Marketing feels that demand will be elastic, with sales sensitive to the product
ID: 342598 • Letter: M
Question
Marketing feels that demand will be elastic, with sales sensitive to the product price. As such, Christina received the following information from marketing: Yearly Sales:1500,1250, 1000 Price: $120, $160, $200 Information on Costs Based on the product design and details that Christina was given, she estimated that the company will have to increase its fixed costs by $146,000 to be able to produce up to 1300 units per year. To produce more than 1300 units, additional equipment and resources will be required, increasing the fixed costs to $180,000 per year. Christina’s initial analysis of the product came to the conclusion that the product will take $180 to produce. Based on this, it would appear that the only option available for the company would be to maximize the price to ensure that the price per unit is higher than the unit variable price. Given the Fixed Cost required for the product of $146,000, at $180 to produce each unit, and a $200 sale price, the break even point for this venture currently lies at 7300 units. Christina studies the problem further and establishes that based on the characteristics of the product, the production methods used, the quantities involved, a learning rate of 83% could be realized utilizing a batch size of 100 units. Analysis This case provides a study in tradeoffs that pit sales, product pricing, fixed and variable costs, and even learning rates against each other. Complete a Break Even (BE) analysis that compares the relationship between production levels and returns, and allows for scenarios to be run in which we can alter: • Yearly production size • Price elasticity • Fixed Costs The BE analysis should help Christina determine if the company will make a profit at the various production/sales targets as provided in the table above. 1) Build the model that spans the possible production rates for the following year. 2) Christina needs to determine whether or not, and under what conditions, the product will generate a profit. 3) Determine which combination of production/pricing will maximize profits. 4) Should WidgetsCo pursue this venture? 5) If Christina’s estimated learning rate was incorrect and the company realized a learning rate of 80%, how much more profit could the company make if they produced 1000 units next year?
Explanation / Answer
First of all let us analyse the relationship between number of pieces sold and selling price Yearly Sales Sales Price As we can see for every increase of 250 pieces Sales Price is increased 1500 120 by 40 $ and there is a linear relationship . So for every increase of 50 pieces 1250 160 sales price is increased by 8 $ . So we can replot the plot as follows : 1000 200 Yearly Sales Sales Price Variable Cost 1500 120 180 1450 128 180 1400 136 180 1350 144 180 1300 152 180 1250 160 180 1200 168 180 1150 176 180 1100 184 180 1050 192 180 1000 200 180 Here in this question learning curve at 83% is talked about in every batch of 100 units but it is not clear when it commences and when it ends . For simplicity let us assume it starts at 1000 pieces where in for every increase in 100 pieces there is a decrease in variable cost by 100-83 = 17%. Yearly Sales Sales Price Variable Cost 1500 120 70.90 85.42*83/100 1400 136 85.42 102.92*83/100 1300 152 102.92 124*83/100 1200 168 124.00 149.4*83/100 1100 184 149.40 180*83/100 1000 200 180.00 Now let us plot fixed costs here and see how the profit , loss & break even works out . Yearly Sales Sales Price Variable Cost Fixed Cost Profit/-loss Break Even (units) A B C D E=A*B-C*A-D F=D/(B-C) 1500 120 70.90 180000 -106354.0974 3666.19 1400 136 85.42 180000 -109194.9689 3559.07 1300 152 102.92 146000 -82198.158 2974.84 1200 168 124.00 146000 -93202.4 3318.33 1100 184 149.40 146000 -107940 4219.65 1000 200 180.00 146000 -126000 7300.00 As we can see from the table above break even point for the company is lowest for the sale of 1300 units and company can start generating profits from 2974.84/(1300/12) = 27.46 = 28th month after commensing business . This is a good business proposition. Now if we assume learning rate is 80% then the whole business scenario will work out as follows : Yearly Sales Sales Price Variable Cost 1500 120 58.98 73.73*80/100 1400 136 73.73 92.16*80/100 1300 152 92.16 115.20*80/100 1200 168 115.20 144*80/100 1100 184 144.00 180*80/100 1000 200 180.00 Now let us plot fixed costs here and see how the profit , loss & break even works out . Yearly Sales Sales Price Variable Cost Fixed Cost Profit/-loss Break Even (units) A B C D E=A*B-C*A-D F=D/(B-C) 1500 120 58.98 180000 -88473.6 2949.97 1400 136 73.73 180000 -92819.2 2890.54 1300 152 92.16 146000 -68208 2439.84 1200 168 115.20 146000 -82640 2765.15 1100 184 144.00 146000 -102000 3650.00 1000 200 180.00 146000 -126000 7300.00 As we can see from the table above break even point for the company is lowest for the sale of 1300 units and company can start generating profits from 2439.84/(1300/12) = 22.52 = 23rd month after commensing business . This is a good business proposition.