Question

1. Earl Massey, director of marketing, wants to reduce the selling price of his company's products by 15% to increase market share. He says, “I know this will reduce our gross profit rate, but the increased number of units sold will make up for the lost margin.” Before this action is taken, what other factors does the company need to consider?

Answer 1

First of all you will need to take into account the demand elasticity of your product. This will help you determine the increase in demand that will occur as a result of price reduction of your product. In other words the first factor to be considered will be the price elasticity of demand for your product. If elasticity is high then the demand for your products (and hence sales) will increase substantially as a result of price reduction.

Secondly the cost structure should be looked at in terms of fixed costs and variable costs. If prices are reduced and demand is increased then the company will have to increase in productions and hence the quantum of increase in fixed costs and variable costs should be determined. The measure of degree of operating leverage will be useful here.

Thirdly the market control of the company’s products should be considered. If the product of the company has a reasonable market control then reduction in price will translate into good increase in sales volume and this increase in volume will help the company offset the impact of decline in prices. However if its products do not have a reasonable market control then even after a price reduction it will struggle to substantially propel the sales volume of its products.