Pricing

Hamburg AG produces a number of pocket computer products. It is an established company with a good reputation that has built on well-engineered, reliable and good-quality products. It is currently developing a product called Techstar and has spend 1.5 million on development so far. It now has to decide whether it should proceed further and launch the product in one year s time.

If Hamburg AG decides to continue with the project, it will incur further development costs of 750.000 straight away. Hamburg AG expects that it could see Techstar for three years before the product becomes out of date (i.e. it is expected to be 3 years on the market).

It is estimated that the Techstars produced and sold in the first year would cost an average of 675 each unit, for production, marketing and distribution costs. Further fixed costs associated with the project are expected to amount 0.9 million (cash out flow) for each year the product is in production.

Because of the cost estimates, the Chief Executive expected the selling price to be in the region of 950. However, the Marketing Director is against the pricing strategy; he says that this price is far too high for this type of product and that he could sell only 6,000 units each year at this price. He suggests a different strategy: setting a price of 625, at which price he expects sales to be 15,000 units each year.

a) The Chief Executive has asked you to help sort out the pricing dilemma. Prepare calculations that demonstrate which of the two suggestions is the better pricing strategy. Should the product be produced? Neglect the company s cost of capital.

b) Hamburg AG found from past experience that in the second year the totals variable costs are 20% less of the first year s costs because of experience curve effects. In the third year the total variable costs are 20% less than the variable costs of the second year. How would the calculations (and the recommendation?) change? (6 points)