MKT558:PRICING STRATEGIES

ProfessorBaojunJiang

CostandProfitabilityAnalysis
Relevantcosts(avoidableandincremental)
Incrementalbreakevenanalysis

DEATH SPIRAL
Discussion:
TheCEO/GeneralManagerofamanufacturerdecided
thattomakeproductlinemanagersmoreaccountable,atthe
endofeach6monthperiod,productsthatdonotcovertheir
averagecostswillnolongerbeallowedforproduction.
Every6months,afewproductsappearedonthekill
listandwereorderedtoceaseproduction.Moreandmore
unprofitableproductshavesurfacedastimegoesby. Whatis
happening?

RELEVANT COSTS
Relevantcosts costsincurredbecauseaproductis
sold,ornotincurredbecauseitisnotsold. Theyinclude
Incremental costs: costsincurredassociatedwithchangesin
pricingandsales(nottotalorfullcost)
o
o

allvariablecosts
somefixedcosts

incrementalfixedcosts(e.g.,adstoinformconsumersofpricechange)
semifixedcosts: fixedoverarangeofsalesbutvaryoutsidetherange
(machine)

Avoidable costs: costsnotyetincurredorcanbereversed(not

sunkcost)
o
o

futurecostsareusuallyavoidable,pastcostsareusuallysunk
futurereplacementcost,nothistoricalreplacementcost
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EXAMPLE 1
ArockbandperformsontwoSaturdayevenings
everymonth.Theycurrentlyprepareanewsetof
songsforeachperformance(show).
o

Overallcostpershow:
Fixedoverheadcost
Rehearsalcosts
Costpershow(performance)
Variablecost(perticket)
Ticketprice:

o
o

$1,500
$4,500
$2,000
$1
$10

Capacity:1,100spectators
Currently,only900ticketsaresold.

PROPOSALS
Profitmarginisverythin.Butthemanagerdoesnot
believeincreasingthepricecansolvetheproblem.
Shehas3proposals.Whichgivesthehighestprofit?
A.

B.

C.

Sell200ticketsatdiscountedpriceof$4toagroupof
studentswhowouldotherwisenotattendtheshowat
regularprice.
Organizeanadditionalshow(ofthesameSaturday
performance)onSundayat$6toallspectators.The
managerexpectstosell700ticketsbut150ofthose
ticketscorrespondtospectatorswhootherwisewould
attendonSaturday.
OrganizeanewseriesofshowsonalternativeSaturdays
at$10perticket.Themanagerexpectstosell800
tickets.100ofthoseticketscorrespondtospectators
whootherwisewouldattendtheregularshow.
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To evaluate profitability, we discount only the

incremental costs to revenues ...
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

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CONTRIBUTION MARGIN
Per Unit
Price
Incremental variable cost
Contribution margin

Total
Sales revenue
Total variable costs
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 BREAKEVEN ANALYSIS

Incrementalbreakevenanalysisvs.breakevenanalysis
Howmuchwouldthesaleshavetoincrease(ordecrease)to
retainthesameprofitfromapricedecrease(orincrease)?
Ittakesintoaccountrelevantcosts
o Itfocusesontheincrementalprofitabilityofpricechanges
regardlessofthecurrentprofitlevel
o

INCREMENTAL BREAKEVEN FORMULA

Derivethis.
S

(TFC 2 TFC1) [( P1 P 2) (VC1 VC 2)] * S1

P 2 VC 2

EXAMPLE 2:WESTSIDE PILLOWS

Westsideproducespillows(monthlyinformationbelow)
Sales
Wholesaleprice
o Variablecosts
o Fixedcosts
IncrementalBreakeven
o
o

4000units
$10.00perunit
$5.50perunit
$15,000

1) Westsideisconsideringa5%pricecutwithoutadditionalfixedcost.Byhowmany%wouldsales
needtoincreasetobreakevenprofitforthe5%pricecut?

2)Replacinggoosefeatherswithsyntheticfillerwilldecreasetheunitvariablecostby$0.22.Byhow
many%wouldsaleshavetoincreasetoassurethe5%pricecut?

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3)Assume,forthispart,thecurrentproductioncapacityis4,000.Toincreaseitby1,000,the
companyhastoinstallanotherworkstationatamonthly costof$800.Assumenochangein
variablecostsforparts3),4)and5).Byhowmuchwouldsaleshavetoincreasetojustifya5%
pricecut?

Incrementalbreakevensalescurve
4)Repeattheincrementalbreakevenexercisefora15%pricedecrease,a15%increase,etc.
Youwillfindmanycombinationsofsalesandpricesthatbreakeventhecurrentprofit.Link
thesepoints,youwillobtainanincrementalbreakevensalescurvewithpriceonthevertical
lineandunitsalesonthehorizontalline.
price

Unit Sales

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Actualsalesresponseandmeasuringimpactoncurrentprofit
5)Thecompanydecidestogowitha5%pricecut.Marketingresearchshowsthatactualsales
willincreaseby25%.Evaluatethefinancialimpactofa5%pricecutonthefirmscurrent
profit.

price

Unit Sales

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DO WE IGNORE FIXED AND SUNK COSTS?

NO!
o Theyareimportant,ignoringthemwillcausebankruptcy
o Buttheydonotaffectoptimalpricingdecision
o Optimalpricinggivesmaximizedprofittocoverthose
costs
o Everycostisincrementalandavoidableinthelongterm
orintheplanningstage

Inclassgameandexercise.

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TAKEAWAY FROM THIS LECTURE

Whenevaluatingtheprofitabilityofapricechange,consideronly
relevantcosts(avoidable andincremental costs,notaveragecost).
Incrementalbreakevensalescurve
o Ittakesintoaccountthechangesofrelevantcosts.
o Itpresentssuccinctlythedividinglinethatseparatesprofitableprice
decisionsfromunprofitableones.
o Thecomparisonwithdemandcurveshowstheprofitabilityofprice
change.
Thepricingtheoryembeddedintheexamplesappliestoallsizeandtypeof
businessthatcannotofferacustomizedpriceforeachcustomer. Wewill
studysegmentationandpricecustomizationlaterinthiscourse.

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NEXT SESSION
EVC,WTP,andValuebasedPricing

Economicvaluetothecustomer
Factorsinfluencingactualwillingnesstopay
ValuebasedpricingandEVCanalysis

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