In this lecture, we'll discuss some basic analytic foundations

for pricing decisions. We'll focus on three key topics. One, we call margin and
contribution analysis. Second, break-even analysis and the third concept is
economic
value to the customer. So let's start with margin analysis and let's do it in the
context of a mini case. This case comes from a
company called Vistakon. So Vistakon is a
subsidiary of Johnson and Johnson and they were the first to launch
disposable lenses. The first lens they
launched what's called Acuvue which was produced by a very unique proprietary
technology and it costed about $0.50 per lens. Patients were advised to
wear these lenses for one week and then dispose
them away and then next week, insert another pair of
lenses in their eyes. Soon after they launched Acuvue
for a number of reasons, some eye care professionals suggested that patients remove
these lenses and
clean these lenses each night and replace
them after two weeks. Which was not exactly what
the Vistakon had suggested. But in response to this
particular usage pattern, Vistakon decided to launch a
new product called Surevue which was specifically
designed for this type of usage which
is two-week usage. They priced it the same as
Acuvue which is $2.50 to eye care professionals and who charge then $4.50
cents to end users. At the time of this, Vistakon was thinking of launching a very
different type of a lens, disposable lens
which they called as one day Acuvue or
daily disposables. This would be a
product that would be daily wear, single-use, truly disposable
lens that offered both convenience and
reduced health risk. These lens costed the Vistakon about $0.25 to manufacturer.
They were priced at $0.65 to
the eye care professional. Then the plan was to sell it to the customer at about
$0.83. So let's think through
this planned launch of one day Acuvue
and ask ourselves, what issues should Vistakon be concerned about as they launched
this new product to complement their existing product line
of Acuvue and Surevue. So typically, when I
pose this question, I get several answers but
the one answer on top is, will the new product
cannibalize existing products? The other responses I get is, will consumers really
want it? Another answer here is, will channel partners or eye care professionals
want to support it? Then there are operations
and production side issues. Can we produce so many units? Do we have the supply
chain and the distribution
network to support it? So all these are important issues but let's
see how many of these we can address by doing
simple margin analysis. So let's start with that
process of margin analysis. If you look at the margin for
each of the three products, so let's start with Surevue. The price for the
patient is $4.50, the price of the ECP is$ 2.50, unit cost is $0.50. So Vistakon
contribution is $2.00. If you look at Acuvue, it's exactly the same. But if you
look at
the one day which is the daily disposable, it's $0.83 to the patients, $0.65 to the
ECP, and the unit cost is $0.25 which means it has $0.40
margin to Vistakon. So a question worthwhile
asking at this stage is, based on these margins, which of these three
products is most profitable? People when they look at this; our students, our
executives. Invariably, they'll
say, "Professor Raju, the most common
answer is one day". That's what I hear.
When I probed further, I ask why you coming
up with one day when $2.00 is actually
more than $0.40. I think they rightly say look, it's not the margin per lens, it's
margin per consumer which is each
customer is going to buy many more of the daily disposables than
they're going to buy Surevue. So that's a good way of
thinking so let's look at that a little bit more carefully now as we go deeper into
this. So $2.00, which is the
margin per lens for Surevue. We multiply that by 52.
Where do we get 52? It's replaced by weekly
which is 26 weeks. You have two eyes so you
are using 52 lenses. So 52 times 2 is a $104. Then for Acuvue again, the per lenses
is
$2.00 multiply that by a 104 because you are
changing it every week, two eyes, 52 times 2 is a 104. You get $208. But then you
multiply the $0.40 margin on one day which is the daily disposable multiply
that by 730, you get $292. So clearly, once you look at
it on a per consumer basis, you find that the daily
disposable is more profitable. This is where now the
real discussion begins. I ask, under what conditions would actually Surevue
be more profitable, even when you look at these data? This is not an easy question.
But as we think about it, the answer comes in
the following way. If you were told that you can
make only a 100,000 lenses, which ones will you make? Then the answer would be, you
will make only Surevues. Why? Because from those
a 100,000 capacity, you can make $2.00 per lens
and that will be 200,000. But with a 100,000
capacity to manufacture, you'll be able to satisfy
very few customers. On each customer, you
will make only $292. So if your capacity were limited, then suddenly Surevue
looks more profitable. So the next question is, what capacity are we talking about
when we're
thinking of $292, $208, $104 versus $2.40? The answer there is, you are assuming
that the number
of customers you have is fixed and you are
going to be able to change each customer from
one lens to another lens. So if your number of customers
is fixed or limited, then clearly the daily
disposable looks profitable. But if your number of lenses
you can make is fixed, then Surevue is more profitable. So let's now put this
in some perspective. When we compute margins, we all worry about
what is the numerator. By numerator I mean
is a $2.00, $2.01, $2.02, is $0.40, $0.41
is it 292 or 293? What I urge you to do is also think about the denominator. Should
it be margin per lens? Should it be margin per customer? What does that depend on?
