What Tesla’s Model 3 Price Cuts Tells Us About Its Margins – Tesla, Inc. (NASDAQ:TSLA) | Seeking Alpha

First, demand for the product at the initial product bundle was below the desired levels. I’ve seen more than one reservation holder comment online that they were contacted by Tesla to ask why they did not purchase the fully-loaded version. Through reservation feedback (i.e., a lack of purchases) and direct customer interviews, Tesla has learned that the market for the fully-loaded package isn’t large enough for their liking. By unbundling the options, Tesla allowed those that value the speed improvement but not other aspects to get in on the performance version (buyers who otherwise would’ve taken a lower-priced version).

Whether or not bundling items makes sense depends on how highly individual customers’ willingness to pay is correlated across the various components. The more variability in value customers have for different features, the more incremental revenue and profit bundling allows. Conversely, when features’ values are highly correlated across different segments, unbundling is the profit-maximizing approach. The classic example for bundling is Microsoft Office: for some users, Excel might be worth $200 but PowerPoint is worth only $50, while the inverse is true for a second group.

Without bundling, the optimal price would be $200 for each product (assuming similar market sizes), but bundling both for $250 allows the seller to capture the full value available. IF features don’t fit this model, they should be relegated to the options sheet. Porsche (OTCPK:POAHY) is the best auto manufacturer in the world in effectively executing this principle.

In Tesla’s case, customers will generally value the speed and acceleration improvements similarly, but the aesthetic features will have more variability in consumers’ values (e.g., white seats and a red exterior may be worth $3K to some, but only $1K to another). Stripping out these extras will ultimately improve Tesla’s M3 ASP and the overall volume of performance versions that they’ll sell.

Second, Tesla’s decision to lower the overall price means they’ve changed their mind on the vehicle’s relative positioning. To be clear, it is not a good practice for companies to suddenly reverse course on their pricing and bundles, and typically indicates they did not do sufficient market research beforehand (it also can signal to consumers the product is not as “premium” as it was originally marketed). However, since no units have actually been sold yet, and Tesla has revised the price downward, they’ve potentially limited the negative consequences of the decision.

This decision also means that Tesla expects enough incremental profit from the lower price point (through higher volume) to offset the $6K they are effectively refunding on the Performance M3s that have already been ordered. For a product to generate more revenue through a price cut, its demand must be elastic at that particular point, but the calculation on profit increases depends on the relative margins (which we’ll discuss later in this article). Suffice it to say that Tesla would be foolish to do such a move unless they had evidence to suggest long-term demand would rise by double-digit figures from this price cut.

Third, Tesla’s price cut on the AWD option to $4K gives us further visibility into the cost of the motor. All companies should price their premium add-ons with margins that raise the overall margin (kind of a “no kidding” statement, but stay with me). Musk has made a public target of 25% margins on the Model 3, which means all upcharge items must have to be something over 25% gross margins to pull the overall average up to the target (since the lower-optioned versions will be below 25%).

That Tesla has lowered the price to $4K for the second motor means the cost to the company must be less than $3K (installed), and likely a fair bit lower than that. As an aside, consider what this means for the Roadster’s potential margins, which will start at $250K, but whose 3 engines and batteries will total less than $40K in cost.

Lastly, Tesla raised the price of the over-the-air update for the autonomous feature. While this has limited impact on recognized revenue and gross margins up-front (revenue cannot be recognized until the feature is delivered), it may bait some customers into spending the extra $3K up-front, since the “penalty” for delay has been increased.

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What Tesla’s Model 3 Price Cuts Tells Us About Its Margins – Tesla, Inc. (NASDAQ:TSLA) | Seeking Alpha.