pricing model for expense optimization

8/3/2019 Pricing Model for Expense Optimization

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Pri

I. Primer

This paper attempts to establish a

typically medium to high volume,

Aerospace and Defense (A&D) sect

Another differentiating factor is th

conventional mass market manufa

hence a conventional use of NPV/I

Secondly, the working capital requ

often non negotiable payment ter

Traditional cost models often att

(BPC).The BPC is typically a sum of

working capital requirements, mat

up in the BPC, an appropriate marg

Also, many times a onetime cost is

cost and process engineering. This

price

These models do not offset cost

function of organizational risk pro

The existing models also do not

projects which are realized within

costs would not impact the proj

threshold value of the NPV and the

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smit the work subject to the following:-

ork in the manner specified by the author or licensor (bu

se of the work).

work for commercial purposes.

ter, transform, or build upon this work.

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cing Model for Expense Optimization

model for evaluating projects in sectors that deal

high variety and often very capital intensive. Ind

or often deal with such requirements.

t the capital expenditure (capex) requirements, he

cturing industry and lower than say power or infr

R project profitability analysis may not be feasible.

irements for the A&D sector is very high owing to

s by both the customers and vendors to these tier

empt to factor risks as a percentage over the

material and the labor costs. The risks considered a

rial price escalations, and financial costs. With all

in is decided and a price is derived upon.

incurred for these projects on account of engineer

is typically amortized over the BPC and becomes

ith regards to revenue streams. Hence the risk c

iling rather than the project risk.

take into account the time value of money. Th

5 years of conceptualization and the error if any

ct profitability greatly. Profitability here is defi

IRR.

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t not in any way that

the copyright holder

Page 1

products that are

stries such as the

re are higher than

astructure sectors

the stringent and

2 & 3 suppliers

asic product cost

re inventory costs,

hese risks padded

ing efforts, tooling

a part of the unit

ost employed is a

y are suitable for

in estimating risk

ed in terms of a


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The markup on account of risk an

historical perspective inflation cost

8%.This markup is then judged on

factor adjudging the risk costs is w

margins are not the only indicator

II. Pricing perspectives

The challenge is to determine the

over costs. If this is done then it is

the pain areas for improvement. F

price has to be a minimum to 25

work backwards and ascertain as t

this 25% is apportioned into differ

maintained for the various source

impact on short term profitability

essence we can work in a manner

a threshold value prior to project i

The advantage in this kind of ap

value of the inflow and uses the c

it allows planning for preserving b

The advantage in using outflows

which will be given by the custom

Steps in working

1. Find BPC = material + Labo2. Find outflow every year of3. Cost of capital/discounting




se of the work).




their impact on decision making is limited. Lets

s necessitate an 8% increase in price YoY and henc

ly in conjunction with its impact on the gross mar

ith their impact on margins and every manager ou

f project profitability.

ptimal revenue without relating to the costs or a

possible to zero on the mark-up via the optimal sa

or instance if by an optimization route it is found

over the cost to generate a threshold value of r

how to apportion this range of 25% in known ris

nt risk baskets and we can be equipped with a thr

of risk such as say working capital, inventory so

hat is the margin and long term profitability that i

akin to target costing, where the operating expe

nitiation.

roach is that it starts with the outflow to deter

st of finance as the basic measure for judging the

th short and long term project profitability meas

is that it is easy to estimate your cost that to e

r.

Cost

BPC/year.

factor is known

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say that based on

e BPC is jacked up

gin. Thus the only

there knows that

y form of markup

le price and hence

out that the sale

turn then we can

areas. Then once

eshold value to be

s to not have any

s the return. So in

ses are pegged at

ining the correct

profitability. Also

res.

stimate the price


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4. Threshold value of return i5. Hit and trial the revenue p

based on the given cost of

6. Check for markup of this re7. Find NPV of all cash outflo8. This NPV of cash outflows i9. Find equivalent annual pay

the Equivalent Basic Prod

due to cash flows realized

10. Find this differential as a %11.X-Y = Z% is the operating e12.

Bracket the operating expe

13.Allocate appropriate %s othreshold value. This thre

based on the industry aver

14.Hence the above processa. BPC this would bb. EQBPC the BPC ac. Sale Price that sad. Risks derived co

threshold values

III. Example

1. Lets say you incur a BPC o2017

2. Cost of capital is known bsuperimposes the compan




se of the work).




fixed(subjective), based on management decision

er year to get a constant value that would yield th

apital

venue over BPC. Say this is X%

s only

s completely debt funded

ment to be made for this debt funded onetime ca

ct Cost (EQBPC).The differential between BPC an

at a later time.

of BPC. Say this is Y%

penses.

nses into different risk baskets.Z% to maximize gross margin and keep other ris

hold value of other risk baskets will be subjecti

ge seen in conjunction with project specific variabl

ill lead to the following:-

e based on current prices hence be accurate.

djusted for time value risk

tisfies both margin and return requirements

nsidering financial cost and categorized into diffe

70000/year from 2014 -2026 and the cash inflow

sed on the current rate of borrowing. (Not comp

risk on the project), however here it is taken as 1

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e threshold return

sh outflow. This is

EQBPC is the risk

k baskets below a

e(a value derived

es)

rent baskets with

ill only start from

letely correct as it

%.


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3. Change random numbers iIRR value, (this cant be op

reduces.

4. Here threshold return is de5. EQBPC is derived, time valu6. Remove % of time value ri

this allocate different %s to

margin. These are the oper

wages, investment on m

appropriate year as a part

Applicability and Limitations of thi

1. Projects which will see an u2. Revenues are realized late

dollar spent.

Authored By

Srikant Rajan

PGDM 2008-10(FT), IFMR Chennai

Contact: +91-9972502500

Mail [email protected]

W - www.mindtrends.blogspot.co

(Musings on contemporary living a




se of the work).




n inflow cell to get a constant number that gener

timized). Please note that if revenue is realized ea

fined as a minimum of7 %( IRR-Cost of Capital)

e risk is quantified. Here it is 15%

isk from total markup % of revenue over BPC (75

inventory, working capital, G&A and margin with

ating expenses apart from material and labor. Expe

chinery, etc is capital/fixed expenditure that c

f outflow if desired.

s Approach

pfront investment, and last for a minimum of 5 yea

than the outflows. A minimum of two years gap i

nd the occasional short story/fiction)

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ates the threshold

rlier, then markup

-15%=60%).From

view to maximize

nses on salary and

n be put in the

rs.

realizing the first

pricing model for expense optimization

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