CVP analysis looks at the relation between cost, profit, and volume. This method can be utilized to decide the optimal selling price of a product.
Optimal selling price
The optimal Selling Price is the price that yields the maximum benefit for the business.
Determining the optimal selling price
CVP analysis is based on the concept of contribution which is a fundamental principle in marginal costing. Contribution is regarded as the determining factor in various decisions. CVP analysis method states that the optimal selling price is the one that generates the maximum contribution for a business.
To understand how CVP analysis can be used to decide on the selling price of a product, let us consider the example of Sweets & Treats Limited, a bakery business.
Example – Using CVP analysis in pricing decisions
Sweets & Treats Limited is considering including butter biscuits as a new addition to the bakery’s menu. Management is worried about the selling price they should set that will achieve the highest profits for the business. Right now, they have three selling prices of $10, $12, and $14 in mind. You would think that the business should set $14 as the selling price, because it is the highest among all options. This would not be wrong if the selling price did not affect the demand for the biscuits. However, in real life, demand for a product decreases when its selling price increases. As a solution to this complication, the management reached out to a market surveying agency to analyze the local area they want to sell the biscuits in for selling prices of $10, $12, and $14. The market survey led to the following results for the next budget period:
So, if the business sets the selling price of $12 for each biscuit, it will result in a profit of $16,000 for the company which is the lowest among than other options.
Thus, if the business sets the selling price of $12, it will result in the highest profits for the business. This is because the total contribution is maximum at this selling price as compared to other options.
Note that, it is not always the highest selling price which will lead to maximum profits, but the total contribution.