CASE STUDY: Use Cost-Volume-Price Analysis to Increase Profit

To show the importance of pricing decisions, this advisory will show how you can make money by selling a product for $15 when your average cost to produce that product is also $15.

Setting prices on your company's products is tricky business. Set prices too high and you may never get the market share you're after. Set them too low and sacrifice profit.

Compared to larger companies, smaller businesses are much more vulnerable to pricing mistakes because they're usually concentrating their efforts -- and building their business -- on fewer products. A larger company spreads its risks over many product lines, so a mistake on one product's pricing won't impact its bottom line as much.

One way the smaller company can lessen the risk of a pricing mistake is by doing more extensive analysis before setting price. Here are the important initial questions:

What is my breakeven on each product?

Can I sell more products by lowering the price, or should I increase the price and sell fewer units?

Given a set price, should I lower the price for quantity orders, and how low can I go and still make a profit?

Do I have enough cushion in my pricing to give my salespeople or reps an additional 5% commission as incentive for more sales?

If I'm going to spend $20,000 on advertising, how many additional units must be sold to get back my investment?

These questions are critical: Most smaller businesses don't have the capital that enable a larger corporation to ride out the consequences of a flawed pricing decision. That's why knowledge of the cost-volume-price relationship of your products is essential for greater profitability and, at times, survival itself. Here's a case study on Carbondale Corporation that will help you better understand how to analyze your pricing and evaluate bulk orders.

Step 1: Prepare the Data

Carbondale Corporation is a manufacturer of converters sold on a private-label basis to large discount chains.  The company has capacity to produce 45,000 converters a year. Planned production for the current year is 20,000 units and involves working the plant for a single shift. An analysis of the company's cost records reveals the following information for the 20,000-unit production level:

Note: Variable costs fluctuate with volume changes while fixed costs don't. They reflect more of a company's capacity to produce.

Variable Cost per Converter:

Manufacturing Cost per Unit               $8

Selling and Administrative Cost per Unit  $2

Total Variable Costs per Unit       $10

Fixed Costs Allocated to This Product Line:

Manufacturing Costs                       $60,000

Selling and Administrative Costs          $40,000

Total Fixed Costs for Carbondale    $100,000

Current Selling Price per Unit: $18

Based on the above data, the average cost per converter for a quantity of 20,000 units is $15, computed as follows:

Average Cost      =     Fixed Costs + Variable Costs

Number of Units

=     $100,000 + ($10 x 20,000)

20,000 Units

=     $100,000 + $200,000

20,000 Units

=           $15 per Unit

So, the average cost per unit is $15 at the 20,0000-unit sales and production level, fully burdened for all costs -- variable and fixed. Note: In the case of fixed costs, they're burdened by the portion of fixed costs allocated to this product.

At a selling price of $18 and volume of 20,000 units, the profit per unit is $3 and the total annual profit is $60,000, calculated as follows:

Sales (20,000 Units X $18)          $ 360,000

Less: Fixed Costs                   ($100,000)

Less: Variable Costs($10 per Unit)  ($200,000)

Operating Profit                $60,000

Note: The input data for your particular company and product should be easy for you to obtain. Talk to your accountant or treasurer.

Step 2: Analyze the New Order (hypothetical or real)

Let's say Carbondale's sales manager just received a large order from a new customer for 10,000 converters, but at a price of $15 each. Important: The $15 price being requested is Carbondale's current average cost per unit. But before you reject the large order on this basis, let's do a little analysis.

Question 1: Is there any scenario under which Carbondale should accept the new order? On the surface it would seem futile (devoid of profit).

Answer: The fixed costs associated with the converter product are already fully absorbed by the 20,000 units already being sold. The new large order, therefore, will not have to absorb any of those fixed costs. Through a little investigating, you determined that you'll need to spend another $10,000 on equipment (a fixed expense) and that you should be able to produce the additional 10,000 units at the same variable cost of $10 each. The next step then is to calculate the new cost-volume-price data on the new order only.

If the result is positive (a profit), the order should be considered. If it is a negative number or near breakeven, the order should be turned down.

Note: In making the calculation, only incremental revenues and costs are considered -- those that are added by this particular order. Again, that's because the fixed costs absorbed by the original 20,000 units are already taken care of. Now let's do the analysis:

Analysis of New Order:

Incremental Revenues

(10,000 Units at $15)                     $150,000

Incremental Costs

Manufacturing                             ($10,000)

Variable Costs ($10 per Unit X 10,000)    ($100,000)

Profit on New Order                   $40,000

As computed, the new order generates an additional profit of $40,000. Now let's look at the total picture -- the effect of the new order on Carbondale's total sales and operating profit.

Here is a condensed income statement:

Without      With

New Order New Order

Sales                               $360,000    $510,000

Less: Fixed Costs                   (100,000)   (110,000)

Less: Variable Costs                (200,000) (300,000)

Operating Profit                    $60,000     $100,000

Operating Profit Margin               16.7%       19.6%

Step 3: Look at the Results

If you accept the new bulk order for 10,000 units at $15 per (a 16.7% discount from list price), which is your fully burdened cost for the initial 20,000 you expect to run through your plant, you'll actually add $40,000 to your bottom line and raise your operating profit from 16.7% to 19.6%.

Question 2: Just how low a price would it make sense to accept? The calculations are simple: Divide the total incremental costs of $110,000 by the number of additional units (10,000) to obtain your breakeven price per unit of $11.

But should you sell the product at $12, if that were the best you could do to get the order, resulting in a profit of $1 per unit for a total added profit of $10,000? It would appear so, but let's look at the new profit margin. Your new sales would be $480,000 ($360,000 plus $120,000 with the new order) and your operating profit would be $70,000 ($60,000 plus $10,000 profit from the new order).

The result. Your operating profit margin drops to 14.6% ($70,000 profit divided by sales of $480,000), compared to 16.7% without the order.

You can accept the new order at the $15 price -- even though your average cost per unit is also $15. Reason: Your profit margin increases to 19.6%, from 16.7%

This is the essence of what is meant by "having more sales but enjoying it less." The trade-off is the increase in the absolute profit of $10,000 versus the decrease in our overall profit margin. The choice is yours. But with these calculations, you at least have the data to make a more informed decision and you may decide to take the new order just to add another customer whose business could increase in the future.

Remember: Exact costs may be hard to determine, and the line between fixed costs and variable costs can be hazy. But all businesses, especially smaller businesses where a mistake in pricing can mean the difference between survival and failure, should use breakeven and contribution margin analysis. It's easy to compute and it can give you the necessary data to maximize your long-term sales and profits.

Other Applications

The analysis used here also can be used for:

Pricing a new product.

Justifying additional salespeople.

Increasing your fixed costs to handle projected or increased sales.

Considering the make-or-buy decision.

Determining the minimum price of your products and the profit contribution of each product.

Assessing a new marketing initiative, e.g., adding a new sales office or territory.

Buying a business. In addition, this type of analysis can be used to evaluate the purchase of a product line, a division of another company or another company altogether.

In these cases, certain fixed costs will be reduced because you will be operating under one umbrella. These reduced costs are referred to as the synergistic benefits and can substantially add to the overall profitability of the combined entity.

Steps to Pricing an Order

Step 1:  Obtain all relevant pricing data, including your company's current fixed and variable costs.

Step 2: Analyze the new order. Include incremental (additional) costs associated with the order. Be sure to adjust for any additional fixed costs.

Will it make a profit?

Step 3:  Prepare two proforma annual condensed profit-and-loss statements for your company. In the first, assume that you reject the order. In the second, assume that you accept it. Now, calculate the operating profit margin for each. Which is higher?