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An Introduction to Quantitative Marketing

An Introduction to Quantitative Marketing. Marketing Math. 22% of American high school seniors report that they are in the top 10% of their high school class. WSJ; 8/30/00 # 3 Recruiter Priority (Analytical Skills)

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An Introduction to Quantitative Marketing

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  1. An Introduction to Quantitative Marketing

  2. Marketing Math • 22% of American high school seniors report that they are in the top 10% of their high school class. • WSJ; 8/30/00 • # 3 Recruiter Priority (Analytical Skills) • ahead of leadership potential, strategic thinking, years of experience, and original and visionary thinking • WSJ Survey of Recruiters; 9/9/02 • You may not like it, but it can get you a job • One of the central themes of this class

  3. Overview • Costs & Revenues • Break even analysis and cannibalization • Mark up • Sensitivity analysis • Pro forma income statements • Economic value calculation • Price response • Expected value calculations • Advice

  4. Costs

  5. Revenues

  6. Profits

  7. Price Response • What should I charge for my product? • When economic value or willingness to pay varies across consumers (thus creating an aggregate demand curve), prices must be set to optimize profits • Tradeoff: lost unit sales with higher prices, but higher margins

  8. Price Response • Exercise: How much would you pay for HDTV? • Constant Elasticity Model • Qty = 1000*price-2 • Elasticity = dQ/dp * p/Q = -2 • Linear Demand Elasticity Model • Qty = 1100-200*price • Elasticity = -200*(p/Q)

  9. Constant Elasticity Model

  10. Linear Demand Model

  11. Cross-Price Elasticity • Two brands • Easy to check that the cross-price elasticity is simply

  12. Estimating Elasticity • Actually pretty simple – take logs • And then run regression… • This is a fairly general approach and will work for other marketing elements (say advertising) or for combinations of elements (say advertising and price)

  13. Optimizing Price • Qty = 1100-200*price • Variable Cost=0.10 • Fixed Cost = 0 • Profit = (1100-200*p)*(p-0.10) – 0 • Set d(Profit/dp) = 0 • p* = 1100/400 + 0.5*0.1 = 2.80 • more generally, p* = (a/2b)+c/2 • where q = a-bp

  14. Optimizing Price (Again) • Qty = 1100*price(-1.04) • Variable Cost=0.10 • Fixed Cost = 0 • Profit = (1100*price(-1.04))*(p-0.10) – 0 • Set d(Profit/dp) = 0 • p* = 2.60 • more generally, p*= c*b/(b+1) • where q = a*pb

  15. Break Even Analysis • Question: how much do I need to sell to break even? • This implies profit=0. • Profit = (P-VC)Q-FC • Set profit = 0 • Q=FC/(P-VC)=FC/Contribution • Q=(FC+Profit)/(P-VC) if non-zero profit desired • Q=(FC)/(P-(VC+tax)) if per unit corporate “tax” • Any fixed expense to numerator, variable expense to denominator

  16. Break Even Analysis • IBM considers a new PC. • $10,000,000 in marketing • $10,000,000 in R&D • Corporate overhead is 20% of revenue. • Retail price is $1,000 • Cost of PC is $200 • How many PCs does IBM need to sell?

  17. Mark-up • Need wholesale price to solve previous problem. • If retailer markup (margin) is 100% (50%), what is wholesale price? • (Retail-Wholesale)/Wholesale=markup • wholesale=retail/(1+markup)=$1000/2=$500

  18. Cannibalization • New product sales also affect existing product sales, and this must be considered in break even analyses.

  19. Cannibalization (HW) • IBM considers a new PC. • $10,000,000 in marketing • $10,000,000 in R&D • Cost of PC is $200 • Corporate profit requirement is $5 MM • Retail price is $1,000, markup is 1/2 • Every 10 sold cannibalizes a $3,000 profit margin workstation • How many PCs does IBM need to sell?

  20. Sensitivity Analysis • Suppose cannibalization rate is not well known … • Critical assumption – at 7PCs / workstation can not be profitable.

  21. Sensitivity Analysis • Suppose R&D is not known … • Not a critical assumption

  22. Sensitivity Analysis • A: If assumption makes no difference, fine! • B: If not, then • Calculate expected cost of error • Compare to expected cost of more info • B1: If info cost<error do research • B2: Else, assess whether risk outweighs benefits • Without quantitative analysis, one can not know whether A or B (B1 or B2) is the case. • Quantitative analysis highlights risks • Would you take a gamble without it?

  23. Pro Forma Income Statements • If your decision affects several years results, then pro forma income statements are a good tool • If necessary for decision, compute present value , where r is discount rate and t is period

  24. Economic Value Calculation Slicing the Value Salami Customer Surplus(Economic Driving Force) VIU Margin(Profit) Price Cost of Production(Loaded) Cost

  25. Economic Value-in-Use Example: A chemical plant uses 200 O-rings to seal valves carrying corrosive materials. Those O-rings cost $5.00 each and must be changed during regular maintenance every two months. A new product has 2 ´ the corrosive resisting power. The value-in-use of the material might be: 1. Annual cost of incumbent = 200 (rings) ´ 6 changes/year ´ $5/O-ring = $6,000 versus = 200 (rings) ´3 changes/year ´ $???/O-ring => VIU of $10/O-ring

  26. Value-in-Use Tips Be sure to include all costs when doing a VIU calculation. Use costs = (Annual) Purchase cost + Fabrication cost + Finishing cost + Inventory cost + Maintenance/Service cost Scrap adjustment + Level-of-requirement adjustment + Changeover cost + Risk premium + other Use the user’s cost of capital when making multi-year calculations. VIU --- be a customer!

