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.