Chapter 2

Profit’s Sensitivity to Price

Conducting a Profit Sensitivity Analysis to Identify volume Hurdles

and the Challenges Inherent in Economic Price Optimization
 Agenda
• Introduction.

• How 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?

• What are the limitations to using elasticity metrics alone for guiding price setting decisions?

• Stretch Question: How is elasticity of demand related to exchange value models for different customers?
 Chapter 2

Repaso / Introducciòn.
1.1) La demanda como función del precio.
Demanda, cantidad de un producto que, por unidad de tiempo, los

compradores potenciales están dispuestos a adquirir a un precio determinado.

Oferta, cantidad de un producto, que por unidad de tiempo, los fabricantes

están dispuestos a vender a un precio determinado.

D- LEYES DE LA DEMANDA Y OFERTA
De acuerdo al número de unidades producidas y
al precio promedio que se cobra, y de acuerdo a
las alternativas de producción y de consumo, se
presentan las curvas de Demanda y Oferta

OFERTA

PRECIO

DEMANDA

CANTIDAD
• Elasticidad-ingreso dQx
Qx dQx Y
Determina la existencia de bienes  Yx  
dY dY Q x
inferiores y superiores
Y

• Elasticidad cruzada dQ x
Qx dQ x Py
Determina las relaciones de  Cx ,y  
dPy dPy Q x
sustituibilidad o complementariedad
Py
 Ingreso total, medio y marginal
IT  P  Q
• Ingreso total es el gasto total de los compradores:

• Ingreso medio es el gasto total dividido

IT por las unidades vendidas:
IMe  P 
Q

• Ingreso marginal es el incremento en el ingreso total ante un

cambio en las unidades vendidas:
IT
IMg 
Q
LA FORMULACIÓN DEL MARGEN DE CONTRIBUCION SOBRE EL PRECIO

• A nivel de cada producto:

𝐌𝐚𝐫𝐠𝐞𝐧 𝐝𝐞 𝐜𝐨𝐧𝐭𝐫𝐢𝐛𝐮𝐜𝐢𝐨𝐧 𝐮𝐧𝐢𝐭𝐚𝐫𝐢𝐨 (𝐌𝐂)

Mc % = 𝐱 𝟏𝟎𝟎%
𝐏𝐫𝐞𝐜𝐢𝐨 𝐝𝐞 𝐯𝐞𝐧𝐭𝐚 (𝐩𝐯)

• Esta fórmula también se puede expresar como sigue:

𝑷𝒓𝒆𝒄𝒊𝒐 𝒅𝒆 𝒗𝒆𝒏𝒕𝒂 𝒑𝒗 −𝑪𝒐𝒔𝒕𝒆 𝒗𝒂𝒓𝒊𝒂𝒃𝒍𝒆 𝒖𝒏𝒊𝒕𝒂𝒓𝒊𝒐 𝒄𝒗

Mc % = 𝐱 𝟏𝟎𝟎
𝐏𝐫𝐞𝐜𝐢𝐨 𝐝𝐞 𝐯𝐞𝐧𝐭𝐚 (𝐩𝐯)

• A nivel global de la empresa:

𝐌𝐚𝐫𝐠𝐞𝐧 𝐝𝐞 𝐜𝐨𝐧𝐭𝐫𝐢𝐛𝐮𝐜𝐢𝐨𝐧 𝐭𝐨𝐭𝐚𝐥 (𝐌𝐂)

MC% = 𝐱 𝟏𝟎𝟎
𝐢𝐧𝐠𝐫𝐞𝐬𝐨𝐬 𝐭𝐨𝐭𝐚𝐥𝐞𝐬 𝐩𝐨𝐫 𝐯𝐞𝐧𝐭𝐚𝐬 (𝐈𝐕)
 Chapter 2

Análisis del umbral de rentabilidad de las ventas.

Volume Hurdle
 Preguntas claves:
• ¿Cuánto tendrá que aumentar el volumen de ventas para incrementar el
beneficio a partir de una reducción de precio?

