Limitations of Break-Even Analysis
Break-even analysis is a useful tool. However, like any tool, there are
limitations to it. Break-even analysis assumes that the fixed and variable costs
remain constant over time. In reality, this is usually not the case. Costs may
change due to factors such as inflation, changes in technology, or changes in
market conditions.
Another limitation is that Break-even analysis makes some oversimplified
assumptions about the relationships between costs, revenue, and production
levels. For example, it assumes that there is a linear relationship between costs
and production. This is not always true. Also, break-even analysis ignores
external factors such as competition, market demand, and changing consumer
preferences, which can have a significant impact on a businesses' top line.

BREAK-EVEN QUANTITY
Break-even quantity (BEQ): the level of sales or output, where costs
equal revenue and the firm is making neither a loss nor a profit.

BREAK- EVEN SALES:

Break even sales is the amount of revenue at which a business earns
a profit of zero.
This sales amount exactly covers the underlying fixed expenses of a
business, plus all of the variable expenses associated with the sales. It is useful
to know the break-even sales level, so that management has a baseline for the
minimum amount of sales that must be generated in each reporting period to
avoid incurring losses.
For example, if a business downturn is expected, the break-even level
can be used to pare back fixed expenses to match the expected future sales
level.
To calculate break even sales, divide all fixed expenses by the
average contribution margin percentage. Contribution margin is sales
minus all variable expenses, expressed as a percentage.
The formula is:
Fixed expenses ÷ Contribution margin percentage = Break even sales

Example of the Break Even Sales Calculation

ABC International routinely incurs $100,000 of fixed expenses in each
month. The company's contribution margin is 50%. This means that the
business reaches a break even sales level at $200,000 of sales per month.
Problems with Break Even Sales
 There are some issues to be aware of before relying upon the break even
sales concept. They are noted below.
Doesn’t predict demand – Although a break-even analysis can tell you
when you’ll break even, it doesn’t give you any insight into how likely that
is to happen. Plus, demand isn’t stable, so even if you think there’s a gap
in the market, your break-even point could end up being a lot more
ambitious than you initially thought.
Depends on reliable data – In short, the accuracy of your break-even
analysis is dependent on the accuracy of your data. If your calculations are
wrong or you’re dealing with fluctuating costs, break -even analysis may
not be the most useful tool in your arsenal.
Too simple – Break-even analysis is best for companies with one price-
point. If you have multiple products with multiple prices, then break -even
analysis may be too simple for your needs. In addition, it’s worth
remembering that costs can change, so your break -even point may need to
be evaluated and adjusted at a later time.
Ignores competition – Another limitation of a break-even analysis concerns
the fact that competitors aren’t factored into the equation. New entrants to the
market could affect demand for your products or cause you to change your
prices, which is likely to affect your break-even point.
BREAK-EVEN OUTPUT:
The break-even level of output informs a business of how many
products it needs to sell to reach the break-even point (BEP). Break-even is
calculated as follows: Break-even = fixed costs ÷ (selling price − variable
costs)
Break-even = fixed costs ÷ (selling price − variable costs)
Example
A business that sells T-shirts wants to find out what its BEP is.
Its fixed costs are £400.
The selling price (per unit) is £10.
The variable costs (per unit) are £6.
Therefore: Break-even = £400 ÷ (£10 − £6)= £400 ÷ £4 = 100
So this business breaks even when it sells 100 T-shirts.

TARGETED PROFIT
Target Profit is the estimated amount of profit the management hopes to
achieve during an accounting period and is forecasted and updated regularly as
per the business’s progress.

