Strategy and tactics of pricing a guide to growing more profitably 5th edition nagle solutions manua

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Chapter 10

Financial Analysis Pricing for Profit I.

Chapter Overview This chapter introduces incremental breakeven analysis as a proactive pricing method for integrating cost and quantitatively assessing the consequence of a price change.

Three forms of the breakeven sales change are examined in several cases including basic, a change in variable cost, and incremental fixed costs. Breakeven sales analysis is also presented for a reactive price change where the company is confronted with a competitors price change. This chapter includes a discussion and examples of breakeven sales curves and points at the relationship between a breakeven approach to pricing and the economic concept of price elasticity. Chapter 9 concludes with an extensive case study on costing and financial analysis.

II.

Key Learning Goals • Explore breakeven analysis and changes in variable cost and incremental fixed costs • Learn how to calculate potential financial implications and create breakeven sales curves.

III.

Major Teaching Points • The key to assessing pricing profitability is to understand when a price change becomes unprofitable or profitable – that is the change in volume required for profitability. The calculation to do this is the Breakeven Sales Change.

• In addition to the Breakeven Sales Change, students should know how to calculate the actual projected profitability of a price change.

• A fundamental strength to this method is that it makes accessible to all managers a simple formula to calculate the boundary or line of pricing profitability – and then invites subjective inquiry of managers from all functions and disciplines to determine the likelihood that the change in volume following a price change will in fact exceed the breakeven level.

• Students should know the several different versions of the breakeven formula and when each is applicable: the proactive breakeven, reactive breakeven, breakeven with changes in variable costs, and breakeven with incremental fixed costs.

IV.

Teaching Suggestions The Teaching Suggestions for The Strategy and Tactics of Pricing, Fifth Edition are located in the “notes” section of the PowerPoint slides. In addition to teaching suggestions, each chapter includes examples and discussion questions.

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V.

Exercises and Caselets Swing vs. Steady Healthy Spring Water Co. Calibrated Manufacturing

VI.

Other Resources a. Cases Beauregard Textile Co. Fabtek (A) b. Suggested Readings Smith and Nagle, “Financial Analysis for Profit Driven Pricing,” Sloan Management Review, Spring 1994, Vol 35, No. 3, pp. 71-84.

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Swing v. Steady Swing Manufacturing and Steady Manufacturing both operate in the widget industry, but with radically different cost structures. Swing is a capital-intensive, automated manufacturer, while Steady is a labor-intensive "job-shop." Monthly operating data are as follows:

Sales Price Variable Fixed Cost Full Cost Current Profit

Swing Manufacturing 5,000 units $10.00 $2.50 $35,000/month $9.50 $2,500/month

Steady Manufacturing 5,000 units $10.00 $5.50 $20,000/month $9.50 $2,500/month

Please answer the following questions. DO NOT calculate the profitability of these changes by calculating profit levels before and after the changes, spreadsheet style.

That approach would take four times longer and not show me that you understand the formulas. Use the simple concept of contribution to calculate just the change in profits due to the proposed price changes.

Swing and Steady both currently have equal (50%) shares of the market. Each is evaluating opportunities to enhance profits. One opportunity involves selling to a lowvalue, but potentially high-volume, market segment not currently served by either company. The potential increase in sales for either company entering that market alone would be at least 40% (2000 units). If they both entered, the potential sales increase would be at least 20% for each of them. Unfortunately, reaching that market would require pricing at $8.50, 15% below current levels. (a) If either company could costlessly segment the market for pricing (that is, charge the 15% lower price only to this new segment without undermining the prices charged to current customers), how much additional profitability could each company earn by achieving a 20% and a 40% increase in sales? Would you recommend that either or both companies pursue this opportunity? (b) In fact, neither Swing nor Steady can effectively segment this market (each must charge one price to everyone). Calculate the break-even sales changes for this opportunity for each of them. Calculate the changes in profit for a 40% increase in sales. Briefly explain why this answer differs from your answer in part a. (c) Which competitor is better positioned to take advantage of this opportunity?

Assuming that neither company can segment the market, what advice would you give to Swing and to Steady regarding this opportunity?

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Swing v. Steady (continued, page 2) Swing took the opportunity to enter the new market segment, cutting its prices 15% to do so. Consequently, Swing's unit sales are now 7,000 monthly at a price of $8.50.

