Managements desire to measure its operating efficiency by financial analysis, and make decisions on pricing and marketing policy by market analysis and decision analysis with considering the international trade indications, even the investors like to measure the actual returns to their expectation of reasonable returns by financial analysis

The profitability ratios are designed to provide answer to the following questions:

a)      Is the profit earned by the firm adequate?

b)      What rate of return does it represent?

c)       What is the rate of profit for various divisions and segments of the firm?

d)      What are the earnings per share?

e)      What was the amount paid in dividends?

f)       What is the rate of return to equity-holders?

The market analysis is established to provide the following answers:

a)      How many the quantity of demand? And how much the value of demand?

b)      How many the quantity of supply? And how much the value of supply?

c)       What is the price elasticity of demand and supply? What is the income elasticity of demand?

d)      How the international trade indication effects on local market?

e)      How much the market share of the Company? And How can it effects its revenue?

f)       How all the above questions effect Company’s sales and production, and price of its products?

Company should produce and sale more than the break-even sales to generate a profit, otherwise, the company will have no profitable or economic purpose for keeping the business. In this chapter some of the above questions will be answered and others will be answered in the other chapters.

 Gross Profit Margin represents the limit beyond which fall in sales prices are outside the tolerance limit. Further, the gross profit margin can also be used in determining the extent of loss caused by theft, spoilage, damage, and so on in the case of those firms which follow the policy of fixed gross profit margin in pricing their products. A high ratio of gross profits to sales is a sign of good management as it implies that the cost of production of the firm is relatively low, or to be indicative of a higher sales price without a corresponding increase in the cost of goods sold. It is also likely that cost of sales might have declined without a corresponding decline in sales price. Netherless, a very high and rising gross margin may also be the result of unsatisfactory basis of valuation of stock, that is, overvaluation of closing stock and or undervaluation of opening stock. A relative low gross margin is definitely a danger signal, warranting a careful and detailed analysis of the factors responsible for it. The important contributory factors may be 1) high cost of production reflecting acquisition of raw materials and other inputs on unfavorable terms, inefficient utilization of current as well as fixed assets, and so on,  2) a low selling price resulting from severe competition, inferior quality of the products, lack of demand.

Gross Profit Margin = (Revenue – Operating Cost) / Revenue * 100

Net Profit Margin is indicative of management’s ability to operate the business with sufficient success not only to recover from revenues of the period, the cost of merchandise or services, the expenses of operating the business (including depreciation) and the cost of the borrowed funds. A high ratio would ensure adequate return to the owners as well as enable a firm to withstand adverse economic conditions when selling price is declining, cost of production is rising and demand for the product is falling. A low ratio has the opposite implications. However, a firm with a low profit margin, can earn a high rate of return on investments if it has a higher inventory turnover.

Operating Profit Ratio = EBIT/Revenue

Net Profit Margin Ratio = Net income/Revenue

The gross margin may show a substantial increase over a period of time but the net profit margin may a) have remained constant, or b) may not have increased as fast as the gross profit margin, or may actually have declined. It may be due to the fact that increase in the operating expenses individually may behave abnormally. And the gross margin may show a decrease over a period of time but the net profit margin may have remained or may have increased faster than gross profit margin, that may be due to the firm generate income other than the revenue of ordinary business.

Return on Investments (ROI) Such ratios are popularly termed as return on investment. There are three different concepts of investments in vogue in financial literature: Total Assets, Capital employed and shareholder’s equity.

Return on Assets (ROA) is indicative of management’s ability to operate the assets including fixed assets, and how much the efficiency of the utilizing assets. Comparing to the industry average ratio, a high ratio indicates that the assets are utilized efficiently and low ratio indicates to the inefficient assets utilization.