Target Profit Analysis

• Target Profit analysis is a small part of cost volume profit analysis, which
is a wider concept.
• Target profit analysis helps us to know how much in sales a company will
need, to reach a certain profit point.
• This covers evaluating the sales level or the amount of revenue that needs
to be generated to earn a targeted profit after covering the fixed overhead
expenditures and variable overhead expenditures in the targeted period.
 It is the next step for the organizations after the break-even platform where
the revenue from the sales is only able to cover fixed & variable overhead without
any profit. In the target profit analysis, the company’s target is to earn the
targeted profit over and above the expenditures.
Advantages
 It provides less variation in the actual results compared to the budgeted
profit. It tends to be more reliable. As well as the target profit gets updated
as per actual results, it becomes more feasible and reliable to use.
 It provides a detailed analysis of the business’s cost structure, including
the fixed cost structure as well as the variable cost structure of the asset.
The incorporation of the selling price & cost of the asset for the evaluation
of the gross margin percentage also shows the profitability of the
company. So, this also helps in the overall evaluation of the company’s
profit-making capability.
 It also helps the management make the decision-making regarding the
business operation and finalize the company’s mission and goal for the
upcoming periods. This analysis can help in predicting the capability and
help in making the decision-making process.
Disadvantages
 The variation is less, but the system is open to manual errors or mistakes.
As the gross margin calculation and the intakes of the variable overheads
are to be incorporated by a person, there are chances of error in calculation,
which may lead to inaccurate results or projections.
 Since this analysis required updates regularly, this could sometimes
become a serious and hectic task for the team.
SAFETY MARGIN
The margin of safety (MOS) or Safety Margin is the difference between
the gross revenue and the break-even point. A financial ratio - the Margin of
Safety calculates the sales that have surpassed the break-even point. This
financial ratio shows the company's actual profit after all fixed and variable costs
have been covered.
Why it is called the Safety Margin Ratio?
This is the point at which a company will begin to lose money. The
business needs a positive Margin of Safety to continue being profitable. The
company is no longer in a loss or profit position once it reaches the break-even
point.

Margin of Safety Definition

One of the guiding principles of value investing is the Margin of Safety
(MOS), according to which securities should only be bought if their share price
is below their estimated intrinsic value.
In short, the distinction between the projected intrinsic value and
the current share price can be theorized as the Margin of Safety. In general, the
Margin of Safety refers to the investor's protection against downside risk when a
security is bought for a significant discount to its intrinsic value.
Formula of Margin of Safety

The Margin of Safety (MOS) = 1 − (Current Share Price / Intrinsic Value)

Say, for example, that an investor believes a company's shares have an

intrinsic value of ₹ 600 but are currently trading at ₹ 800. The MOS in this
instance is 33%, which means that the share price has a 33% range before it
reaches the estimated intrinsic value of ₹ 600.
Margin of Safety in Accounting
The gap between current or projected sales and sales somewhere at the
break-even point represents the Margin of Safety as a financial metric.
The previously stated formula is divided by actual or anticipated sales to produce
a percentage value, and this ratio is sometimes used to represent the margin of
safety. The amount is used to notify a firm's administration of the current margin
in current sales or estimated and budgeted sales before the firm experiences a loss
in both break-even and forecasting calculations.
Application of The Margin of Safety in Investing
 Firstly, in addition to preventing potential losses, the Margin of Safety can
increase returns on particular investments. For instance, if an investor
buys an undervalued stock, the stock's market price may rise in the future,
giving the investor a much higher return.
 Secondly, investors can use the Margin of Safety to compare the company's
share price to its current market price and utilize the difference as
justification for purchasing securities. It implies that the stock prices have
remarkable upside potential.
 Thirdly, the Margin of Safety protects the investor from an unexpected
decline in the market. Understanding a stock's intrinsic value is crucial
before an investor purchases it at a discount. Therefore, such an analysis
can be carried out by estimating growth rates based on the performance of
the business over the years, growth trends, and potential future projections.
 Lastly, originally predicted outcomes frequently outperform actual
outcomes. Regarding production and sales, the Margin of Safety will be of
little use because the business already knows whether it is making money.
Importance of The Margin of Safety in Accounting
The size of a company's Margin of Safety is crucial to its viability. It
illustrates how sales can drop before the company experiences a loss. If the
business's Margin of Safety is large, the likelihood that it will suffer a loss is low,
but if it is small, even a slight decline in sales could result in a loss.
A high Margin of Safety is frequently preferred because it denotes optimal
performance and a company's capacity to withstand market volatility.
Measures to Improve an Unsatisfactory Margin of Safety:
Contrary to a high Margin of Safety, a low margin of safety might signify
a precarious financial position and needs to be improved by raising sales. It will
protect the investors from mistakes and bad choices. Higher fixed costs are a
common reason why margins of safety are lower.
Such businesses require a high level of activity. The following actions may be
taken to increase an inadequate Margin of Safety because a low Margin of Safety
is cause for concern-
 Boost the selling price.
 Reduce the variable costs, the fixed costs, or both.
 By using the underutilized production capacity, the output volume can be
increased.
 Put an end to the production of unprofitable products and focus only on
those that are.
Significant Factors to Remember About the Margin of Safety
 A Margin of Safety is a constructed safety net that allows some losses to
be accumulated without having a significant negative impact.
 The Margin of Safety combines quantitative and qualitative factors to
evaluate a target price and a safety margin that involves reducing that target
in investing.
 With buying shares at price levels well below their target, a Margin of
Safety is built in particular instances where estimates were inaccurate or
biased.
 The Margin of Safety is constructed into break-even forecasts in
accounting to allow for some wiggle room in those estimates.
 CHAPTER – 9: CAPITAL BUDGETING

