BUSINESS DISCUSSION 4

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CHAPTER

16 Pricing and Credit

Decisions

LEARNING OBJECTIVES

By studying this chapter, you should be able to…

16-1 Discuss the role of cost and demand factors in setting a price.

16-2 Apply break-even analysis and markup pricing. 16-3 Identify specific pricing strategies. 16-4 Explain the benefits of credit, factors that affect

credit extension, and types of credit. 16-5 Describe the activities involved in managing credit.

INTRODUCTION (slide 1 of 2)

• Pricing and credit decisions are vital to the success of a company because they influence the relationship between the business and its customers, and they directly affect both revenue and cash flows.

• Very few business owners have any formal training in how to set the prices for the products and services they sell. • Many times, their prices are based on what

competitors are charging, some percentage above their costs, or what their suppliers suggest.

INTRODUCTION (slide 2 of 2)

• Value should always be at the heart of a pricing strategy. • Value – The extent to which a good or service is perceived by

a customer as meeting his or her needs or wants, measured by the customer’s willingness to pay for it.

• Price – A specification of what a seller requires in exchange for transferring ownership or use of a product or service. • Often, the seller must extend credit to the buyer in order to

make the exchange happen. • Credit – An agreement between a buyer and a seller that allows

for delayed payment for a product or service.

16-1 SETTING A PRICE

• The total sales revenue of a firm is a direct reflection of two components: 1. Sales volume. 2. Price.

• Pricing indirectly affects sales quantity. • Setting a price too high for the value being offered

may result in lower quantities sold, reducing total revenue.

16-1a Pricing Starting with Costs (slide 1 of 3)

• The price must be sufficient to cover total cost plus a margin of profit that sustains the company and moves it forward.

• Costs react differently as the quantity produced or sold increases or decreases. • Cost of goods sold increases as the quantity of products sold

increases. • Operating expenses remain constant at different levels of

quantity sold, or fixed costs.

• Average pricing – An approach in which the total cost for a given period is divided by the quantity sold in that period to set a price.

Total cost Cost of goods sold Operating expenses= +

16.1 Cost Structure of a Hypothetical Firm, 2019

Sales revenue (25,000 units @ $8) $200,000 Cost of goods sold ($2 per unit) (50,000) Gross profits $150,000 Operating expenses (75,000) Net profits (before interest and taxes) $ 75,000

(50,000 75,000) Average cost $5

25,000 +

= =

16-1a Pricing Starting with Costs (slide 2 of 3)

• Average pricing overlooks the reality of higher average costs at lower sales levels.

16.2 Cost Structure of a Hypothetical Firm, 2020

Sales revenue (10,000 units @ $8) $ 80,000 Cost of goods sold ($2 per unit) (20,000) Gross profits $ 60,000 Operating expenses (75,000) Net profits (before interest and taxes) $(15,000)

(20,000 75,000) Average cost $9.50

10,000 +

= =

16-1a Pricing Starting with Costs (slide 3 of 3)

• Pricing at less than total cost can be used as a special short-term strategy to increase demand. • Sometimes, business owners offer loss leaders, merchandise

they intentionally sell below the direct product cost with the expectation that customers will buy more as they learn of other products and services the business has available.

• Some businesses may use a freemium (a combination of the words “free” and “premium”) strategy.

• Freemium strategy – A strategy that offers customers basic features at no cost based on the idea that they will upgrade to advanced products or services at subscription prices.

16-1b Pricing Starting with Customers (slide 1 of 3)

• Cost analysis can identify a level below which a price should not be set under normal circumstances. • However, it does not show by how much the final

price might exceed that minimum figure and still be acceptable to customers.

• Demand factors must be considered before making this determination.

16-1b Pricing Starting with Customers (slide 2 of 3)

ELASTICITY OF DEMAND • Elasticity of demand – The degree to which a change

in price affects the quantity demanded. • Elastic demand – Demand that changes significantly when

there is a change in the price of a product or service. • Example: Electronic products.

• Inelastic demand – Demand that does not change significantly when there is a change in the price of a product or service.

• Example: Milk.

• The concept of elasticity of demand is important because the degree of elasticity sets limits on or provides opportunities for higher pricing.

16-1b Pricing Starting with Customers (slide 3 of 3)

PRICING AND A FIRM’S COMPETITIVE ADVANTAGE • A product’s competitive advantage is a demand factor

in setting price. • If consumers perceive the product or service as an important

solution to their unsatisfied needs, they are likely to demand more of it.