Steady, however, was belatedly forced to match Swing's price in order to retain its customers in this market. Steady's management believes that it would have lost at least 60% of its business had it failed to reduce its price. Unfortunately, Steady is now operating at a loss. (d) Was Steady's decision to cut price financially justified?

Assume that if Steady were to withdraw from this market, it could reduce its fixed costs by half (by giving up its lease on the rental property and eliminating other sundry costs).

The other half of its fixed cost is debt service on assets with no resale value. (e) Given the financial information that you have at this point, would Steady be better off to withdraw from this market altogether?

Fortunately, crisis has a way of focusing the mind. After reading Michael Porter's Competitive Advantage, Steady's management decided to analyze the entire value chain of which widgets are a part. Steady learned that at least 3500 units of current market demand comes from companies that must modify the commodity widget they buy to meet their specific needs. This creates an opportunity for Steady to integrate forward, casting specialized widgets to meet the needs of each user. While Steady's costs of manufacturing will rise substantially, the increase will be less than what buyers currently spend to modify the generic widgets.

To make specialized widgets, Steady would need to invest in additional fixed capital generating a fixed charge of $3,000 monthly and refocus its entire operation to produce specialized widgets exclusively. Steady's management believes that it could charge prices at least $6.00 higher than the going commodity price, but would incur additional variable cost of $3.00 more per unit. [Note: this decision would preclude Steady's continued production of generic widgets, unless of course Steady opted to buy all new buildings and equipment for the new operation, which would generate incremental fixed costs of $23,000 monthly rather than the $3,000 assumed above.] (f) What is the minimum monthly unit sales that Steady would require to make it more profitable as a specialty widget manufacturer than it is currently as a commodity manufacturer? (g) How much additional profit would Steady earn as a specialty widget, given its minimum case scenario of 3500 specialty units at a $6.00 price premium?

©2011 Pearson Education, Inc. publishing as Prentice Hall

Swing v. Steady Instructor's Note (a) If either company could costlessly segment the market for pricing (that is, charge the 15% lower price only to this new segment without undermining the prices charged to current customers), how much additional profitability could each company earn by achieving a 20% and a 40% increase in sales?

Would you recommend that either or both companies pursue this opportunity?

Answer:

Swing CM = $6.00

Steady CM = $3.00

For a 20% sales increase: $6 x 1,000 units = $6,000

$3 x 1,000 units = $3,000

For a 40% sales increase: $6 x 2,000 units = $12,000

$3 x 2,000 units = $6,000

Yes, both companies should pursue this opportunity. (b) In fact, neither Swing nor Steady can effectively segment this market (each must charge one price to everyone). Calculate the break-even sales changes for this opportunity for each of them. Calculate the changes in profit for a 40% increase in sales. Briefly explain why this answer differs from your answer in part a.

Answer:

Swing −1.50 7.50 + ( −1.50 ) = +. 25 =−

Steady −1.50 4.50 + ( −1.50 ) = +.50 =−

Part A assumed that we could take this additional business without undermining prices on previous business. (c) Which competitor is better positioned to take advantage of this opportunity? Assuming that neither company can segment the market, what advice would you give to Swing and to Steady regarding this opportunity?

Answer: This is an attractive opportunity for Swing and it should pursue this new business.

This is not an attractive opportunity for Steady.

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Swing v. Steady Instructor's Note, page 2 (d) Was Steady's decision to cut price financially justified?

Answer:

Steady P CM −1. 50 = 4. 50 = − . 333 =

Yes, the potential loss substantially exceeds this amount. (e) Given the financial information that you have at this point, would Steady be better off to withdraw from this market altogether?

Answer:

Contribution without price cut: $4. 50 2, 000 units = $9, 000 − $20, 000(FC) = −$11, 000

Contribution with price cut: $3. 00 5, 000 units = $15, 000 − $20, 000(FC) = −$5, 000

Conclusion: Steady is better off staying in the market with a lower price, losing $5,000 per month, unless more than $15,000 of its $20,000 per month fixed cost is avoidable by withdrawing. (f) What is the minimum monthly unit sales that Steady would require to make it more profitable as a specialty widget manufacturer than it is currently as a commodity manufacturer?

