Strategic Management

# 3

Current Sales = 40,000,000

(CM) Contribution margin = Sales * CMR = 40,000,000*40% = 16,000,000

Fixed Costs = 3,000,000

Operating Profit = CM – fixed cost = 16,000,000 – 3,000,000 = 13,000,000

1. Spend 2,000,000 in advertising, expected to increase sales by 25%

Expected sales = 40,000,000 * (1 + 25%) = 50,000,000

Contribution margin ratio = CMR = 40%

Contribution margin = Sales * CMR = 50,000,000 * 40% = New Fixed Costs = Earlier fixed cost +

Ad. Expensin = 3,000,000 = 2,000,000 = 5,000,000

Operating Profit = CM – New Fixed cost = 20,000,000 – 5,000,000 = 15,000,000

2. Reduce price by 20%, price – demand elasticity is -3.0

Variable cost ratio in beginning = 1 – CMR = 1- 40% = 60%

Variable cost in beginning = 40,000,000 * 60% = 24,000,000

Number of units sold = Variable cost/variable cost per unit = 24,000,000/12 = 2,000,000

Average price of good = total sales/number of units sold = 40,000,000/2,000,000 = 20

Increase in sales = Price elasticity of demand * Reduction in price = 3 * (-20%) = 60%

New Price = 20 * (1 – 20%) = 16

New Level of total sales = New Price * Earlier quantity sold * (1 + increase in sales) = 16 * 2,000,000 * (1 + 60%) = 51,200,000

New Variable Costs = Variable cost per unit * earlier quantity sold * (1 + increase in sales) = 12 * 2,000,000 * (1 + 60%) = 38,400,000

Fixed cost = 3,000,000

New Level of operating profit = 51,200,000 – 38,400,000 – 3,000,000 = 9,800,000

Operating profit increased ni first strategy, decreased in second strategy

The 1st strategy will generate the higest overall profits.