Healthy Spring Water Company

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HEALTHY SPRING WATER COMPANY

PROBLEM 1a

DEFINING THE PRICE-VOLUME TRADEOFF
FOR A 20% PRICE INCREASE

The Health Spring Water Company sells bottled water for offices and homes. The price of the water is $20 per 10 gallon bottle and the company currently sells 2,000 bottles per day. Following is a summary of the company’s income and costs on a daily basis.

Sales Revenue$40,000
Incremental Variable Costs$16,000
Nonincremental Fixed Costs$20,000

Note: You can assume that variable costs are constant so that the average of them is the variable cost relevant for a change in sales.

One can calculate the change in sales volume necessary for the price change to be profitable by using the following Basic Breakeven Sales Change formula:

% BE Sales Change = - Change in Price
(Basic Calculation)CM + Change in Price

The company is enjoying stable demand with its current pricing, but management is looking for ways to increase profitability. One suggestion is that the company reposition its water as a premium product, justifying a higher price. If successful, the company believes that it could charge 20% more for its water than it does now.

1.What is the maximum sales loss (in % and units) that Healthy Spring could tolerate before a 20% price increase would fail to make a contribution to profit? (That is, what is the basic breakeven sales change?)

2.By how much would Healthy Spring’s contribution increase if its sales declined by 15% following the price increase?

HEALTHY SPRING WATER COMPANY

PROBLEM 1b

BREAKEVEN CALCULATIONS WITH
A CHANGE IN VARIABLE COSTS

It is usually not possible to raise a price substantially without also improving the product and/or its promotion. Consequently, a price change often involves a corresponding change in the incremental variable cost.

% BE Sales Change = - Change in CM
(with a Change in VC)CM + Change in CM

= - (Change in Price - Change in VC)
CM + (Change in Price - Change in VC)

Notice that when the change in variable costs is zero, this becomes just the basic calculation that we used to analyze a simple price change. Note that the easiest way to do this calculation is in units of currency (e.g., dollars). If you use percents for the changes, the change in CM or VC must be stated as a percent of the original price, not as a percent of the original contribution margin or variable cost.

Healthy Spring Continued:

3.In order for Healthy Spring to reposition itself as a premium water, management believes that it will have to upgrade the packaging of its product. The company will deliver the water in glass rather than plastic bottles and the bottles will have to be “safety sealed” to insure their cleanliness until the covering is removed in the customer’s home. These changes will ad $1.00 per bottle to the variable cost of sales.

Given this increase in variable cost, what is the maximum amount of sales that Healthy Spring could afford to lose and still profit from repositioning its water at a 20% higher price?

HEALTHY SPRING WATER COMPANY

PROBLEM 1c

BREAKEVEN CALCULATIONS WITH
INCREMENTAL FIXED COSTS

While variable costs are always incremental for a price change, some fixed costs may be incremental as well. For example, if a lower price requires more production capacity that involves semifixed costs, or if a higher price would enable the firm to sell of (or avoid building) some capacity that involved semifixed costs, then those costs would be incremental to the pricing decision. Fixed costs, however, cannot be included when calculating the contribution margin to calculate the basic breakeven sales change, because they are not relevant for producing all units.

To insure that a price change adequately reflects the increase or decrease in fixed costs that would result, one must add an additional term to the breakeven sales quantity calculation.

Unit BE Sales Change...
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