Answer:

( New FC ) P − VC 5, 000 units + Old CM + ( P − VC ) New CM $3, 000 = − . 50 5, 000 + $6 = −2 , 000

=

The minimum monthly sales to remain as profitable is: 5, 000 − 2, 000 = 3, 000

(g) How much additional profit would Steady earn as a specialty widget, given its minimum case scenario of 3,500 specialty units at a $6.00 price premium?

Answer:

Change in profit: ( −$3, 500 − $3, 000 ) $6 = $3, 000

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HEALTHY SPRING WATER COMPANY DEFINING THE PRICE-VOLUME TRADEOFF FOR A 20% PRICE INCREASE The Healthy Spring Water company sells bottled water for offices and homes.

The price of the water is $20 per 10 gallon bottle and the company currently sells 2000 bottles per day. Following is the company's income and costs on a daily basis.

Sales revenue $40,000 Incremental Variable cost $16,000 Nonincremental Fixed cost $20,000 [Note: you can assume that variable costs are constant so that the average of them is also the variable cost relevant for a change in sales.]

The company is enjoying stable demand with its current pricing, but management is looking for ways to increase profitability. One suggestion is that the company reposition its water as a premium product, justifying a higher price. If successful, the company believes that it could charge 20% more for its water than it does now.

1. What is the maximum sales loss (in % and units) that Healthy Spring could tolerate before a 20% price increase would fail to make a positive contribution to its profitability? (That is, what is the basic break-even sales change?)

2. By how much would Healthy Spring's contribution increase if its sales declined by 15% following the price increase?

3. In order for Healthy Spring to reposition itself as a premium water, management believes that it will have to upgrade the packaging of its product.

The company will deliver the water in glass rather than plastic bottles and the bottles will be "safety sealed" to insure their cleanliness until the covering is removed in the customer's home. These changes will add $1.00 per bottle to the variable cost of sales.

4. To reposition its water as a premium product, Healthy Spring will require an increase in its advertising and promotion budget of $900 daily. What is the maximum sales loss that Healthy Spring could tolerate before a 20% price increase would fail to increase its net profit? (That is, what is the break-even sales change including the incremental fixed cost of the advertising campaign?)

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HEALTHY SPRING WATER COMPANY Instructor's Note 1. What is the maximum sales loss (in % and units) that Healthy Spring could tolerate before a 20% price increase would fail to make a positive contribution to its profitability? (That is, what is the basic break-even sales change?)

− P −20% −$4 = = = −25% CM + P 60% + 20% $12 + $4 −25% 2000 units = −500 units 2. By how much would Healthy Spring's contribution increase if its sales declined by 15% following the price increase?

B    sales −  sales$CM (new)  E  

− 15% − (− 25%)2000units $16= $3,200 3. In order for Healthy Spring to reposition itself as a premium water, management believes that it will have to upgrade the packaging of its product.

The company will deliver the water in glass rather than plastic bottles and the bottles will be "safety sealed" to insure their cleanliness until the covering is removed in the customer's home. These changes will add $1.00 per bottle to the variable cost of sales.

− ( P − C ) − ( 4 − 1) = = −20% CM + ( P − C ) 12 + ( 4 − 1) −20% 2000 units = −400 units 4. To reposition its water as a premium product, Healthy Spring will require an increase in its advertising and promotion budget of $900 daily. What is the maximum sales loss that Healthy Spring could tolerate before a 20% price increase would fail to increase its net profit? (That is, what is the break-even sales change including the incremental fixed cost of the advertising campaign?)

$900 = −340 units $15 unit $900 −20% + = −17% $15 2000 units −400 units +

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Calibrated Manufacturing Calibrated Manufacturing makes an electronic component that is in great demand. The component sells for $20 each. Calibrated's current capacity is 10,000 units per week. For the last few months, however, the company has been receiving new orders at a rate of 14,000 units per week, and now has a substantial backlog. The company expects this order rate to continue, if it maintains its price. Calibrated's current operating data follows: Sales Revenue Variable Costs Fixed Costs Pretax Profit

$200,000 100,000 80,000 20,000

For each incremental addition of 500 units of output weekly, Calibrated would need to purchase new equipment that would add $1500 to weekly fixed costs.

