HD is considering boosting its advertising to make more people aware of the benefits of this device in general and of its own brand in particular. What if HD’s marketers recommend increasing national advertising by 50% to $15 million (assume no change in the variable cooperative component of promotional expenditures)? This represents an increase in fixed costs of $5 million. What increase in sales will be needed to break even on this $5 ­million increase in fixed costs?

A quick way to answer this question is to divide the increase in fixed cost by the contribution margin, which we found in a previous analysis to be 21%:

Thus, a 50% increase in advertising expenditures must produce a sales increase of almost $24 million to just break even. That $24 million sales increase translates into an almost 1 percentage point increase in market share (1% of the $2.5 billion overall market equals $25 million). That is, to break even on the increased advertising expenditure, HD would have to increase its market share from 4% to 4.95% ($\text{\$}123,809,524÷\text{\$}2.5\text{ billion}=0.0495$ or 4.95% market share). All of this assumes that the total market will not grow, which might or might not be a reasonable assumption.

HD also wants to consider hiring more salespeople in order to call on new retailer accounts and increase distribution through more outlets. Even though HD sells directly to wholesalers, its sales representatives call on retail accounts to perform other functions in addition to selling, such as training retail salespeople. Currently, HD employs 60 sales reps who earn an average of $50,000 in salary plus 10% commission on sales. The product is currently sold to consumers through 1,875 retail outlets. Suppose HD wants to increase that number of outlets to 2,500, an increase of 625 retail outlets. How many additional salespeople will HD need, and what sales will be necessary to break even on the increased cost?

One method for determining what size sales force HD will need is the workload method. The workload method uses the following formula to determine the sales-force size:

where

HD’s sales reps typically call on accounts an average of 20 times per year for about 2 hours per call. Although each sales rep works 2,000 hours per year $(50\text{weeks}\text{per}\text{year}\times 40\text{hours}\text{per}\text{week)}$, they spent about 15 hours per week on nonselling activities such as administrative duties and travel. Thus, the average annual available selling time per sales rep per year is 1,250 hours $(50\text{weeks}\times 25\text{hours}\text{per}\text{week})$. We can now calculate how many sales reps HD will need to cover the anticipated 2,500 retail outlets:

Therefore, HD will need to hire 20 more salespeople. The cost to hire these reps will be $1 million $(20\text{salespeople}\times \text{\$}50,000\text{salary}\text{per}\text{sales}\text{person})$.

What increase in sales will be required to break even on this increase in fixed costs? The 10% commission is already accounted for in the contribution margin, so the contribution margin remains unchanged at 21%. Thus, the increase in sales needed to cover this increase in fixed costs can be calculated by:

That is, HD’s sales must increase almost $5 million to break even on this tactic. So, how many new retail outlets will the company need to secure to achieve this sales increase? The average revenue generated per current outlet is $53,333 ($100 million in sales divided by 1,875 outlets). To achieve the nearly $5 million sales increase needed to break even, HD would need about 90 new outlets ($\text{\$}4,761,905÷\text{\$}53,333=89.3$ outlets), or about 4.5 outlets per new rep. Given that current reps cover about 31 outlets apiece ($1,875\text{ outlets}÷60$ reps), this seems very reasonable.

HD is also considering lowering its price to increase sales revenue through increased volume. The company’s research has shown that demand for most types of consumer electronics products is elastic—that is, the percentage increase in the quantity demanded is greater than the percentage decrease in price.

What increase in sales would be necessary to break even on a 10% decrease in price? That is, what increase in sales will be needed to maintain the total contribution that HD realized at the higher price? The current total contribution can be determined by multiplying the contribution margin by total sales:^v

Price changes result in changes in unit contribution and contribution margin. Recall that the contribution margin of 21% was based on variable costs representing 79% of sales. Therefore, unit variable costs can be determined by multiplying the original price by this percentage: $\text{\$}168\times 0.79=\text{\$}132.72$ per unit. If price is decreased by 10%, the new price is $151.20. However, variable costs do not change just because price decreased, so the contribution and contribution margin decrease as follows:

So a 10% reduction in price results in a decrease in the contribution margin from 21% to 12%.^vi To determine the sales level needed to break even on this price reduction, we calculate the level of sales that must be attained at the new contribution margin to achieve the original total contribution of $21 million:

So,

Thus, sales must increase by $75 million $\left(\text{\$}175\text{ million}–\text{\$}100\text{ million}\right)$ just to break even on a 10% price reduction. This means that HD must increase market share to 7% $\left(\text{\$}175\text{million}÷\text{\$}2.5\text{billion}\right)$ to achieve the current level of profits (assuming no increase in the total market sales). The marketing manager must assess whether or not this is a reasonable goal.

As a final option, HD is considering extending its product line by offering a lower-priced model. Of course, the new, lower-priced product would steal some sales from the higher-priced model. This is called cannibalization—the situation in which one product sold by a company takes a portion of its sales from other company products. If the new product has a lower contribution than the original product, the company’s total contribution will decrease on the cannibalized sales. However, if the new product can generate enough new volume, it is worth considering.

To assess cannibalization, HD must look at the incremental contribution gained by having both products available. Recall in the previous analysis we determined that unit variable costs were $132.72 and unit contribution was just over $35. Assuming costs remain the same next year, HD can expect to realize a contribution per unit of approximately $35 for every unit of the original product sold.

Assume that the first model offered by HD is called HD1 and the new, lower-priced model is called HD2. HD2 will retail for $250, and resellers will take the same markup percentages on price as they do with the higher-priced model. Therefore, HD2’s price to wholesalers will be $140 as follows:

If HD2’s variable costs are estimated to be $120, then its contribution per unit will equal $20 $\left(\text{\$}140–\text{\$}120=\text{\$}20\right)$. That means for every unit that HD2 cannibalizes from HD1, HD will lose $15 in contribution toward fixed costs and profit (that is, ${\text{contribution}}_{\text{HD2}}–{\text{contribution}}_{\text{HD1}}=\text{\$}20–\text{\$}35=–\text{\$}15$). You might conclude that HD should not pursue this tactic because it appears as though the company will be worse off if it introduces the lower-priced model. However, if HD2 captures enough additional sales, HD will be better off even though some HD1 sales are cannibalized. The company must examine what will happen to total contribution, which requires estimates of unit volume for both products.

Originally, HD estimated that next year’s sales of HD1 would be 600,000 units. However, with the introduction of HD2, it now estimates that 200,000 of those sales will be cannibalized by the new model. If HD sells only 200,000 units of the new HD2 model (all cannibalized from HD1), the company would lose $3 million in total contribution $(200,000\text{units}\times –\text{\$}15\text{per}\text{cannibalized}\text{unit}=–\text{\$}3\text{million})$—not a good outcome. However, HD estimates that HD2 will generate the 200,000 of cannibalized sales plus an additional 500,000 unit sales. Thus, the contribution on these additional HD2 units will be $10 million (i.e., $500,000\text{units}\times \text{\$}20\text{per}\text{unit}=\text{\$}10\text{million}$). The net effect is that HD will gain $7 million in total contribution by introducing HD2.

The following table compares HD’s total contribution with and without the introduction of HD2:

The difference in the total contribution is a net gain of $7 million $\left(\text{\$}28\text{ million}–\text{\$}21\text{ million}\right)$. Based on this analysis, HD should introduce the HD2 model because it results in a positive incremental contribution. However, if fixed costs will increase by more than $7 million as a result of adding this model, then the net effect will be negative and HD should not pursue this tactic.

Now that you have seen these marketing tactic analysis concepts in action as they related to HD’s new product, here are several exercises for you to apply what you have learned in this section in other contexts.