Question

In her first post MBA consulting engagement with a client from the chemical sector AK had to suggest a price for a novel pest control product that would provide almost permanent freedom from household pests after 5 annual applications. The product consisted of a dispenser called DSpray and sealed pouches containing the pest control chemical. These pouches, called KPouches, could be easily inserted into the DSpray dispenser and the homeowner could spray the house without the need for professional help. After 5 such applications, the home would essentially be pest-free forever. In order to start putting everything together, AK visited the client and collected the following pieces of information after speaking with employees in several divisions: • Based on the market research done by the company, the optimum retail price for the DSpray dispenser was $20 which included a combined 40% margin for the retailer and distributor. The company’s price was the retail price minus these margins. No KPouch was included with the DSpray. • There was sufficient manufacturing capacity available for both the dispenser and spray pouches. • The average cost-of-goods-sold for a DSpray dispenser was $10. • The company had decided upon a retail price of $2 for each KPouch and the combined retailer and distributor margin would be 50%. The company’s price was the retail price minus these margins. The cost-of-goods sold for the KPouch was $0.50. • A total of 5 Kpouch annual applications would be sufficient to protect a home for several years. The customer had to buy the dispenser and one pouch at the beginning and then buy one pouch every year in the following 4 years. • Market research had indicated that once a homeowner bought DSpray, the retention rate for KPouches in each of the subsequent years was likely to be only 60%. In other words, if a customer bought the KPouch in any given year, there was only a 60% chance that she would also buy in the subsequent year. The client could keep the retail price of the KPouch at $2 and attach a small beeper to DSpray that would remind customers at the end of every annual cycle to buy the KPouch. As per an internal estimate, the end customer would not be willing to pay anything extra for the beeper but adding it would increase the retention rate to 80%. Assuming that the client has to buy the beeper from an outside vendor what is the maximum cost of the beeper that could be justified?

Answer 1

Based on the facts, it is found that the client's margin from sale of DSpray and KPouch are as below:

Retail Price - Retailer & Distributor Margin - COGS = Client's Margin

DSpray $20 less 40% (=$8) less $10 = $2

KPouch $2 less 50% (=$1) less $0.5 = $0.5/year

If the retention probability is 60% before the beeper is supplied by the client to customer, then purchasing probability in the 2nd year is 60% and hence the probabilty margin is $0.5*60% which is $0.3.

Likewise, if the retention probability is 80%, the probaility margin rises to $0.4 ($0.5*80%). Hence if the client has to supply beeper to the customer, and source it from an external vendor, the maximum cost that should be paid for the same should be $0.1/pouch ($0.4 - $0.3).