No other fixed costs would become incremental for this price change. Labor costs currently account for half of all variable costs. Additional hires, however, are expected to be more costly than the average of current employees because of their lower productivity. Although new hires are paid (wages + fringe benefits) only 80% of the current average, they can produce only two-thirds as much output per hour. Consequently, labor costs for additional output with new hires is 20% higher than the current average.

Calibrated is debating whether to keep its current price and expand to meet the demand or to raise its price to reduce demand somewhat before deciding whether or not to expand.

1. How much would Calibrated's weekly profits increase if it expanded to meet the entire amount of its current excess demand?

2. Prepare an analysis of a 10% price increase.

• Calculate the break-even sales quantity (percent and units).

• Calculate the new $ contribution margin per unit.

3. Develop a break-even table showing the change in Profit Contribution for changes in sales between –5% and –30%. To do this, you will need to determine first: • What is the baseline "initial sales" from which you are beginning?

• From that baseline, how would you treat the semi-fixed costs?

• Are they additions to cost (positive numbers) or are they savings (negative numbers)?

• What does the column labeled "Change in Profit Contribution" mean here? What is it a change from?

4. If Calibrated believes that orders will fall off by no more than 15% following a 10% price increase, should it go through with the price increase or should it hold the price constant and meet all the excess demand with an increase in production?

5. What risks might be to Calibrated of increasing price to maximize profit?

6. What risks might there be to Calibrated of expanding output rather than reducing demand through a price increase?

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Calibrated Manufacturing Instructor's Note 1. Answer:

$ CM (before) = $20 – $10 per unit New Variable Cost = $5 = ($5  1.2) = $11 $ CM (after expansion) = $20 – 11 = $9.00 per unit Increase in Total Contribution Margin ( 9 4000 ) $36, 000 ( 8 1500 ) −12, 000 Less Increase in Fixed Costs Net Profit Contribution from Expansion $24, 000

2. Answer:

% CM =

9 = . 45 or 45% 20

Basic $BE =

−10 −.10 = = −.1818 or − 18. 2% 45 + 10 55

Unit BE = −.1818 14, 000 = −2548 units

Notice that we have used a base line of 14,000 units since this represents the demand at the current price. We also must consider that a reduction in sales of this size enables the company to avoid five increases in semi-fixed costs (at $1,500 each) because 2500 fewer units of capacity would be required. To calculate the change in sales required to cover the incremental fixed costs, we need to calculate the new dollar contribution margin per unit. It is $11: the new price, $22, minus the relevant variable cost, $11. The resulting break-even which considers the semi-fixed costs would be: Unit BE = −2548 +

−5 $1, 500 = −3230 units 11

This indicates that we can avoid still another 500 units of semi-fixed cost, so the final equation would be: Unit BE = −254 B +

−6 $1, 500 = −3366 units 11

3. Answer: There are several key points for the students to discover and for the instructor to highlight when discussing the break-even table on the next page.

One must be careful to separate conceptually the effects of the price change from effects of current excess demand. To do so, the analysis begins at base line sales level of 14,000 units, the amount of sales that could be made if price was not changed. A price increase would reduce demand from that level. Consequently, the "change in sales" is negative.

The fact that the resulting demand is still greater than current sales is relevant, but must be kept a conceptually separate issue. Similarly, the change in semi-fixed costs is negative since a price increase would enable Calibrated to avoid incurring some semifixed costs that it would have to incur if it expanded to meet the demand for 14,000 units.

The change in contribution margin is calculated by using the following formula: $ CM = ( Actual Unit Change − BEP Unit Change)  New $ Contribution Unit

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The 0% calculation would be: ( 0 − ( −2548 )  11 = $28, 028

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Calibrated Manufacturing Instructor's Note Analysis of a 10% price increase when facing excess demand Change in Change in Change in Change in Sales Contribution – Semi-fixed = Profit (Percent) (Units) Margin Costs Contribution –0% 0 28,028 0 $28,028 –5% –700 20,328 –1,500 $21,828 –10% –1,400 12,628 –3,000 $15,628 –15% –2,100 4,928 –6,000 $10,928 –18.2% –2,548 0 –7,500 $7,500 –20% –2,800 –2,772 –7,500 $4,728 –25% –3,500 –10,472 –10,500 $28 –30% –4,200 –18,172 –12,000 –$6,172

