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Applying Profit Analysis to Marketing Strategies

Instructor: John Hamilton

John has tutored algebra and SAT Prep and has a B.A. degree with a major in psychology and a minor in mathematics from Christopher Newport University.

In this lesson we will discuss marketing strategies and how to apply profit analysis. This will include defining the term and identifying its basic components, along with actually calculating profit analysis for business purposes.

What is Profit Analysis?

Do you work in a restaurant and need to project future sales or even to consider whether to open in a new location? Maybe you work in the energy industry and need to decide between coal or gas use. Or perhaps you need to make some pricing decisions in the banking industry.

Profit analysis, also known as 'cost-volume-profit analysis' (CVP), is a short-term accounting predictive method that managers use to make various economic decisions. Moreover, managers want to know about the potential profitability of a company's services and products. It should be duly noted that, since this particular form of cost accounting tends to be used mainly for short-term decisions, it is a simplified model of more complex accounting techniques.

In addition to stores and manufacturing companies, profit analysis is used for a wide variety of business and marketing services like restaurants, energy industries, or banks. Ironically, even non-profits can use profit analysis to deal with resource allocation issues.

Profit is what is left after cost is subtracted from the price
profit

Three Basic Components

Let us break down CVP into its three basic components:

  1. Cost - how much money is needed to provide a service or manufacture a product
  2. Volume - the hours of a service provided or the number of products built
  3. Profit - the price at which a service is rendered minus the cost it takes to render the service, or the price of a product minus the cost it takes to make the product. The money left over is the profit.

Other Components

Further components involved in profit analysis exist. These include:

  • Total costs - add fixed costs, semi-variable costs, and variable costs together and you get the total costs
  • Fixed costs - these are costs such as rents and salaries
  • Semi-variable costs - these are costs such as overtime salaries
  • Variable costs - these are changing costs such as paid commissions and materials

Assumptions

Since profit analysis is a short-term and simplified version of accounting, several assumptions are made before the actual analysis takes place. The sales price, the variable cost per unit, and the total fixed cost are all set in advance as constant.

An extremely important concept in profit analysis is the notion of the breakeven point. This is the point at which the company experiences neither a loss nor a profit. In fact, at this juncture the company's total costs and total revenues are equal.

Another critical concept in profit analysis are target income sales. These are the necessary sales for a company to reach its previously specified dollar sales amount.

Example

For example, let us say that a company called Ted's Toy Trucks wants to sell more of its new item, the red truck. It could run a profit analysis to see if lowering the price would achieve this goal. This would determine both the breakeven point and the target income. The profit analysis would yield one of two conclusions.

First, it might say that lowering the price is a good idea and profits would increase.

Second, it could determine that selling more red trucks at a lower price would never yield a profit, even with the increased sales.

Then the company could decide either to leave the price the same, or eventually raise the price. Although raising the price may well be the best option, there are no real guarantees in the business world, and so it may or may not work.

Performing an Actual Calculation

Now, let us try doing an actual mathematical calculation. Bill's Bicycle Hut wants to sell a blue beach cruiser (Bill's favorite color) at a fair price of $200 per bicycle. His total fixed expenses are $25,000, and he has set target profit of $35,000.

Furthermore, it costs Bill $50 in variable expenses to make each bicycle. At first glance it would seem that Bill simply makes $150 per bicycle (profit = price - cost, or $150 = $200 - $50.) However, the company has those other fixed expenses as well that must be factored in.

The formula is:

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