• ¿Cuánto puede caer el volumen de ventas para que el aumento de precios

deje de ser rentable?
 Base o estándar de comparación
• Comparar efectos de un cambio de precio con el nivel de rentabilidad de
un producto o con rentabilidad presupuestada.
 Análisis del umbral de rentabilidad de las ventas
• Empresa XYZ
Ventas: 20,000 unidades
PVP: S/. 47.20 (inc. IGV)
Precio: S/.40.00 (sin IGV)
Costo variable: S/.22.00
Costo fijo: S/.300,000

¿Qué ocurre si el precio baja 8%?

 Análisis del umbral de rentabilidad de las ventas

Contribución perdida
a causa del precio
P1 = S/.40 P1 = S/.40 (c)
Contribución P2 = S/.36.80
Contribución Contribución
no afectada obtenido por
(a) volumen
(a)
(d) (e)
CV = S/.22 CV = S/.22
Costos
Costo variable Costo variable variables
(b) (b) adicionales
(f)
20,000 und 20,000 und ¿? und
Contribución ANTES del Contribución DESPUÉS del
cambio de precio cambio de precio
 UVA = Umbral de ventas adicionales
− ∆ 𝑑𝑒 𝑝𝑟𝑒𝑐𝑖𝑜𝑠 𝑆/.
% UVA =
𝑚𝑐𝑖 𝑆/.+ ∆ 𝑑𝑒 𝑝𝑟𝑒𝑐𝑖𝑜𝑠 𝑆/.

− (𝑆/.36.80 −𝑆/.40)
% UVA =
(𝑆/.40 −𝑆/.22)+(𝑆/.36.80 −𝑆/.40) .
− (−𝑆/.3.20)
%𝑈𝑉𝐴 = = 0.2162 = 21.62%
𝑆/.18 +(−𝑆/. 3.20)

Rpta.: La reducción de precios (-8%) es rentable sólo si genera un incremento de

ventas superior al 21.62%
 Análisis del umbral de rentabilidad de las ventas
• UVA = 21.62%
• Si la empresa XYZ aumenta en 21.62% su volumen de ventas respecto al
nivel actual, la disminución de precios es rentable.
• Actualmente vende 20,000 unidades.
• Deberá incrementar volumen de ventas en 4,324 unidades para mantener
rentabilidad actual.
 Cambio de la contribución
• Cambio de la contribución derivado de cualquier cambio en el precio:

[Δ de ventas – UVA en unds] x nuevo mc$

Donde:

Δ de ventas = incremento o disminución de ventas luego de aplicar el cambio

de precio.
 Cambio de la contribución
Nuevo precio: S/.36.80

Costo variable: S/.22.00

Nuevo margen de contribución:

S/.36.80 – S/.22.00 = S/. 14.80

Hallar cambio en la contribución, si el incremental de ventas luego de cambio

de precio es: 4,000 y si es 5,000 unidades.
 Cambio de la contribución

a) 4,000 unidades

(4,000 – 4,324) x S/.14.80 = – S/.4,800

b) 5,000 unidades

(5,000 – 4,324) x S/.14.80 = S/.10,000

 Análisis del umbral de rentabilidad de las ventas

• Empresa XYZ

Ventas: 20,000 unidades

Precio: S/.40.00

Ingresos: S/.800,000

Costo variable: S/.22.00

Costo fijo: S/.300,000

¿Qué ocurre si el precio SUBE 8%?

 UVA = Umbral de ventas adicionales
− ∆ 𝑑𝑒 𝑝𝑟𝑒𝑐𝑖𝑜𝑠 𝑆/.
% UVA =
𝑚𝑐𝑖 𝑆/.+ ∆ 𝑑𝑒 𝑝𝑟𝑒𝑐𝑖𝑜𝑠 𝑆/.

