Problem 15 - Accounting

Question

Media outlets such as ESPN and Fox Sports often have Web sites that provide in-depth coverage of news and events. Portions of these Web sites are restricted to members who pay a monthly subscription to gain access to exclusive news and commentary. These Web sites typically offer a free trial period to introduce viewers to the Web site. Assume that during a recent fiscal year, ESPN.com spent \(\$ 1,800,000\) on a promotional campaign for the ESPN.com Web site that offered two free months of service for new subscribers. In addition, assume the following information: \(\begin{array}{ll}\text { Number of months an average new customer stays with the } & \\ \text { service (including the two free months) } & 25 \text { months } \\ \text { Revenue per month per customer subscription } & \$ 10.00 \\\ \text { Variable cost per month per customer subscription } & \$ 2.00\end{array}\) Determine the number of new customer accounts needed to break even on the cost of the promotional campaign. In forming your answer, (1) treat the cost of the promotional campaign as a fixed cost, and (2) treat the revenue less variable cost per account for the subscription period as the unit contribution margin.

Step-by-Step Solution

Answer

9,000 new customer accounts are needed to break even on the promotional campaign.

Step 1: Calculate Monthly Contribution Margin

To find the contribution margin for each customer per month, subtract the variable cost from the revenue. Contribution Margin = Revenue per month - Variable cost per month = $10 - $2 = $8 per month.

Step 2: Calculate Total Contribution Margin Per Customer

Multiply the contribution margin per month by the average number of months a customer stays, including the two free months. Total Contribution Margin per Customer = Contribution Margin per month * Number of months = $8 * 25 = $200.

Step 3: Calculate Break-Even Point

Determine the number of new customers needed by dividing the total fixed cost of the promotional campaign by the total contribution margin per customer. Number of New Customers = Total Fixed Costs / Total Contribution Margin per Customer = $1,800,000 / $200 = 9,000 customers.

Key Concepts

Contribution Margin

The contribution margin represents the portion of sales revenue that exceeds total variable costs. It is a critical metric for understanding how much each product or service sold contributes to covering fixed costs and generating profit. To calculate the contribution margin per unit, you subtract the variable cost per unit from the sales price per unit. In this case, for ESPN.com, the monthly revenue per subscription is \(10, and the monthly variable cost is \)2. Thus, the contribution margin is:

• \(10 - 2 = 8 \) per month.

The contribution margin per customer for the whole subscription period is found by multiplying the monthly contribution margin by the number of months a customer remains subscribed, which includes the trial period:

• \(8 \times 25 = 200 \).

This calculation provides the total contribution each customer makes towards covering fixed costs.

Fixed Costs

Fixed costs are expenses that do not change with the level of goods or services produced. They remain constant even when production volume varies. In the context of the ESPN.com exercise, the promotional campaign cost of $1,800,000 is considered a fixed cost. No matter how many new customers are acquired, this cost remains the same.

• Examples of fixed costs include:
  • Rent
  • Salaries of permanent staff
  • Marketing campaigns

Understanding fixed costs are crucial for break-even analysis, as they need to be covered before any profits can be realized. In this problem, the promotional campaign needs income generated by a certain number of customer subscriptions to break even.

Variable Costs

Variable costs are costs that change directly with the amount of products or services produced. Unlike fixed costs, they fluctuate with production volume. For a subscription service like ESPN.com, the variable cost for each customer subscription is the cost associated with servicing a customer for a month.

• This cost is $2 per month in this scenario.

Variable costs are important in the calculation of the contribution margin. By knowing the variable cost, businesses can determine how much revenue each additional sale brings beyond the cost of that sale. This helps in setting prices, forecasting profits, and planning production. Understanding these costs ensures that every sale contributes positively to covering the fixed costs and potentially generating a profit.

Promotional Campaign Strategy

A promotional campaign strategy is a planned, time-limited series of activities designed to promote a product or service to its target audience. For ESPN.com, offering a promotional strategy with two free trial months is aimed at attracting and converting viewers into paying subscribers.

• Objectives of a promotional strategy can include:
  • Increasing brand awareness
  • Boosting sales and revenues
  • Enhancing customer loyalty

Promotions like free trials aim to reduce perceived risk for new customers, encouraging them to try the service before committing financially. However, it must be balanced against the cost of acquiring such customers. By determining the break-even point (the minimum number of new customers needed through the promotion to cover costs), businesses can evaluate the effectiveness and financial viability of their promotional strategies.