2 cost and profitability analysis
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2 Cost and Profitability AnalysisTRANSCRIPT
MKT 558: PRICING STRATEGIESProfessor Baojun Jiang
Cost and Profitability Analysis
Relevant costs (avoidable and incremental)
Incremental break‐even analysis
DEATH SPIRAL
Discussion:
The CEO/General Manager of a manufacturer decided that to make product line managers more accountable, at the end of each 6‐month period, products that do not cover their average costs will no longer be allowed for production.
Every 6 months, a few products appeared on the “kill” list and were ordered to cease production. More and more unprofitable products have surfaced as time goes by. What is happening?
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RELEVANT COSTS
Relevant costs costs incurred because a product is sold, or not incurred because it is not sold. They include
Incremental costs: costs incurred associated with changes in pricing and sales (not total or full cost)
o all variable costs
o some fixed costs incremental fixed costs (e.g., ads to inform consumers of price change)
semi‐fixed costs: fixed over a range of sales but vary outside the range (machine)
Avoidable costs: costs not yet incurred or can be reversed (not “sunk cost”)
o future costs are usually avoidable, past costs are usually “sunk”
o future replacement cost, not historical replacement cost
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EXAMPLE 1
A rock band performs on two Saturday evenings every month. They currently prepare a new set of songs for each performance (show).
o Overall cost per show: Fixed overhead cost $1,500
Rehearsal costs $4,500
Cost per show (performance) $2,000
Variable cost (per ticket) $1
Ticket price: $10
o Capacity: 1,100 spectators
o Currently, only 900 tickets are sold.
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PROPOSALS
Profit margin is very thin. But the manager does not believe increasing the price can solve the problem. She has 3 proposals. Which gives the highest profit?
A. Sell 200 tickets at discounted price of $4 to a group of students who would otherwise not attend the show at regular price.
B. Organize an additional show (of the same Saturday performance) on Sunday at $6 to all spectators. The manager expects to sell 700 tickets but 150 of those tickets correspond to spectators who otherwise would attend on Saturday.
C. Organize a new series of shows on alternative Saturdays at $10 per ticket. The manager expects to sell 800 tickets. 100 of those tickets correspond to spectators who otherwise would attend the regular show.
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Analysis Discount Sunday morning
New Show
Price
x unit sales
= revenue
- other lost sales
Revenue Gain
Rehearsal Incremental Cost
Show Incremental Cost
Change in Variable Cost
Incremental Cost
Net Profit Contribution
To evaluate profitability, we discount only the incremental costs to revenues ...
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CONTRIBUTION MARGIN
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Per Unit Total
Price Sales revenue Incremental variable cost Total variable costs
Contribution margin Total contribution
Percentage Contribution Margin (%CM) Calculation
%CM = (Contribution Margin/Price)(100)
The %CM is extremely important to pricing because:
* It is the share of the selling price over relevant variable costs that contributes to the firm's bottom line (total relevant fixed cost and profit ).
INCREMENTAL BREAK‐EVEN ANALYSIS
Incremental break‐even analysis vs. break‐even analysis
How much would the sales have to increase (or decrease) to retain the same profit from a price decrease (or increase)?
o It takes into account relevant costs
o It focuses on the incremental profitability of price changes regardless of the current profit level
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INCREMENTAL BREAK‐EVEN FORMULA
Derive this.
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EXAMPLE 2: WESTSIDE PILLOWS
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Westside produces pillows (monthly information below) o Sales 4000 units
o Wholesale price $10.00 per unit
o Variable costs $5.50 per unit
o Fixed costs $15,000
Incremental Break‐even
1) Westside is considering a 5% price cut without additional fixed cost. By how many % would sales need to increase to break even profit for the 5% price cut?
2) Replacing goose feathers with synthetic filler will decrease the unit variable cost by $0.22. By how many % would sales have to increase to assure the 5% price cut?
3) Assume, for this part, the current production capacity is 4,000. To increase it by 1,000, the company has to install another workstation at a monthly cost of $800. Assume no change in variable costs for parts 3), 4) and 5). By how much would sales have to increase to justify a 5% price cut?
Incremental break‐even sales curve
4) Repeat the incremental break‐even exercise for a 15% price decrease, a 15% increase, etc. You will find many combinations of sales and prices that break‐even the current profit. Link these points, you will obtain an incremental break‐even sales curve with price on the vertical line and unit sales on the horizontal line.
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price
Unit Sales
Actual sales response and measuring impact on current profit
5) The company decides to go with a 5% price cut. Marketing research shows that actual sales will increase by 25%. Evaluate the financial impact of a 5% price cut on the firm’s current profit.
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price
Unit Sales
DO WE IGNORE FIXED AND SUNK COSTS?
NO!
o They are important, ignoring them will cause bankruptcy
o But they do not affect optimal pricing decision
o Optimal pricing gives maximized profit to cover those costs
o Every cost is incremental and avoidable in the long term or in the planning stage
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In‐class game and exercise.
TAKEAWAY FROM THIS LECTURE
When evaluating the profitability of a price change, consider only relevant costs (avoidable and incremental costs, not average cost).
Incremental break‐even sales curve
o It takes into account the changes of relevant costs.
o It presents succinctly the dividing line that separates profitable price decisions from unprofitable ones.
o The comparison with demand curve shows the profitability of price change.
The pricing theory embedded in the examples applies to all size and type of business that cannot offer a customized price for each customer. We will study segmentation and price customization later in this course.
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NEXT SESSION
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EVC, WTP, and Value‐based Pricing
Economic value to the customer
Factors influencing actual willingness‐to‐pay
Value‐based pricing and EVC analysis