• A pricing tactic that often reflects a competitive advantage is prestige pricing. • Prestige pricing – An approach based on setting a high price

to convey an image of high quality or uniqueness. • The influence of prestige pricing varies from market to market,

from product to product, and from service to service.

16-2 APPLYING A PRICING SYSTEM

• In order to properly evaluate a pricing system, a small business owner must understand potential costs, revenue, and product demand for the venture. • A key to that understanding is the ability to

determine when enough products and services have been sold to cover the operating expenses of running the business—or, more simply, the ability to recognize the break-even point.

16-2a Break-Even Analysis (slide 1 of 3)

• Break-even analysis – Analysis that requires the examination of cost-revenue relationships and the incorporation of sales forecasts.

• Break-even analysis allows the entrepreneur to compare alternative cost and revenue estimates in order to determine the acceptability of each price.

• Break-even analyses are usually represented by formulas and graphs.

16-2a Break-Even Analysis (slide 2 of 3)

EXAMINING COST-REVENUE RELATIONSHIPS • Break-even point – Sales volume at which total sales revenue

equals total costs and expenses.

Total fixed operating costs and expenses Break-even point

Unit selling price Unit variable costs and expenses =

−

• The higher the total fixed costs, the more units the firm must sell to break even.

• The greater the difference between the unit selling price and the unit variable costs and expenses, the fewer the units the firm must sell to break even.

• Contribution margin – The difference between the unit selling price and the unit variable costs and expenses.

• To evaluate other break-even points, the entrepreneur can plot additional sales lines for other prices on the chart.

16.3 Break-Even Graphs for Pricing

16-2a Break-Even Analysis (slide 3 of 3)

INCORPORATING SALES FORECASTS • Demand for a product typically decreases as

price increases; however, in certain cases, price may influence demand in the opposite direction. • Therefore, estimated demand for a product at

various prices, as determined through marketing research, should be incorporated into the break- even analysis.

• To incorporate estimated demand into the break-even analysis, a demand curve can be added to the break-even chart.

• This graph allows a more realistic profit area to be identified.

16.4 A Break-Even Graph Adjusted for Estimated Demand

16-2b Markup Pricing

• Markup pricing – An approach based on applying a percentage to a product’s cost to obtain its selling price.

• In calculating the selling price for a particular item, a retailer adds a markup percentage (sometimes referred to as a markup rate) to cover: 1. Operating expenses. 2. Subsequent price reductions (such as markdowns and employee

discounts). 3. The desired profit.

• Markups may be expressed as a percentage of either the selling price or the cost.

Markup Markup expressed as a percentage of selling price 100

Selling price = ×

Markup Markup expressed as a percentage of cost 100

Cost = ×

16-3 SELECTING A PRICE STRATEGY

• Break-even analysis and similar techniques give owners an idea of how much they need to sell to cover their costs, but such analyses should not by themselves determine the final price. • Price determination must also consider characteristics

of targeted customers and the firm’s marketing strategy. • Price strategies that reflect these considerations include:

• Penetration pricing. • Price skimming. • Follow-the-leader pricing. • Variable pricing. • Price lining. • Option product and service pricing.

16-3a Penetration Pricing

• Penetration pricing strategy – A technique that sets lower than normal prices to hasten market acceptance of a product or service or to increase market share.

• This strategy can sometimes discourage new competitors from entering a market niche if they mistakenly view the penetration price as a long-range price.

• A firm that uses this strategy sacrifices some profit margin to achieve market penetration.

16-3b Price Skimming

• Price skimming strategy – A technique that sets very high prices for a limited period before reducing them to more competitive levels.

• This strategy assumes that certain customers will pay a higher price because they view a product or service as a prestige item.

• Use of a skimming price is most practical when there is little threat of short-term competition or when startup costs must be recovered rapidly.

16-3c Follow-the-Leader Pricing

• Follow-the-leader pricing strategy – A technique that uses a particular competitor as a model in setting prices.

• A small business in competition with larger firms is seldom in a position to consider itself the price leader.

16-3d Variable Pricing

• Variable pricing strategy – A technique that sets more than one price for a product or service in order to offer price concessions to certain customers.

16-3e Optional Product and Service Pricing

• Companies often seek to increase the amount that customers spend by offering optional products or services that increase the total price paid by the customer.

• Local, state, and federal laws must be considered in setting prices.