It depends on what is your key resource or
your binding constraint. If your key resource
happens to be or your binding
constraint happens to be production capacity, then you should be looking
at margin per lens. If you're binding constraint happens to be the number of
customers you can access, then you should be
looking at margin per customer. So think about it. A traditional retailer. When you
ask them how do
you compute your margins? They say, "we'll compute margins per square foot of shelf
space". Why do they do that? They do that because for
a traditional retailer, shelf space is their
critical resource they can't change that
in the short run. But now if you ask a law
firm or a consulting firm, they don't say, "we
compute margins per square foot of office space". Why do they not compute margins
per square foot when
a retailer does? Well because office space is
not their key constraint, their key constraint is the number of
consultants they have. So they compute revenue
per consultant hour in deciding which
opportunities are more interesting or more attractive. So let's reflect on this. We
all worry about the
precision by which we compute margins which is I often refer to
as the numerator. What is strategically more important actually
is the denominator. Should it be margin per lens, should it be margin per customer,
should it be margin
per square foot, or should it be margin
per consultant hour? It all depends on what
is your key resource. So if you do not do that right, everything else goes wrong.
Because if you are
computing margin per lens when customer is
your key constraint, then you are most likely
to make wrong decisions. So keep a focus on the
right denominator. So in this particular case, we'll assume going
forward that there is no capacity constraint
so for Vistakon, the key constraint is actually
the number of customers. So now lets start looking at another question that comes
up in the discussion which is, will the eye care professionals
like this product? So now let's start looking at the margins of the eye
care professional. As you look carefully in the
table, what do you find? What you find is for
the new product, the eye care
professional is going to make $131.40 per customer. Compare that with what they
were making for Acuvue. For Acuvue, they're
making $208 per customer. For sure, of course they were making less which is a
$104. So once you look at the channel margins or the margin to your
channel partner, I think you can
conclude that there is a good likelihood that your eye care professionals will not
be as interested
in this product. But then I think a deeper discussion
might lead us to say, "What if it is cheaper for them to sell daily disposables?''
If it's cheaper for them
to sell daily disposable, then may be a $131.40
is sufficient. But the answer to that is, it's probably harder for them
to sell daily disposables. They'll have to stock more, they'll involve more working
capital and more space, but it is not likely
to be easier to sell daily disposables than it is to sell either one week
or biweekly lenses. Also look at profit-sharing. When we look at the table for the
earlier two products,
Surevue and Acuvue, it's very interesting to see that the annual contribution for
ECP and Vistakon was
exactly the same. Which means, whatever was
the total size of the pie, they were splitting it equally. But now we look at
daily disposables, their plan is to actually split the pie unevenly.
What does that mean? It means most likely, it's not just about lower
margins to the channel, it's also about fairness
or lack of fairness. Why? Because now you're not going to split
the pie evenly. Let's say if you were to
split the pie evenly which is change the price in such a way that
the two products now, all three products are shared 50-50 between you and
the channel partner. How do you get to that? Well, you have to
lower the price to the ECP at 54 cents
instead of 65 cents. Once you do that, you
get 211.70, 211.70. Now, all channel
margins are equal between Vistakon and ECP. But then what you see is this product
is
really not that great. Why? Because it
makes just a little bit more than what they were making on the weekly product. What
do we conclude from this? What we conclude from this is a good thoughtful margin
analysis can peel the onion and
helps us identify, A, is the new product really better than our
existing products. B, if you look at the margins more thoughtfully and include our
channel partners also, then we can understand their
incentives or lack thereof. Then finally, we can also look at what the retail price
to the
customer is going to be. Of course, in the
daily disposable case, it's going to be higher than it was for Surevue and Acuvue,
so we have to worry about
consumer response also. So simple margin analysis
of the type we did lays open many interesting insights
that one has to keep in mind as one launches new products or prices
them appropriately. So what is margin analysis? It's simply a table of costs and
prices for every member
of the value chain. The person who's
taking the idea to market, channel
partners, end-users, for every relevant product
within the product line, and often across competitors. What it does, it reveals
everyone's incentives in
a purchase transaction. A careful examination
allows us the discovery of potential problems such as cannibalization and
channel conflict. It also provides useful input
for subsequent analysis. Now, let's move to
the next concept which is break-even analysis. Again, this is extremely useful in
making
pricing decisions. It's also extremely useful in making other business decisions.
