02_-_marketing_math_full_version.pdf

1 Marketing Management Qiang Liu Marketing Math ?Marketers need to look for new opportunities ? and put hard data ahead of gut feelings.? -- David Pottruck, former CEO, Charles Schwab 2 Father of Modern Marketing Science Frank M. Bass 1926 - 2006 at Krannert 1961-1982 Introduced in 1962, 1969 3 Agenda & Administration ? Break-Even homework is due: 5:50pm, Wed, Jan 21 ? Marketing math ? Vocabulary and definitions ? Arithmetic useful for marketing cases and decisions 4 Agenda & Administration ? Break-Even homework is due: 5:50pm, Wed, Jan 21 ? Marketing math ? Vocabulary and definitions ? Arithmetic useful for marketing cases and decisions 5 Marketing math: Relevance ? General relevance to business decisions ? Analyses don?t make decisions; managers make decisions ? Analyses provide inputs that help make good decisions ? Business decisions are often messy ? knowing what analysis to use and how to use it is usually more difficult than performing the calculations ? Specific need for course cases ? Analyses we review focus on those needed for course cases: our focus is on basic data analyses only ? Different cases require different evidence (some cases are more data driven and others more qualitative) 6 Common analyses in marketing ? Break-even analysis (BE) ? Total and Incremental Break-Even Volume (TBEV and IBEV) and cannibalization ? Margin analysis and multiple margins (channels) ? Trends, growth rates, and changes over time ? Lifetime value of the customer (LTVC) 7 Definitions ? Costs ? Variable costs and fixed costs ? In the long run, all costs are variable ? Avoidable vs. unavoidable fixed costs ? Unavoidable FC: any cost that will not be affected by the decision ?Should be ignored in analyzing a new investment ?Don?t cry for the spilled milk. ? Avoidable FC: any cost that can be ?avoided,? or changes depending on the decision ?Should always be counted in decision-making 8 Distinguish between types of cost ? Your company proposes launching a new product. ? If the product is launched, the company will require $500K in new equipment, otherwise no cost is incurred. ? In researching the new product, your firm spent $100K on marketing research. Do you put the $100K into your fixed costs that need to be recovered from the new product project when you make new product go/no go decision? ? Your firm needs to replace a piece of equipment to maintain its current operation, at a cost of $1M. Someone suggests that, instead of replacing the equipment, the firm should buy an upgraded equipment so that it can also produce a new product at the same time, at a cost of $1.40M. What are the FC that need to be recovered by the new product? 9 Concorde Fallacy Investors (and governments!) keep on investing in loss-making project just because they have already wasted a lot of money on them! 10 Definitions and formulae ? Definitions Total Profit = Total Revenue - Total Cost = Total Revenue ? Total Variable Costs ? Total Fixed Costs = (Unit Volume * Unit Price) - (Unit Volume * Unit Variable Cost) - Total Fixed Cost = Unit Volume * (Unit Price - Unit Variable Cost) - Total Fixed Cost = Unit Volume * Unit Contribution - Total Fixed Cost = Total Contribution - Total Fixed Cost Unit Contribution Total Contribution 11 Break-even? ? Break even just means that profit=0 ? 0=Total Profit=Unit Volume*(Unit Price ? Unit Variable Cost) ? Total Fixed Cost ?Unit Volume*(Unit Price ? Unit Variable Cost) = Total Fixed Cost ? Now, solve for any variable you want ? Total break even volume ?solve for Unit Volume ? BE contribution ? solve for Unit Price- Unit VC ? BE price ? solve for Unit Price ? Obviously, you must be given the other variables (or be able to compute or estimate them) 12 Total break-even unit volume (TBEV) Cash break-even APPLICATION 1a-Cash Break-Even: The XYZ Company makes a product that has a manufacturer?s suggested retail price (MSRP) of $10. The ?street price? is $9 which gives retailers a $4 profit margin. The unit variable cost is $3. Fixed costs include $17,000,000 for consumer advertising, $5,000,000 for consumer promotion, $12,000,000 for trade promotion, a $20,000,000 sales force budget, and $6,000,000 for general and administrative expense. Total Fixed Cost $60M TBEV = --------------------------- = --------------------- = 30M units Unit Contribution $2.00 Unit Price = End ?User Price ?Channel Margin = $9-$4=$5, and Unit Contribution is equal to Unit Price- Unit Variable Cost = $5-$3= $2. 