Quantitative Exercise 1 Quantitative Exercise 1 Due Jan 27 P

Quantitative Exercise 1 Quantitative Exercise 1 Due Jan 27 Pimco Inc. and Aarco Inc. both operate in the spindle industry, but with very difficult cost structures. PIMCO is a capital-intensive, automated manufacturer, while AARCO is a labor-intensive job shop. Monthly operating data are as follows Pimco Inc. Aarco Inc Sales (units) Price (S) Variable Cost/unit (S) Fixed Cost/month (S) Full cost/unit (S) Current Profit/month ()2500 5000 10 2.5 35,000 9.5 5000 10 5.5 20,000 9.5 2500 Both these firms are exploring whether it would be profitable to sell their spindles to the low-value, but potentially high-volume, market segment, which is not currently served by either of them. Reaching this market would require pricing their spindles at $8.50, which is 15% below the current price. At $8.50, each firm could sell 2000 spindles in this low-value market 1. Assume that the low-value market is distinct from the high-value market, and products can be sold at different prices in these two markets. That is, selling at a lower price in the low-value market would not undermine spindle price in the high-value market. What is the incremental profit that would accrue to PIMCO and AARCO, if sales volume increases by 40% (2,000 units)? Given our set of assumptions, for which firm is it a viable strategy to sell to the low-value market? 2. On studying more about the two market segments, it was clear that it is impossible to sell the spindles at a low price in the low-valuce without undermining the price for the high value segment. Therefore, assume that the price is same for both the market segments Compute for each firm the change in breakeven volume, if they choose to sell the spindle at $8.50 for both segments 3. Based on your breakeven analysis for section (b), discuss which company is better geared to exploit this opportunity

Solution

1) The new market has a price of $8.5 per unit and sales are 2000 for both firms. Hence additional revenue is $17000. The fixed cost is same for the entire production and is already accounted for in high value market. Hence the cost of supplying additional 2000 units are $2.5*2000 = $5000 for Pimco and $5.5*2000 = $11000 for Aacro, This makes the the incremental profit = $17000 - $5000 = $12000 for Pimco and $17000 - $11000 = $6000 for Aacro.

It is a viable strategy for both firms because both are able to sell the additional units profitably.

2) When price is $8.5 per unit in total, we see that their additional profits are unchanged but their profits now turn negative. Previously revenue was $10*5000 = $50000 for both but now it is $8.5*5000 = $42500. The cost structure is same and therefore total cost is $35000 + $2.5*5000 = $47500 for Pimco so Pimco bears a loss of $42500 - $47500 = -$5000. In total Pimco\'s profit is $12000 - $5000 = $7000 only.

For Aacro, the cost is $20000 + $5.5*5000 = $47500 and its profits are now $42500 - $47500 = -$5000. Its total profit is $6000 - $5000 = $1000.

Now see that the break even quantity previously was

TR = TC

10*Q1 + 8.5*(40%*Q1) = 35000 + 2.5(Q1 + 40%*Q1)............Q1 is the quantity in market 1 (high valued market)

13.4Q1 - 3.5Q1 = 35000

Q(break even for Pimco) = 3535.

After the uniform price implementation , this quantity changes to

TR = TC

8.5*(*Q1 + 40%*Q1) = 35000 + 2.5(Q1 + 40%*Q1)

Q (new break even for Pimco) = 4166

The same for Aarco is 3508 that now changes to 4761.

c) The break even quantity for Pimco rises by 631 units from 3535 to 4166 while the same increases by 1253 from 3508 to 4761 units. Hence Pimco is in a better position with respect to the break even position as it is achieved quite early and profits are also higher