  27. Example of Value Based Selling AT&T beats IBM & Lockheed for$1.4B TMAC Award Washington—The Treasury Department last week awarded a $1.4 billion Treasury Multiuser Acquisition Contract (TMAC) to an AT&T led team which reportedly came in as high bidder over lower bids from IBM Corp. and Lockheed Corp. Industry sources last week said that AT&T’s bid of $1.4 billion for the contract was nearly $500 million more than the lowest bid of $931 million reportedly submitted by the Lockheed led team. It is believed that IBM Corp.’s bid fell in the middle of the two at approximately $1.1 billion. —Electronic NewsMonday, July 22, 1991.

  28. IBM & LockheedProtest AT&T Win Washington—IBM Corp. and Lockheed Corp last week told the GSA Board of Contract Appeals that the government cannot justify the more than $500 million premium it will pay for awarding high-bidder AT&T the Treasury Multiuser Acquisition Contract (TMAC). In separate protests filed last week with the GSA Board, unsuccessful bidders IBM and Lockheed asked that award of the massive Internal Revenue Service contract to AT&T be overturned. An initial hearing on the protests will likely be held early this week. —Electronic NewsMonday, July 29, 1991.

  29. GSA Board Halts$1.4B AT&T Pact Washington—The GSA Board of Contract Appeals last week halted a potential $1.4 billion computer contract award to AT&T, charging the Treasury Department failed to adequately justify the selection of a far more costly proposal by AT&T over a much lower bid by IBM and Lockheed Missiles and Space. The board upheld the protests of IBM and Lockheed, and ordered the Treasury Multiuser Acquisition Contract (TMAC) sent back to the agency for further consideration. —Electronic NewsMonday, September 30, 1991.

  30. IRS Reinstates $1.4B AT&T Pact Washington—The Internal Revenue Service last week re-awarded a $1.4 billion computer contract to AT&T six months after the first award was ordered overturned by a contract appeals board. The IRS said its decision to re-confirm the original award of the Treasury Multiuser Acquisition Contract (TMAC) to AT&T was based on “an in-depth analysis” of the proposal offered by AT&T as well as those from competing bidders IBM Corp. and Lockheed Missiles and Space. “While the cost of the AT&T proposal was the highest of the three, it represented the best value to the government when all factors, including technical capabilities, management and support services, the risk of future additional costs, and the impact on productivity of the IRS user workforce were considered for each of the three different proposals,” the IRS said Friday. —Electronic News, Monday, March 23, 1992.

  31. Expected Value Calculation • Expected Value (x) = S (x*prob (x)) • Two market segments exist, business class and leisure class. • There are 200 business travelers and 100 leisure travelers. • Business travelers pay $1000/ticket • Leisure travelers pay $200/ticket • What is the expected price of the ticket?

  32. Expected Value Calculation • Prob (ticket holder is business) = (200/(200+100)) = 2/3 • Prob (ticket holder is leisure) = 1/3 • Expected Value (x) = S (x*prob (x)) • Expected Revenue = (2/3)*$1000 + (1/3)*$200 = $667 + $67 = $734

  33. Advice • In cases, there are many, many numbers and many, many analyses. • The foregoing are only a small set. • Without structure you will quickly get lost (sometimes even with structure). • Even harder in real world, because you need to sort through and collect much more information. • So, how to proceed?

  34. Advice • Step 1: Define the problem that is trying to be solved • For example, if the goal is to determine, will this idea fly, then a break even analysis makes sense.

  35. Advice • Step 2: Break the problem into smaller pieces • E.g., what does one need to know to do a break even? • Fixed costs, then variable costs, then prices • Solve these one by one • What are all the variable costs? Are they known, if so, great. If not: • Can they be determined? • Assembly line produces 1000 units per year but costs $1000 • If not – sensitivity analysis

  36. Advice • Step 3 • Once all the pieces are there, and have been solved one by one, add them back up, BE=FC/(P-VC) • Do not try to do everything at once • Last, remember, the analyses must have some purpose, otherwise you will get lost. Always start with the objectives.

  37. Summary • Assessing the merits of a business opportunity invariably means working the numbers • Marketing combines precise numbers with rough assumptions • Vaguely right beats precisely wrong • Sensitivity analysis and research mandated if assumptions affect answers • But so does finance - what is the cost of capital?

  38. Key Takeaways • Elasticities • Break Even • Sensitivity Analysis • Cannibalization • Economic Value • Pricing Techniques & Mark Up • Expected Value

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