− (𝑆/.43.20 −𝑆/.40)
% UVA =
(𝑆/.40 −𝑆/.22)+(𝑆/.43.20 −𝑆/.40) .
− (𝑆/.3.20)
%𝑈𝑉𝐴 = = - 0.1509 = - 15.09%
𝑆/.18 +(𝑆/. 3.20)

Rpta.: El aumento de precios (+8%) es rentable sólo si la reducción de ventas no

supera el 15.09%.
 Análisis del umbral de rentabilidad de las ventas

• UVA = – 15.09%

• Si la empresa XYZ aumenta su precio en 8%, puede tolerar una caída en

ventas, hasta de 15.09% para que ese cambio de precios sea rentable.

• Máximo puede permitirse perder hasta 3,019 unidades de venta.

 Análisis del umbral de rentabilidad de las ventas

• Si la caída en ventas supera el 15.09%, la pérdida de contribución del menor volumen de ventas
ya no iguala la ganancia de la contribución derivada del incremento de precios, por lo tanto no
genera la misma contribución antes del cambio de precio.
 Cambio de la contribución
Nuevo precio: S/.43.20

Costo variable: S/.22.00

Nuevo margen de contribución:

S/.43.20 – S/.22.00 = S/. 21.20

Hallar cambio en la contribución, si fuera la caída en las ventas luego del

cambio de precio: 2,500 y si es 3,500 unidades menos de venta.
 Cambio de la contribución

a) 3,500 unidades menos de venta

(– 3,500 – (– 3,019)) x S/. 21.20 = – S/.10,200

b) 2,500 unidades menos de venta

(– 2,500 – (– 3,019)) x S/. 21.20 = S/.11,000

 Ventas umbral incorporando cambio en costo variable
• Ante variaciones de costos variables y reducciones del precio ¿cuánto tiene
que aumentar el volumen de ventas para que el cambio de precios propuesto
sea rentable?

% de variación de las
= – Δ en mc S/.
ventas umbral Nuevo mc S/.
(UVA)
 Ventas umbral incorporando cambio en costo
variable
• En base a los mismos datos del ejemplo anterior, los costos variables (cv)
disminuyen en 1% (-S/. 0.22) y los precios disminuyen en 5% (-S/.2.00).

INICIAL NUEVO VAR

Precio S/. 40.00 S/. 38.00 -5%
(p)
Costo variable S/. 22.00 S/. 21.78 -1%
(cv)
 Ventas umbral incorporando cambio en costo
variable
% de variación de las – Variación en mc S/.
=
ventas umbral Nuevo mc S/.
(UVA)
Inicial mc S/. = precio inicial – cv inicial = S/. 18.00
Nuevo mc S/. = nuevo precio – nuevo cv = S/.16.22
Variación en mc S/. = S/. 16.22 – S/. 18 = – S/. 1.78

−(−1.78)
𝑼𝑽𝑨 = = 0.1097 = 10.97%
16.22
 Ventas umbral incorporando cambio en costo
variable
• Ante una disminución del cv en S/.0.22 y disminución del precio en 5%, se
requiere incrementar las ventas en 10.97% para mantener la rentabilidad
inicial.
• Es decir vender 2,195 unidades adicionales.

• ¿Qué pasa si cv aumenta 2% y precio de venta incrementa 5%?

 Ventas umbral incorporando cambio en costo
fijo
• La mayor parte de costos fijos (CF) no afectan a la rentabilidad adicional
de una decisión de precios.

• Pero algunos sí: aerolínea que debe renovar los interiores de sus aviones y
de sus instalaciones en el aeropuerto para dejar de ser línea económica y
posicionarse como clase premium.

• Restaurante que cambia el menú de su carta con precios más altos y debe
imprimir nuevas cartas y publicidad.

• Rediseño de embalaje de un producto.

 Ventas umbral incorporando cambio en costo fijo
• La empresa XYZ debe aumentar su capacidad de planta que le permita
producir el incremental requerido para hacer frente a la disminución de
precios de 8%.

