Marlow Fasteners: responding to a rival's price cut
Marlow Fasteners makes a single industrial component sold to UK equipment builders at £40 per unit. Monthly volume is steady at 12,000 units, variable cost is £22 per unit and monthly fixed costs are £150,000. Marlow's economist estimates own-price elasticity of demand at −1.6 over the relevant range and income elasticity of demand at +2.1, reflecting that demand is derived from customers' capital spending. A competitor has announced a 6% price reduction and Marlow's sales director wants to respond with a 5% cut of its own. The board is also told that a forecast recession will reduce Marlow's customers' incomes by 3% next year, and that cross-price elasticity of demand between Marlow's component and the competitor's product is +0.8. Marlow has spare capacity. The finance director is worried about contribution rather than revenue and wants a written appraisal before the pricing meeting.
1. Calculate the effect of a 5% price cut on volume, revenue and contribution, and advise the board whether to proceed.
Read the worked answer
%ΔQ = −1.6 × (−5%) = +8%, so volume = 12,000 × 1.08 = 12,960 units.
- Revenue: 12,960 × £38 = £492,480, against 12,000 × £40 = £480,000 → up £12,480 (+2.6%).
- Contribution: (38 − 22) × 12,960 = £207,360, against (40 − 22) × 12,000 = £216,000 → down £8,640. Fixed costs are unchanged, so profit falls from £66,000 to £57,360.
Why the two answers conflict: revenue is maximised where marginal revenue is zero, i.e. where |PED| = 1. Contribution is maximised where MR = marginal cost. With unit variable cost v and price P, a price cut raises contribution only if |PED| > P ÷ (P − v) = 40 ÷ 18 = 2.22. At 1.6, Marlow is well short of that threshold, so the cut buys volume too expensively.
Advice: do not lead with a blanket cut. Defend on availability, lead time and specification, and if a price response is unavoidable, discount selectively to the customers with the highest switching risk rather than across the whole book.
2. Using the elasticity estimates, quantify what happens to Marlow if it holds price and the rival cuts by 6%, compared with matching the 6% cut. What should Marlow do?
Read the worked answer
Hold price. Cross elasticity +0.8 × competitor's −6% = −4.8% volume (−576 units). Income effect: −3% × 2.1 = −6.3% (−756 units). Combined multiplier 0.952 × 0.937 = 0.892 → 10,704 units. Contribution = 10,704 × £18 = £192,672, down £23,328.
Match with 6%. Price £37.60, unit contribution £15.60. Own-price effect adds 9.6% volume: 12,000 × 0.892 × 1.096 ≈ 11,732 units. Contribution = 11,732 × £15.60 = £183,019 - about £9,650 worse than holding price.
Matching destroys more contribution than it recovers, because Marlow is buying back volume it already largely has at a lower unit margin, and it is not the price leader. Better: hold the list price, protect the accounts most exposed to the rival, and reduce dependence on customers whose demand tracks the competitor.
Caveats to flag: these are point estimates, and derived demand in capital goods is usually more cyclical than a 3% fall in customer income implies, which would worsen both outcomes.