In CVP analysis, we often use a fixed price when we are estimating output in order to achieve a target profit. For instance, if the owners of REVLAND wanted a profit of $22,000 per month, they might calculate production as follows:

Sales price per unit = $400

Variable costs per unit:

Electronics = $95

Materials = $55

Commissions at 4% = $16

Labor = $120

Total variable cost per unit = $286

Contribution margin = $400 – $286 = $114.

Fixed costs plus target profit = $80,000 + $22,000 = $102,000

$102,000 divided by $114 = 894.73684 units, which rounds to 895 units.

The resulting CVP analysis would be:

However, if we take the demand curve into account, we might see sales drop as we increase the price.

For instance, if you currently buy your morning coffee drink for $4.99 plus tax from a local shop, and the same drink from the big shops and other smaller shops was comparable, but then your favorite coffee place started increasing prices, at what point would you find an alternative?  $5.10? $5.50? $6.00? And if all the stores increased prices, at what point would you find an alternative, such as tea or coffee from home?

Most products have some amount of price “elasticity”, which means that consumers will find alternatives when prices increase; thus, the slope of the demand curve.

With total variable costs at nearly $300, it doesn’t make sense for the company to even consider selling below that price unless it wants to engage in a price war (often called penetration pricing) and is willing to lose money in order to get the product into the market. However, eventually, the company would have to raise the price in order to make a profit and stay in business.

Let’s run a sensitivity analysis on our CVP statement to see the effects of various levels of sales based on the demand curve:

Notice that variable costs per unit change because the 4% commission on sales is tied to the sales price. Decreasing the price to 350 increases sales but results in a loss due to the lower price. Raising the price to $500 increases the bottom line, but results in less profit than a target price of $450. If you run the calculation for a $550 price, you’d see that the company would only sell 300 units and would lose money, so the optimum price seems to be a bit higher than the $400 the company originally set, assuming that fixed costs don’t change as volumes change within this range of analysis.

With some fine-tuning, the company may find that a slightly higher price, such as $460, would drop unit sales down a bit, say to 520, but increase the bottom line to about $9,300. However, the only way to actually find out is to enter the market based on the best information available and then adjust based on actual results.

Also notice that in order to sell 895 units, the company would have to drop the price to somewhere around $360, which would result in a loss of over $12,000 based on the demand curve created by the marketing consultants.

Target Pricing for Service Businesses

Many service-based businesses struggle to come up with a fair and profitable pricing strategy. There is no original price to reference, as there is in retail and manufacturing, and often a service may be unique. In addition, the pricing formula for services should account for the intangible aspects of running a business, such as time and value.

However, the general concept is the same and follows the same kind of pattern as pricing products:

1. Calculate costs. Providing services includes direct costs (labor, materials) and indirect costs (overhead).
2. Perform market analysis. Keynote speakers charge anywhere from $1,000 to $100,000 and beyond, depending on the speaker and the venue. Accounting and legal services, however, are more bound by market forces, since the services offered are fairly competitive, although there are certainly attorneys who can charge a premium fee based on notoriety, experience, and specialization.
3. Establish return on investment. Many small business owners, both service and product based, forget to factor in their own time. If you own an accounting firm and you pay your staff a living wage but don’t take a salary yourself as a partner or proprietor, you need to factor that into the amount of profit that your firm shows at the end of the year. If you put $100,000 into the business to “capitalize” it (your investment into the business) and you would normally be paid as an employee $125,000 annually for the same services you are providing for your business, and you could have left your $100,000 in an investment that paid 8%, then your business needs to clear $125,000 + ($100,000 * 8%) or $133,000 just for your business to be equal to the opportunity cost of owning that business, and even then, you simply own your own job at that rate. Also, there are additional taxes, such as self-employment taxes, and costs such as paying 100% of your health insurance, that are not taken into account in this simple example. In reality, in exchange for the risk of entrepreneurship, the business owner should expect and demand and plan for far greater returns than just “breaking even” at the same amount of money he or she would have made leaving savings in the bank and working a “job”. Also, small business owners tend to put in far more than just 40 hours a week. All of this needs to be taken into account in determining the amount of total revenue the business must bring in to make it worthwhile.
4. Set rates. Once a service business has established fixed and variable costs plus a reasonable return on investment, management must establish rates that, in combination with volume of work, will result in the desired net profit. These rates could be hourly, such as the attorney who charges $400 per hour, or by contract, such as the keynote speaker who charges $10,000 for a half-hour presentation. In addition, many businesses are combinations of service and product, such as your local auto mechanic who charges an hourly rate plus parts that are being sold to you with a markup.
5. Focus on volume. In order to achieve the desired volume, the service business will have to advertise and market, just as any other business. An established firm can project volume based on prior years, adjusted for current events (for instance, during the pandemic, many businesses had to revise their business plans significantly and could not base next year’s budget on last year’s results) but new firms will have to use flexible budgeting and concentrate on marketing strategies to hit goals.

Now check your understanding of how to establish a price to maximize profits.