• La nueva inversión en costos fijos es de S/.25,000 y permite producir 7,000

unds adicionales.
 Ventas umbral incorporando cambio en
costo fijo
• ¿Cuánto sería el aumento mínimo de ventas requerido para justificar la
disminución del precio en 8%, considerando aumento en costos fijos de
S/.25,000?

Se requiere:

Variación del margen de contribución

Nuevo margen de contribución
Ventas iniciales
Cambio de costo fijo
 Ventas umbral incorporando cambio en
costo fijo
Variación de las
Δ de CF S/.
ventas umbral = – Δ mc S/. x Q inicial + Nuevo mc S/.
Nuevo mc S/.
en unds

Variación de las
Δ de CF S/.
ventas umbral = – Δ mc S/. + Nuevo mc S/. x Q inicial
Nuevo mc S/.
en %
 Ventas umbral incorporando cambio en costo fijo

Se requiere:
Variación del margen de contribución:
Inicial mc:
P1 – cv = S/.40 – S/.22 = S/. 18
Precio disminuye 8%
Nuevo mc:
P2 – cv = S/.36.80 – S/. 22 = S/.14.80

Variación mc = S/.14.80 – S/. 18 = – S/. 3.20

 Ventas umbral incorporando cambio en
costo fijo
Variación de las
Δ de CF S/.
ventas umbral = – Δ mc S/. x Q inicial + Nuevo mc S/.
Nuevo mc S/.
en unds

Variación de las
ventas umbral = – ( – S/.3.20 ) x 20,000 + S/.25,000
S/. 14.80 S/.14.80
en unidades
Variación de las
ventas umbral = 6,014 unidades
en unidades
 Ventas umbral incorporando cambio en costo fijo
Δ de CF S/.
Variación de las = – Δ mc S/. + Nuevo mc S/. x Q inicial
Nuevo mc S/.
ventas umbral
en %
Variación de las
– ( – S/.3.20 ) + S/. 25,000
ventas umbral =
S/.14.80 S/.14.80 x 20,000
en %

Variación de las
ventas umbral = 0.3007 = 30.07%
en %
 Ventas umbral incorporando cambio en
costo fijo

• Para obtener beneficios de una reducción del precio de 8%, las ventas deben aumentar en más
de 6,014 unidades (30.07%), que es menor a las 7,000 unidades que representa la capacidad
adicional que adquiere la planta.
 Ventas umbral incorporando cambio en costo
fijo
• Para la reflexión antes de tomar una decisión:

• ¿Cuál es la probabilidad de que las ventas aumenten MÁS que el

mínimo umbral (6,014 unds), generando más beneficios?

• ¿Cuál es la probabilidad de que las ventas aumenten MENOS que el

mínimo umbral (6,014 unds), reduciendo los beneficios?

• ¿Qué facilidad hay para dar marcha atrás en la decisión del precio e
inversión en ampliar la capacidad, si se da el caso que las ventas no
varían lo suficiente?
 Ventas umbral incorporando cambio en costo fijo

• Para la reflexión antes de tomar una decisión:

• ¿Qué facilidad hay para dar marcha atrás en la decisión del precio e inversión en ampliar la
capacidad, si se da el caso que las ventas no varían lo suficiente?

• ¿Y si la reducción de precios incrementa las ventas por encima de la capacidad instalada?

 Ventas umbral incorporando cambio en costo
fijo
• Para la reflexión si ampliar la capacidad de planta es “costo hundido”:

• Si el incremento de ventas es mayor al 21.6% pero inferior al 30.07%,

fue una mala decisión la inversión.

• Se deberá bajar el precio lo suficiente para utilizar capacidad instalada,

aunque ese precio no cubra totalmente los costos. Subvencionar con
otros productos.
 Ventas umbral ante fijación de precios
reactiva
• Se aplica cuando el cambio de precios de un competidor afecta nuestras
ventas si no reaccionamos.

