Small Business Management Chapter 16 PowerPoint

© 2020 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
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

 

(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

 

(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.

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.

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.

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

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.

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.

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.

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
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
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

Small Business Management Chapter 16 PowerPoint

Recommended

Recommended

More Related Content

What's hot

What's hot (16)

Similar to Small Business Management Chapter 16 PowerPoint

Similar to Small Business Management Chapter 16 PowerPoint (20)

Recently uploaded

Recently uploaded (20)

Small Business Management Chapter 16 PowerPoint