Ask business owners how they go about solving problems and they will tell you that they gather relevant information, understand best practices on that topic, analyze the situation, evaluate possible alternatives and in the end select solutions that yield the least downside risk while providing a reasonable return on investment.
It's a good approach and good advice for decision-makers.
It is a wonder to me why many of these same business owners do not take a studied approach when addressing the important issues of deciding what products to offer and how to price them.
Manufacturers, retailers and service providers need to make decisions about which products to sell at what volumes, at what cost and quality, and at what price points. Other issues may be applicable, such as what level of advertising and customer service support is necessary for particular products. Capital leveraging decisions may arise as to when to invest in additional equipment or when a business should downscale certain parts of their operation.
Use of cost-volume-profit (CVP) analysis allows us to analyze company, business unit and product level production and pricing dynamics. This analysis can help managers make better decisions.
When a store owner is deciding to add a new product, or a manager is responding to a bid request, it is wise to know all of the true costs that will be applied in order to properly set pricing to achieve a desired level of profit. Without performing CVP for a service or product, one does not know how much profit is made — if any.
CVP measures break-even levels, contribution margins and operating leverage. From these analyses, it is possible to quantitatively approach various business problems to find and implement near-optimal solutions.
Break-even is simply a level of revenue where fixed and variable costs are covered. Fixed costs are those necessary for a business to keep its doors open. Variable costs are the expenses required to sell a product or deliver a service — generally a combination of material and labor costs.
Since most businesses sell a variety of goods or services, CVP allows us to measure the contribution margin for each offering sold in the product or service mix. This enables us to make more optimal production and pricing decisions across a company or market area.
Operating leverage measures how much the business assets are used to produce goods and services. Production or service capacity costs set too high create losses. If capacity expenditures are too low, then higher profit opportunities are missed.
As a business consultant, I review financial information to understand the health of a business and look for areas that require attention. When I see that pricing decisions and job quotes are built on intuition or a one-size-fits-all hourly shop rate, I know that there is a wide disparity in profitability for each job or product delivered. This means that the rest of the business is out of alignment.
The goal of a manager is to efficiently deploy company resources to maximize profits. This cannot be done when a manager does not know the profitability of specific products and services. CVP analysis can lead these managers out of the woods.
To use CVP analysis effectively, one needs to understand all of their true variable and fixed costs.
In order to understand the true costs, it is necessary to track actual costs and then compare them to estimated costs.
This variance analysis provides a history of true costs from which lessons are learned. Such knowledge can be applied to similar future pricing decisions.
Cost-Volume-Profit is a fundamental analytical approach used in Management Accounting. CVP can provide data necessary to build management decision models for making choices about product mix and pricing.
Developing basic CVP skills will pay large dividends for business owners and managers.
Business consultant Harley Luplow of Harbor Springs earned a law degree from Indiana University and a master's in business administration from Georgetown University. Luplow can be reached at 709-9000 or firstname.lastname@example.org.