Review

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Review

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

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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.

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Mini Case Study Self-Expedited Death Spiral
Year Stores
1985 1
1987 5
1992 37
1996 850
1999 950
2003 2000
2005 4700

• 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.

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What Could Have MG Done?

• Channel strategy

• Pricing strategy

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Pricing Based on Markup / Margin
A retailer buys a sofa for 1000. What will be
the retailers selling price if it decides to go
with (a) 30 markup and (b) 30 margin?

• Markup
• The markup is 100030300
• Selling price 3000 300 3300
• Margin
• Selling price p, say.
• The is p30/100
• p 30003p/10. So, p 4285.7

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Chapter 9Financial Analysis

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Types of BEP
Type II BEP of a fixed-cost investment
Type I BEP of a price change
BEP Analysis
Type III BEP of the change in variable cost
Type IV BEP of Cannibalization
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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?

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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.
Current Price
Option 1
Option 2
PortaShelf 100
80 120
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Example Type I BEP
Option 1 Decrease price by 20 to 80
Price 80 Variable unit cost (marginal cost)
60 Markup 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
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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
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Example Type I BEP
Option 2 Increase price by 20 to 120
Price 120 Variable unit cost (marginal cost)
60 Markup 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
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Example Type I BEP
Option 2
A 20 increase in price increases the markup by
33and 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
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How to get the percentage of need sales volume

• Price increase by x

• Price decrease by x

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Total, Variable, and Fixed Costs
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Type II BEP analysis chart for a picture frame
store
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Formulas for Type II BEP Analysis
In Units
Break-Even Point
In Dollars
1 -
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Formulas for Type II BEP Analysis
In Units
Break-Even Point
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Example Type II BEP in Units
Practice

• 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)

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Example Type II BEP in dollars?
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?

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Formula for Type II BEP Analysis
In Dollars
Break-Even Point
1 -
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Example Type II BEP in Dollars
BEP ()


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Example Type II BEP in Dollars
Practice

• 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?

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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?

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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?

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Formula for Type III BEP Analysis
Break-Even Point
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Solution

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

BEP

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

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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?

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Formula for Type IV BEP Analysis
Break-Even Rate (
)
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Solution

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

• 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.

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Next Lecture

• Price Levels