CAPITAL BUDGETING MEANING

Capital Budgeting is defined as the process by which a business
determines which fixed asset purchases or project investments are acceptable
and which are not. Using this approach, each proposed investment is given a
quantitative analysis, allowing rational judgment to be made by the business owners.
Capital asset management requires a lot of money; therefore, before making
such investments, they must do capital budgeting to ensure that the investment will
procure profits for the company. The companies must undertake initiatives that will
lead to a growth in their profitability and also boost their shareholder’s or investor’s
wealth.
Features of Capital Budgeting
Capital Budgeting is characterized by the following features:
 There is a long duration between the initial investments and the expected
returns.
 The organizations usually estimate large profits.
 The process involves high risks.
 It is a fixed investment over the long run.
 Investments made in a project determine the future financial condition of an
organization.
 All projects require significant amounts of funding.
 The amount of investment made in the project determines the profitability of a
company.
Importance of Capital Budgeting:
a) Long term effect on the firm:
The capital budgeting decisions will have an effect on the organization for
a very long term, in terms of its profitability and the cost. An appropriate
 decision leads to a very high return to the firm where as a wrong decision
might put the firm’s survival under question.
b) Higher Risk:
Investment in long term assets not only increases the average return of the
firm, but also leads to fluctuations in the earnings. This makes the firm
risky. The longer the period of the project larger will be the risk. Hence it
can be said that the Capital budgeting decisions affects the future of an
organization.
c) Large amount of Investment:
Capital Budgeting decision requires large initial investment or cash
outflow for the acquisition of fixed assets or for the implementation of
large projects. Hence it is essential to carefully estimate and make
arrangements from various sources to get these funds.
d) Irreversible Decisions:
Capital budgeting decisions are investment in long term assets which are
not easily reversible without much loss. The reasons is that it is very
difficult to find a market for such used capital assets and also those assets
cannot be used for any other alternative purpose. Hence firm incurs huge
loss if a wrong capital investment decision is made.
e) Affects entire cost structure:
Based on the capital expenditure decision taken by an organization many
associated cost arises such as supervision charges, insurance, interest to
debt fund and dividend to equity and preference shareholders, rents and
salaries etc. If the investment fails to make expected profits then it affects
the firm’s profitability as the firm as to bear all these costs.
f) Helps in Investment Decision

