Agriculture Reference
In-Depth Information
New Breakeven $13,752,656
Old Breakeven $11,097,703
Additional Sales $2,654,953
In this scenario, if BF&G decided to reduce selling price by 2 percentage points, its breakeven
would increase by $2,654,953 or roughly 24 percent. Again, volume-cost analysis does not
answer the question of what should be done—this is still the manager's decision. What
volume-cost analysis does, in this case, is to show the manager that if BF&G cuts price by
two percentage points, BF&G must increase sales by $2,654,953 to be in the same fi nancial
position as they were before the price cut. It is the manager's job to decide whether or not
this move makes sense in the BF&G market area.
One word of caution about price changes: lowering the price may increase sales only
temporarily. For many food and agribusiness fi rms, total demand may well be reasonably
constant in a market area and/or during a season. Competitors may react to a fi rm's price
reduction with a similar price cut. The net effect may be to lower price and CTO for all fi rms
in the market without any appreciable increase in sales. The obvious result is much lower
profi ts (or higher losses).
In only the most unusual circumstances can a fi rm afford to sell any product at a price
lower than its variable cost. The variable cost for a product represents, for all practical pur-
poses, the lowest possible price for that product. To sell when variable cost is not being
covered, means that some of the variable costs are not covered, and none of the overhead can
be covered. Losses will be less if the sale is not made at all, because in this case only fi xed
costs are lost at zero sales volume.
So, when would a fi rm sell product below its variable cost? Two possibilities exist
where this decision may make economic sense. First, recall the pricing strategies outlined in
Chapter 7
. One of these strategies was identifi ed as “loss leader” pricing. In this case, the
product is priced below its total cost, and sometimes even below its variable cost. For
example, in order to gain additional customers, a supermarket may price milk below the sup-
plier cost. The low price would be advertised in the store's weekly fl yer for customers to see.
The strategy used by the store, in this case, is to get customers into the store by advertising
a product at a very attractive price. The store makes money on the other items customers
purchase on their trip to the store. This strategy may backfi re, however, if the store has a lot
of customers who come in only to shop for specials.
The second scenario, where selling below variable cost makes sense, is related to the
demand factor of tastes and preferences. Suppose a fi rm has an inventory of a specifi c type of
farm equipment. The fi rm is notifi ed that the manufacturer is planning to introduce a new
model that has many new features and will sell at the same price. As potential customers
become aware of this new model, they have little use for the fi rm's inventory of the old model.
Hence, if the fi rm is to generate any revenue from this inventory, it will most likely have to cut
the selling price—probably signifi cantly. This strategy may make more sense than having to
write-off obsolete inventory, or sell the equipment later at an even higher level of discount.
Graphical analysis
Graphical illustration of volume-cost relationships is quite useful for many managers
as a means of visualizing how changes in price, various costs, or volume impacts profi t.
Figure 12.7
illustrates BF&G's breakeven point and graphically shows its profi t at the cur-
rent $13.410 million sales volume. (Note that profi t is the difference between total revenue
