Cost-volume-profit analysis and business decision-making

CVP Analysis

The best way to approach this situation is to understand some basic concepts. First, each product has fixed costs. Thus, the fixed costs are going to exist in every year a product is sold. This has ramifications for the X5 in the final year.

The second factor that needs to be considered is cost-volume-profit analysis. This technique is used to determine the contribution to fixed costs that each product makes. Thus, CVP is used to find the price point at which the profit is maximized. The key point to remember is that as the price falls, volume increases. The company cut sell all the product by cutting the price to the variable cost level, but that will not deliver any profit. But there is a point at which profit is going to be maximized, and that is the point at which the company should price each product. Then, the only decision left to make will be with respect to the R&D investment.

Strategy

The X5 is selling well, and the X6 is entering into the growth phase. The X7 is launching and it is important to build market share quickly with that product. The more it sells, the better the bottom line will be. It is a high-volume, low margin product. The strategy utilized over the four years is as follows:

Year by Year Decisions: Pricing & R&D Allocations

PRODUCT

DECISION

2011

2012

2013

2014

2015

X5

Price

$250

$195

$195

$195

R&D %

33%

0%

0%

0%

0%

Discontinue?

NO

NO

NO

NO

YES

X6

Price

$340

$340

$340

$340

$340

R&D %

34%

34%

34%

0%

0%

Discontinue?

NO

NO

NO

NO

NO

X7

Price

$195

$120

$120

$120

$120

R&D %

33%

66%

66%

75%

Discontinue?

NO

NO

NO

NO

NO

2012

The overall organizational performance for the year was $302,305,534, which is reasonably strong performance. This was driven by successes with the X5 and X6 products. The X7 is still in the growth phase and arguably could have seen stronger performance. The X7 lost money on the year. But the other two products both generated considerable income and made some market share gains. That is to be expected, but there is a question of whether sales were too much. With slim margins, these products were still profitable, but it seems that perhaps there was some money left on the table here, even though on the surface it looked like a good year. I am starting to doubt my strategy.

2013

In 2013, the company earned $492,784,534. The X5 actually lost money -- it had maxed out its sales last year and there was little left. So it will be cut going forward. The X6 was profitable, at $183,579,258. There remains some potential for this product. The X7 earned $21,363,404, and this was with sales of 1.1 million. There are still a lot of sales on the table for this product, so it will be interesting to see if the sales pick up rapidly over the next two years. At this point, that will be critical for success.

2014

In this year, the X6 earned just $7,365,846. It is not unexpected, since the price has been cut pretty far to generate sales. We will be cutting this product, as there is little else that we can squeeze out of it. The X7 earned $139,271,351. This product will be the only product left in the lineup. Despite being offered at a very low price, it has only reached 11% saturation, which means a lot of money has been left on the table thus far. Moving units will be essential, but the price will remain the same, to keep the way that we are executing the plan as close to the strategy as possible.

2015

In this year, we only had one product remaining. The cumulative score was $1,179,223,655, which is a terrible score. The final profit on the X7 was pretty good - $539,801,834 but it is clear that we did not make enough money on the other products early on. The good news is that saturation of the X7 was up to 27%, but the bad news is that we cut costs a lot to generate sales for the X7, but could not generate enough to account for the way that the company mishandled the X5 and X6.

Review and Implications

The first thing noticed here is that the sales figures did not match with what the CVP spreadsheet predicted. So where the sheet predicts that $120 on the X7 is worth 1.26 million units sold, the actual sales were at 480,412. When your predictive tool is that wrong, then it isn't much value. I like the concept of CVP here -- analyzing the elasticity of demand to determine at what price the profit will be highest - but the tool needs to be more informative, because prices were set way too low. I will work with my own CVP calculation, because it will be more accurate, once I determine the slope line that tells me the price elasticity of demand.

The other thing that happened here, aside from the tool failing to give me accurate information about demand under specific pricing and R&D investment decisions, is that I went into the exercise with very little in the way of coherent strategy. In essence I spent time playing with the spreadsheet -- which yielded dramatically incorrect data -- instead of focusing on having a sound strategy based on numbers that I crunched myself. As a consequence of this sloppy strategizing, I was left with poor decisions based on a faulty model. I had no backup plan, and when things started going awry, I had little response other than to start cancelling projects and hoping the X7 would work out for me.

As such, I anticipate better results next time. The math will tell me what my strategy needs to be, and I trust my math. At the end of the day, using models as decision-making tools can be quite powerful, but only if the models give you outputs that make sense. That was not the case here, and dismal results showed as evidence of that. I used some back of the envelope calculations and came up with pricing at $255, $445 and $145, and ended up with $1.66 million in profit. This tells me that I am on the right track. Cost volume profit analysis requires running the simulation a few times, so I should be too hard on things about having a poor performance, but I felt like if I run numbers, and did my own math I would get a better score and that is exactly what happened.