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Pricing and Product Strategy Breakeven Pricing

Pricing and Product Strategy Breakeven Pricing. Financial Analysis. Managers should develop a baseline to measure the effects of a price change. Managers should calculate an incremental breakeven for the price change to determine under what market conditions the change will prove profitable.

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Pricing and Product Strategy Breakeven Pricing

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  1. Pricing and Product Strategy Breakeven Pricing

  2. Financial Analysis Managers should develop a baseline to measure the effects of a price change. Managers should calculate an incremental breakeven for the price change todetermine under what market conditions the change will prove profitable. • Two basic questions are asked in incremental breakeven analysis: • How much would the sales volume have to increase to profit from areduction in price? • How much could the sales volume decline before a price increasebecomes unprofitable?

  3. Example Westside Manufacturing Monthly Data: Westside is considering a 5% price cut to become more competitive with othersuppliers. Management does not foresee any changes in fixed cost structure.How much will sales have to increase for Westside to profit from a 5% price cut?

  4. Finding the breakeven sales change . . . . Contribution lost due to price change (c) P1=$10.00 P1=$10.00 P2=$9.50 Contribution gained due to volume increase (e) Unaffected Contribution (d) Contribution (a) VC=$5.50 VC=$5.50 Additional Variable Costs (f) Variable Costs (b) Variable Costs (b) Sales Volume 4,000 Sales Volume 4,000 Sales Volume ?? Contribution Before Price Change Contribution After Price Change

  5. Finding the breakeven sales change . . . . The minimum sales change necessary to maintain at least the same contribution can be directly calculated by calculating the percent breakeven sales change, or: Percent breakeven sales change = - Price Change Old CM + Price Change - CM Change New CM - ($10.00 - $9.50) $4.50 + (- $0.50) 0.125 or 12.5% OR = = Unit breakeven sales change = 0.125 x 4,000 = 500 units

  6. Finding the breakeven sales change . . . . Therefore If Westside’s sales volume exceeds the breakeven sales change of 500 units, then the 50 cent price cut will be profitable. Therefore, sales must increase by more than 12.5% to add to the profit contribution. The effect of an increase in unit price is calculated using the same equation. In this case, however, we are concerned with how much sales volume reduction Westside can absorb before profit contribution is adversely affected by the price increase.

  7. Breakeven sales incorporating changes in variable costs . . . . The variable costs for a product/service can change given different volumeof sales (production). Example: Westside Manufacturing’s 5% price cut is accompanied by a 22 cent reduction in their variable cost per pillow as Westside changes from goose down to a new and cheaper synthetic filler. Therefore, variable cost has been reduced from $5.50 before the price change to $5.28 after the price change. Your task is to determine how much the sales volume will have to increase to assure that Westside’s proposed price cut is profitable?

  8. Breakeven sales incorporating changes in variable costs . . . When variable cost changes along with a price change, simply subtract the variable cost change from the price change before calculating the breakeven sales change. % BE sales change = - (Price Change – VC Change) Old CM + (Price Change – VC Change) - CM Change New CM OR CM Change = (Price Change – VC Change) = -$0.50 – (-$0.22) = -$0.28 % BE Sales Change = -(-$0.28) $4.50 + (-$0.28) = 0.066 or +6.6% In units, the BE sales change = 0.066 x 4,000 = 265 units Thus, Westside needs to sell a total of 4,265 units to maintain current level of profitability.

  9. Finding the breakeven sales change given a change in variable costs . . . . contribution lost due to price (a) P1 = $10.00 P2 = $9.50 contribution gained due to volume (c) unaffected contribution (b) VC1 = $5.50 contribution gained due to VC (f) VC2 = $5.28 additional variable costs (e) variable costs (d) Sales Volume 4,000 Sales Volume ??

  10. Finding the breakeven sales change given a change in fixed costs . . . . Fixed costs can change with large changes in sales volume. For example, a semiconductor manufacturer may not be able to meet demand without adding more manufacturing equipment or possibly a new manufacturing facility. Calculating sales volume necessary to recover a fixed cost expenditureis a simple exercise: Breakeven sales volume = Change in Fixed Cost Price – Variable Costs

  11. Breakeven sales incorporating changes in fixed costs . . . . Example: A lumber manufacturer installs additional dry kiln capacity to manufacturing operations at a total fixed cost expenditure of $850,000. The lumber company currently sells lumber at an average annual price of $400 per thousand board feet (MBF). The lumber company’s variable cost of production is $385 MBF. Breakeven sales volume = $850,000 = 56,667 MBF $400 - $385

  12. Breakeven sales incorporating changes in fixed costs . . . . To do a breakeven analysis involving both a price change and a change in fixed costs, add: [1] the breakeven sales change for a price change and [2] the breakeven sales volume for the related fixed investment. Unit Basis Unit Breakeven Sales Change • CM Change • New CM Initial Unit Sales Change in Fixed Cost New CM = x + Percent Basis Percent Breakeven Sales Change • CM Change • New CM Change in Fixed Cost New CM x Initial Unit Sales = +

  13. Breakeven sales incorporating changes in fixed costs and a change in price . . . . Example: Westside Manufacturing is considering a 5% price cut. Recall that we have already calculated that sales must increase 12.5% to make a profit with the price cut. Westside is already operating at capacity. To increase sales by 12.5% will require that Westside install equipment with a monthly fixed cost of $800. The new equipment increases output by 1,000 units per month. What is the minimum sales increase required to justify a 5% price cut given that $800 of fixed costs will be incurred per month?