• When a small business markets a line of products, some of which may compete with each other, pricing decisions must take into account the effects of a single product price on the rest of the line. • This often results in product line pricing.

• Product line pricing – A technique that places different prices on a range of products or services to reflect the benefits to the customer of parts of the range.

16-4 OFFERING CREDIT

• The major reason for granting credit is to make sales.

• Credit encourages decisions to buy by providing an incentive for customers who can buy now but would prefer to pay later.

• An added bonus to the seller is that credit provides records containing customer information that can be used for sales promotions, such as direct-mail appeals to customers.

16-4a Benefits of Credit

• Benefits of credit to buyers include the following: 1. Access to working capital, often allowing for continuity of operations. 2. The ability to satisfy immediate needs and pay for them later. 3. Better records of purchases on credit billing statements. 4. Better service and greater convenience when exchanging purchased

items. 5. The ability to establish a credit history.

• Benefits of credit to sellers are as follows: 1. Facilitation of increased sales volume. 2. The ability to earn money on unpaid balances. 3. A closer association with customers because of implied trust. 4. Easier selling through telephone- and mail-order systems and online. 5. Smoother sales peaks and valleys, since purchasing power is always

available. 6. Easy access to a tool with which to stay competitive.

16-4b Factors That Affect Selling on Credit

• There are five factors related to the entrepreneur’s decision to extend credit: 1. The type of business.

• Retailers of durable products typically grant more credit than do retailers that sell perishables or small service firms with primarily local customers.

2. Credit policies of competitors. 3. Customers’ ages and income levels. 4. The availability of working capital.

• Credit sales increase the amount of working capital needed by the business doing the selling.

5. Economic conditions.

16-4c Types of Credit (slide 1 of 4)

• There are two broad classes of credit: 1. Consumer credit – Financing granted by retailers

to individuals who purchase for personal or family use.

2. Trade credit – Financing provided by suppliers to client companies.

16-4c Types of Credit (slide 2 of 4)

CONSUMER CREDIT • The three major kinds of consumer credit accounts are:

1. Open charge account – A line of credit that allows the customer to obtain a product or service at the time of purchase, with payment due when billed.

2. Installment account – A line of credit that requires a down payment, with the balance paid over a specified period of time.

• An installment account is a vehicle for long-term consumer credit, useful for large purchases, such as a car, home appliance, or home renovation.

3. Revolving charge account – A line of credit on which the customer may charge purchases at any time, up to a pre- established limit, and must pay a percentage of the balance monthly.

16-4c Types of Credit (slide 3 of 4)

CREDIT CARDS • Credit card – An alternative to cash whose use

provides assurance to a seller that a buyer has a satisfactory credit rating and that payment will be received from the issuing financial institution.

• There are two basic types of credit cards: 1. Bank credit cards.

• Examples: MasterCard and Visa. 2. Retailer credit cards.

• Many department stores issue their own credit cards specifically for use in their outlets or for purchasing their products or services from other outlets.

16-4c Types of Credit (slide 4 of 4)

TRADE CREDIT • Firms selling to other businesses may specify terms of sale.

• Example: 2/10, net 30, which means that the seller is offering a 2 percent discount if the buyer pays within 10 days of the invoice date, and failure to take this discount makes the full amount of the invoice due in 30 days.

• Sales terms for trade credit depend on the product sold, as well as the buyer’s and the seller’s circumstances. • The larger the order and the higher the credit rating of the buyer, the

better the sales terms will be, assuming that individual terms are fixed for each buyer.

• The greater the financial strength and the more adequate and liquid the working capital of the seller, the more generous the seller’s sales terms can be.

16-5 MANAGING THE CREDIT PROCESS

• Major considerations in developing and operating a comprehensive credit management program for small business include: • Evaluation of credit applicants. • Billing and collection procedures. • Laws pertaining to credit regulation.

16-5a Evaluation of Credit Applicants (slide 1 of 3)

• Evaluating the credit status of applicants begins with the completion of an application form. • The information obtained on this form is used as the basis for

examining an applicant’s creditworthiness.

THE FOUR CREDIT QUESTIONS • In evaluating the credit status of applicants, a seller

must answer the following questions: 1. Can the buyer pay as promised? 2. Will the buyer pay? 3. If so, when will the buyer pay? 4. If not, can the buyer be forced to pay?

