User:Vikas0903/Value addition based pricing

Presently most of companies (especially in manufacturing) have total cost (TC) based pricing method. It is same age-old formula, which puts margin or markup on TC. For eg.,

Price (P) = TC / (1- M) where M is margin percentage)

TC can be divided into 2 components: - raw material (RM) and - value addition (VA), which also includes all overheads

absolute Margin (M) = P - TC or in other words margin is premium over total costs which we are charging to our customer for adding value to raw material.

before going further lets have few facts, objectives and assumptions;

Fact: Every company has fixed manufacturing capacity Company objective: To maximise profit Assumption: Company faces infinite demand for its products

Now problem with TC based pricing is it does not tell us how to differentiate between 2 orders. For eg. Lets assume that a company is producing two products A & B,

Product   RM      VA      TC       M      P       Absolute margin A       10      40     50       50%    100        50 B       40      10     50       50%    100        50

From above table, if a company is facing A & B orders, it may consider both orders equally profitable. If criteria is margin percentage or even if absolute margin, both orders fare equally.

But are they so?

consider margin per VA, (money earned on work done) for both products, for A it is 1.25 while for B it is 5.

In above method, VA for first part is 300% more than in second part and still company is charging same margin. In simpler words, A spends 4 days in manufacturing, eats-up resources and generates same amount of money as that of B, which spends only 1 day in company (assuming 10 VA is equal to one day).

From company’s point of view, it would like to have more of B as with fixed capacity it will be able to do more no. of projects (=100/10= 10 B type orders) and hence total profit will be (50 x 10 = Rs. 500 for 100% utilization)

But if it is stuck up with A type orders, it can do only (=100/40 = 2.5 no. of orders). In this situation it will earn net profit of (50 x 2.5 = Rs. 125 for 100% utilization).

From Customer’s point of view, assuming he is making rational choice; he would like to place those orders with us for which we are providing more value for less money. So based on present pricing method, he will have more tendency to place A type orders with us. Also in cases of multiple part no. in same RFQ, he can choose to give us those parts for which we are adding more value for less money.