Question

10. Mr. Jim Stewart was examining a pricing decision on two of his company's household products. The regular size RS2 product sold to retailers at a price of $36 per 24-can case and was retailed at a price of $1.99 per can while the wholesale and retail price of the large-size RS2 was $46 and $3.99. Mr. Stewart's largest competitor sold Easi, a one-sized product similar to RS2 but of slightly lower quality and brand appeal. packaged in a can as big as RS2 Large at the same prices of RS2 Regular. Mr. Stewart's salespeople had been pressuring him to lower the price of RS2 Large to the level of RS2 Regular to compete with lower priced Easi. He gathered the following data to help him decide what to do. a) Raw material costs per case were $9.60 for the regular RS2 and $14.80 for the large size. Variable manufacturing costs per case were $5.05 for RS2 Regular and $6.85 for RS2 Large. There was talk that raw materials might increase by eight per cent next year, but Mr. Stewart thought that there was only a 50-50 chance that this would occur. b) Manufacturing fixed costs were $600,000, delivery fixed costs $75,000, selling fixed costs $350,000, advertising fixed costs $489,000, general and administrative overhead $300,000, depreciation $60,000. These costs were expected to rise on average five per cent next year and would not change with a package size change. c) Last year RS2 Regular sold 75,000 cases and RS2 Large 42,000 cases. RS2 total market share of its category last year was 42 per cent. Easi had 28 per cent share. The category was expected to grow 2.8 per cent in total next year. d) Variable marketing costs per case were $2 delivery and $2.40 selling. These costs were expected to rise nine per cent next year. Mr. Stewart's sales manager argued that total RS2 sales would increase, maybe as much as 40 per cent over last year, if the new price was implemented. He argued that the RS2 Regular size would still be stocked by convenience stores and smaller grocery outlets instead of the larger size and that the current price could be maintained with no more than a one-third drop in volume of RS2 Regular. Mr. Stewart thought the Regular drop would be more likely one-half of last year's volume and that Large would only double over last year. f) There was a rumor in the trade that Easi, expecting a raw materials cost increase of eight per cent and no major moves by RS2, would be increasing its price by nine per cent next year. Other concerns such as product image with the customer, plant capacity, and retailer reaction were being looked at concurrently by his analysts, but in the meantime, Mr. Stewart thought he would begin his analysis of the pricing proposal by pushing some of the numbers around that he already had. What advice would you give him?

Answer 1

The table below contains the profit estimates for current year, next year profit calculation with revised pricing for RS2 large & next year profit calculation with current pricing.

Current Year:

When the RS2 regular is limited to convenience stores & small grocery outlets, Mr.Stewart estimates that the sales would halve. Hence, it is assumed 50% of RS2 regular sales would be to retail customers & 50% of sales would be through wholesale customers. Hence, the pricing per can for regular is assumed to be average of $1.5 & $1.99 i.e. $1.745. It is assumed that majority of sales for RS2 Large would be from larger outlets & hence price per can is assumed to be wholesale price i.e. $1.92 per can. Variable & Fixed Costs are taken as per the given details. Fixed costs are allocated based on sales volume against regular & large.

Next Year with Revised Pricing:

As the RS2 regular is sold only to convenience stores & small grocery outlets, the price would be retail price. I assumed that price increase for this would be 8% to adjust for the estimated increase in raw material cost. RS2 Large is estimated to be priced the same as Easi i.e. 9% growth on last year wholesale price. In line with Mr.Stewart's estimates, volume for regular is assumed to halve & large is assumed to be doubled. Fixed & Variable costs are taken as per the estimated inflation provided in the details. Fixed costs are allocated based on sales volume against regular & large.

Next Year with Revised Pricing:

It is assumed that the price would grow by 8% from current year pricing to adjust for estimated inflation in raw material cost & the volume for both regular & large is expected to grow at the market growth rate of 2.8%. Fixed & Variable costs are taken as per the estimated inflation as provided in the details. Fixed costs are allocated based on sales volume against regular & large.

	Current Year			Next Year - Revised Pricing			Next Year - Current Pricing
	Regular	Large		Regular	Large		Regular	Large
Projected Can Sales	1,800,000	1,008,000		900,000	2,016,000		1,850,400	1,036,224
Price per Can	1.745	1.92		2.1492	1.635		1.8846	2.07
Revenue	3,141,000	1,932,000		1,934,280	3,296,160		3,487,264	2,144,984
Raw Material Costs/can	0.40	0.62		0.42	0.64		0.42	0.64
Variable Manufacturing Cost/can	0.21	0.29		0.21	0.29		0.21	0.29
Variable Marketing - distribution Cost/can	0.08	0.08		0.09	0.09		0.09	0.09
Variable Marketing - selling Cost/can	0.10	0.10		0.11	0.11		0.11	0.11
Total Variable Cost/Can	0.79	1.08		0.83	1.12		0.83	1.12
Variable Costs	1,428,750	1,090,740		743,625	2,263,867		1,528,893	1,163,628
Gross Margin	1,712,250	841,260		1,190,655	1,032,293		1,958,371	981,356
Fixed Man Costs	384,615	215,385		194,444	435,556		403,846	226,154
Delivery Fixed Costs	48,077	26,923		24,306	54,444		50,481	28,269
Selling Fixed Costs	224,359	125,641		113,426	254,074		235,577	131,923
Advertising	313,462	175,538		158,472	354,978		329,135	184,315
General & Adm	192,308	107,692		97,222	217,778		201,923	113,077
Dep & Amort	38,462	21,538		19,444	43,556		40,385	22,615
Total Fixed Costs	1,201,282	672,718		607,315	1,360,385		1,261,346	706,354
Profits	510,968	168,542		583,340	(328,092)		697,025	275,002
Total Profits		679,510			255,248			972,027

Recommendation:

As it can be seen from the above calculations,increased volume with reduction in prices for RS2 Large doesn't sufficiently compensate margin reductions & drop in volumes for RS2 regular. Hence, it would be better for the company to keep the pricing similar to last year with 8% price growth to adjust for expected raw material price increase.