Question

Pricing

Hamburg AG produces a number of pocket computer products. It is an established company with a good reputation that has built on well-engineered, reliable and good-quality products. It is currently developing a product called Techstar and has spend € 1.5 million on development so far. It now has to decide whether it should proceed further and launch the product in one year ́s time.

If Hamburg AG decides to continue with the project, it will incur further development costs of € 750.000 straight away. Hamburg AG expects that it could see Techstar for three years before the product becomes out of date (i.e. it is expected to be 3 years on the market).

It is estimated that the Techstars produced and sold in the first year would cost an average of € 675 each unit, for production, marketing and distribution costs. Further fixed costs associated with the project are expected to amount € 0.9 million (cash out flow) for each year the product is in production.

Because of the cost estimates, the Chief Executive expected the selling price to be in the region of € 950. However, the Marketing Director is against the pricing strategy; he says that this price is far too high for this type of product and that he could sell only 6,000 units each year at this price. He suggests a different strategy: setting a price of € 625, at which price he expects sales to be 15,000 units each year.

a) The Chief Executive has asked you to help sort out the pricing dilemma. Prepare calculations that demonstrate which of the two suggestions is the better pricing strategy. Should the product be produced? Neglect the company ́s cost of capital.

b) Hamburg AG found from past experience that in the second year the totals variable costs are 20% less of the first year ́s costs because of experience curve effects. In the third year the total variable costs are 20% less than the variable costs of the second year. How would the calculations (and the recommendation?) change? (6 points)

Answer 1

a) Which pricing strategy is better

i) 6,000 units sale at 950 Euros

The following statement shows the profitability for Hamburg AG at Euros 950 selling price.

Particulars	Year 0	Year 1	Year 2	Year 3
Sales (Units) - A		6,000	6,000	6,000
Selling price per unit - B		€                950	€                950	€                950
Sales In Euros C = A x B		€    5,700,000	€    5,700,000	€    5,700,000
Variable cost per unit - D		€                675	€                675	€                675
Contribution per unit E= B - D		€                275	€                275	€                275
Total contribution F = E x A		€    1,650,000	€    1,650,000	€    1,650,000
Less: Fixed Costs		€        900,000	€        900,000	€        900,000
Less: Development costs	€              750,000	€                    -	€                    -	€                    -
Cash from Operation	€           (750,000)	€        750,000	€        750,000	€        750,000
Total cash from Operation	€          1,500,000

ii) 15,000 units at Euors 625.

Particulars	Year 0	Year 1	Year 2	Year 3
Sales (Units) - A		15,000	15,000	15,000
Selling price per unit - B		€                625	€                625	€                625
Sales In Euros C = A x B		€    9,375,000	€    9,375,000	€    9,375,000
Variable cost per unit - D		€                675	€                675	€                675
Contribution per unit E= B - D		€                (50)	€                (50)	€                (50)
Total contribution F = E x A		€      (750,000)	€      (750,000)	€      (750,000)
Less: Fixed Costs		€        900,000	€        900,000	€        900,000
Less: Development costs	€              750,000	€                    -	€                    -	€                    -
Cash from Operation	€           (750,000)	€ (1,650,000)	€ (1,650,000)	€ (1,650,000)
Total cash from Operation	€        (5,700,000)

Note: In both the cases, the development cost of € 1.5 million already incurred is not relevant (sunk cost) and hence not considered.

Conclusion: The best pricing strategy is € 950. Although, the units sold are lesser, it is sufficient to generate profits after covering the fixed costs and the further development costs.

At € 625, although the units sold are higher, the contribution per unit is negative. Hence, it will always result in overall loss.

The product should be produced and sold at € 950.

b. If variable costs reduces by 20% each year, what would be the conclusion

Particulars	Year 0	Year 1	Year 2	Year 3
Sales (Units) - A		6,000	6,000	6,000
Selling price per unit - B		€                950	€                950	€                950
Sales In Euros C = A x B		€    5,700,000	€    5,700,000	€    5,700,000
Variable cost per unit - D		€                675	€                540	€                432
Contribution per unit E= B - D		€                275	€                410	€                518
Total contribution F = E x A		€    1,650,000	€    2,460,000	€    3,108,000
Less: Fixed Costs		€        900,000	€        900,000	€        900,000
Less: Development costs	€              750,000	€                    -	€                    -	€                    -
Cash from Operation	€           (750,000)	€        750,000	€    1,560,000	€    2,208,000
Total cash from Operation	€          3,768,000
Particulars	Year 0	Year 1	Year 2	Year 3
Sales (Units) - A		15,000	15,000	15,000
Selling price per unit - B		€                625	€                625	€                625
Sales In Euros C = A x B		€    9,375,000	€    9,375,000	€    9,375,000
Variable cost per unit - D		€                675	€                540	€                432
Contribution per unit E= B - D		€                (50)	€                   85	€                193
Total contribution F = E x A		€      (750,000)	€    1,275,000	€    2,895,000
Less: Fixed Costs		€        900,000	€        900,000	€        900,000
Less: Development costs	€              750,000	€                    -	€                    -	€                    -
Cash from Operation	€           (750,000)	€ (1,650,000)	€        375,000	€    1,995,000
Total cash from Operation	€              (30,000)

Conclusion:

Even if the variable costs reduces by 20% each year, the ideal pricing strategy would be to price at € 950 as the overall profitability increases at this price.