  14. Breakeven sales incorporating changes in fixed costs and a change in price . . . . Unit BE Sales Change = 0.125 x 4,000 units + $800 = 700 units $4 Percent BE Sales Change = 0.125 + $800 = 0.175 or 17.5% $4 x 4,000 units The fixed cost of an added 1,000 units of capacity does not exceed the breakeven sales change needed to be profitable given the price change and the added fixed cost. What would happen to the pricing decision if Westside already invested in the new capacity prior to the proposed 5% price cut?

  15. Relationship Between Pricing and the Product Line • The product has the biggest impact on pricing since the product influences consumer psychology and is used to segment the market. • Most firms sell multiple products. In other words, these firms have product lines. Firms must know how the sales of one product affects the sales of other products in their product line in order to maximize firm performance. A product within a product line can have one of three relationships with another product in a firm’s product line: Substitute Indifferent Complementary

  16. Substitute Products If an increase in sales of one product directly decreases the sales of another product, then the products are considered to be substitutes. Typically, products within the same product category, or product class, are substitutes. A firm that sells substitute products must be aware of the effects that a pricing strategy for one product will have on that product’s substitute.

  17. Substitute Products . . . Source: Wall Street Journal, August 4, 2008

  18. Substitute Products Example Price/Gallon Var. Cost/Gallon $ ContributionMargin/Gallon Regular Unleaded 1.30 1.10 0.20 Premium Unleaded 1.50 1.20 0.30 What effect results from a 5% price increase in premium grade? If premium grade sales were independent of regular grade sales, then we would expect: Contribution Margin = (0.30/1.50) x 100 = 20% Breakeven Sales Change = (-5/(20 + 5)) = -20% Sales can decline up to 20 percent with a 5% price increase in premium grade and still remain profitable.

  19. Substitute Products Premium grade sales are not independent of regular grade sales! Even with a decrease in premium grade sales, the 5% price increase could still be a profitable strategy. From experience, it’s known that one-half of the company’s consumers will substitute regular grade for premium. Thus, the decline in dollar contribution margin from lost sales in premium is: [$0.30/gallon minus the gain in contribution from regular sales] Adjusted Contribution Margin = $0.30 – (0.5 x $0.20) = $0.20 Percent Contribution Margin = ($0.20/$1.50) = 13.3% Breakeven Sales Change = (-5/(13.3 + 5.0)) = -27.3%

  20. Substitute Products Summary The company can profit from a 5% price increase in premiumgrade as long as one-half of the consumers switch to regulargrade fuel and premium sales do not decline more than about27 percent.

  21. Complementary Products If an increase in sales of one product directly increases the sales of another product, then the products are considered to be complements. Calculating the effect of complementary product is exactly like calculating the effect for a substitute product except that you add to the contribution margin rather than subtract.

  22. Complementary Products Example: UnitPrice UnitVar. Cost Unit $ ContributionMargin Computer 1,500 1,000 500 Software Program 175 100 75 Printer 1,450 950 500 What’s the effect of a 10% price decrease for a computer? If computer sales are independent of software and printer sales, then a 10% price decrease would result in the company earning a 33.3% contribution margin on the computer. The breakeven sales change for the 10% price decrease would be 42.9%. Thus, sales would have to increase 42.9% to be profitable with a 10% price decrease in the cost of a computer.

  23. Complementary Products We know, however, that the sales of computers directly affects the sales of software programs and printers. Selling more computers results in greater sales of software and printers. If the “average” computer buyer purchases two software programs and one-half of the computer buyers buy a printer, then the relevant contribution margin will be much greater than 33.3%. Adjusted Contribution Margin = $500 + (2 x $75) + 0.5(500) = 900 Percent Contribution Margin = ($900/$1,500) = 60% Breakeven Sales Change = (-(-10)/(60.0 – 10.0)) = 20.0%

  24. Complementary Products Summary The company can profit from a 10% price decrease for their computers as long as computer sales increase by at least 20%. Previously, when the computer sales were considered independent of software and printer sales, the computer sales would have had to increase 42.9% to offset the 10% price decrease. Product bundling can facilitate the sales of complementary products . . . .

  25. Breakeven Sales Simulation Westside Manufacturing’s Proposed 5% Price Cut

  26. Scenarios 1 through 4 are Losses Scenario 5 is Breakeven Scenarios 6 through 9 are Profitable Breakeven Sales Simulation

  27. Breakeven Sales Curve and Price Elasticity Price $14.00 Inelastic Demand $13.00 +25% $12.00 +20% +15% $11.00 +10% +5% $10.00 Baseline Elastic Demand $9.00 -5% -10% -15% $8.00 $7.00 2,000 3,000 4,000 5,000 6,000 7,000 8,000 Unit Sales Volume

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