Variación de las Δ de precio de

ventas umbral = competidor %
Nuestro mc %
en %

Nota.- mc% es el margen de contribución de nuestra empresa expresado en

porcentaje (p – cv) / p se consideran datos iniciales, es decir antes del cambio de
precio.
 Ventas umbral ante fijación de precios reactiva
• Si el principal competidor disminuye sus precios en 12%.

• Nuestros datos antes de cambiar precios son:

• Precio: S/. 40

• Cv: S/. 22

Variación de las Δ de precio de

ventas umbral = competidor % – 12% = – 12% = – 0.2666
=
en % mc % S/. 40 – S/.22
45%
S/.40
 Ventas umbral ante fijación de precios
reactiva

• Determinar consecuencias:

• Si el competidor disminuye precios en 12%, y se espera que las ventas de XYZ disminuyan
más del 26.6%. Sería menos perjudicial para la rentabilidad de XYZ igualar la reducción
del precio que perder ventas.
 Ventas umbral ante fijación de precios reactiva
• Determinar consecuencias:

• Si el competidor disminuye precios en 12%, y se espera que las ventas

de XYZ disminuyan menos del 26.6%. Sería menos perjudicial para la
rentabilidad de XYZ permitir que su competidor incremente sus ventas
antes que reducir el precio para bloquearlo.
 Ventas umbral ante fijación de precios
reactiva

• ¿Si el competidor en lugar de disminuir precio aumenta en 12%?, ¿Cuáles serían las acciones a
realizar?
 Chapter 2

Profit’s Sensitivity to Price

(Continue)
Conducting a Profit Sensitivity Analysis to Identify volume Hurdles
and the Challenges Inherent in Economic Price Optimization
 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 Equation

p = Q (P – V) – F

p – Profit
Q – Quantity Sold (Volume)
P – Price
V – Variable Costs
F – Fixed Costs
 Profit Sensitivity Analysis
p = Q (P – V) – F

• Effects of a price change

• Direct effect on profit through price
• Indirect effect on profits by moderating the quantity sold
• No effect on costs, variable nor fixed
• Laws of economics implies that for a normal good, as price increases, volume decreases, fewer purchases are made

• Price Sensitivity Analysis analyzes the sensitivity of profits to price changes

• Volume Hurdles are identified through the profit sensitivity analysis. They define the required changes
in volume to justify a price change.
 Volume Hurdle
• Consider a Price Change
• How would volume need to change in order to improve profitability?
• Call this the Volume Hurdle

• Let the initial price and quantity be denoted by the subscript i, and the final price and quantity be denoted by the subscript f

pi = Qi(Pi-V)-F
pf = Qf(Pf-V)-F

• Condition: any price change must improve profitability

pf > pi

• Use algebra to rearrange the equations and simplify to identify the volume hurdle.
 Volume Hurdle
The change in volume must be
%Q ≥ – %P
greater than this ratio for the price
%CMi + %P change to yield higher profits
Where
Qf – Qi Percent Change in Volume
%Q ≡
Qi
Pf – Pi
%P ≡ Percent Change in Price
Pi

Pi – Vi
%CMi ≡ Initial Contribution Margin as a
Pi percentage of the original price
 Fixed Costs Don’t Matter, Variable Costs Do.

%Q ≥ – %P
%CMi + %P

• Notice Fixed Costs have no effect on a

marginal price change decision
• Your 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 What Variable Costs should
much value do they get for how high a price. be considered for defining
• Fixed costs are key in the decision to enter or the Volume Hurdle?
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.
 Volume Hurdle for a Price Cut
• Price cut, where %P is negative, requires a
positive increase in volume to improve profitability
%Q ≥ – %P
• The amount of the required volume increase is
dependent on the size of the size of the contribution %CMi + %P
margin.
• Large CM implies a small Q is required.
• Small CM implies a larger Q is required

• Strong implications with respect to tactical price

cuts
• Discounts
• Short term sales
• Creates a volume hurdle for the tactical price cut to
make sense to the firm

