In particular, we need to determine how to price our products so that they continue to be competitive and profitable. First, let’s think about the basic factors that affect profitability. Net income is revenues minus expenses. Return on assets is net income divided by total assets.
Net income = revenues + expenses
Return on assets = net income ÷ total assets
“Return on assets provides a simple measure for evaluating how well we use our
assets to create profits. We need to determine how to create a return on assets that will satisfy our stockholders.
Let us assume we have decided on an automated production process that will require an initial investment in assets of $5 million. Also, expenses created by this process are mostly fixed. Exhibit below summarizes, from our prior discussions, our expected initial investment and expected operating results for the next two years.
(Click to large)
We expect our return on assets to be only 2.5% ($126 $5,000) in the first year. By the second year, we expect to be earning a higher profit, and we believe our future profitability will be much higher. If our investment in assets remains at approximately $5 million, our return on assets should increase to 8.7% in year two. What we can see from above Exhibit is that assets and expenses are pretty well determined by our production process and will not increase much until we can sell more of our product than we can produce. The real issue, then, is how to generate as much revenue as possible from our product.
As the major purpose of our company is to earn a satisfactory return for our stockholders by creating value for our customers. We have a valuable product, and we can produce it efficiently. Though these are necessary attributes of a successful business, they do not guarantee our success. We have to develop a strategy for creating profits by competing with other producers. Again, the basics are pretty straightforward. Revenue depends on two factors, number of units sold (generally referred to as sales volume) and price per unit.
Sales revenues = sales volume x price per unit
The more units we sell at a given price, the more revenue we earn. More revenue means higher net income and higher return on assets. Also, we know that sales volume and price are indirectly related. As price goes up, sales volume goes down. Therefore, we need to determine a price that will allow us to maximize our revenues. What we can charge is affected by the prices charged by our competitors and what our customers are willing to pay.
The industry is dominated by a few major producers. All of these companies produce very similar products. Consequently, competition is based largely on price. Each company attempts to sell its products at as low a price as possible. All of the companies charge about the same amount. One company cannot raise its prices without losing customers. If a company’s prices get much higher than those of other companies, customers simply will buy from a competitor who sells at a lower price.
Producers, then, must set prices that are close to their competitors’ and that allow them to earn a reasonable profit. The most efficient producers earn the most money because they keep their production and marketing costs low. To keep these costs low, it is usually necessary to produce in high volume because so many of the costs are fixed, as we have seen for our company. Companies have to invest a lot in plant assets to get into this business. Therefore, we have to sell a lot of product to cover the costs of our investment and earn a reasonable return on assets.”