4. Answer: Calibrated should raise its price. Note that the "change in profit" shown on the break-even table is not the amount that this firm would earn above what it is earning now. It is the amount that this firm would earn in excess of the $24,000 that it could earn if it did not raise its price but increased capacity to satisfy completely the excess demand. Remember, we began the conceptual analysis of the price change from the 14,000 unit level of current demand. Consequently, if Calibrated increased its price by 10% resulting in a 15% decline in demand for its product to 11,900 (=14,000 – 2,100), it could expand to meet that demand and earn $10,928 more than it would earn if it did not increase price but simply expanded to meet all the demand. Calibrated's total increase in earning above what it is earning now (before having either expanded or raised price) would be $34,928 ($24,000 + $10,928).

5. Answer: Calibrated might do better not to maximize its current profit. A price increase could attract new competitors. Alternatively, it could enable current competitors to gain larger volumes that would enable them to gain cost advantages (due to economies of scale or experience) over Calibrated in the long run.

6. Answer: Calibrated's expenditures on semi-fixed costs could become sunk. If demand weakened, Calibrated still would have to bear the cost of maintaining that excess capacity. *

This graphical illustration was prepared by Gerald E. Smith of Carroll School of Management, Boston College, Chestnut Hill, MA 02467, using publicly available sources. Copyright© 2001, Gerald E. Smith.

©2011 Pearson Education, Inc. publishing as Prentice Hall

A GRAPHIC IL LUSTRA TION OF CA L IBRA TED MA NUFA CTURING QUESTION # 1 : I t is v e r y pr of it a ble t o i nc r e ase c ap a ci t y t o 1 4 ,0 0 0 un i t s.

I w ill r e ali ze a g ain i n co nt r ibu t i o n o f $ 9 6 ,0 0 0; wh i ch n et s o u t t o a ga in in p ro f i t o f $6 8 , 00 0 a f t e r su bt r act in g o ut in c rem e n t al FC.

$ 40

In it ial Co nt r ib ut ion

In c rem e nt al Co n t r ib u t io n $ 2 4 x4, 0 0 0 = $ 9 6 ,0 0 0

In c r Con t r ibu t i o n L ess I nc r FC Ne t Incr Pr o f i t

$ 9 6 ,0 0 0 $ 2 8 ,0 0 0 $ 6 8 ,0 0 0

$ 16

Var i abl e Co st s

10 ,0 0 0 Uni t s

1 4 ,0 0 0 Un i t s

QUESTION # 2 : B ut , i f I r ai se pr ice 1 5 % I ca n ab so r b a r ed u ct i o n in sal es v olu m e of 2 0 %, an d st i ll ac hi eve t he sam e p r of it ab ili t y I w ou ld h a ve a t 1 4 , 0 0 0 u nit s , w hich is $ 6 8 ,0 0 0 f ro m #1 a bo v e. T hu s, t h e p r ic e e f fe c t ( a g ai n ) e xa ct ly o f f se t s t he v o lu m e ef f ec t ( a loss) . Bu t , I r ece iv e a bo n us as w ell , sin c e I no lo ng e r h ave t o i nv est in 2 m ach in e s ( @$ 7 ,0 0 0 eac h ) . Th i s inc re m e nt a l f i xe d co st ef f ect is wo rt h $ 1 4 , 0 0 0 i n sa vi ng s . T hus, I make m y o ri g in al $ 6 8 ,0 0 0 g ain , p l us an add it ion a l sa v in g s of $1 4 ,0 0 0 .

$ 40

Gai n d u e t o Pr i ce Ef f ec t

Loss d ue to Vo lum e Ef f e ct

In it ial Co nt r ib ut ion

$ 16

Var i abl e Co st s

1 0 ,0 0 0 Uni t s

1 4 ,0 0 0 Un i t s

11 ,2 0 0 Uni t s *

This graphical illustration was prepared by Gerald E. Smith of Carroll School of Management, Boston College, Chestnut Hill, MA 02467, using publicly available sources. Copyright© 2001, Gerald E. Smith.

©2011 Pearson Education, Inc. publishing as Prentice Hall