16-5a Evaluation of Credit Applicants (slide 2 of 3)

THE TRADITIONAL FIVE C’S OF CREDIT • A customer’s ability to repay trade credit is often

evaluated in terms of the five C’s of credit: 1. Character.

• Character is the fundamental integrity and honesty that should underlie all human and business relationships.

• For business customers, character is embodied in the business policies and ethical practices of the firm, generally measured by their credit history.

2. Capacity. • Capacity refers to the customer’s ability to conserve assets, and

to faithfully and efficiently follow a financial plan. • A business customer should have sufficient cash flows to pay

bills.

16-5a Evaluation of Credit Applicants (slide 3 of 3)

3. Capital. • Capital consists of the cash and other liquid assets owned by the

customer. • A prospective business customer should have sufficient capital to

underwrite planned operations, including an appropriate amount invested by the owner.

4. Collateral. • Collateral represents enough assets to secure the debt. • It is a secondary source for loan repayment in case the

borrower’s cash flows are insufficient for repaying a loan. 5. Conditions.

• Conditions refer to economic factors, such as business cycles and changes in price levels, and adverse factors that might limit a business customer’s ability to pay, such as strong new competition, labor problems, and fires and other natural disasters.

16-5b Sources of Credit Information

• Pertinent credit data can be obtained from several sources, including: • A customer’s previous credit history. • Financial statements. • Credit bureaus.

• Credit bureaus – Privately owned organizations that summarize different firms’ credit experiences with individual consumers.

• Bankers. • Formal trade-credit agencies.

• Trade-credit agencies – Privately owned organizations that collect credit information on businesses.

16-5c Aging of Accounts Receivable

• Aging schedule – A categorization of accounts receivable based on the length of time they have been outstanding. • Regular use of an aging schedule allows

troublesome collection trends to be spotted so that appropriate actions can be taken.

• Immediate attention must be given to the most overdue customers.

• The length of the overdue account should be considered as well as the overdue amount.

16.5 Hypothetical Aging Schedule for Accounts Receivable

16-5d Billing and Collection Procedures

• Timely notification of customers regarding the status of their accounts is essential for keeping credit accounts current.

• A firm that is extending credit must have adequate billing records and collection procedures if it expects prompt payments.

• Perhaps the most effective weapon in collecting past-due accounts is reminding the debtors that their credit standing may be in jeopardy.

• Effective collection practices usually consist of a series of steps, each somewhat more forceful than the preceding one. • Historically, the process has started with a gentle written reminder,

with subsequent steps including telephone calls, registered letters, personal contacts, and referral to a collection agency or attorney.

• The best known and most widely used ratio used to monitor expenses associated with credit sales is the bad-debt ratio. • Bad-debt ratio – Bad debts divided by credit sales.

16-5e Credit Regulation (slide 1 of 2)

• The use of credit is regulated by a variety of federal laws, as well as state laws that vary considerably from state to state. • The most significant piece of credit legislation is the

federal Consumer Credit Protection Act, which includes the 1968 Truth-in-Lending Act.

• Its two primary purposes are: 1. To ensure that consumers are informed about the terms of a

credit agreement. 2. To require creditors to specify how finance charges are

computed.

16-5e Credit Regulation (slide 2 of 2)

• Other federal legislation related to credit management includes the following: • Fair Credit Billing Act.

• The Fair Credit Billing Act provides protection to credit customers in cases involving incorrect billing.

• Fair Credit Reporting Act. • The Fair Credit Reporting Act gives certain rights to credit

applicants regarding reports prepared by credit bureaus. • Equal Credit Opportunity Act.

• The Equal Credit Opportunity Act ensures that all consumers are given an equal chance to obtain credit.

• Fair Debt Collection Practices Act. • The Fair Debt Collection Practices Act bans the use of

intimidation and deception in collection, requiring debt collectors to treat debtors fairly.

Key Terms aging schedule average pricing bad-debt ratio break-even analysis break-even point consumer credit contribution margin credit credit bureaus credit card elastic demand elasticity of demand follow-the-leader pricing strategy freemium strategy inelastic demand

installment account markup pricing open charge account penetration pricing strategy prestige pricing price price lining strategy price skimming strategy product line pricing revolving charge account trade-credit agencies trade credit value variable pricing strategy

