Mwai Springs: Matching a Rival's Price or Finding Another Way
Mwai Springs bottles water in Mangochi and sells 40,000 bottles a month at MK500 each to shops in three districts. Variable cost is MK300 a bottle and fixed costs are MK5 million a month, giving a monthly profit of MK3 million. A new competitor has entered the market at MK450 a bottle and the sales manager wants to match that price. A survey of similar past price changes in the region suggests the price elasticity of demand is about −1.8 over this range. The company's only delivery truck is fully used on the current three districts, and 30 per cent of production is lost to bottles that break in transit on rough feeder roads. The owner is also considering a 500 ml sachet sold through rural kiosks at MK150, with variable cost of MK90 and a new filling line that would add MK2 million a month in fixed costs.
1. Using the elasticity estimate, calculate the effect of matching the competitor's price. Advise the sales manager.
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A move from MK500 to MK450 is a 10 per cent cut. With elasticity of −1.8, quantity rises by 10 × 1.8 = 18 per cent, from 40,000 to 47,200 bottles.
Before: contribution per bottle = 500 − 300 = MK200; total contribution = 40,000 × 200 = MK8,000,000; less MK5,000,000 fixed costs gives MK3,000,000 profit.
After: contribution = 450 − 300 = MK150; total contribution = 47,200 × 150 = MK7,080,000; profit = MK2,080,000.
Matching the price destroys MK920,000 of profit a month, roughly 31 per cent of current profit, despite selling 7,200 more bottles. The reason is that the cut applies to all 40,000 existing bottles, costing MK2,000,000 of contribution on those alone, while the extra 7,200 bottles add only 7,200 × 150 = MK1,080,000.
To hold profit at MK3 million the firm would need contribution of MK8,000,000, which at MK150 requires 8,000,000 ÷ 150 = 53,333 bottles - a 33.3 per cent increase, implying an elasticity of about −3.3. The estimate would have to be nearly twice as large to justify the cut. Elasticity estimates are uncertain, but with that margin of error the decision is robust. The sales manager should not match. Cutting also invites retaliation and teaches buyers to wait for discounts, and the rival may be a small entrant with limited capacity that cannot serve the three districts anyway.
2. Evaluate the sachet proposal. What volume is needed and what else must be true before committing?
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Standalone break-even. Contribution per sachet = 150 − 90 = MK60. New fixed costs of MK2 million a month require 2,000,000 ÷ 60 ≈ 33,334 sachets a month before the sachet line contributes anything. That is the minimum, not the target.
Three further conditions. First, distribution. The truck is fully used, so every sachet must be carried by new capacity - a hired vehicle, a third-party distributor or a bigger truck - and that cost is not in the MK2 million. Second, breakage. Thirty per cent of bottles already break on feeder roads; sachets sold through rural kiosks travel precisely those roads, so the packaging must be tested or the effective realised price per sellable unit falls. Third, and most important, cannibalisation. If a sachet buyer is a current bottle buyer, the firm loses MK200 of contribution and gains MK60, a net loss of MK140 per switch. If one in five sachet sales is a switcher, the line needs far more than 33,334 units to add value.
Recommendation. Pilot in one district with a hired distributor for three months. Measure incremental contribution, not sachet volume: track sales of bottles in the same outlets and count switching. Commit to the MK2 million monthly fixed cost only if the pilot shows the sachet reaches buyers who were not buying bottles, and only if the delivery capacity can be funded.
3. The owner says: 'Any price above variable cost is worth taking.' Assess this rule using the situation above.
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The rule is a short-run rule and it is being misapplied. It is valid when three conditions hold together: there is genuinely spare capacity, the low price applies only to the extra units and cannot leak into existing sales, and the order is one-off so it does not reset customer expectations. None of those conditions holds here.
First, the MK450 price would apply to all 40,000 bottles, not only to the extra units. The extra bottles earn MK150 each, but the existing ones lose MK50 each. The correct test is total contribution before and after, which falls from MK8 million to MK7.08 million. Marginal reasoning cannot be used when the price is posted to the whole market.
Second, capacity is not spare. The truck is fully used and 30 per cent of output breaks in transit, so every extra bottle consumes scarce distribution and adds breakage. The relevant comparison is not MK450 against MK300, but MK450 against MK300 plus the opportunity cost of the truck capacity and the value of the existing MK500 sales.
Third, the rule ignores time horizon. In the long run all costs, including the MK5 million of fixed costs, must be covered or the firm should exit. A price that covers variable cost but not fixed costs can be right for a brief period to keep cash coming in during an unavoidable slump, but it is a survival measure, not a strategy.