Cost-volume-profit analysis and product pricing strategy

¶ … 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.

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 may be a little myopic in my approach, knowing that even with the gains made this time around with the $141 price tag, that product still has incredible potential for future revenue. If there is something that I can do to drive even more revenue out of that product I will find a way.

Lastly, it is important to note that these results provide justification for the usage of the cost-volume-profit analysis technique. The technique has delivered superior results. As it happened, I pursued lower prices for the X7 based on the principle of penetration pricing, but by using the CVP technique I have clearly demonstrated that this strategy was supposed to work, and it did.

In conclusion, having had the chance to work this cycle a couple of times has allowed me the opportunity to gather the data that I need in order to pursue better, more profitable price points and R&D allocations on these three products. I have improved my performance significantly over the last time warp and I feel that if I had another time warp, I would be able to deliver even better results as I refine my analytical techniques and my usage of the cost-volume-profit technique.