• Strategic price cuts, where a resetting of the

industry price level lower, creates a similar volume
hurdle, which should be informed by the assurance
that a larger market is available at the new lower
price.
 Volume Hurdle for a Price Hike

• Price Rise, where %P is positive, %Q ≥ – %P

will allow for a reduction in volume, %CMi + %P
up to a point.
• The amount of forfeited volume is
dependent on the contribution margin.
• Small CM can handle a large Q
decrease
• Large CM needs a smaller Q
decrease
• Enter a new market or new distribution
channel, change in competitive
environment, or variable costs have
been creeping up industry wide and a
price rise is seen as possible.
Profit Sensitivity towards Price Cuts
Retailer Manufacturer Broker
• 50% Contribution • 25% Contribution • 1% Contribution
Margin Margin Margin

• 15% Price Cut • 5% Price Cut • 0.1% Price Cut (10

bp)

• 43% Volume Growth • 25% Volume Growth • 11.1% Volume Growth

Required to Break Required to Break Required to Break
Even on the Decision Even on the Decision Even on the Decision
Profit Sensitivity towards Price Increases
Retailer Manufacturer Broker
• 50% Contribution • 25% Contribution • 1% Contribution
Margin Margin Margin

• 15% Price Rise • 5% Price Rise • 0.1% Price Rise (10

bp)

• 23% Volume Loss or • 14% Volume Loss or • 9.1% Volume Loss or

Less Decrease Would Less Decrease Would Less Decrease Would
Leave the Firm More Leave the Firm More Leave the Firm More
Profitable Profitable Profitable
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 • 50% Contribution

Margin Margin

• 15% Price Rise • 15% Price Cut

• 23% Volume Loss or • 43% Volume Growth

Less Decrease Would Required to Break
Leave the Firm More Even on the Decision
Profitable
Volume Hurdle as a Function of P Given a 25% CM

Volume Hurdle for Firm with a 25% Contribution Margin

15%

10%

Percent Change in Price

5%

0%

-5%
Increasing Profits
Zone of
Not Economically
-10% Possible Results
for Normal Goods
Decreasing Profits
-15%
-40% -20% 0% 20% 40% 60% 80% 100% 120%
Percent Change in Volume

• Sticking with the convention of economists of using volume as the

horizontal axis, we have plotted the volume hurdle for varying price
changes
 Elasticity of Demand
• Elasticity of Demand is the ratio of the observed percent change in volume to an executed percent change in price

%Q
e
%P
• Sticking with economic conventions, we have used e (pronounced epsilon) is used to denote the elasticity of demand with
respect to price
• Numerically, elasticity of demand is usually negative, implying at a higher price, fewer units are sold
• By convention, economists usually drop the sign in speaking of price elasticity, thus a large price elasticity has a large
absolute value yet is negative, while a low elasticity of demand has a small absolute value and is also negative.
 Highly Elastic Markets Favor Price Cuts
Elastic Demand Curve (e = -10) and
Volume Hurdle for Firm with a 25% Contribution Margin

15%

Decreasing Profits 10%

Percent Change in Price

5%

0%
Increasing Profits
-5%

-10%

-15%
-40% -20% 0% 20% 40% 60% 80% 100% 120%
Percent Change in Volum e

• Elastic markets mean a small price change induces a

large volume change
• |e| > 1
• Most brands face elastic markets
Inelastic Markets Favor Price Increase

Inelastic Demand Curve (e = -0.5) and

Volume Hurdle for Firm with a 25% Contribution Margin

Increasing Profits
15%

10%

Percent Change in Price

5%

0%

-5%

-10%
Decreasing Profits
-15%
-40% -20% 0% 20% 40% 60% 80% 100% 120%
Percent Change in Volum e

• Inelastic markets mean that a large price change is required to

induce a noticeable volume change
• |e| < 1
• Many industries face inelastic markets
 Relevant Elasticities
• There is a difference between strategic price changes and tactical price changes
• Short term, lock-in may enable a price rise to go through
• lock in can form from the purchase of complimentary products (autos and suburbs, or software and OS)
• Long run, markets change in their makeup.
• New entrants, new substitutes.
• (switch to fuel efficient cars, switch to mass transit and bicycles.)