ROA = Net income/Average total assets *100

ROA = Profit Margin * Assets turnover

Also, the investment turnover can be considered along with the net profit margin. Investment turnover is a revenue divided by average total assets which shows how much one dollar contribute to generate the revenue. High sales-to-assets ratio (Assets Turnover) may have several causes: 1) the company uses its assts efficiently; 2) it is working close to capacity, so that it may be difficult to increase sales without additional invested capital; or 3) The company produces high volume, low margin products

Return on Capital Employed (ROCE). The capital employed is net working capital plus fixed assets. Comparing this ratio to the industry average and over time would provide sufficient insight into how efficiently the long-term funds of owners and creditors are being used. The higher ratio the more efficient is the use of the capital employed.

ROCE = Net income/Average capital employed *100

Return on ordinary Shareholder’s Equity (ROE) measures the profitability exclusively the return on the real owners’ funds. This is probably the single most important ratio to judge whether the firm has earned a satisfactory return for its equity-holders or not. Its adequacy can be judged by comparing it with the past record of the same firm, inter-firm comparison and comparisons with the overall industry average. The higher rate is, the more efficiency in utilizing the owners’ funds.

ROE = (Net income-Preference dividend)/Average Ordinary Shareholder’s Equity *100

ROE = Leverage ratio * Assets turnover x profit margin x debt burden

Earnings Per Share (EPS) is as measure of profitability of a firm from the owner’s point of view, should be used cautiously as it does not recognize the effect of increase in equity capital as a result of retention of earnings. In other words, if EPS has increased over the years, id does not necessarily follow that the firm’s profitability has improved because the increased profits to the owners may be the effect of an enlarge equity capital as a result of profit retentions, though the number of ordinary shares outstanding still remains constant.

EPS = (Net income-Preference dividend)/Number of ordinary shares outstanding

Price-Earnings (P/E) measure the price that investors are prepared to pay for each dollar of earnings. A high ratio may indicate that investors think that firm has good growth opportunities or that its earnings are relatively safe and therefore more valuable.

P/E = Stock price/EPS

 Operating leverage is the fixed cost to total costs, when the fixed cost increases; it indicates that Company depends on fixed assets for its production process and increasing the depreciation which lead to increasing the fixed costs. The more fixed costs incurred the higher operating leverage, higher risk and higher break-even point for sales that lead to increase in profit more than the increase in sales.

Operating Leverage (OL) = ∆% in Profit / ∆% in volume of sales

Operating Leverage (OL) = (Volume of Sales * Contribution Margin per unit)/ (Volume of Sales *

                                                Contribution Margin per unit) + Fixed Cost

Where: Contribution Margin = Revenue – Variable Cost

Operating leverage and break-even point help the management to know the impact of the expansion for equipment or machineries and fixed assets. The risk of operating leverage is if the company could not sell above the break-even point, loss will occurred. This is not the final and lonely tool for taking a decision; the management should compute cash-flow forecasts and net present value for the cash-flows.

For determining the quantity and value of the goods that is required to be produced and sold to achieve specific operating income, the management should apply the below formula

Quantity required to be sold = (Fixed Cost + Target Operating Income)/Contribution Margin per unit

                Where : Target Income before Tax = Target income after tax / (1-Tax rate)

Value of goods required to be sold = (Fixed Cost + Target Operating Income)/Contribution Margin%

                Where : Contribution Margin% = Contribution Margin/Total Revenue

 When a company sells goods to customers, management does not expect to be paid soon, these bulk of unpaid bills are accounts receivables, Credit Manager or Sales Manager and financial manager require to answer the below questions:

1.       How long is the Company gonna give customers to pay their bills?

2.       Is the Company prepared to offer prompt payment discount? And what are the prompt payment discount conditions? How much this discount rate?

3.       How much credit is prepared to extended for each customer?

4.       How the money is collected from customers?

To answer those questions, we need to discuss the following:

For extending credit period or determining the credit period, the Company must compare the profitability of additional sales with opportunity costs of additional accounts receivables as per the below Table I. If the increased sales profits exceed the required return on investment for the additional receivables, the change in credit period is worthwhile.

