Pricing Model for Expense Optimization I.

Primer This paper attempts to establish a model for evaluating projects in sectors that deal products that are typically medium to high volume, high variety and often very capital intensive. Industries such as the Aerospace and Defense (A&D) sector often deal with such requirements. Another differentiating factor is that the capital expenditure (capex) requirements, here are higher than , conventional mass market manufacturing industry and lower than say power or infrastructure s sectors hence a conventional use of NPV/IRR project profitability analysis may not be feasible. Secondly, the working capital requirements for the A&D sector is very high owing to the stringent and he often non negotiable payment terms by both the customers and vendors to these tier 2 & 3 suppliers Traditional cost models often attempt to factor risks as a percentage over the basic product cost (BPC).The BPC is typically a sum of material and the labor costs. The risks considered are inventory costs, The working capital requirements, material price escalations, and financial costs. With all these risks padded up in the BPC, an appropriate margin is decided and a price is derived upon. Also, many times a onetime cost is incurred for these projects on account of engineering efforts, tooling cost and process engineering. This is typically amortized over the BPC and becomes a part of the unit amortized price These models do not offset cost with regards to revenue streams. Hence the risk cost employed is a hese function of organizational risk profiling rather than the project risk. The existing models also do not take into account the time value of money. They are suitable for o . projects which are realized within 5 years of conceptualization and the error if any in estimating risk error costs would not impact the project profitability greatly. Profitability here is defined in terms of a defined threshold value of the NPV and the IRR.

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The markup on account of risk and their impact on decision making is limited Lets say that based on he limited. historical perspective inflation costs necessitate a 8% increase in price YoY and hence BPC is jacked up an 8%.This markup is then judged only in conjunction with its impact on the gross margin. Thus the only factor adjudging the risk costs is with their impact on margins and every manager out there knows that margins are not the only indicator of p project profitability. II. Pricing perspectives The challenge is to determine the optimal revenue without relating to the costs or any form of markup over costs. If this is done then it is possible to zero on the mark mark-up via the optimal sale price and hence the pain areas for improvement. For instance if by an optimization route it is found out that the sale price has to be a minimum to 25% over the cost to generate a threshold value of return then we can work backwards and ascertain as to how to apportion this range of 25% in known risk areas. Then once o this 25% is apportioned into different risk baskets and we can be equipped with a threshold value to be maintained for the various sources of risk such as say working capital, inventory so as to not have any impact on short term profitability that is the margin and long term profitability that is the return. So in essence we can work in a manner akin to target costing, where the operating expenses are pegged at a threshold value prior to project initiation. oject The advantage in this kind of approa is that it starts with the outflow to determining the correct approach determin value of the inflow and uses the cost of finance as the basic measure for judging the profitability Also profitability. it allows planning for preserving both short and long term project profitability measures. ng The advantage in using outflows is that it is easy to estimate your cost that to estimate the price which will be given by the customer. Steps in working 1. Find BPC = material + Labor Cost 2. Find outflow every year of BPC/year. 3. Cost of capital/discounting factor is known /discounting
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4. Threshold value of return is fixed fixed(subjective), based on management decision 5. Hit and trial the revenue per year to get a constant value that would yield the threshold return based on the given cost of capital he 6. Check for markup of this revenue over BPC. Say this is X% 7. Find NPV of all cash outflows only PV 8. This NPV of cash outflows is completely debt funded 9. Find equivalent annual payment to be made for this debt funded onetime cash outflow. This is the Equivalent Basic Product Cost (EQBPC).The differential between BPC and EQBPC is the risk due to cash flows realized at a later time time. 10. Find this differential as a % of BPC. Say this is Y% 11. X-Y = Z% is the operating expenses. Y 12. Bracket the operating expenses into different risk baskets. 13. Allocate appropriate %s of Z% to maximize gross margin and keep other risk baskets below a threshold value. This threshold value of other risk baskets will be subjective(a value derived subjective( based on the industry average seen in conjunction with project specific variables) variables 14. Hence the above process will lead to the following: following:a. BPC this would be based on current prices hence be accurate. b. EQBPC the BPC adjusted for time value risk c. Sale Price that satisfies both margin and return requirements d. Risks derived considering financial cost and categorized into different baskets with threshold values III. Example 1. Lets say you incur a BPC of 70000/year from 2014 -2026 and the cash inflow will only start from 2017 2. Cost of capital is known based on the current rate of borrowing. (Not completely correct as it borrowing. superimposes the company risk on the project) however here it is taken as 10%. project),

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3. Change random numbers in inflow cell to get a constant number that generates the threshold IRR value, (this cant be optimized). Please note that if revenue is realized earlier, then markup lue, reduces. 4. Here threshold return is defined as a minimum of 7 %( IRR-Cost of Capital) 5. EQBPC is derived, time value risk is quantified. Here it is 15% 6. Remove % of time value risk from total markup % of revenue over BPC (75%-15%=60%).From (75% this allocate different %s to inventory, working capital, G&A and margin with a view to maximize margin. These are the operating expenses apart from material and labor. Expenses on salary and . wages, investment on machinery, etc is capital/fixed expenditure that can be put in the appropriate year as a part of outflow if desired. Applicability and Limitations of this A Approach 1. Projects which will see an upfront investment, and last for a minimum of 5 years. 2. Revenues are realized later than the outflows. A minimum of two years gap in realizing the first dollar spent.

Authored By Srikant Rajan PGDM 2008-10(FT), IFMR Chennai Contact: +91-9972502500 Mail -Srikantrajan263@gmail.com W - www.mindtrends.blogspot.com (Musings on contemporary living and the occasional short story/fiction)

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