• For many consumer products, the category level demand is inelastic, but the brand level demand is
elastic.
• Implying, that while industry wide price increases would help the profitability of the category, individual
suppliers face elastic demand as consumers demonstrate a willingness to switch brands.
 Measured Elasticities
Category Brand Choice Category

Bacon -1.25 -0.32

Margarine -2.22 -0.12
Butter -1.24 -0.74
Ice Cream -1.89 -0.68
Paper Towels -4.00 -0.74
Sugar -4.03 -0.57
Liquid Detergents -3.95 -1.70
Coffee -1.65 -1.42
Soft Drinks -2.66 -0.42
Bath Tissue -3.85 -0.80
Potato Chips -2.50 -0.88
Dryer Softeners -4.08 -1.19
Yogurt -1.57 -0.35
 Price Optimization
• The 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:
 Ve Note … this is a heroic, and
P
1 e known to be false, assumption,

– At the optimal price, the quantity sold is

 e
 P
Q  Qi   
 Pi 
– Where Qi and Pi the current demand and price
 Optimal Price
Measure
Variable Cost V $5
Fixed Cost F $750,000
Elasticity of Demand e -1.8
Demand at $1 Qo 10,000,000

Under the conditions, find

Optimal Price P* $11.25
Contribution Margin CM $6.25
Resultant Demand Q 128,211
Resultant Profit p $51,319
 Profit Optimization
Profit Optimization for a Firm
Variable Costs = $5, Fixed Costs = $750,000.
Elasticity of Demand = -1.8, Total Demand of 12.5 MM

$50 $60
$45 $40
$40
$20
$35

(In thousands)
$30 $0

Profit
Price

$25 ($20)
$20 ($40)
$15
($60)
$10
$5 ($80)
$- ($100)

0
50

10

15

20

25

30
Quantity
(In Thousands)

Price Profit

p = Q (P – V) – F
 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 capture

• Non-measurable for revolutionary products

• Small versus large price changes may exhibit different a elasticity

• Upward versus downward price changes may exhibit different a elasticity

Pricing Strategy, NOT ENGINEERING

There are many quantitative models.

The value added insight

is knowing when to use which quantitative model,
what information should be used to inform the model,
and which qualitative influences
can override purely quantitative arguments.
 Summary

• A 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 hikes

• Inelastic markets favor price increases

• Elastic Markets favor price decreases

• Given the elasticity of demand, one could identify “optimal prices”

• But beware of cautionary caveats in blindly using math, for which elasticity should be used
 Chapter 2

Profit’s Sensitivity to Price

Exercises
1. Consider a retailer considering a 33-percent-off sale on blenders currently priced
at $54. The retailer pays $29 per blender from the manufacturer.

a) What is the initial contribution margin?

b) What is the proposed sale price and the percent change in price captured per unit
sold?

c) What is the volume hurdle that must be achieved for the sale on blenders to improve
profits through the sale of blenders alone?