13 Total break-even unit volume (TBEV) Accounting break-even APPLICATION 1b-Accounting Break-Even: It turns out that XYZ company also had to purchase equipment. The equipment cost $100,000,000 and is straight-line depreciated over 10 years with no residual value. Total Fixed Cost + Depreciation $60M + $10M TBEV = ----------------------------------------- = ------------------ = 35M units Unit Contribution $2.00 14 Incremental break-even unit volume (IBEV) for fixed cost actions APPLICATION 1b: The XYZ Company is considering a $15,000,000 increase in the advertising budget. Incremental Expenditures $15,000,000 IBEV = --------------------------------- = ---------------- = 7,500,000 units Unit Contribution $2.00 where, Incremental Expenditures are $15,000,000, and Unit Contribution is $2.00, as computed for the TBEV in APPLICATION 1a. 15 IBEV and changes to unit contribution APPLICATION 1c: Assume that the XYZ Company normally sells 90,000,000 units and is considering a $.50 price cut (i.e., $4.50 instead of $5.00). Old Unit Volume * Unit Contribution Loss IBEV = --------------------------------------------------------- New Unit Contribution (90,000,000 * $.50) $45,000,000 = --------------------------- = -------------------- = 30,000,000 units $1.50 $1.50 where, Old Unit Volume is 90,000,000, Unit Contribution Loss is the unit price reduction, $.50, and New Unit Contribution = New Unit Price - New Unit Variable Cost = $4.50 - $3.00 = $1.50. 16 IBEV for complex actions APPLICATION 1b/c: The XYZ Company increases advertising by $15,000,000 and reduces price by $.50. Incremental Expenditures + Old Unit Volume * Unit Contribution Loss IBEV = --------------------------------------------------------------------------------------- New Unit Contribution $15,000,000 + (90,000,000 * $.50) = --------------------------------------------- $1.50 $15,000,000 + $45,000,000 = ------------------------------------ = 40,000,000 units. $1.50 NOTE: Notice that 40,000,000 > 37,500,000 = 7,500,000 + 30,000,000, which is the sum of the IBEVs from 1b and 1c ? Why? 17 Cannibalization ? Whenever a marketing action for one product in the product line may ?steal? sales away from other products in the line, ?cannibalization? must be considered ? For example, when the Pentium III was introduced, some sales were ?cannibalized? from Pentium II (and other Intel chips). Also, if the Pentium II price is cut, that may cannibalize Pentium III sales. Why is cannibalization important? ? You must avoid double-counting in order to keep track of the true incremental contribution 1964 1963 1982 18 Cannibalization rate ? Cannibalization rate is quoted as the percentage of New Product Unit Volume that would have gone to the Old Product had the New Product not been introduced. Old Product Volume Loss CR = ------------------------------------ New Product Volume Is it possible that actual CR > 100%? 19 Cannibalization APPLICATION 1d: The XYZ Company is considering the introduction of a second product. This product will have a unit price of $4.00 and will cost $2.50 to produce.What would be the incremental contribution if the XYZ Company?s actual cannibalization rate were 25%? Assume sales of the old product are 90,000,000 and that sales of the new product will be 20,000,000 units. ? The product will do better than breakeven ? how do we know? ? What will total contribution be? 20 Cannibalization Application 1d: Incremental contribution with cannibalization Incremental Contribution with Cannibalization = NP Units * NPUC ? OP Units * OPUC = NP Units * NPUC ? (NP Units * CannRate* OPUC) = NPUnits * (NPUC ? CannRate * OPUC) = 20,000,000 ($1.50 ? .25 * $2.00) = $20,000,000 in incremental profit where, NPUnits refers to the number of units forecasted to be sold of the new product, CannRate is the cannibalization rate, OPUnitsrefers to the number of the old product units that would be sold if new product were not introduced, OPUC is the Old Product?s unit contribution. Introducing a new product with a cannibalization rate of 25% and a lower margin results in net $20,000,000 in incremental profit. If you mistakenly ignored cannibalization, you would have assumed that the new product would generate $30,000,000 in profits. 