The long-term investment decisions are time-consuming as it takes several

years for accomplishment beyond the current period. Uncertainty defines the
involvement of the risk in it. Management loses his flexibility and liquidity of
funds when making an investment decision. It must be considered while
accepting the proposal.
g) Wealth Maximization
Motivate the organization to invest in long term investment to safeguard
the interest of the shareholder in the organization. If the organization invests in
certain projects in a planned manner, the shareholder will show their interest in
the organization. It will help them to maximize the growth of the organization.
Any expansion of the organization is further related to the growth, sales, and
future profitability of the firm and assets based on capital budgeting.
Techniques/Methods of Capital Budgeting
In addition to the many capital budgeting methods available, the following list
outlines a few by which companies can decide which projects to explore:
1 Payback Period Method
It refers to the time taken by a proposed project to generate enough income to
cover the initial investment. The project with the quickest payback is chosen by the
company.
Formula:

Payback Period = Initial Cash Investment

Annual Cash Flow

A project requires an investment of ₹ 1, 00,000 and the estimated life of the

project is 8 years. The project generates an annual cash inflow of ₹ 20,000.
Calculate the payback period of this project.

Solution:
Original investment = ₹ 100000

Annual Cash flow = ₹ 20000

PBP = 5 years

Merits of Pay Back Period:

 It is easy to calculate and simple in understanding.

 Very low cost is involved in implementing this method.
 Under this method selection and rejection of a project is easy.
 The results are more reliable.
 In case of tight money conditions, PBP method helps in judging the quick
pay back project which avoids locking up of funds in projects that yields
high returns but takes a longer period of time.

Demerits of Pay Back Period:

 This method does not consider the time value of money.

 This method does not consider the profitability of economic life of the
asset. Earnings after payback period are ignored.
 Total return on investment is also not considered.
 There is no standard procedure for setting the payback period. Hence it is
difficult to determine the maximum acceptable payback period.

Decision Rule :( Accept/Reject Rule):

If the payback period calculated for a project is less than the maximum or
standard payback period fixed by the management, it will be accepted. On the
other hand if the payback period calculated for a project is more than the
maximum or standard payback period fixed by the management, it will be
rejected.

2 Net Present Value Method (NPV)

Net present value method is considered as the best method in evaluating
the capital investment proposal. NPV method takes into account the time value
of money. The cash inflows that are to be received in the future at different
periods are discounted at a particular discount rate. Then the present value of cash
inflows is compared with the present value of cash outflows to judge the best
proposal.

Merits of NPV Method:

 NPV considers the time value of money.

 It considers the cash flows of the entire life of the project.
 NPV is most preferred in case of mutually exclusive projects.
 It takes into account the firm’s objective of wealth maximization of the
shareholders
 It considers a discount rate to calculate the present value of cash flow which
is equal to the cost of capital.

Demerits of NPV:

 NPV is difficult to understand and calculate when compared to Non-

discounted methods.
 Calculation of discounting rates is difficult and lengthy and time
consuming process.
 In case of unequal lives of projects this method is not of much use.
 Also in case of different cash outlays this method will not provide exact
answer.

Decision Rule (Accept / Reject Criteria):

If the NPV of a project is positive then the project is selected for investment and
on the other hand if the NPV is negative, the project is rejected.

Accept if NPV > Zero

Reject if NPV < Zero

Present Value can be calculated as under:

Where i = Discount rate,

n = Number years after which the money is received.

NPV = Present Value of cash inflow – Present Value of cash outflow

Example of NPV method:

Find the NPV for a project which require an initial investment of ₹ 18000 and
which involves a net cash inflow of ₹ 5000 each year for 5 years. The cost of
funds is 9%. There is no scrap value. (PV of annuity of Rupee 1 for 5 years at 9%
per annum is ₹ 3.890)

Solution:

PV of cash inflow 5000 X 3.890 ₹19450

less: Initial investment ₹ 18000

Net Present Value (NPV) ₹ 1450

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