Tesla Pricing Strategy: Decisions, Ethics, and Market Challenges

Pricing Policies and Government Subsidies

Tesla currently benefits from — and is, in fact, relying on — government subsidies to sell its cars. These subsidies take the form of electric vehicle (EV) tax credits that purchasers obtain when they buy a Tesla. The problem is that these credits are granted to consumers only for a set duration. Once the government ends the subsidy, sales drop drastically, as has been the case in Hong Kong, where tax incentives were essentially the entirety of Tesla's pricing strategy — and once those incentives ended, sales were decimated.

In Norway, currently Tesla's biggest European market, consumers pay no import tax or any of the purchase taxes that apply to non-EV cars, which represents a significant incentive (Tesla 10-K, 2018, p. 22). In the Netherlands, sales soared because a tax incentive was set to expire, prompting companies to acquire a Tesla Model S under the then-current tax rate of 4% before it climbed to 22% in 2019. Unless something acts to keep these incentives in place, Tesla's luxury EVs may become unaffordable to their target market.

The same challenges are being encountered in the United States and Canada, where Tesla has recently sued the government for discrimination after its incentives program ended before Tesla buyers were able to take possession of their Model 3 orders (Tesla 10-K, 2018). These cases collectively illustrate how deeply Tesla's pricing strategy is entangled with government policy.

Tesla's Price-Setting Process and Sustainability

Tesla's price-setting process is currently based on reflecting the value and integrity of the product. Tesla's EVs are marketed as luxury vehicles — even the Model 3 is marketed as a luxury EV for the middle class. For that reason, Tesla does not offer discounts on new cars or negotiate its prices: "We market and sell our vehicles directly to consumers through an international network of company-owned stores and galleries which we believe enables us to better control costs of inventory, manage warranty service and pricing, maintain and strengthen the Tesla brand, and obtain rapid customer feedback" (Tesla 10-K, 2018, p. 5).

For the Model X and Model S, this method is sustainable and profitable — so long as EV tax incentives remain available to buyers. However, as recent history has suggested, once those incentives disappear, Tesla may see revenues decline drastically. That is one reason there is such urgency to bring the Model 3 to market. It is intended to be a base-model EV priced at $35,000, and CEO Elon Musk has stated that Tesla will offer a $25,000 vehicle within three years. The problem is that at these prices Tesla would be losing money: manufacturing costs are too high and margins are virtually non-existent, which is why no Model 3 units are currently being sold at the base price of $35,000. Tesla cannot afford to lose money on sales at this stage.

Cost Analysis and Contribution Margins

Incremental costs occur for Tesla when it seeks to expand operations to meet target production goals. For example, the company had to increase operations to 24 hours a day, seven days a week in order to meet its production goal of 5,000 EVs per week, and it had to build a tent structure to facilitate operations — absorbing substantial incremental costs as a result. These costs could have been avoided, moreover, by examining the available options and selecting the lower-cost alternative through a differential cost analysis. Tesla could have reduced its production goal; the costs of ramping up production at the facility were not necessary and did not improve the company's long-term outlook.

The difference between incremental costs and avoidable costs is that the former are necessary and must be absorbed by the company whenever it seeks to do something such as increase production to meet market demand, while the latter are costs that could be avoided by choosing a less expensive option to achieve the same goal.

Regarding contribution margins, Tesla aims for a margin in the mid- to high-teens for its EVs, with the contribution margin for the Model S, Model X, and Model 3 pegged at approximately 20%. Tesla aims to deliver far more cars than the approximately 100,000 EVs it delivered in 2017. However, with demand weakening due to production backlogs and the phase-out of tax incentives, Tesla's window of opportunity may be narrowing.

Tesla must invest in a breakeven analysis in order to identify the precise number, model, and type of EVs it must sell to become profitable. With creditors pressing and a potential bid to take the company private under discussion, Tesla needs to demonstrate to investors the exact point at which it becomes profitable. As LeBruto, Ashley, and Quain (1997) point out, the contribution margin aspect of financial analysis can be used to enhance a company's financial results — and that is precisely what investors will want to see.

References

Hardman, S., Shiu, E., & Steinberger-Wilckens, R. (2015). Changing the fate of fuel cell vehicles: Can lessons be learnt from Tesla Motors? International Journal of Hydrogen Energy, 40(4), 1625–1638.

LeBruto, S. M., Ashley, R. A., & Quain, W. (1997). Using the contribution margin aspect of menu engineering to enhance financial results. International Journal of Contemporary Hospitality Management, 9(4), 161–167.

Tesla 10-K. (2018). Retrieved from https://www.sec.gov/Archives/edgar/data/1318605/000156459018002956/tsla-10k_20171231.htm

Wright, P. (1987). A refinement of Porter's strategies. Strategic Management Journal, 8(1), 93–101.