Question

Question 2: Should you reduce the price or increase advertising?

The selling price is $50/unit, variable costs are $40/unit, and fixed costs are $3,000 in total. Sales volume decreased to 200 units because of a recession.
You are considering two options to stimulate sales:
(1) Reduce the price to $48/unit. This will increase sales volume by 20%.
(2) Buy additional advertising for $300 and keep the original price. This will increase sales volume by 20%.

Use the gross approach to decide whether you should do nothing (the status quo), reduce the price, or increase advertising.

	status quo	(1) reduce the price	(2) increase advertising
Volume in units
Revenue	$	$	$
Variable costs	$	$	$
Contribution margin	$	$	$
Fixed costs	$	$	$
Profit*	$	$	$

* enter losses as a negative number: e.g., a loss of $500 should be entered as -500, not as (500) or ($500).

What should you do?

Reduce the price

Do nothing   

Increase advertising

Answer 1

	status Quo	Reduce the Price	Increase Advertising
Volume in Units	200	240	240
Revenue	$ 10000	$ 11520	$ 12000
Less: Variable Cost	$ 8000	$ 9600	$ 9600
Contribution Margin	$ 2000	$ 1920	$ 2400
Fixed Cost	$ 3000	$ 3000	$ 3300
Profit/ Loss	$ - 1000	$ - 1080	$ - 900

Conclusion - If we compare three options we can see loss are minimal in option 3 i.e increase advertising expenses. Hence organisation should increase advertising cost by $ 300.

Status Quo

Revenue = Volume * Sale price per Unit Variable Cost = Volume * Variable cost per Unit

= 200 units * $ 50 per Unit = 200 units * $ 40 per Unit

= $ 10000 = $ 8000

Reduce the Price

If we reduce the price then Sales volume will be increase by 20%

New Sales Volume = Original Sales Value + 20% of original sales volume

= 200 units + (200 units *20%)

= 200 units + 40 units

= 240 units

Revenue = Volume * Sale price per Unit Variable Cost = Volume * Variable cost per Unit

= 240 units * $ 48 per Unit = 240 units * $ 40 per Unit

= $ 11520 = $ 9600

Increase in advertising

If we increase advertising expenses then volume will increase by 20% . Hence new volume will be 240 units (Working has been prepared above)

Revenue = Volume * Sale price per Unit Variable Cost = Volume * Variable cost per Unit

= 240 units * $ 50 per Unit = 240 units * $ 40 per Unit

= $ 12000 = $ 9600

New Fixed Cost = Original Fixed Cost + Additional advertising expenses

= $ 3000 + $ 300

= $ 3300

Thank You