Selvam's Saree Price Cut: Revenue Up, Profit Down
Selvam sells handloom cotton sarees in Kanchipuram. In January he sold 400 sarees at ₹1,200 each. In February he reduced the price to ₹1,000 and sold 520 sarees. Each saree costs him ₹700 in direct material and making charges, and his fixed costs are ₹1,20,000 per month. His friend says the price cut was a success because sales revenue rose from ₹4,80,000 to ₹5,20,000. Selvam is now considering two expansion routes: (i) admit his cousin as a partner who will bring ₹5,00,000, or (ii) convert the business into a private limited company with three shareholders. He is worried about liability if a consignment of sarees is damaged in transit and customers claim refunds. He also wants to know whether a further 10% price cut would be wise if the same elasticity continues.
1. Calculate the price elasticity of demand using the percentage method and interpret the result.
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Using the initial values as the base:
- Percentage change in quantity = (520 − 400) ÷ 400 × 100 = 30%
- Percentage change in price = (1,000 − 1,200) ÷ 1,200 × 100 = −16.67%
- Price elasticity of demand = 30 ÷ 16.67 = 1.8 (ignoring the negative sign)
Since the value is greater than 1, demand is elastic. A 1% fall in price is associated with about a 1.8% rise in quantity demanded. This is plausible for handloom sarees if buyers are price-sensitive and close substitutes are available. The practical implication is that a price reduction can increase total revenue, but that does not automatically mean profit rises, because each saree now earns a smaller contribution. Elasticity also may not remain constant if the price is cut again or if competitors react.
2. Calculate contribution and profit before and after the price cut. Was the price cut a success? Advise Selvam.
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| January | February | |
|---|---|---|
| Selling price per saree | 1,200 | 1,000 |
| Variable cost per saree | 700 | 700 |
| Contribution per saree | 500 | 300 |
| Quantity | 400 | 520 |
| Total contribution | 2,00,000 | 1,56,000 |
| Fixed costs | 1,20,000 | 1,20,000 |
| Profit | 80,000 | 36,000 |
Revenue rose by ₹40,000, but contribution fell by ₹44,000 and profit fell by ₹44,000. The price cut was therefore not a success in profit terms. Selvam confused revenue with contribution. The fixed costs did not change, so the whole fall in contribution hit profit. To justify a price cut, the extra volume must be large enough to offset the lower contribution per unit. Selvam should either restore part of the price, reduce variable cost, or find a price that generates more total contribution.
3. Compare partnership and private limited company for Selvam's expansion, focusing on liability and continuity, and recommend one.
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A partnership is easy and inexpensive to form, and the cousin's ₹5,00,000 would strengthen capital. But partners have unlimited liability: if damaged sarees lead to refund claims beyond the firm's assets, Selvam's personal property is at risk. A partnership may also dissolve on the death or retirement of a partner, so continuity is uncertain. A private limited company gives limited liability to shareholders and has a separate legal identity; it continues even if a shareholder dies or sells shares. It can raise capital from more shareholders, which suits expansion and risk-bearing. The disadvantages are compliance costs, audit and disclosure requirements, and the need to keep company and personal finances strictly separate. Given Selvam's specific worry about customer claims, the private company is the better recommendation, provided he is willing to bear the compliance burden.
4. If elasticity remains 1.8, calculate the effect of a further 10% price cut from ₹1,000. Should Selvam do it?
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A 10% cut takes the price to ₹900. With elasticity 1.8, quantity rises by 18%: 520 × 1.18 = 613.6 units, say 614. Contribution per saree becomes ₹900 − ₹700 = ₹200. Total contribution is about 614 × ₹200 = ₹1,22,800. After fixed costs of ₹1,20,000, profit is only about ₹2,800. This is a knife-edge result. If demand rises by less than assumed, or if the elasticity falls as the price goes lower, Selvam makes a loss. The calculation also assumes fixed costs stay constant and competitors do not respond. He should not make the cut on this evidence; a better move is to test a smaller reduction or to protect contribution through cost control.