Question

Ritewell sells pens at a current price of £10, producing a revenue of £120,000 per month, of which 20% is spent on advertising. The marketing manager wants to increase sales to 16,000 units per month, and is considering whether to increase advertising or reduce price to achieve this target. He has estimated that the PED for Ritewell’s pens is –1.5 and the AED is 1.8. a) Calculate how much would need to be spent on advertising to achieve the target sales. b) Calculate how much of a price cut would need to be made to achieve the target sales. c) Explain which is the better decision in terms of achieving the desired target.

Answer 1

Revenue = 120000

Current price = 10

= > Quantity demanded at price 10 = 12000

Total amount spent on advertising = 20% of revenue

                                                       = 120000/5 = 24000

AED = percentage change in quantity demanded /percentage change in advertising expenditures

= 1.8

Let the new amount to be spent on advertising for this change = A0

Desired number of sales = 16000

Hence the change in demand required = 16000-12000 = 4000

Therfore 1.8 = [(4000/12000)]/[( A0-24000)/24000]

= > 1.8 = (1/3)*24000/( A0-24000)

= > 1.8= 8000/( A0-24000)

= > -1.8*24000 + 1.8 A0 = 8000

= > 43200 + 8000 = 1.8 A0

= > A0 = 28444.44

b) Now assume new price = P0

Therefore:-

[(16000-12000)/12000]/[ (P0 – 10)/10] = -1.5

= > (1/3)*10/[ P0 – 10] = -1.5

= > 10/ 3 = -1.5 P0 + 15

= > 1.5 P0 = 15-10/3

= > P0 = 7.78

The profit earned by increasing advertising expenditure = 160000 – 28444.44 = 131555.56

The profit earned by reducing price = 16000*7.78 – 240000 = 1000480

Since the profit earned is greater when only advertising expenditure is increased hence the better method is to go with raising advertising than doing a price cut if the company wants to increase its sales.