d) Suppose that instead of having this sale, a Young pricing expert suggested that the
Price of blenders be increases to $59. What would be the allowable loss in sales of
blenders that would still leave the retailer in a more profitable position?
2.- Consider a Scandinavian wind turbine manufacturer attempting to understand the
profit impact of a price change on turbines. Currently, a 1.5-megawatt (MW) wind turbine
has a total price of $1.7 million to an electric generator but faces only a $1.3 million in
marginal cost to deliver. The Scandinavian wind turbine manufacturer has a 35% market
share.
a. What is the initial contribution margin?
b. If the wind turbine manufacturer considered dropping the price by 3%, what would be
the new price, and what volume hurdle must be cleared for the price change to improve
profits?
c. If the wind turbine manufacturer considered raising the Price by 3 percent, what would
be the new Price, and what would be allowable volume loss for the Price change to
improve profits?
d. Discussion Question: A U.S. competitor sells comparable wind turbines for $1,675,000
and has 25 percent market share. Given the information, should the Scandinavian wind
turbine manufacturer raise or lower prices by 3 percent? What is the reasoning behind
your suggestion?
3. Consider a firm with a current contribution margin of 30 percent.
a. What is the volume hurdle associated with a 1% price decrease? What is the
allowable volume loss associated with a 1% price increase?

b. What is the volume hurdle associated with a 5% price decrease? What is the
allowable volume loss associated with a 5% price increase?

c. What is the volume hurdle associated with a 10% Price decrease? What is the
allowable volume loss associated with a 10% price increase?

d. What is the volume hurdle associated with a 20% Price decrease? What is the
allowable volume loss associated with a 20% price increase?
4. For a firm with a current contribution margin of 50%, plot the volume hurdle as
price goes from a decrease of 40%to an increase of 40%. Are profits more sensitive to
increases or price decreases?
5) For a consumer product, the manufacturer's suggested retail price (MSRP) is $49. The manufacture`s
price to the retailer is $25. The manufacturer faces a marginal cost of $15 per unit to produce.

a) What is the current contribution margin for this product at the retail level if priced at the MSRP? What is
the current contribution margin for this product at the manufacturer level? What is the current contribution
margin for this product for the value chain if priced at MSRP?

b) What is the volume hurdle associated with a 15-percent-off sale at the retail level to leave the overall
value chain more profitable?

c) Assume that the retailer seeks to share the burden of a price discount with the manufacturer such that its
promotional price is reduced by 15 percent while the price its pays for the product also decreases by 7.5
percent. What is the volume hurdle faced by both the retailer and manufacturer under this scenario?

d) What decrease in manufacturer price to the retailer would deliver the same volume hurdle to both the
retailer and manufacturer as a 15-percent-off sale e retail level?
6. For a consumer product, the MSRP is $19. The wholesale price from the manufacturer to the retailer is
$12.50. The manufacturer faces a marginal cost of $8.50 per unit to produce.

a. What is the current contribution margin for this product at the retail level if priced at the MSRP? What is
the current contribution margin for this product at the manufacturer level? What is the current contribution
margin for product for the value chain?

b. what is the volume hurdle associated with a $2-off sale to leave the overall value chain more profitable?

c. Assume that the retailer seeks to lay the entire burden of the sale on the manufacturer, such that its
promotional price is reduced by $2 and the price that it pays the manufacturer for the product decreases by
$2. What is the volume hurdle faced by both the retailer and manufacturer under this scenario.

d. What decrease in manufacturer price to the retailer would deliver the same volume hurdle to both the
retailer and manufacturer as a $2 – off sale at the retail level?
7. The short-run elasticity of demand for a consumer product is measured from NPD
data at Ɛ = 2.9.

a. What is the expected unit sales increase to result from a 10 percent price decrease?

b. If the contribution margin for the value chain is 60 percent, what is the volume

hurdle for a 10 percent price decrease?

c. Should the value chain expect a 10-percent-off sale to improve its profits?
8. The short-run elasticity of demand for chicken breasts is measured by the National
Chicken Council to be Ɛ = - 0.75

a. What is the expected unit sales decrease from a 10 percent price increase

b. If the contribution margin for the value chain is 30 percent, what is the allowable

volume loss for a 10 percent price increase?

c. Should the value chain expect a 10 percent price increase in chicken breasts to

improve profits?
9. A computer maker is considering improving its product. It currently produces a

desktop computer at a marginal cost of $249, and the computer sells for $289. The

improved version of its product would have a new marginal cost of $289 and would be

priced at $359. What volume hurdle does this manufacturer face?