 

 

Note

AR avg collection 30 days

AR avg collection 40 days

Total

$

$

$

$

 

Additional Contribution

1

 

xxxxx

 

xxxxxx

xxxxx

Less: Additional Cost

 

 

 

 

 

 

                Bad debts

2

xxxx

 

xxxx

 

 

                Funding debtors

3

xxx

xxxxx

xxx

xxxxx

xxxx

Additional profit and loss

 

 

xxxxx

 

xxxxxx

xxxx

 Note 1: (Price – Variable Cost)/Price = Contribution Margin

 

 

AR avg collection 30 days

AR avg collection 40 days

Additional Sales (Sales * category portion)

xxxxx

xxxxx

Additional Contribution (Contribution Margin * Additional Sales)

 

 

 Note 2: Bad debts

                AR avg collection 30 days = Bad debt percentage * Additional Sales

                AR avg collection 40 days = Bad debt percentage * Additional Sales

Note 3: Funding debtors

                Additional AR avg collection 30 days = 30/365 * additional sales

                Additional AR avg collection 40 days = 40/365 * additional sales

Cost of funding accounts receivable

                Cost of Funding AR avg collection 30 days = Additional AR avg collection 30 days * Interest Rate

                Cost of Funding AR avg collection 40 days = Additional AR avg collection 40 days * Interest Rate

 

Average Period

Collection

Free Risk

Opportunity

Total

 

Percentage

Interest

Cost

 

Additional Sales

$100,000

Additional Cost of Sales

$60,000

Contribution Margin

40,000

Additional Receivables

Under < =30 days

30

$35,000

10%

$291.67

Between 31-60 days

45.5

$45,000

10%

$568.75

Between 61-90 days

75.5

$20,000

10%

$419.44

Subtotal

$100,000

-$1,280

Cost of Collection within 30 days (5% cash discount)

-$1,750

Cost of collection over 30 days

-$6,500

Doutful or bad debts

-$2,350

Additional income

28,120

Required return on Investment

35%

$35,000

Variance

-$6,880

 The net payment period should be compared to the days’s sales outstanding, the net payment period should be less than or equal the day’s sales outstanding. Very long collection period will indicate to either poor credit selection or an inadequate collection effort, the liquidity position will be adversely effected, there will be likelihood of a large number of accounts receivables becoming bad debts. Too short collection period, it avoids the risk of receivables being bad debt as well as the burden of high interest on outstanding debtors, it may have adverse effect on the volume of sales of the company. Without reasonable credit, sales will be severely curtailed.

Average Collection Period = 365 * Average net accounts receivables / Revenue

Days’ Sales Outstanding (DSO) = Outstanding Accounts Receivables at end of specific time/Average daily credit for the period

Average Past Due = DSO – Net Payment Period

To reduce the average past due will be in changing the discount terms or determining the discount, the company must determine the discount via the below formula and example table. If the increased speed in collections offset the cost of offering the discount. If the opportunity costs of accelerated collections are greater than the cost of the discount, the discount is worthwhile.

Savings in speeding collection= Interest rate * collections * number of days squeezed ÷ 365

 

Cost of offering discount= Discount Rate * Collections

Or if the effective annual discount rate is less than or equal to Effective annual Interest rate, the discount rate and discount period is worthy.

Effective annual Interest rate= Free-risk Interest rate * Discount Period ÷ 365

 

Effective Annual Rate= (Discount Rate/1-Discount Rate) * 365/(Net Payment period – Discount Period)

For extending credit or offering credit to customer or not, the management should consider the expected monetary value of the net present value as per below formula. If EMV is positive, the credit extension or offer is worthy.

