In the long run under normal circumstances, the selling price must cover the cost (i.e., variable cost plus fixed cost) and give a reasonable amount of profit. This is essential for the survival of a business. In the short run due to adverse market conditions, the selling price may have to be fixed below total cost but it should be above variable cost. In other words, the selling price may be temporarily fixed at marginal cost plus contribution basis and the amount of contribution depends upon demand and supply, the acuteness of competition, non-cost factors etc. The important thing to consider is that fixation of selling price below total cost may be made only at on a short-term basis.
Blimey Choo Shoe Company, a shoe manufacturing company, is contemplating to enter into a fiercely competitive business venture to bid for its products to be used by the Chinese contingent participating in the upcoming Olympic Games, 2008. These are special circumstances, and therefore the company must put its costing structure under a systematized pricing technique to arrive at various suitable pricing options for bidding purposes. The pricing technique briefed in the introduction above is technique based on Cost-Volume-Profit analysis (CVP) technique. CVP is a study of the interrelationship between sales, costs, and operating profits. Whenever there are changes in output, sale price, variable or fixed cost of the product, CVP analysis provides the resultant effects. This analysis is based on certain principles and underlying assumptions detailed as under:
- Reducing the cost of goods sold and operating cost from the total revenue of product sold calculate operating income. Non-operative revenue and non-operative expenditures do not exist for the purposes of CVP analysis.
- The difference between revenue and variable cost is called the contribution margin. Only variable cost is deducted from revenue to arrive at contribution margin.
- Fixed costs remain constant at every level and do not increase or decrease with changes in output. Any change in total costs is the result of a change in variable costs.
- Variable costs fluctuate directly with output. In other words, variable costs vary in the same proportion in which the volume of output or sales varies.
- All costs are capable of being bifurcated into fixed and variable elements.
- Selling prices remain constant even with the volume of production or sales changes.
- The behaviour of both sales revenue and expenses is linear throughout the entire range of activity. Sales and expenses are affected only by volume.
- Production and sales remain identical.
- Inventories do not change significantly from period to period.
- The analysis either covers a single product or assumes that sales mix, when a mix of products is sold, remains constant as the level of total quantity sold changes.
Under CVP technique, the factors that play a decisive role in price fixation are Variable Costs, Contribution, and Fixed Costs (Overheads). . .