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¶ … profit analysis was introduced, but the execution was lacking. One of the important factors is that CVP analysis requires a number of data points so that the elasticities of demand for the product can be determined. There is still going to be the wild card of R&D investment, but setting prices is an important determinant of demand. Working on theory rather than data last time, the results were perhaps less than stellar. The key, however, is to learn from the mistakes that we make and build a better company next time.
Underlying Theory
Last time out, the prevailing theory was that the X5 should be cheaper, the X6 more expensive and the X7 should be much cheaper. The X5 is going to sell out anyway, so whatever we do with that product is only going to make a few million in difference. Nevertheless, we know that the X5 has to be cancelled for the 2015-year, which means that we want to come as close to 100% saturation as possible in the first three years, and maximize profit.
The X6 was believed to have a relatively low price elasticity of demand. This product is the premium product in the range, and was therefore expected to sell at a premium price as long as we were able to invest enough in improving it to justify the higher price. R&D allocation is tricky in the sense that it is a fixed amount in total for the company, but the way it is allocated across product lines is going to dictate the sales that we can generate from our different products.
The X7 has a fairly low variable cost, and a high potential market of 17,500,000. The other products, by contrast, only have a potential sales of 6,000,000. If we consider what this means for total revenue, the potential remaining market beginning in 2012 for the three products, by revenue, at current price points is as follows:
Units Left
Price
Revenue
X5
4965000
1,415,025,000
X6
5450000
2,343,500,000
X7
17500000
3,325,000,000
What this shows is that the X6 and X7 are where the money is. We need to get the pricing right on these products. If some R&D needs to be sacrificed on the X5, it is probably far enough into the product life cycle, that the cost will not be significant. The opportunity cost of not investing in the X6 and X7 is going to be significant, based on how much revenue we left on the table with these products last time.
Time Warp Strategy
The strategy this time will focus on what we learned last time. We priced the X5 at $275, cut it to $265 and held on too long. This time, the price will be set at $270. This product will not receive any R&D, and will be cut prior to 2015. Because the X5 has the highest fixed costs of any product, it will be unable to cover those fixed costs in the 2015-year, at the end of its product life cycle.
The...
It experienced growth through the first three years, but faded in 2015. Our performance was higher than what was achieved by the Schmoe regime, but did not maximize sales. We still believe that a higher price will maximize profit, even if a few sales are sacrificed. Thus, a price of $440 will be utilized. The R&D for the X6 will need to be around the same -- it will sell close to capacity in the four years regardless.
The X7 will receive an aggressive strategy. We now have the data needed to determine a cost-volume-profit analysis. We know that the floor for pricing is the variable cost of $65. We know from the Joe Schmoe scenario and from our own analysis last year that the slope of the price/demand line is 38,252. This is the price elasticity of demand. This tells us that the point of revenue maximization is a price point of $108. However, we have the variable and fixed costs so we may as well input those. When we do, we arrive at a price point of maximum profit of $141, so that is the price point we will use. This assumes 67% R&D from the beginning.
Results
2012
X5
X6
X7
Total
Price
R&D
0
33
67
Profit
172682
153516
-25487
300711
Saturation
27
16
2
2013
X5
X6
X7
Total
Price
R&D
0
33
67
Profit
229097
270796
507208
Saturation
54
33
4
2014
X5
X6
X7
Total
Price
R&D
0
0
Profit
94792
317355
73087
485234
Saturation
86
59
7
2015
X5
X6
X7
Total
Price
x
R&D
x
0
Profit
x
118279
259770
378049
Saturation
86
15
Total profit: $1,752,777,185
This performance, data-driven, is quite a bit better than before. The performance of the X7 product in particular has driven success. In the prior simulation, the X7 never really got off the ground, so this represents a much greater level of success.
Next time, the strategy will involve a more refined approach to the X5 and X6, both products that the full CVP process what not applied to. An examination will be made with respect to the X7 as well. I…
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