CVP, Probabilities and Target profits

A meeting of senior managers at the Newcastle

Division has been called to discuss the pricing strategy for a new product. Part ofthe discussion will focus on the problem offorecasting
sales volume. In the last year a significant number of new products have failed to achieve theirforecast sales volumes. The financial
accountant has already stated that the profit forthe year-end will be lowerthan budget and the main reason forthis is the disappointing
sales of new products.

A newtechnique for estimating the probability of achieving target sales and profits will be discussed. This

requires managers to estimate demand forthe new product and assign probabilities. The management accountant is in favour ofthis approac
as she wants to avoid having a single estimate for sales.

Details of pricing strategies

The first strategy is to set a selling price of

$170 with annual fixed costs at $22,000,000. A number of managers are in favour ofthis strategy as they believe it is important to reduce
costs.

The second strategy is too having a much higher expenditure on advertising and promotions and set a selling price of $190. With

the higher selling price the annual fixed costs would increase to $27,000,000. The marketing department are very clearthat greater
expenditure on advertising and promotions is essential forthis product.

The following probability distribution has been agreed with the

managers after consultation and is the same for both selling prices. Awide range of managers from all departments have agreed to this
estimate.

Estimated demand (units) Estimated probability (units)

150,000 0.1

160,000 0.4

180,000 0.3

200,000 0.1

210,000 0.1

Estimated standard deviation of sales 18,547 units

Variable costs per unit

The managers estimate that the variable cost per unit is

$35.

Target Profits

The target profits identified by the managers are given below. The probability ofthe new product only achieving

break-even is very important. A profit greaterthan $ 4,000,000 is the required return forthe new product. lfthe product cannot achieve a
profit greaterthan $ 4,000,000 it is very unlikely that managers will accept it.

Questions

Question 1

(a) For both pricing strategies

calculate the probability of:

(i) A profit greater than$1 500,000

(ii) A profit of$0 (break-even)

(iii) A profit greater than$4,000,000

Question 2

Assuming that the target profit forthe new product is$4,000,000 discuss whether your answerto (1) helps managers choose

between the two pricing strategies.

Question 3

Discuss howthis technique can be applied to a large multinational company with a wide

range of products
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