Here, we're going to talk about three different types
of break-even analysis. The first one we're
going to talk about is let's hypothesize that
the Acuvue team or the daily disposable
teams in this case is planning to spend two million dollars
advertising budget. How do they justify such a budget to their
senior management? Second, we already
discussed this partly, what if they were
thinking of lowering the wholesale price
from 65 cents to 54 cents in order to satisfy
the eye care professionals? How much more would they
have to sell to break-even? The third break-even
concept we are going to focus on
which again is very critical is how much
cannibalization can we tolerate from Acuvue when we
are launching a new product? So again, recall when I pose this question to most
of our students, the very first thing they ask is this product will cannibalize. So
we'll look at all
these three very carefully as we go forward. Let's start with the first one, the
two million
dollar advertising. What kind of analysis can
the team do to either justify it or to realize
whether it's worthwhile or not? We do this in a very simple way, we ask ourselves,
"How much
money do we make per lens?" The answer is we make
40 cents per lens. Again remember, it's 65 cents
minus 25 cents is 40 cents. So each lens we sell, we will make 40 cents. We are
planning to spend two million dollars
on advertising. So two million divided by 40 cents is five million lenses. That
means we'll have to sell five million more
lenses in order to be able to justify a two million dollar
expense on advertising. That's a nice analysis, but I don't think
it's good enough. To make it even better, I think you need
to translate this into not lenses as
the denominator, but again consumers
as the denominator. So if we translated
into consumers as the denominator, each consumer, let's assume if we can get them,
stays with us for about a year, in which year they'll
consume about 730 lenses. So, five million
divided by 730 is 6,849 new users.
What does that mean? The two million dollar of
advertising will pay off, if we can get 6,849 new users. This I believe is a better
way to present your results rather than saying I need to sell five million more
lenses. Advertising does not affect
lenses, it affects users. So again, keep in mind the
choice of the denominator. When you justify your
recommendations to the committee, to the senior management, try to use the right
denominator. It helps you convey
your message better. So this is break-even
of type one, which is you are thinking of spending some money
on advertising. Similar analysis can be done, if these two million
were to be spent on advertising to improve the
quality of the product, how much more we'd have to sell. Now let's go to the next
type of break-even analysis
which is reducing price. So we considered
this case earlier. If [inaudible] wanted to have
equal margins to both the ECB's as well as themselves
they would have to reduce the wholesale price from
65 cents to 54 cents. So the question then
we ask ourselves is that's great it'll make
our ECP is happier, but how much more will
we have to sell if we reduce the price from
65 cents to 54 cents, and how would we analyzed that? Let's do this slowly
step-by-step. At 65 cents our
margin is 40 cents. Why? 65 minus 25 is 40 cents. If we're proposing a new
wholesale price of 54 cents, our margin will be 29 cents. How do we get 29 cents?
54 cents minus 25 cents, which is the cost of making the lens of the
margin is 29 cents. How much more we would have to sell at a margin of 29 cents,
relative to a margin of
40 cents to break-even? Well, we do you think about
this as the following. Let's suppose we were selling
a 100 lenses at 40 cents. How much money we would make? It'll be a 100 times 40
cents. Then the question is,
how much do we have to sell at 29 cents to break-even? So, there will be a 100
times 40 is equal to this unknown
number times 29 cents. So, what is this unknown number? It'll be a 100 times
40 divided by 29, which is a 137.9. Which means we need a 37.9 percent increase in
unit sales, for us to break-even, if we are thinking of
lowering the price from 65 cents to 54 cents. The next question is,
is this possible? How does this help? What we could do is, we could do a small test
market in a small region, where we lower the
price from 65 to 54, and see whether we get a boost
of at least 37-38 percent. If we do, at least it's
worth considering further. Let's think of
another possibility. What if we did this analysis and the answer turned out
to be 200 percent? Which is, we need to increase our unit sales by 200 percent.