EMV = p * PV(REV-Cost) – (1-p) * PV(Cost)

Where: p = the probability that the customer will pay up or repeat orders

                                PV = Present value

                                REV = Additional revenue, Cost = Additional Cost

 

If there are many alternatives for increasing the cash, the Company should compute the percentage of cost of alternative of factoring is computed as follow:

 + Annual Interest = proceeds of factoring * interest rate                                xxxx

+ Annual factor fee = monthly receivables * factor fee *12          + xxxx

- Annual Saving                                                                                                 - xxxx

Cost of factoring                                                                                               xxxx

Cost percentage = Cost of factoring ÷ Funds received

 

 Without reasonable demand, no one will establish a business, any business starting or development plan is depended on the demand that is reflect the quantity of products that are bought by consumers at specific price. The sales manager or the management should prepare demand analysis based on the result of marketing research. We can summarize in how the analysis of demand will be made and from where the raw data is collected.

Most of the countries publish trade and finance statistics which shows many raw data such as how many quantity country produce, import, export and maintaining as stock for specific products, and number of population in different district or governorate and in total country, income per capita, Average income per person,GDP, Country’s revenue and expenditures, inflate rate, unemployment rate, interest rate. Also, some industry association or governmental body publishes statistics for specific area and companies such as market share, production or sales. The marketing research provide the company some specific raw data via marketing survey such as the expenditure allocation of family’s and person’s monthly or yearly income, average yearly or monthly income per family or person and consumer’s behaviors based on several geographical, demographic and psychographic factors e.g. culture, social class, money, personality, lifestyle and age, gender, rate, education and others.

Forecasting demand and Supply

Economic Equation Approach: In this approach, the historical aggregate demand in marcoeconomics is computed as follow:

Demand = Production + Import – [Export + (Initial Stock – Final Stock)]

And there is another method for computing the demand but in value only. Chain ratio method calculate the demand based on supply chain sequence on the concerned product. The formulation used is as follow:

Demand = Number of population * Income per Capita * Allocation of total expenses * allocation of spend on specific product

The historical aggregate supply in this approach, is computed as follow:

Supply = Production + Import

Statistical Approach: The economic approach provides only the historical data of demand, but it does not compute the estimated demand of forecasted demand. In Statistical approach, the demand can be estimated/forecasted by using one of the two methods:

a)      Time Series Method

b)      Regression and Correlation Method

1.       Line Program equation Method

2.       Nonliner program equation Method

3.       High-Low Method

To understand how to apply the above method for determining the supply and demand equation as the below exampled equations, you should read more detailed about those method by reading statistical books for business.

Y = a + bX1 + cX22                      Where: Y = Demand, X1 = Time, price , X2 = Production or income

Y = a + bX1                 Where: Y = Supply, X1 = Time or import

Basic Economic Concepts

Company should determine price, income and cross elasticity of demand that compute the degree of changing the quantity of demand to the changing in price, income or price of substitute or complement goods. Elasticity of demand help the management to forecasting the sales based on the estimated demand if the price of the product has been changed. Also, elasticity of demand and supply help management to know the level of the price of its products that can maximize its revenue.

Elasticity of demand or supply is computed as below method:

                                                   i.      ARC Method

ED = %∆q/%∆x = [(q1 – q2)÷(q1+q2)/2]/ [(x1 – x2)÷(x1+x2)/2]

Where X is either price, income, price of complement or substitute goods

                                                 ii.      Simple Method

ED = %∆q/%∆x = [(q1 – q2)÷q1] / [(x1 – x2)÷x1]

Where X is either price, income, price of complement or substitute goods

                                                iii.      Mathematical Method

f(x) = f(x)

The factors that effect price elasticity of demand are following:

a)      Substitute good are available

b)      Multiusage of goods

c)       Percentage of price to consumer’s income

d)      Kind of goods (necessary, inferior, Luxury)

e)      Price Level

f)       Passage of time

The Factors effect that supply curve are as follow:

a)      Production

b)      Technology

c)       Prices of other goods

d)      Price expectation

e)      Taxes and governmental subsidies

If the result if elasticity is >1, means the demand or supply is elastic. If it is = 1, means the demand or supply is unitary elastic, but if is it < 1 the demand or supply is inelastic, if it is 0, it means, it is perfectly inelastic.