21 Break-Even Cannibalization Rate (BECR) ? The maximum percentage of the new product?s sales that can be cannibalized (stolen) from the old product while breaking even (assuming no changes to fixed costs!) Solution 1. Break even means profit = 0. 2. ? = 0 = NPUnits * NPUC ? (NPUnits * CR * OPUC) ? FC 3. In the case that FC = 0 4. Solve for CR (cannibalization rate) 5. BECR = NPUC / OPUC 22 Break-Even Cannibalization Rate (BECR) APPLICATION 1e: What is the Break-Even Cannibalization Rate if everything is same as application 1d? What can you conclude from the comparison of BECR and the actual CR? BECR = NPUC / OPUC = $1.50 / $2.00 = 75% What if FC > 0? BECR = NPUC / OPUC ? FC/(OPUC*NPUnits) ? What does the 75% mean? 23 Margin analysis: Channel margins It is often important to assess margins across distribution channels ? Retail, wholesale, and manufacturer price differ ? Retail price is used in assessing consumer response ? Manufacturer price is used in calculating contribution ? Retail and wholesale profits are frequently specified in percentage terms. Keep careful track of your formula inputs! ? Margin = [price ? cost] / price. Thus price = cost / [1 ? margin] ? Mark-up = [price ? cost] / cost. Thus price = cost * [1 + mark-up] Manufacturer Distributor Retailer Customer Mfgr Price Retailer Cost Retail Price Unit Contribution Distributor Profit Retail Profit Variable Cost 24 Channel margins ? XYZ sells overseas through distributors. If the export arm of XYZ uses a 20% mark-up on cost and a regional wholesaler sells to achieve a 25% margin then at what cost do retailers purchase the product from XYZ? XYZ (manufacturer) selling price = $5 Export Arm SP = Cost x (1 + Mark-up) = ($5 x 1.20) = $6 Regional Wholesaler SP (WSP) = Cost/(1 ? Margin) = $6/(1-.25) = $8 Note: It is often necessary to go back and forth from retail selling price to manufacturer selling price. Also, note that the price above is NOT the retail price 25 Trends, Growth Rates, Bumps, etc. ? Rule #1: Always plot your data against time and look for: ? Trends, growth rate (the slope), shape (linear, exponential), bumps (reversals, changes), other changes (did the trend slow down? speed up?) ? Rule #2: Figure out how fast relevant economic measures are changing ? Simple percent change: (Amount end ? Amount begin ) --------------------------------------- Amount begin ? Problem: cumbersome and not very useful How should we account for time? ? CAGR: compound annual growth rate = 1 1 ? ? ? ? ? ? ? ? ? n begin end Amount Amount 26 Lifetime value of a customer (no discount) ? Increasingly, marketing strategies have focused on customer value for time horizons longer than one year APPLICATION 3a: Marketing research revealed that direct mailing a product sample creates loyal XYZ customers. Costs include the sample ($3) and $1 shipping and handling. One in four recipients of the sample are expected to become loyal XYZ customers. XYZ plans to send a $1 coupon to these customers each year to maintain loyalty (with $.50 postage). Loyal customers purchase 6 units of XYZ product each year and do not buy competing products. However, each year 10% switch to competitor?s product (and then purchase only that competitor?s product). Lifetime Value of the Customer (LTVC) for a 5-year time horizon = Cumulative Retention Rate t * Net Customer Contribution t = 1.0 * (-$4) + .9 * $10.50 + .81 * $10.50 + .729 * $10.50 + .656 * $10.50 = $28.50 27 Summary: Marketing math ? Breakeven is the basis of more complex techniques like discounted cash flow ? understand it! ? Most analyses are algebra and vocabulary ? You need to know when to apply each ? Terms such as ?price/unit? and ?cost/unit? change meaning depending on which channel member is the focus of your analysis (manufacturer, wholesaler, retailer) ? Cases are usually written from the manufacturer?s point of view (but not all are) ? Collect and analyze data that will be useful in decision- making ? but numbers are only one input ? Numbers support cogent recommendations for action ? they are pieces of evidence, not conclusions ? Data must be analyzed appropriately to provide useful insights ? Analyses don?t make decisions; people make decisions