Model Answer
0 min readIntroduction
Product pricing is a critical element of the marketing mix, directly impacting a firm’s profitability and market share. Determining the optimal price involves navigating a complex interplay of costs, competition, customer value perception, and broader economic conditions. Simultaneously, businesses increasingly rely on financial performance metrics beyond traditional accounting measures. Economic Value Added (EVA), developed by Bennett Stern Stewart in 1991, is one such metric, representing the true economic profit generated by a company, considering the cost of capital. This answer will explore the diverse approaches to product pricing and comprehensively discuss the concept and computation of EVA in a business context.
Product Pricing Approaches
Several approaches guide product pricing decisions. These can be broadly categorized as follows:
- Cost-Plus Pricing: This is the simplest method, adding a predetermined markup to the cost of production. While easy to implement, it ignores market demand and competitor pricing.
- Competition-Based Pricing: Prices are set based on competitor pricing. This can involve pricing above, at, or below competitors, depending on the firm’s positioning.
- Value-Based Pricing: This approach sets prices based on the perceived value of the product to the customer. It requires a deep understanding of customer needs and willingness to pay.
- Demand-Based Pricing (Dynamic Pricing): Prices fluctuate based on demand. Airlines and hotels frequently use this strategy.
- Penetration Pricing: Setting a low initial price to quickly gain market share. This is often used for new product launches.
- Skimming Pricing: Setting a high initial price to capture early adopters willing to pay a premium. This is common for innovative products.
- Psychological Pricing: Utilizing pricing tactics that appeal to consumer psychology, such as odd-even pricing ($9.99 instead of $10).
Economic Value Added (EVA) – Concept and Computation
EVA, also known as economic profit, is a measure of a company’s financial performance based on the residual wealth calculated by deducting the cost of capital from the net operating profit after tax (NOPAT). It provides a more accurate picture of profitability than traditional accounting metrics like net income, as it explicitly considers the cost of all capital employed.
Formula for Computing EVA
EVA = NOPAT – (WACC * Capital Employed)
Where:
- NOPAT (Net Operating Profit After Tax): Operating profit after deducting taxes. Calculated as EBIT * (1 – Tax Rate).
- WACC (Weighted Average Cost of Capital): The average rate of return a company expects to compensate all its different investors.
- Capital Employed: The total amount of capital invested in the business, including equity and debt.
Steps in Computing EVA
- Calculate NOPAT: Determine the company’s operating profit and subtract taxes.
- Calculate WACC: Determine the cost of equity and cost of debt, and weight them by their respective proportions in the capital structure.
- Calculate Capital Employed: Determine the total capital invested in the business.
- Apply the Formula: Subtract the cost of capital (WACC * Capital Employed) from NOPAT to arrive at EVA.
Example of EVA Calculation
Let’s consider a company with the following data:
- EBIT: $10 million
- Tax Rate: 30%
- WACC: 10%
- Capital Employed: $50 million
Step 1: Calculate NOPAT
NOPAT = $10 million * (1 – 0.30) = $7 million
Step 2: Calculate Cost of Capital
Cost of Capital = 10% * $50 million = $5 million
Step 3: Calculate EVA
EVA = $7 million – $5 million = $2 million
This indicates that the company generated $2 million in economic profit after covering the cost of its capital.
Advantages of Using EVA
- Focus on Value Creation: EVA directly measures whether a company is creating value for its shareholders.
- Improved Decision-Making: EVA encourages managers to make decisions that increase economic profit.
- Better Capital Allocation: EVA helps allocate capital to projects that generate the highest returns.
- Performance Measurement: Provides a clear and concise metric for evaluating performance.
Disadvantages of Using EVA
- Complexity: Calculating EVA can be complex, requiring adjustments to accounting data.
- Short-Term Focus: EVA can sometimes encourage a short-term focus on maximizing current profits.
- Accounting Distortions: EVA is still based on accounting data, which can be subject to manipulation.
Conclusion
In conclusion, effective product pricing requires a nuanced understanding of various approaches, ranging from cost-based to value-based strategies. Simultaneously, EVA provides a robust financial metric for assessing true economic profitability, going beyond traditional accounting measures. While EVA has its limitations, its focus on value creation and capital allocation makes it a valuable tool for managers and investors alike. The integration of strategic pricing with performance metrics like EVA is crucial for sustainable business success in a competitive landscape.
Answer Length
This is a comprehensive model answer for learning purposes and may exceed the word limit. In the exam, always adhere to the prescribed word count.