Cost-Volume -Profit Analysis 121THE ROLE OF PRICING IN CVP ANALYSIS
CVP analysis is often erroneously used to set prices. The PinCVPdoes not
stand for “price”; it stands for “profit.” A rule to remember: There is no such
thing as “cost-based pricing.” Prices are market driven. If a firm finds itself in
a competitive market where competition among rivals is based on delivering
comparable value to customers at the lowest cost, the market sets the price. As
Adam Smith wrote centuries ago, only the most efficient firms will survive. To
use CVP analysis in this situation, one starts with estimates of the market-
driven price and then calculates the profitability given probable unit demand
and the current cost structure. If the forecasted profit is not sufficient to sat-
isfy investors, one must then focus on reducing costs, not raising prices.
Incumbent firm behavior in the U.S. health care industry after deregula-
tion in the 1980s is a perfect example of incorrect use of this technique. New
entrants into the lower, more profitable segments of this industry—for exam-
ple, the walk-in clinics that have sprung up in metropolitan areas—gave pa-
tients (and insurance providers) a lower-cost option than traditional hospitals
for minor health-care procedures. Large hospitals responded to this loss of seg-
ment revenue by spreading their costs (mostly fixed) over their remaining
health-care offerings and raising prices. With those higher prices, the clinics
were able to offer lower-priced alternatives for more complex procedures.
With the loss of these revenues, the hospitals responded in the same manner.
This is called the “doom loop,” and it led to the closing of many such institu-
tions. The proper move for the hospitals should have been to pare expenses on
the noncompetitive offerings.
For firms that compete by differentiating themselves from rivals by offer-
ing additional value to customers at comparable cost, pricing should be based
on value to the customer, not cost. Microsoft certainly does not price its prod-
ucts on the costs to develop and deliver them. Bill Gates long ago understood
the value of an industry-standard PC operating system and has priced Micro-
soft’s offerings accordingly. The key here, of course, is that the additional value
must exceed the costs to create it. CVP analysis in this situation is basically no
different than previous examples. Only here, one starts with estimates of the
value-basedprice and then calculates the profitability given probable unit de-
mand and the current cost structure. If the forecasted profit is not sufficient to
satisfy investors, one must then focus not simply on raising prices but on reduc-
ing costs or increasing the willingness of consumers to pay more.
Predatory Pricing
In recent years a legal battle raged between two of the nation’s largest tobacco
companies.^13 The Brooke Group Inc. (previously known as Liggett Group Inc.)
accused Brown & Williamson Tobacco Corporation of predatory pricing in the
wholesale cigarette market. At trial in federal court the jury decided that
Brown & Williamson had indeed engaged in predatory pricing against Brooke.