retail segment
One retail segment that has fared reasonably well in the internet era is home improvement – contractors tend to want to see and feel their purchases before paying, and there aren’t such great efficiencies in placing bulk orders for lumber and other bulky building materials online.
Sales of lumber specifically account for a significant fraction – above 5 percent – of revenues at Home Depot and its competitors, so considerable time and effort goes into their pricing. Lumber prices are typically set in dollars per hundred board feet and fixed relative to the price of a standard size 2-inch by 4-inch board.
Setting prices was complicated by the fact that different Home Depot stores faced very different levels of competition. In this question, we will focus on the 100+ stores in the tri-state region of North Carolina, South Carolina, and Virginia. The situations faced by the various stores ranged from essentially local monopolies in isolated towns like Florence, South Carolina, to head-to-head competition with Lowe’s (another chain of home improvement superstores with a substantial presence in the Southeastern United States) in mid-size cities like Raleigh-Durham, North Carolina, to fierce competition among many local and national superstores in metropolitan areas like Richmond and Fairfax County (suburban Washington, DC), Virginia. At present, lumber prices are set locally and local pricing policies varied widely (even in similar market areas).
Part I
Consider the situation of markets like Asheville, NC or Florence, SC where Home Depot enjoys an effective monopoly. Managers’ experiences in these areas indicate that quantity of lumber sold would decline linearly as prices increased. In Florence, total annual sales of lumber are projected to be 360,000 hundred-board-feet at the current price of $7 per hundred board-feet. Each one-dollar increase in price would reduce sales by 120,000 hundred-board-feet. The lumber market in Asheville is about one-half the size of the market in Florence. Thus, Asheville sales decline by only 60,000 hundred-board-feet for every dollar increase in price. The relationship between price and forecasted sales for the two markets is given in Table 1 below. The cost of purchasing the lumber sold was $6 per hundred-board-feet throughout the tri-state region, including the costs of distribution to stores and wastage. Additional costs for in-store space and staff did not vary significantly with the level of lumber sales. But for accounting purposes, these costs were allocated to lumber sales at a cost of $0.50 per hundred-board-feet.
Question 1 (a) Restricting yourself to the $0.25 pricing increments in Table 1, what do you propose as the price for lumber in Florence? Based on this answer (and without further calculation), can you infer the price you’d wish to set in Asheville (it may help to think about what is similar and what is different across the two markets)? (150 points)
Part II
In markets like Raleigh-Durham where Home Depot competes with Lowe’s, matters are considerably more complicated since the impact of any change in Home Depot’s prices depends critically on how Lowe’s management reacts to those price changes. If Lowe’s does not respond at all, then each dollar reduction in price will increase Home Depot’s projected yearly sales by 300,000 hundred-board-feet. This increase in demand is relative to the base sales level of 240,000 hundred-board-feet that would be projected at a price of $8. However, if Lowe’s management chooses to match Home Depot’s price reduction, then Home Depot’s demand will increase by only 120,000 hundred-board-feet for a $1 reduction in price, again off a base of 240,000 hundred-board-feet at a price of $8.
In thinking about the Raleigh-Durham market, assume that Lowe’s faces similar cost and market conditions as Home Depot (i.e. market competition is symmetric). Further assume that both companies’ cost structures are very similar to the situation in Florence, SC (i.e., $6.00 per hundred-board-feet in costs of goods sold and $0.50 in allocated overhead per hundred-board-feet).
Question 1 (b) Restricting your attention to prices of $7 or $8 (and similar prices by Lowe’s), calculate the implications for Home Depot of these different prices. What would you recommend as a pricing strategy for Home Depot? (150 points)
Question 1 (c) Despite its relative success to the present, Home Depot is concerned about the growing potential for competition from online sellers. The company has been torn between providing general information on the web and using the web to sell merchandise. The general information includes “how-to” tips (e.g., information about installing shelves) and support for local stores such as maps to the nearest store. The broader retailing strategy includes an online catalog or even the ability to sell merchandise by posting prices on the web. What do you think would be the tradeoffs involved with selling merchandise via the web? How might it affect your pricing decisions in the tri-state area? (100 points)
Table 1: Projected lumber demand in Florence and Asheville (in hundred board feet)
Price Projected sales in Florence Projected Sales in Asheville
$9.00 120000 60000
$8.75 150000 75000
$8.50 180000 90000
$8.25 210000 105000
$8.00 240000 120000
$7.75 270000 135000
$7.50 300000 150000
$7.25 330000 165000
$7.00 360000 180000
$6.75 390000 195000
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