Question

Assume the current ad spending for company Y is $4,000,000 with a sales of $34,000,000. Company X plans to spend additional $1,000,000 on advertising. It is estimated that the elasticity of ad is .25 for the initial sales increase. Furthermore, from historical data, it is learned that the carry-over effect of such ad is about 30% and the product profit contribution ratio is 35%.

Does it make sense to spend the additional $1,000,000 ? Why or why not? (5 points)

Since 30% carry-over effect is just an estimate and is subject to error. The management wants to do a sensitivity analysis. What should the minimum carry-over effect be to justify (break-even) the $1,000,000 additional spending? (5 points)

Answer 1

Answer:-

1) Yes it makes sense to put $1,000,000 more on advertising as it contributes to 35% of the product profit The primary use for advertising elasticity of demand is making sure advertising expenses are justified by their returns. A price comparison of AED and price elasticity of demand (PED) can be used to calculate whether more advertising would maximize profit. PED applied alongside AED can help determine what impact pricing changes may have on demand. For maximum profit, a company's advertising-to-sales ratio should be equal to minus the ratio of the advertising and price elasticities of demand, or A/PQ = -(Ea/Ep). If a company finds that their AED is high, or if their PED is low, they should advertise heavily.

2) Total Sales- $34,000,000

Suppose Company cuts its current ad spending from $4,000,000 to $3,000,000 to increase the sales

Units Sold= ($34,000,000 +0) /($3,000,000-$1,000,000)

Units Sold= $34,000,000/$2,000,000

Carry over effect for break even minimum should be 17%

Which would lead to $51,000,000 of total sales.