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BUSM 107

 Main Examination MOCK PAPER Suggested Solutions

PART A (mandatory)

QUESTION 1

At its simplest, the problem facing the company can be reduced to make a choice between two alternative strategies. Either it can maintain its present, high-price policy and suffer a continuing fall in demand or it can revert to its previous policy of seeking a competitive price. This latter policy can best be interpreted as pricing at the top end of the competitors’ price range. A further alternative that might be considered is for predatory pricing below the competition, but this raises more complicated marketing issues. An analysis of these alternatives requires the following steps:

1. Projection of total industry demand for 2015

2. Estimation of Permashine’s market share, at various possible prices

3.  Estimation of the variable costs of production

4. A contribution analysis using this information.

Total industry sales are best represented on a graph, from which a steadily rising trend can be discerned, despite a slight drop in 2014. If a straight line is fitted to all seven years’ data by linear regression, it is found that

Sales (000s) = 1771 + 141 × (Year number = 1–7) giving a prediction of 2,900 for 2015. However, this is exactly equal to 2014 sales and recent history indicates a more rapidly rising trend. The final four years of data give a regression line of:

Sales (000s) = 1165 + 245 × (Year number = 4–7) and a prediction for 2015 of 3,125. It would appear that Mr. Williams’ estimate of 300,000 bottles for 2015 is probably conservative, although a slight drop was experienced in one previous year. A range from 2,850 to 3,200 would cover the reasonably possible outcomes.

The market share for Permashine will obviously depend on the price charged. The only information for which we have reliable data is for the 99p price and for a price set at the top end of the competitors’ range, which is equivalent to a price of 80p in 2014. (We perhaps ought to consider inflationary trends into 2015, but these are likely to be quite small and the analysis may be best conducted in terms of 2014 price levels and then adjusted to 2015 levels.)

At the higher price, market share fell by 5.5% in the first year and a further 4% in the second year, indicating a considerable degree of product loyalty. This fall also seems consistent with Mr Williams’ view that there is a floor below which demand will not fall, although it is not clear on what evidence he bases his opinion. It is, therefore, reasonable to predict that market share may well fall by a further 3.5% in 2015 if the 99p price is maintained, giving a demand of (3,000 × 10%) 300,000 bottles in 2015. A range of 250,000–350,000 bottles would cover most of the likely possibilities.

If the price is dropped to the top end of the competitors’ range (i.e. 80p), we could probably assume that the previous market share of 24% could be attained again. The real question is how long it will take to achieve this level of sales. The market was sticky in a downward direction; how sticky will it be upwards? This is difficult to answer, but my own inclination is to think that it may take a couple of years to regain the previous position; some of those who gave up Permaclean because of its price may be satisfied with a competing product and not return. Thus, the movement from 13.5% share back to 24% may well yield only 18 or 19% share in 2015. Such a view is also consistent with Mr Williams’ assertion that a price of 75p would give a 20% market share in 2015. Thus, the best prediction of demand in 2015 is probably 540,000 bottles at a price of 80p (and may be 600,000 bottles at 75p).

Finally, there is the issue of estimating the variable costs of production. The direct labour and materials costs are clearly variable, with perhaps a slight increase in labour costs (due to overtime?) at the higher end. Departmental overhead also seems to be categorised correctly, with the fixed element being equivalent to an annual cost of £36,000. Factory overhead is more difficult to assign; however, it can only refer to items not attributable to the Department (as these would come under Departmental overhead). Although it appears to be a variable cost, this is only because it is allocated on the basis of direct labour costs. It is possible that it contains a small variable element (e.g. electricity costs, if these are not separately metered) but it must also include substantial fixed elements (e.g. rates). However, it is small in total and no great damage will be done to the analysis if it is assumed to be totally fixed. Selling and administration costs are almost certainly totally fixed, for the sales force is remunerated on the basis of a salary, not commission. Thus the truly variable costs amount to about 35p per bottle (i.e. 17.5p + 8p + 9p + a small proportion of 3.5p); certainly 40p would be an overstatement.

We are now in a position to perform a contribution analysis. At the 99p price: Contribution = 300,000 × (99p − 35p) = £192,000

At the 80p price:
Contribution = 540,000 × (80p − 35p) = £243,000

At the 75p price:
Contribution = 600,000 × (75p − 35p) = £240,000

Thus, the lower prices are clearly better than the highest, although there is little to choose between 80p and 75p. Such a choice would require more information.

A decision tree analysis with most likely, optimistic and pessimistic industry sales forecasts and market shares could also be performed, again using two or three possible prices. Crudely, even if pessimistic forecasts are made for the performance with an 80p price, compared with optimistic forecasts at the 99p price, the ordering of the alternatives is only just reversed:

Contribution (optimistic) = 375,000 × (99p − 35p) = £240,000

Contribution (pessimistic) = 500,000 × (80p − 35p) = £225,000

Overall, there is every likelihood that the lower price will give the better results. However, even with the lower price, it is probable that not more than 600,000 bottles will be sold, compared with a plant capacity of 800,000 and a marginal cost of production between 35p and 40p. It may, therefore, be possible for Permaclean to find another outlet for this unused capacity. For example, it may wish to consider export sales, bulk sales to commercial cleaning firms or the production of a supermarket own-label product.

Provided these additional sales do not affect existing sales of Permaclean, any price in excess of the marginal cost of production (plus any additional costs incurred in meeting the special order) will generate additional contribution to profit. To extend the discussion along these lines, students can be asked to give examples of products that are commonly sold at different prices. Supermarket ‘own’ brands, electricity and telephone services, rail fares and airlines provide some examples. In general, if a market can be effectively segmented, differential pricing provides improved contribution because those consumers who are willing to pay more than the lower ‘market’ price are made to do so, while only those who would not buy at the higher price are given the benefit of the lower price. The art is segmenting the market!

PART B

QUESTION 2 [40 marks]

Students need to consider the following points among others:

Oil is a main cost for the airline companies.

Oil price is affected by demand and supply but also political powers, reduced activity due to Covid-19 situation, spending cuts from big consumers. Students need to consider and analyse all these points including the ethical factors that is reflected in the Environmental agencies’ acts.

If a company makes a budget for next year, what shall they consider for the oil price that will include? Which budgets will be affected and why?

QUESTION 3 [40 marks]

Students need to consider the role of CVP in decision making. Students need to discuss and make a classification of the main costs including the variable and fixed costs of running an airline company. Then, students need to support the argument about the company’s future profitability by identifying the potential contribution margin which plays the major role in the company. Students need to consider financial and non-financial factors in supporting the decision about profitability.