Your regular price is $30/unit, unit variable cost is $20/unit and fixed costs a
ID: 2388002 • Letter: Y
Question
Your regular price is $30/unit, unit variable cost is $20/unit and fixed costs are $3,000 per month. Because of the recession, your sales have dropped to 200 units a month, so you are losing money. You are considering two options to increase sales:
(1) reduce the price to $28/unit, or
(2) run an advertising campaign, which will cost you $300 a month, but keep the price at $30/unit.
In both scenarios, you estimate that sales will increase by 20%, from 200 to 240 units per month.
Required:
a) Compute total revenues, costs and profits under the status quo (original situation), and for each of the two new options.
Explanation / Answer
A)
Status Quo
---------------
Revenue: $30 X 200 units = $6,000
Variable Costs: $20 X 200 units = $4,000
Contribution Margin: $6,000 - $4,000 = $2,000
Fixed Costs: $3,000
Profit: $2,000 - $3,000 = -$1,000
Reduce Price
---------------
Revenue: $28 X 240 units = $6,720
Variable Costs: $20 X 240 units = $4,800
Contribution Margin: $6,720 - $4,800 = $1,920
Fixed Costs: $3,000
Profit: $1,920 - $3,000 = -$1,080
Advertising
---------------
Revenue: $30 X 240 units = $7,200
Variable Costs: $20 X 240 units = $4,800
Contribution Margin: $7,200 - $4,800 = $2,400
Fixed Costs: $3,000 + $300 = $3,300
Profit: $2,400 - $3,300 = -$900
B) 3 Run the advertising campaign. This is the most profitable of the three choices.
C) This depends on how much you have invested in the company, how long you think the recession will last and that you will be losing money, and how much money you have to sustain your losses. If you don't have enough money or capital to survive the losses, you must shut down your company. However, shutting down your company might make consumers lose trust in your brand, making it harder to sell if you ever come back. Also startup costs and other things might make it harder to start your company again. So if you think your losses will only be for short term, it might be best to keep your company open if you can afford it. If you can't afford it, then you will have to shut down, but it might make it difficult to start up your company again and you might have lost customers that used to be loyal to you because you were not open for a period of time. All in all, it makes no sense to run a company that is losing money, but it depends on how long you think this will be happening. If it is only for a month or two, it might hurt you more to shut it down and reopen then it would if you just had the losses. If it is for a long period of time, it wouldn't make any sense to run a company that is losing money.
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