Presentation on theme: "Profit’s Sensitivity to Price"— Presentation transcript:
1 Profit’s Sensitivity to Price Chapter 2Profit’s Sensitivity to PriceConducting a Profit Sensitivity Analysis to Identify volume Hurdles and the Challenges Inherent in Economic Price Optimization
2 AgendaHow do price changes influence the ability to capture customers?How sensitive are profits to price changes when we include the influence of price changes to sales volumes?When considering a price cut, what is the necessary increase in sale volumes to improve the firm’s profits?When considering a price increase, what is the allowable decrease in sale volumes that will leave the firm more profitable?How does elasticity of demand enable executives to optimize prices?2
3 Profit Sensitivity Analysis If we know that the best price lies within a range, what is the effect of a small change in price?Profit Equationp = Q (P – V) – Fp – ProfitQ – Quantity Sold (Volume)P – PriceV – Variable CostsF – Fixed Costs
4 Profit Sensitivity Analysis Price Sensitivity Analysis analyzes the sensitivity of profits to price changesVolume Hurdles are identified through the profit sensitivity analysis. They define the required changes in volume to justify a price change.
5 Volume Hurdle pf > pi pi = Qi(Pi-V)-F pf = Qf(Pf-V)-F Consider a Price ChangeHow would volume need to change in order to improve profitability?Call this the Volume HurdleLet the initial price and quantity be denoted by the subscript i, and the final price and quantity be denoted by the subscript fpi = Qi(Pi-V)-Fpf = Qf(Pf-V)-FCondition: any price change must improve profitabilitypf > piUse algebra to rearrange the equations and simplify to identify the volume hurdle.
6 Volume HurdleThe change in volume must be greater than this ratio for the price change to yield higher profits– %DP%DQ ≥%CMi + %DPWhereQf – Qi%DQ ≡Percent Change in VolumeQiPf – Pi%DP ≡Percent Change in PricePiPi – Vi%CMi ≡Initial Contribution Margin as a percentage of the original pricePi
7 ExampleA retailer is selling T-shirt for $40 to his customers which he purchase from the wholesaler at a price of $30. Normally the demand is 50 units per month. If the retailer plans to increase the price by $50 per unit, how much should be the allowable volume drop?Ans: -50%
8 Fixed Costs Don’t Matter, Variable Costs Do. Notice Fixed Costs have no effect on a marginal price change decisionYour overhead is your problem, not the customers. From a value perspective, customers never care about your cost structure. Only you do. They only care about value – how much value do they get for how high a price.Fixed costs are key in the decision to enter or stay in the industry. Once in the industry, they make no difference to marginal profitability decisions.Fixed costs more of an investment or strategy issue than a pricing issue.– %DP%DQ ≥%CMi + %DP
9 Volume Hurdle for a Price Cut Price cut, where %DP is negative, requires a positive increase in volume to improve profitabilityThe amount of the required volume increase is dependent on the size of the size of the contribution margin.Large CM implies a small DQ is required.Small CM implies a larger DQ is requiredStrong implications with respect to tactical price cutsDiscountsShort term salesCreates a volume hurdle for the tactical price cut to make sense to the firm– %DP%DQ ≥%CMi + %DP
10 Volume Hurdle for a Price Hike Price Rise, where %DP is positive, will allow for a reduction in volume, up to a point.The amount of forfeited volume is dependent on the contribution margin.Small CM can handle a large DQ decreaseLarge CM needs a smaller DQ decrease– %DP%DQ ≥%CMi + %DP
11 Profit Sensitivity towards Price Cuts Retailer50% Contribution Margin15% Price Cut43% Volume Growth Required to Break Even on the DecisionManufacturer25% Contribution Margin5% Price Cut25% Volume Growth Required to Break Even on the DecisionBroker1% Contribution Margin0.1% Price Cut (10 bp)11.1% Volume Growth Required to Break Even on the Decision
12 Profit Sensitivity towards Price Increases Retailer50% Contribution Margin15% Price Rise23% Volume Loss or Less Decrease Would Leave the Firm More ProfitableManufacturer25% Contribution Margin5% Price Rise14% Volume Loss or Less Decrease Would Leave the Firm More ProfitableBroker1% Contribution Margin0.1% Price Rise (10 bp)9.1% Volume Loss or Less Decrease Would Leave the Firm More Profitable
13 Price Increases and Decreases have Non-Symmetrical Effects on Profit Price Cuts require Larger Changes in Volume than Price Rises to leave the firm equally well off.50% Contribution Margin15% Price Rise23% Volume Loss or Less Decrease Would Leave the Firm More Profitable50% Contribution Margin15% Price Cut43% Volume Growth Required to Break Even on the Decision
14 Price Elasticity of Demand Price elasticity of demand measures the responsiveness of the quantity demanded for a product or service to a change in the price of the product or serviceEd = price elasticity of demandΔQ = quantity change in demandΔP = quantity change in demandQ1, P1 = original quantity demanded and price, respectively
18 Other elasticities in Pricing Income elasticity of demandCross price elasticity of demand
19 Income Elasticity of Demand Income elasticity of demand: responsiveness of the quantity demanded of a product or service to a change in personal incomeIf EI is negative, the product is an inferior good Income goes up fewer units are demanded (switch to steak, less hamburger)If EI is positive, the product is a normal good Demand increases as income increasesIf 0<EI<1, the product becomes less important in households’ consumption planIf EI >1, the product becomes more important as income increases.
20 Cross-Price Elasticity of Demand Cross price elasticity of demand: responsiveness of demand for a product to a change in the price of another productIf EC is negative, the two products are complementaryIf EC is positive, the two products are substitutes
21 Price OptimizationThe above analysis implies that optimal pricing can be found, one where in increase or decrease in price leads to less profit than otherwise would be found.Assuming a constant elasticity of demand over a wide range of price, through integral calculus we find the Optimal Price for elastic markets at:At the optimal price, the quantity sold isWhere Qi and Pi the current demand and price
22 Optimal Price Measure Under the conditions, find Optimal Price P* Variable CostV$5Fixed CostF$750,000Elasticity of Demande-1.8Demand at $1Qo10,000,000Under the conditions, findOptimal PriceP*$11.25
23 Key Challenge of Price Optimization What is the relevant Elasticity of Demand? Always a “historic” number, not forward looking number.Dependent upon the economic conditions, competing alternatives, tastes of the market, and other market factors, all of which are constantly changing.Can be influenced by the firm’s actions: Branding enables higher prices, discounting can reset price expectations lower lowering the potential price captureNon-measurable for revolutionary productsSmall versus large price changes may exhibit different a elasticityUpward versus downward price changes may exhibit different a elasticity
24 SummaryA Profit Sensitivity Analysis should be used to identify Volume Hurdles for tactical pricing actions (Discounts, Price Promotions, Specific Sales Opportunities)Profit is asymmetrically sensitive to price cuts vs. price hikesInelastic markets favor price increasesElastic Markets favor price decreasesGiven the elasticity of demand, one could identify “optimal prices”24