A bakery’s price cut versus cost reduction
A small bakery sells 8,000 loaves a month at KSh 60 each. Variable cost is KSh 38 per loaf and fixed costs are KSh 160,000 a month. Capacity is 10,000 loaves a month. A supermarket chain has opened nearby, and sales are flat. The owner proposes cutting the price to KSh 54, expecting to fill capacity. A nearby college estimates price elasticity of demand for the bakery’s bread at −1.8. The baker can either cut price, spend KSh 20,000 a month on a delivery van and loyalty cards, or negotiate a 10% cut in flour prices. Flour is 60% of variable cost. The owner wants a decision based on numbers, not intuition.
1. Calculate the current monthly profit, contribution per loaf and break-even quantity.
Read the worked answer
Contribution per loaf = price − variable cost = 60 − 38 = KSh 22. Total contribution at 8,000 loaves = 8,000 × 22 = KSh 176,000. Fixed costs are KSh 160,000, so monthly profit = 176,000 − 160,000 = KSh 16,000.
Break-even quantity = fixed costs ÷ contribution per loaf = 160,000 ÷ 22 = 7,273 loaves (rounded up). The bakery is selling 8,000 loaves, only 727 above break-even, so a small fall in volume would wipe out profit. Capacity is 10,000 loaves, giving a margin of 2,000 loaves above current sales.
The current position is therefore profitable but fragile. The supermarket’s entry matters because the bakery has little cushion: a 9% fall in sales would reach break-even, and any price reduction lowers the contribution that absorbs fixed costs. This is the baseline against which the three options must be judged.
2. Using the elasticity estimate, evaluate the proposed price cut to KSh 54.
Read the worked answer
At KSh 54, contribution per loaf = 54 − 38 = KSh 16. Break-even quantity = 160,000 ÷ 16 = 10,000 loaves, exactly full capacity. To make any profit, the bakery would have to sell more than capacity, which is impossible without expansion.
The price cut is 6 ÷ 60 = 10%. With elasticity −1.8, quantity demanded rises by 1.8 × 10% = 18%, from 8,000 to 8,000 × 1.18 = 9,440 loaves. Projected profit = (9,440 × 16) − 160,000 = 151,040 − 160,000 = −KSh 8,960. The bakery moves from a KSh 16,000 profit to a KSh 8,960 loss, a deterioration of KSh 24,960.
The cut fails because the contribution loss on existing sales is large: 8,000 × (22 − 16) = KSh 48,000, while the extra 1,440 loaves contribute only 1,440 × 16 = KSh 23,040. Even at full capacity of 10,000 loaves, the bakery would only break even at KSh 54. A price cut should be rejected unless variable cost falls first or demand is much more elastic than −1.8.
3. Compare the price cut with the van-and-loyalty-card option and the flour-price negotiation, then recommend a course of action.
Read the worked answer
Price cut: projected loss of KSh 8,960; break-even requires full capacity. Reject.
Van and loyalty cards: cost KSh 20,000 a month. At KSh 22 contribution, extra sales needed to cover the cost = 20,000 ÷ 22 = 909 loaves, an 11.4% increase. That is plausible but not guaranteed; if it generates 1,000 extra loaves, profit rises by (1,000 × 22) − 20,000 = KSh 2,000, a small gain. The option carries execution risk and does not improve the underlying cost structure.
Flour price cut: flour is 60% × 38 = KSh 22.80 per loaf. A 10% cut saves KSh 2.28, reducing variable cost to KSh 35.72 and raising contribution to KSh 24.28. At the same 8,000 loaves, profit = (8,000 × 24.28) − 160,000 = 194,240 − 160,000 = KSh 34,240, an improvement of KSh 18,240 a month with no demand risk.
Recommendation: negotiate the flour price first, and use part of the gain to fund a modest loyalty scheme rather than a blanket price cut. If the flour negotiation fails, test the van on a limited route for one month and measure incremental sales before committing. Do not cut price to KSh 54; the numbers show it destroys profit and still requires full capacity to break even.