Review

Unit contribution, margin and markup Fixed vs. variable costs Problems with cost-plus pricing (e.g., Death Spiral).

Team Assignment

Project

Mini-Presentation

Problems with Cost-plus Pricing

Cost-plus pricing will lead to over-pricing in a weak market.

Cost-plus pricing will lead to under-pricing in a strong market.

Mini Case Study: Self-Expedited “Death Spiral”

In 2007 Movie Gallery changed the 7-day rental period to 5-day.

The 7-day option was retained, at an additional fee.

In the same year Movie Gallery filed for bankruptcy protection and stocks dropped below $1.

Year # Stores

1985 1

1987 5

1992 37

1996 850

1999 950

2003 2000

2005 4700

What Could Have MG Done?

Channel strategy

Pricing strategy

7

Pricing Based on Markup / Margin

Markup The $ markup is $1000*30%=$300 Selling price = $1000 + $300 = $1300

Margin Selling price = p, say. The unit contribution is p*30/100 p = 1000 + 0.3*p, so p=$1428

A retailer buys a sofa for $1000. What will be the retailer’s selling price if it decides to go with (a) 30% markup and (b) 30% margin?

Chapter 9

Financial Analysis

Types of BEP

BEP Analysis

Type III: BEP of the change in variable cost

Type II: BEP of a fixed-cost investment

Type I: BEP of a price change

Type IV: BEP of Cannibalization

Types of BEP

BEP Analysis

Type III: BEP of the change in variable cost

Type II: BEP of a fixed-cost investment

Type I: BEP of a price change

Type IV: BEP of Cannibalization

Ask The Right Questions

The cost question in pricing is not: What prices do we need to cover costs and

achieve our profit objectives?The cost questions in pricing are:

How much sales gain would be required to profit from a price cut?

How much sales loss would be tolerable to profit from a price increase?

What costs can we afford to incur and still earn a profit?

Example: Type I BEP

PortaShelf is considering either raising or lowering their current price by 20%.The company would like to know how many units would have to be sold under these price changes to maintain the current profit margin of 10%.

PortaShelf $100 $80 $120

Current Price Option 1 Option 2

Option 1 – Decrease price by 20% to $80

Price = $80Variable unit cost (marginal cost) = $60Markup = $80 - $60 = $20

Therefore, each unit sold currently contributes $20 to fixed cost recovery and profit.

Say that fixed costs (plant, administration) are $30 million.

Thus, twice as many units must be produced to maintain the same profit level.

Profit = [2 million units x $80] – [(2 million units x $60) + $30 million]

(total revenue) (variable cost) (fixed cost)

= $10 million

Example: Type I BEP

Option 1

A 20% reduction in price reduces the unit contribution by 50% and requires that unit sales double to achieve the current level of profitability.

Questions – Does PortaShelf have the operating capacity to double capacity?

If the answer is no, then both variable unit costs and fixed costs will likelyincrease as PortaShelf:

Example: Type I BEP

Option 2 – Increase price by 20% to $120

Price = $120Variable unit cost (marginal cost) = $60Markup = $120 - $60 = $60

Therefore, each unit sold currently contributes $60 to fixed cost recovery and profit.

Say that fixed costs (plant, administration) are $30 million.

Thus, production can be reduced by about 33% in order to maintain the current profit level.

Profit = [667,000 units x $120] – [(667,000 units x $60) + $30 million](total revenue) (variable cost) (fixed cost)

= $10 million

Example: Type I BEP

Option 2

A 20% increase in price increases the markup by 33%and requires that unit sales be only 2/3rds the current amount to maintain the current level of profitability.

Depending on the organization of their operations, PortaShelf may notrequire various cost items that contribute to either their variable or fixedcosts. For example, they may be able to:

Example: Type I BEP

Price increase by x%

How to get the percentage of need sales volume

Price decrease by x%

Types of BEP

BEP Analysis

Type III: BEP of the change in variable cost

Type II: BEP of a fixed-cost investment

Type I: BEP of a price change

Type IV: BEP of Cannibalization

Total, Variable, and Fixed Costs

Type II BEP analysis chart for a picture frame store

Formulas for Type II BEP Analysis

Break-Even Point =

Break-Even Point =

Total Fixed CostContribution Per Unit to Fixed Cost

In Units:

In Dollars: Total Fixed CostVariable Cost Per Unit

Price1 -

Break-Even Point = Total Fixed Cost

Unit Price – Unit Variable Price

In Units:

Formulas for Type II BEP Analysis

Example: Type II BEP in Units

Leeds Manufacturing sells bookcases for $100 each. They have variable costs of $50. They want to build a new production line with total fixed cost (TFC)of $200,000. What will be the break-even point(BEP) in units to cover this new line?

BEP = TFC / (Unit Price – Unit Variable Cost)

Practice

Example: Type II BEP in dollars?

Sun Manufacturing sells bookcases at a price of $100 a piece.

Variable costs per unit are $50. They want to build a new production line with a

fixed cost of $200,000. What will be the break-even point (BEP) in $$$ to cover this new line?

Practice

Total Fixed CostVariable Cost Per Unit

Price1 -Break-Even Point =

In Dollars:

Formula for Type II BEP Analysis

Example: Type II BEP in Dollars

BEP ($) = Total Fixed Cost

1 - Variable Cost per unit /Price

$200,000

1 - .5=

= $400,000

Example: Type II BEP in Dollars

Leeds Manufacturing sells bookcases. They want to build a new production line which will cost $200,000 and produce 4,000 new bookcases per year. If variable cost per unit is $50 dollars, and demand is virtually unlimited, how much must they charge for each bookcase if they want to breakeven in the first year?

Practice

Sun Manufacturing sells bookcases at a price of $100 a piece.

Variable costs per unit are $50. They want to build a new production line with

a fixed cost of $200,000. What will be the break-even point (BEP) in $$$ to cover this new line?

Example: Type II BEP in dollars

Practice

Types of BEP

BEP Analysis

Type III: BEP of the change in variable cost

Type II: BEP of a fixed-cost investment

Type I: BEP of a price change

Type IV: BEP of Cannibalization

Example: Type III BEP

Sun Manufacturing sells bookcases at a price of $100 a piece.

Variable costs per unit are $50. Suppose that the unit variable costs have changed

to $60, what will be the percentage increase in sales volume in order to make the profit remains the same?

Break-Even Point = ( Unit Contribution_oldVC

Unit Contribution_newVC) -1

Formula for Type III BEP Analysis

Solution

Margin at the old unit variable cost is $50 Margin at the new unit variable cost is $40

-1= 25%5040BEP =

To make sure the profit remains the same, the sales volume has to go up by 25%.

Types of BEP

BEP Analysis

Type III: BEP of the change in variable cost

Type II: BEP of a fixed-cost investment

Type I: BEP of a price change

Type IV: BEP of Cannibalization

Example: Type IV BEP

Sun Manufacturing sells bookcases at a price of $100 a piece.

Variable costs per unit are $50. Suppose that the company is considering introduce

a new brand that sells $120 and costs $60 each, what will be the percentage of sales for the new brand that is coming from the existing brand, so that the profit remains the same?

Break-Even Rate = ( Unit Contribution_new offering

Unit Contribution_old offering

Formula for Type IV BEP Analysis

)

Solution

Margin of the existing product is $50 Margin of the new product is $60

5060BEP = = 83.3%

To make sure the profit remains the same, the new product can take up to 83.3% of the market share from the existing product.

Next Lecture

• Price Levels