�CHAPTER�16��Pricing and Credit Decisions
LEARNING OBJECTIVES
INTRODUCTION (slide 1 of 2)
INTRODUCTION (slide 2 of 2)
16-1 SETTING A PRICE
16-1a Pricing Starting with Costs (slide 1 of 3)
16.1 Cost Structure of a Hypothetical Firm, 2019
16-1a Pricing Starting with Costs (slide 2 of 3)
16.2 Cost Structure of a Hypothetical Firm, 2020
16-1a Pricing Starting with Costs (slide 3 of 3)
16-1b Pricing Starting �with Customers (slide 1 of 3)
16-1b Pricing Starting �with Customers (slide 2 of 3)
16-1b Pricing Starting �with Customers (slide 3 of 3)
16-2 APPLYING A �PRICING SYSTEM
16-2a Break-Even Analysis (slide 1 of 3)
16-2a Break-Even Analysis (slide 2 of 3)
16.3 Break-Even Graphs for Pricing
16-2a Break-Even Analysis (slide 3 of 3)
16.4 A Break-Even Graph Adjusted for Estimated Demand
16-2b Markup Pricing
16-3 SELECTING A �PRICE STRATEGY
16-3a Penetration Pricing
16-3b Price Skimming
16-3c Follow-the-Leader Pricing
16-3d Variable Pricing
16-3e Optional Product and Service Pricing
16-4 OFFERING CREDIT
16-4a Benefits of Credit
16-4b Factors That �Affect Selling on Credit
16-4c Types of Credit (slide 1 of 4)
16-4c Types of Credit (slide 2 of 4)
16-4c Types of Credit (slide 3 of 4)
16-4c Types of Credit (slide 4 of 4)
16-5 MANAGING THE �CREDIT PROCESS
16-5a Evaluation of �Credit Applicants (slide 1 of 3)
16-5a Evaluation of �Credit Applicants (slide 2 of 3)
16-5a Evaluation of �Credit Applicants (slide 3 of 3)
16-5b Sources of �Credit Information
16-5c Aging of �Accounts Receivable
16.5 Hypothetical Aging Schedule for Accounts Receivable
16-5d Billing and �Collection Procedures
16-5e Credit Regulation (slide 1 of 2)
16-5e Credit Regulation (slide 2 of 2)
Key Terms
Longenecker19e_PPT_Ch16_Final_31.pdf

�CHAPTER�16��Pricing and Credit Decisions
LEARNING OBJECTIVES
INTRODUCTION (slide 1 of 2)
INTRODUCTION (slide 2 of 2)
16-1 SETTING A PRICE
16-1a Pricing Starting with Costs (slide 1 of 3)
16.1 Cost Structure of a Hypothetical Firm, 2019
16-1a Pricing Starting with Costs (slide 2 of 3)
16.2 Cost Structure of a Hypothetical Firm, 2020
16-1a Pricing Starting with Costs (slide 3 of 3)
16-1b Pricing Starting �with Customers (slide 1 of 3)
16-1b Pricing Starting �with Customers (slide 2 of 3)
16-1b Pricing Starting �with Customers (slide 3 of 3)
16-2 APPLYING A �PRICING SYSTEM
16-2a Break-Even Analysis (slide 1 of 3)
16-2a Break-Even Analysis (slide 2 of 3)
16.3 Break-Even Graphs for Pricing
16-2a Break-Even Analysis (slide 3 of 3)
16.4 A Break-Even Graph Adjusted for Estimated Demand
16-2b Markup Pricing
16-3 SELECTING A �PRICE STRATEGY
16-3a Penetration Pricing
16-3b Price Skimming
16-3c Follow-the-Leader Pricing
16-3d Variable Pricing
16-3e Optional Product and Service Pricing
16-4 OFFERING CREDIT
16-4a Benefits of Credit
16-4b Factors That �Affect Selling on Credit
16-4c Types of Credit (slide 1 of 4)
16-4c Types of Credit (slide 2 of 4)
16-4c Types of Credit (slide 3 of 4)
16-4c Types of Credit (slide 4 of 4)
16-5 MANAGING THE �CREDIT PROCESS
16-5a Evaluation of �Credit Applicants (slide 1 of 3)
16-5a Evaluation of �Credit Applicants (slide 2 of 3)
16-5a Evaluation of �Credit Applicants (slide 3 of 3)
16-5b Sources of �Credit Information
16-5c Aging of �Accounts Receivable
16.5 Hypothetical Aging Schedule for Accounts Receivable
16-5d Billing and �Collection Procedures
16-5e Credit Regulation (slide 1 of 2)
16-5e Credit Regulation (slide 2 of 2)
Key Terms