How price elasticity effects on the total revenue. The below table shows the management decision for increasing and decreasing the price of elastic and in elastic demand of product against total revenue

 

Management Decision

Elastic demand >1

Inelastic demand <1

Unitary elastic demand

Price Up

Total Revenue is Down

Total Revenue is Up

Revenue no change

Price Down

Total Revenue is Up

Total Revenue is Down

Revenue no change

 Under pure monopoly and monopolistic competition markets and in short-term, the profit can be maximized when company produces and sales at level of output at which marginal revenue equals marginal cost.

Inflation rate push the costs of production up which lead the suppliers to increase the price, inflation is appeared when the demand exceed the supply. Also, inflation absorbs or cut the real income of sellers, it redistributes the income from creditor to debtor. Other than the above disadvantage of inflation is make the long-term contract difficult to be negotiated, increase the interest rate of loans. Inflation rate is calculated as follow:

Inflation rate = (Current Consumption Price Index – Prior year’s Consumption Price Index)/ Prior year’s Consumption Price Index

 

Monetary and Fiscal Policies

Taxes: Sales Tax and Value Added Tax impact on spending money for consumption which effects on demand, such taxes pushes the consumer’s price up that lead the consumer to reduce his/her plan purchasing plan for consumptions. Price elasticity of demand and supply can determine who most will bear tax, if the elasticity of supply is more the elasticity of demand, the seller or producer will bear the tax more than consumer and vise versa. Income Tax does not impact on demand, it has indirect and week impact on the prices. Increasing taxes is used for contractionary to reduce the demand.

Governmental subsidies: If government raise its hands from supporting some specific industry, demand will decrease as fisical contractionary policy to reduce the inflation.

Reserves, discount and interest rates are used as monetary tools for expansionary and contractionary policies. Higher reserves rate for deposits maintaining in Federal or Central Banks, discount rate for commercial papers, and interests rates for treasury bills, deposits and loans decreased the money on consumer’s hand, which reduce the demanded quantity of goods and reduce the inflation, but keeping higher interest rate for longer time, may lead the investor to maintain his/her money into bank and not establishing business or constructing projects that will lead to recession crisis and vice versa for expansionary policies to going out from the recession.

Open Market: Government intend to sell bonds and commercial papers to collect money from consumer’s hand and reduce his/her consumption of goods for contractionary policy to reduce inflation impact, and purchase bonds for expansionary policy.

Foreign Trade Policies

Government may take protective policy to protect domestic producers from being driven out, therefore, government may apply the following policies

1) Tariffs are consumption taxes designed to restrict import.

2) Import Quotes set fixed limited quantities on different products

3) Antidumping rules to prevent foreign producers from dumping “excess goods” on domestic market at less than their costs to eliminate the domestic competitors.

4) Exchange Currency Controls

5) Economic Integration

If the Country faces inflation and has surplus in its balance payments, Country may decrease its exports or increase its imports by decreasing import tariffs and increasing the value of its currency against the foreign currency to allow importer to buy from outside and resell the goods locally at cheaper price.

In case of facing recession and deficit in balance payments, country may decrease its import and increase its exports by depreciating the value of its currency against the foreign currency and increasing the import tariff.

But the above two cases are rarely to be happened, practically, most of the country specially the third world countries face inflation that meet deficit in balance payments or recession that meets surplus in balance payments. In those most occurring events, the fiscal and monetary policies are useful for solving such problems.

Countries may have Free trade bilateral agreement for all products or specific products or enter Free Trade Area, Customs Union, Common Union and economic union which impact on the domestic market and local producers’ and consumers’ behavior. Such economic integration may transfer the trade or create trade, it depends on the efficiency of country that is producing the products, economic integration is opening new market for efficient producers that increase their market shares, productions and revenue and may lead to merging ineffective producers to each other to other effective producers to enable them to compete, or lead government to support specific industry producers to compete the foreign producers.

