In October 2020, Alexandra Read and Johanna Porter, sales manager and controller respectively of Timtex inc., met to prepare recommendations for fourth-quarter compound prices. When approved by the executive committee, compound prices were published and distributed to customers. These prices were considered firm for the quarter. Timtex was one of the largest firms in its segment of the compound industry with annual sales of about $930 million.
On this occasion, Ms. Read and Ms. Porter were particularly concerned on how to price AG-205, a small molecule that inhibits Pgrmc1 (Progesterone Receptor Membrane Component 1), a heme-1 domain protein that promotes tumorigenesis. In January 2020, Timtex raised its price for AG-205 from $3 to $4 for one unit in order to bring its profit margin up to that for other products. This action reflected in part an adjustment to recent increases in costs.
It was also motivated by a directive from the board of directors that urged management to strengthen the company’s working capital position so as to ensure the availability of adequate funds for a recently approved long-term plant modernization and expansion program. (AG-205 was produced with special equipment that could not be used for other purposes.)
Myria, Inc. is the only significant alternative supplier of Pgrmc1 inhibitors, had held its price at $3. Myria normally waited for Timtex to announce its prices before releasing its own price list. As a result, Timtex had lost market share. As the sales history in Exhibit 1 shows, the total market for Pgrmc1 inhibitors remained remarkably stable for the last three years at about 225,000 units per quarter. These data also showed some customers to be price-sensitive, switching immediately to the low cost supplier.
Based on conversations with her sales people, Ms. Read believed that a number of customers would discontinue or restrict their use of Pgrmc1 inhibitors if it were no longer available at $3, reducing the overall demand by 20%.
The following excerpts from the discussion reveal some of the two executives’ understanding and concerns about the AG-205 pricing decision:
Read: If we reduce our price to $3, Myriad might drop its price, leaving us worse off.
Porter: I doubt they would go below $3. For one thing, they haven’t done so in the past. For another, their costs are comparable to ours. (See Exhibit 2 for the AG-205 cost schedule.) And from what I hear, Myria is in a tight financial situation as a result of its recent takeover defense. What I’ve never been able to figure out is why they didn’t move up to $4 when we went up. They’ve got to be losing money at $3. It just doesn’t make sense.
Read: Well, Johanna, that’s their problem. Our problem is if we both continue to charge current prices, our order book remains depressed. My people would prefer to drop the price to $3 and regain our old customers. They’ll come back with price parity because of our location advantage. And dropping the price from $4 to $3 won’t affect the sales of any of our other products.
Porter: That may be well and good for sales morale, but how do we justify pricing below cost?
Read: This choice between $3 and $4 is beginning to look more difficult than I thought. So which is it going to be?
Exhibit 1: Quarterly prices and sales (units)
Exhibit 2: Timtex estimated cost per unit of AG-205 at various volumes of production units
Answer the following questions based on the above case:
Which costs are relevant for pricing? Remember fixed costs are irrelevant. Do not judge the costs by the numbers, but rather by their description.
Recalculate Exhibit 2 using only the relevant costs for pricing. The deliverable for this question is a table like that of exhibit 2 but with fewer lines (only those for the relevant costs). Make sure to total the costs for each production volume.
Timtext and Myriad have two prices to choose from: $3 and $4. What will be the profits (not including fixed costs) for each company in each pricing option? Please show calculations and list all assumptions. Think of this question in terms of the prisoners’ dilemma and fill out the table below with the profits.
What will be the outcome of this game? (i.e., what prices will the companies choose?). Is this the best outcome possible?
This game is similar to the prisoners’ dilemma with one big exception: Myriad observes Timtext’s pricing before making a decision. How can Timetex use this to sustain the higher prices-higher profit outcome? (Please remember that collusion is not a legal option.)
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