Business – 10.4 Finance and accounting strategy – Accounting data and ratios | e-Consult
10.4 Finance and accounting strategy – Accounting data and ratios (1 questions)
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A market‑penetration pricing strategy involves setting prices lower than competitors to quickly gain market share. Its effect on the two ratios can be summarised as follows:
- Inventory Turnover:
- Lower prices stimulate demand, leading to faster sales and higher inventory turnover (Cost of Goods Sold ÷ Average Inventory).
- However, if the price cut is too deep, profit margins may become unsustainable, causing the firm to reduce production and potentially increase inventory levels later.
- Operating Profit Ratio (Operating Profit ÷ Sales × 100%):
- Sales revenue rises, but operating profit may fall because the reduction in price erodes the contribution margin on each unit sold.
- If the increase in volume is sufficient to cover the lower margin, the ratio can stabilise or even improve; otherwise, it will decline.
Benefits: Rapid market share growth, economies of scale, and improved cash flow from quicker inventory turnover.
Risks: Margin compression, potential price wars, and the danger of being perceived as a low‑value brand, which can hinder future price increases.
Overall, the strategy can boost inventory turnover but may pressure the operating profit ratio unless the volume increase sufficiently offsets the lower margins.