Analysis on market opportunity, if supply is bigger than demand, it means that there is supply surplus and the market is saturated, but if the demand is bigger than supply , it means that there is demand surplus or the market change is still available. Therefore, forecasted demand and forecasted supply should be compared as per the below table

 

Year

Projection:

Demand

Supply

Opportunity

2015

1,000,000

800,000

200,000

2016

1,100,000

800,000

300,000

 The market opportunity encourage the current producers to increase their production, encourage new market entrances, and lead to expansion of old importer.

 Table II Some Companies’ strategies against some economic policies and situations

 

Economic Policies

Against Economic situation

Results

Conditions

Company’s strategies

Increase Taxes rate (e.g. sales and VAT)

Inflation

- Product price will go up

- Forecasted/ estimated market demand will be reduced.

- Move the supply curve toward up, and reduce the production and importation.

- Decreasing in supply establish an increasing demand supply that push the price higher than before.

- Total revenue will be declined if the demand is elastic and increased if the demand is inelastic

- If price elasticity of demand is higher than price elasticity of supply and demand is elastic such as luxury products

 

 

 

 

 

 

 

 

 

 

 

- If price elasticity of demand is lower than price elasticity of supply and demand is inelastic such as necessary products

- Producers can not reduce its fixed costs in the short-term, but they can postpone its capital investment plan, and maintain its unit contribution margin in the short-term, Company reduces its production gradually due to decreasing in aggregate demand until they can reduce the fixed costs. When producers reduce their fixed costs and market opportunity is shrinking in long-term, producers will decrease their production in decreasing in aggregate demand

-adventurer management may reduce the price to increase the quantity of sales which reduce the total average cost through increasing their production and obtaining new market shares of ineffective producers.

- In this condition, Producers may not need to reduce its fixed costs, but they may postpone their capital investment plan, and may reduce their levels of production gradually and may increase their unit contribution margin gradually to maintain their total revenue at same level.

Decrease Taxes rate (e.g. sales and VAT)

Recession

- Product price will go down

- Forecasted/ estimated demand will be increased

- Move the supply curve toward down, and increase the production and importation.

- increasing in supply establishes an increasing supply surplus that push the price down than before.

- Total revenue will be increased if the demand is elastic and decreased if the demand is inelastic

- If price elasticity of demand is higher than price elasticity of supply and demand is elastic such as luxury products

 

 

 

- If price elasticity of demand is lower than price elasticity of supply and demand is inelastic such as necessary products

 

 

 

 

 

- Producers can reduce the price to increase the sales or be committed in capital expenditures such as establishing plant or acquiring machines to produce more products and reduce the associated average fixed costs and increase the revenue and net income

 

Increase interest rate

Inflation

- Forecasted/ estimated demand for consumptions will be decreased.

- Small and intermediate investors transferred from creating business project to depositing money into banks

- Banks finance only the projects that generate returns more than the interest rate.

- If the return of current business is higher than the new interest rate

 

 

 

 

 

- If the return of current business is lower than the new interest rate

 

-Businessmen may keep their business running as long as the return of their business generate higher return than the interest rate. But the high interest rate will reduce loans requested by businessmen.

 

 

 

-Businessmen or Company that has idle money is preferred to deposit their money to invest their money in certificate of deposit or treasury bills or bonds as long as returned of investments of the alternative business is lower than the public interest (free-risk interest). Even the current business that its return is lower than public interest may not be ceased.

Decrease interest rate

Recession

- Forecasted/ estimated demand for consumptions will be increased

- Small and intermediate investors transferred from depositing money into banks to creating business project

- Banks finance all the business activities.

 

-the lower free-risk interest is, the more loan may be requested to run business that generate higher return.

