If you’ve taken our online Coordinator Course, you are already familiar with the universal concept of a ValueHub™ and its Orchestration. However, to capture enough value to make a profit we’ll need to understand how to calculate performance and how much is needed to break-even.
First, let’s have a look at the ValueHub™ Orchestration (PDF) and in particular the image to the right:
Although the figure is self-explanatory, it should be clear that -regardless if you begin with orchestrating demand or supply- you’ll need both to be able to capture any value as profit.
If we perceive value acquisition and value creation as cost, and value delivery as performance, the question remains: how much do we need to sell to make a profit?
How do we know what causes margin variations? How do we identify the impact on our bottom line, following changes we’ve made in the price-volume mix, product-customer mix or any other mix? How do we evaluate how price increases offset costs or contribute to margin growth? How do we gauge the performance of product innovations?
Obviously, we need to know the cost (fixed and variable) involved in delivering value. Once we know this, we can calculate how much product we need to sell to (at least) break-even. Besides what we should achieve (break-even), we also want to measure our performance against what could be achieved (potential).
In part, this can be achieved using a Cost-Volume-Profit (CVP) Analysis. It looks at fixed costs, variable costs. sales price and sales volume to determine Gross Profit Margin.
CVP Formula: Break-even Sales Volume = Fixed Costs / (Sales - Variable Costs)
Price and Volume
The two variables that define and confine revenue are sales price and sales volume, i.e., the Price/Volume Mix. Volume relates to the size of the market at a given price level, while the price is relative to the maximum price a customer is willing to pay (= reservation price).
Let’s assume the fixed costs of offering product A are estimated at 50.000 euro per year, while the variable costs are determined at 25 euro per unit. The reservation price is 110 euro, while the serviceable available market (SAM) is 15.000 customers (= reservation volume). We’ve decided on a premium pricing strategy -given our strengths relative to the competition- and sell the product indirectly at 75 euro, using our existing dealer network. After a year we’ve sold 2.500 units.
We can now calculate our Gross Profit Margin (GPM) as well as our GPM Growth Potential:
PRICE/VOLUME MIX (Product A, 75 Euro, 2018): Fixed cost = 50.000 euro/year Variable cost = 25 euro/unit (costs relative to the number of units produced) Reservation Price = 110 euro/unit Advertised Sales Price = 75 euro/unit Reservation-Price Ratio = (75 - 25) / (110 - 25) = 68% Market Size = 15.000 units (from research, at zero-margin price point) Reservation Volume = 15.000 * 0,68 = 10.200 units (at 75 euro/unit) BREAK-EVEN PERFORMANCE: Break-even Sales Volume = 50.000 / (75 - 25) = 1.000 units (CVP) COMMERCIAL PERFORMANCE: Operating Revenue = 2.500 * 75 = 187.500 euro Market Share = 2.500 / 10.200 = 17% Reservation-Price Ratio = 75 / 110 = 68% Sales Performance Ratio = 17% * 68% = 11,3% Operating Income = ((75 - 25) * 2.500) - 50.000 = 75.000 euro (Gross Profit Margin) Growth Potential = 1.125.000 -/- 187.500 = 937.500 euro
Based on the reservation price, market size, fixed costs and variable costs we can now draw a break-even level, covering all price points. This, however, does not provide us with an estimation of the actual market size at a specific price point. Obviously, we could if we consider price/volume to be constant, meaning, regardless of the size of the market customers will have the same perception of value, What we’ve added to the equation is the concept of ‘reservation volume’ – it is the volume we could obtain, given the price level.
We believe the price/volume for a given product/market is constant because the value attributed to a product by a customer at a certain price level is constant. In other words, because we can calculate how much we need to sell to break-even, the same graph can also be applied to determine how much we could sell.
If we plot the break-even volume at various sales prices we’ll get a break-even level (blue line). By running the reservation level parallel to it (green line), we can now estimate the reservation (sales) volume at a certain price point, or more specific, determine how much units we could sell at the current price.
Two areas are ‘out-of-bounce’: if revenue drops below the blue line the value orchestration is unsustainable (by itself), whereas the likelihood of achieving revenue above the green line is practically inconceivable (given the reservation price and reservation volume). Between the blue and green line, it is game-on.
Obviously, costs vary depending on the business strategy, horizontal strategy, strategic partnerships, pricing strategy, distribution strategy, innovation, industry structure, level of competition, the scale of the operation, substitutes, and so on. However, these rather simple formulas demonstrate how we can calculate relative performance. Even if we change strategy, for instance, ignore our dealer network and sell directly to end-users at a lower price, we are still able to compare relative performance year-over-year.