Profit Analysis Is a Tool

¶ … profit analysis is a tool by which the profit of a product can be maximized by analyzing the fixed and variable costs of a product in relation to its price. The key concept in CVP analysis is the contribution margin. The contribution margin is calculated as follows:

Profit = Total revenue -- total variable costs -- total fixed costs

The contribution margin can be calculated on the basis of the company as a whole, the product as a whole or as the contribution margin per unit (Eldenburg, no date). For example, for the year 2005, the X5 contribution margin would be as follows under Joe Schmoe's strategy:

82,616,699 = 362,007,649 -- 202,724,283 -- 76,666,667

There are a few things that can be learned from the CVP analysis in this case. The most noticeable thing is something that was used in the Time Warp 1 analysis. Prior to Time Warp 1, I did a breakeven analysis on each product. The X5 has the highest fixed costs of the three products at $70 million. Joe Schmoe had failed to recognize that these high fixed costs would make the product unprofitable in 2009. The per unit calculation of the CVP for the X5 showed the following results:

Contribution margin = $250 -- 140 = $110.

At $110, the number of units sold to cover the $70 million fixed costs associated with producing the X5 would be:

70,000,000 / 110 = 636,363

During my last run, sales of the X5 in 2008 were 698,046 and declining rapidly. The remaining untapped market was just 406,801. This trend strongly indicates that the X5 was highly unlikely to meet the breakeven sales point. Indeed, Schmoe's strategy saw sales of 516,188 in that year, well below the breakeven point. The only change I made to the X5 was to reduce its R&D budget, meaning that I could expect even lower sales than Joe Schmoe had attained. Lowering the price was unlikely to help, given the small size of the remaining potential market. Therefore, the decision to discontinue the X5 after 2008 was the right one.

For the next simulation, little is going to change with respect to X5 strategy. The X5 product is in a mature stage of business. No matter what changes are made, the X5 will be discontinued after 2008 because it will be unable to meet the breakeven sales point. In addition, there is little reason to believe that at its stage of the product lifestyle that it will benefit from R&D money more than the other two products. Thus, the decision to cut its R&D budget will stand. This leaves the question of price. The cost-volume-price analysis lacks one key ingredient to make it relevant when determining price levels -- it lacks insight into price elasticity of demand. While there may be merit to cutting the price in order to win a few extra sales and boost overall profit, there is also reason to set this issue aside -- product mix.

Product mix is one of the most important uses for CVP analysis. The CVP analysis, when used on a company-wide basis, can yield insight into the best mix of products and aid in decisions with regard to R&D allocations. In this case, we have a base logic for R&D allocations -- the X6 needs to be feature-rich in order to attract buyers. The X7 needs only to be current in its features. The X5 is more or less locked into a particular sales, revenue and profit trajectory. Adjustments made at this point in the product life cycle may impact total company profitability by a few million in either direction, but the real profit potential lies in the X6 and X7. Under Joe Schmoe the X6 had a contribution margin of $400 -- 250 = $150. I hypothesized that if the features were improved I could raise the price and therefore the contribution margin. I delivered a margin of $450 - $250 = $200 or $50 more contribution margin than the Schmoe strategy. This came at a cost of a $6.6 million increase to the R&D cost. In 2007 for example this equated to $8.50 per unit, meaning that I added $41.50 per unit to the net profit. This came at a slight reduction in sales. Schmoe sold 5.363 million units and I sold 5.298 million units. Thus, for the X6 Joe did $150 * 5.363 = $804.45 million in profit. I did $191.50 * 5.298 = $1,014.56 million in profit. This is because there is low price elasticity of demand on the X6, especially when its features are improved. The next strategy will build on that theory, testing the upper limits of profitability for the product. Using the price elasticity information that we have from Time Warp 1, we can estimate the ideal price point for the X6 product, given its current level of R&D investment. This can be found in Appendix A. The ideal price point for the X6 therefore is $432.