 Price that maximizes the profit is determined by one of the following method:

a)      Mathematical method

First, we should determine the Demand Equation e.g. Quantity of Demand (Q) = 100 – 5 * Price (P)

Second, we should get the price in function of quantity e.g. P = (- Q/8) + 16

Third, we formulate the total revenue equation e.g. R = Q * (-Q/8)+16) = -Q2/8+16Q

Fourth, Formulate the total cost e.g. C = 2Q2+3Q + 500,000

Fifthly, we determined the marginal revenue and marginal costs by calculating the derivatives of R and C, to be as follow:

R’ = Q/4 + 16

C’ = 4Q+3

Sixthly, Price is determined when the marginal revenue equals marginal costs, therefore, the quantity can be sold and price that maximize the profit are computed as follow

1.       Determined Quantity

C’ = R’

4Q+3 = Q/4+20

Q = 52/15

2.       To determined Price, the above determined quantity need to be compensated in price equation in step 2 above.

P = -3.5/8 +16

P = 15.5

Also, the maximum total revenue can be computed by using liner program e.g.

Objective R= 10Q1 + 15Q2

Constraints: Section1: 2Q1+1Q2 ≤ 200

                       Section2: 1Q1+2Q2 ≤ 200

Where: Q1 & Q2 ≥ 0

And this can be calculated by using liner program to know how to calculate this method, read pure mathematics.

b)      Pricing for target profit Method

The practical and most common methods for pricing the products are:

                                                   i.            Pricing depends on average incremental cost plus profit margin

Incremental cost is the additional total costs occurs when the production level increases, and it is different from marginal cost. Under this method, the price is determining when the price equals the average incremental cost. The price equation as follow

Price = Average Incremental Cost * [Demand elasticity/(Demand elasticity – 1)]

But many companies don’t calculate the demand elasticity; therefore, the price equation is as follow:

Price = Average Incremental cost * (1+Profit Margin%)

Some companies use the average variable cost plus profit margin%.

                                                 ii.            Pricing depends on average total cost plus return on capital

Some companies have pricing policy to achieve target return on investment capital as follow:

Price = [Total Cost + (Required Return * Investment Capital)] ÷ Quantity of Production

This method is more appropriate if the company produces or sell one product

                                                iii.            Pricing for maximizing revenue to achieve target profit

First, we should determine the Demand Equation e.g. Quantity of Demand (Q) = 100 – 5 * Price (P)

Second, we should get the price in function of quantity e.g. P = (- Q/8) + 16

Third, we formulate the total revenue equation e.g. R = Q * (-Q/8)+16) = -Q2/8+16Q

Fourth, Formulate the total cost e.g. C = 2Q2+3Q + 500,000

Fifthly, we determined profit by deducting the total cost (C) from total revenue (R) e.g. Profit = [Q2/8+16Q] – [Q2/8+16Q]

Sixthly, we specify the target profit, let say the management want to achieve profit of $150,000, therefore, the amount of $150,000 should be replace profit side of the equation

$150,000 = [Q2/8+16Q] – [Q2/8+16Q]

Therefore, the quantity is determined by solving the two above equations in step 5 and 6, and the quantities are compensated in equation in step 6 to obtain the price that achieve the maximum revenue and target profit.

                                               iv.            Pricing Non-routing production or based on job order

If there is excess capacity more than enough to cover the order, the company needs to identify variable costs associated with the special order that are not normally incurred. Such variable costs are relevant costs and determine the minimum acceptable (breakeven) price. If the company is operating at or near capacity, the minimum acceptable price is the normal sale price. When there is no excess capacity, a special order should be taken only if the price offered exceeds the normal price.

In case of excess capacity, the price of special order should be greater than or equal to the relevant costs include the average variable costs per unit. But in case of at or near full capacity, relevant costs will include variable costs and the opportunity cost arising from any lost sales, and the price should be greater than or equal to this relevant cost. The cost management will be covered and summarized adequately in chapter: Payables, purchases and expenses.