Then maybe there is no
need to probe further, because you know from
past experience that, that is unlikely to happen. So this break-even
analysis gives you some interesting guidelines
of what to do next, and also helps us rule out some really dominated
alternatives in certain cases. Now let's look at the third
type of break-even analysis, which is what we call as
cannibalization break-even. Remember cannibalization is often the first comment
that comes up whenever we asked the question in this
particular case, or other cases, when a company is adding a new
product to the product line. But now reflect back, is cannibalization really
a concern in this case? It's truly not, because
in this particular case, this new product gives
us $292 per customer, whereas the previous ones
were giving us either 204, or 208, or 104. So cannibalization is
really not an issue here. Why? Because we would like all our customers to
move from a product that gives us $104 per customer
to $292 per customer. So, even though, early on this is the first
comment that comes up, when you think a
little bit deeply. Cannibalization is really not a concern for daily disposables.
But for us to study the
concept of cannibalization, which we'd like to do because
it's an important concept, let's look at another event
from this very case study. This company at some
point in time launch Surevue when it already
had Acuvue on the market. So, let's use that as an example. Acuvue will gives us
$208 per customer, whereas Surevue gives us 104. How do I know what level
of cannibalization can I tolerate from Surevue before
it becomes unprofitable? How do we think through
this carefully? So, this is one way
to consider this. Let's say we have a sample
of a 100 customers, who are currently buying Surevue. So we have them in front of
us. How much money are we making
from these customers? The answer is a 100 times $104. Why $104? Because they
are buying Surevue. Let's say we ask each
of these customers. What were they buying
before they bought Surevue, and we go one-by-one. Let's say we do this
hypothetically exercise, where we asked each one of them, what were they buying
before they bought Surevue? The first ones says, I was buying Acuvue, the second
one says,
I was buying Acuvue. The third one says I
was using glasses. What is the maximum number of Acuvues we can here before we say
Surevue
is not profitable? In other words, what is the maximum draw Surevue
you can have from Acuvue, before we deem it unprofitable? Let's call this number
Max. Then how do we arrive
at this Max number? How much I'd be making today
from these a 100 customers? It's 100 times 104. For Surevue to be profitable, this
a 100 times $104
has to be greater than this Max We can tolerate
times 208. Why 208? Because these people
were earlier buying Acuvue and we're making
$208 from each one of them. So, the Max has to be less than 100 times 104
divided by 208 which is 50. That means, we can out most tolerate 50 percent
cannibalization, from Acuvue if we were
launching Surevue. If the cannibalization
is more than 50, then Surevue is going to
lead to lower profits. Why? Because, it's
drawing more customers from Acuvue than we can handle. Exactly at 50, it's equal.
So now let's put this
in some perspective. More generally then break-even cannibalization is equal to the
margin on the new product, divided by the margin on
the existing product. In this particular case, it's a 104 divided by
208 which is 50 percent. Let's ask another question. What if we have more
than one product? In this particular case, the company just had Acuvue and they are
launching Surevue. What should we use
in the denominator, if we have more
than one product?. One possible answer is, we can use the weighted margin on
existing products
in the denominator. That's an approximation, but it's a good enough approximation,
is better than using one product. So, let's reflect back on what we have covered
in this lecture. We covered margin, or
contribution analysis. In this particular case, the one thing I do
not want you to forget is remember the
importance of the denominator. We have finance people, accounting people who
spend a lot of time, a lot of effort in precisely determining
what the numerator is. Is it $208, is it $209, is it 42 cents, is it 43 cents. But
if you have the
denominator wrong, everything else is wrong. Why does the retailer use dollars per
square
foot of shelf space, and why does the
consulting company use dollars per consultant hours. They use it because that is
their critical resource. For the retailer, the
critical resources is, shelf space, and
for the consultant, it's consultant to hours. So make sure you have
the denominator right. Just look at this example. Had we use lenses
the denominator, we would have concluded that daily disposable is
less profitable. But when you use customer as a denominator we conclude that, daily
disposable is actually the most profitable
product for the company. For break-even analysis, these provide very useful
insights
for pricing decisions. Cannibalization
break-even can give us input into branding
decisions also. For example, if you use an umbrella brand which
Professor Khan talked about, cannibalization may be higher
because the two will be very visible to the customer that both products come
from the same brand. So these Analysis; margin analysis and break-even analysis,
help us make better
pricing decisions, but I would go a step
further and say, they help us make better
business decisions.