CVP Analysis and Product Mix Strategy in Business Simulation

Introduction to CVP Analysis and Contribution Margin

Cost-volume-profit (CVP) 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, 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, n.d.). For example, for the year 2005, the X5 contribution margin under the strategy examined here would be:

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

X5 Product Analysis and Discontinuation Decision

There are several important insights to be drawn from the CVP analysis in this case. The most significant relates to the breakeven analysis conducted on each product prior to Time Warp 1. The X5 carries the highest fixed costs of the three products at $70 million. A critical failure in the baseline strategy was not recognizing that these high fixed costs would render the product unprofitable by 2009. The per-unit CVP calculation for the X5 yielded the following result:

Contribution margin = $250 − $140 = $110

At a contribution margin of $110 per unit, the number of units required to cover the $70 million in fixed costs associated with producing the X5 would be:

70,000,000 ÷ 110 = 636,363 units

During the previous simulation run, X5 sales in 2008 were 698,046 units and declining rapidly, with the remaining untapped market standing at just 406,801 units. This trend strongly indicated that the X5 was highly unlikely to reach the breakeven sales point. Indeed, the baseline strategy saw sales of only 516,188 units in that year — well below breakeven. The only modification made to the X5 in the revised strategy was a reduction in its R&D budget, which could be expected to produce even lower sales than the baseline. 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 correct one.

For the next simulation, little will change with respect to X5 strategy. The product is in a mature stage of its product life cycle. Regardless of what changes are made, the X5 will be discontinued after 2008 because it will be unable to meet its breakeven sales point. There is also little reason to believe that, at this stage of the product life cycle, the X5 would benefit from additional R&D investment more than the other two products. Accordingly, the decision to cut its R&D budget will stand. This leaves the question of price — however, the cost-volume-profit analysis lacks one key ingredient for setting price levels: insight into price elasticity of demand. While there may be merit in cutting the price to capture a few extra sales and boost overall profit, there is also reason to set this question aside in favor of examining product mix.

Product Mix Strategy and R&D Allocation

Product mix is one of the most important applications of CVP analysis. When applied on a company-wide basis, CVP analysis can yield insight into the optimal mix of products and support decisions regarding R&D allocations. In this case, a base logic for R&D allocations is clear: the X6 needs to be feature-rich in order to attract buyers, while the X7 needs only to remain current in its features. The X5, by contrast, is essentially locked into a particular sales, revenue, and profit trajectory. Adjustments at this stage of the product life cycle may shift total company profitability by a few million dollars in either direction, but the real profit potential lies in the X6 and X7.

X6 Pricing and Contribution Margin Optimization

Under the baseline strategy, the X6 had a contribution margin of $400 − $250 = $150. The hypothesis was that improving the X6's features would allow for a higher price and therefore a higher contribution margin. The revised strategy delivered a margin of $450 − $250 = $200 — an increase of $50 per unit over the baseline — at a cost of a $6.6 million increase in R&D expenditure. In 2007, for example, this additional R&D cost equated to $8.50 per unit, meaning that $41.50 per unit was added to net profit.

This came at a slight reduction in sales volume: the baseline sold 5.363 million units while the revised strategy sold 5.298 million units. However, comparing total profit reveals the advantage of the revised approach. The baseline strategy generated $150 × 5.363 million = $804.45 million in profit, while the revised strategy generated $191.50 × 5.298 million = $1,014.56 million in profit. This difference reflects the low price elasticity of demand for the X6, particularly when its features are improved. The next strategy will build on this finding, testing the upper limits of profitability for the product. Using the price elasticity data from Time Warp 1, the ideal price point for the X6, given its current level of R&D investment, is estimated at $432 (see Appendix A).