Cost-Volume-Profit Time Warp

Decisions are important matters that must take many factors into account, and nowhere is this truer than in the world of business. There, choices made by those who hold the power to make them can have the potential to affect whole industries, put careers at stake, and even revolutionize the world of technology as it is known today. This company is one such company, and suffice it to say that the author has had adequate opportunity to examine the possible decisions that might be made from the beginning of the year 2012 to the end of the year 2015. In particular, the recent introduction of cost-volume-profit analysis to the mix of influences upon the choices that have been made over the last four years should have made a substantial difference to the outcomes in terms of profit for the company. Yet when the actual numbers are examined, instead, it appears to be the case that the scenarios as set up at the beginning of 2012 did not actually mirror reality very closely. The strategies devised using cost-volume-profit analysis were not able to increase profits beyond the levels that can be attained either by doing nothing and leaving the status quo intact or by making intuitive guesses in response to data gathered on a year-by-year basis.

X5

The X5 is a tablet that was pulling its weight as of the beginning of 2012, and yet, as the situation continued to evolve, it became clear that discontinuation was the direction to take with this product. Though the X5 is meant to be a low-end, low performance tablet computer, strangely, the X7—meant to be the mid-priced, mid-performance option—is set at nearly one hundred dollars below the price of the X5. After performing cost-volume-profit analyses based upon the data from the previous year, it became apparent that the fault there was with the X7 rather than with the X5. (The strategy matrix developed based upon these and other results is available in the appendix.) At its current price and phase in the growth cycle, the X5 could then be expected to improve upon its sales numbers from the previous year, going up to one million units. This part was achievable, but subsequent losses were unavoidable. The portion of the research and development budget that had previously been allocated to the X5 was cut to zero, with the goal of selling the product as complete.

From that point forward, the decisions from the cost-volume-profit analysis projections were followed consistently, yet in the end, the X5 did not appear to make any appreciable contribution to raising the score above status-quo levels. This may be in part because the plan recommended after doing the initial cost-volume-profit analysis involved discontinuing the product midway through this time period. Thus, the X5 was less able to contribute from that point forward than the other two tablets, which perhaps made the company into a bit of a three-legged dog, so to speak, lacking everything it needed in order to proceed forward in a not ungainly fashion. However, the X6 proved much easier to manage than the X5.

X6

The X6 is, in some ways, a simple and straightforward beast. It is the premium product, an idea that appeals to a certain subset of customers. Fortunately, it also happens to have been in a growth phase at the beginning of this recent four-year cycle, thus providing it with great potential for profit. Indeed, because both volume and profit estimates in the cost-volume-profit analysis could afford to be generous, the price was able to be raised for all of the first three years. Increments of five percent had already been suggested as part of the cost-volume-profit analysis, whether a product’s price was being modified in the positive direction or whether it was being changed in the negative direction. Then, as cost-volume-profit analysis suggested, the product was discontinued from that point forward. Again, this may have been a dubious decision, but it is what the strategy matrix has already set forth. Later, the possibility of changing marketing strategies in midstream will be discussed, but for the information available, the best decisions possible were made within the structures given.

As for the research and development budget of the X6, it was decided that since zeroing out the X5 in this regard had freed all the funds to be divided between the X6 and the X7, this division should be fairly even to start with. However, the X6 deserved slightly less than half because it had already had the benefit of substantially more development going in. In addition, it was predicted to be much closer to the shakeout phase than the X7. Thus, forty percent was the final number chosen, and this number remained constant across the first three years. Then, with the discontinuation of the X6, research and development, of course, went down to zero, as would be expected. The X7, by contrast, continued to be a strong player through all four of the years that were examined.

X7

The most striking thing about the X7 initially was that its price was so low, at only $190, which both seems intuitively low for a mid-range tablet and was in fact well below the price of the X5, as was previously mentioned. Again relying on the somewhat cautious five-percent increments suggested by the cost-volume-profit analysis results, and beginning the very first year, the X7’s price was raised each year. This seemed to provide adequate but not amazingly impressive numbers for both volume and profits. Of course, because the X7 hogged more than its fair share of the research and development budget, taking sixty percent the first three years and one hundred percent in the final year, its fixed costs were higher going in. This may explain why its profitability figures were not as stand-out as one might feel they should be under the circumstances. After all, the X7 seemed to become an increasingly popular product over these last four years, and that ought to have influenced the overall results more strongly.

Results

The final results (also shown in the appendix) were disappointing. A status-quo approach for these four years is known to yield final profits around $1.2 billion. An intuitive strategy based on adapting to the unique circumstances of each year gives around $1.3 billion under ideal circumstances. By contrast, even with all the additional trouble caused by the need to make calculations, cost-volume-profit analysis managed to generate the worst strategy yet. Following the course that was recommended at the beginning of 2012 based on cost-volume-profit analysis, the final cumulative profits were only $1.1 billion. Since this is a counter-intuitive result, it is worthy of some discussion.

Discussion

There are a couple possible explanations for the discouraging results. One may be that the extrapolations made from 2012 results should not have carried so much weight in subsequent years, as has been explained: “[Cost-volume-profit] analysis is based on . . . the short run, the short run being a period of one year, or less, in which the output of a firm is restricted to that available from the current operating capacity” (Drury, 1992, p. 205). This suggests that in the future, should these four years be revisited again by some wild chance, it would be good to perform a cost-volume-profit analysis each year, rather than once every four years. In addition, there may simply have been too much uncertainty in the mix, as some researchers have observed: “Cost-volume-profit analysis is frequently used by management as a basis for choosing among alternatives . . . [T]he fact that traditional [cost-volume-profit] analysis does not include adjustments for risk and uncertainty may, in any given instance, severely limit its usefulness” (Jaedicke & Robichek, 1964, p. 917). Indeed, it seems that cost-volume-profit analysis had quite limited usefulness for these four years. However, there is still hope for similar situations.

Conclusion

Overall, the performance review of the three tablets combined did not prove to be anything impressive even though cost-volume-profit analysis was used this time around. There may have been multiple relatively minor reasons for this, but in the end, perhaps the truth is that if cost-volume-profit analysis were a perfect tool, there would be no risk in running a business; everyone would get it right the first time around. However, to really achieve perfection, a person needs not just one attempt at a given time period. That person needs to have access to endless iteration, which in truth, is something that can never happen in real life—only in a movie. 

References

Drury, C. (1992). Cost-volume-profit analysis. In Management and Cost Accounting (pp. 205-235). New York, NY: Springer Publishing.

Jaedicke, R. K., & Robichek, A. A. (1964). Cost-volume-profit analysis under conditions of uncertainty. Accounting Review, 917-926.

(Appendix omitted for preview. Available via download)