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Pitfalls
Although this analytic technique can be very powerful, it is rife with assumptions. One must use this
methodology carefully, because ceteris paribus exists only in textbooks.
Price and Variable Cost Changes
The scenario analysis discussed earlier illustrates a situation where a change in pricing required an
adjustment in the estimated variable cost percentage. Since the dollar amount of variable cost per unit
is assumed to remain relatively constant, a decrease in price of the unit would make the variable cost
higher on a percentage basis. Likewise, variable cost factors are subject to market pressures. In 2008,
petroleum cost indexes increased over 100%. One must constantly monitor trends and make the
requisite adjustments to the variable cost percentage.
Product Mix
The earlier analysis of Company X over the four quarters assumed a constant product mix. Few
companies, if any, offer only a single product. Company X has a service offering and two products
groups, one high-end and the other midrange. Each of the three has a different cost structure, which
implies that the calculated cost structure, 34% of sales variable and fixed costs of $672 annually, is
correct if and only if the mix remains constant. The 10K SEC filing does report the service revenue
separately at $165 million for the year and that it was relatively constant at 15% of total revenues for
each of the four quarters. In addition, a close read of the annual report discloses that this service is
mostly break/fix and totally outsourced, which means that the cost of service, reported at 45% of
service revenue, is predominantly variable in nature. In addition, an industry report by an investment
house estimates the ratio of high-end to midrange at 40:60 for the period, yielding sales estimates of
$375 [40% × ($1,102 - $165)] and $562 [60% × ($1,102 - $165)], respectively. The variable costs for
the two product classes, however, are not reported, but a competitor familiar with the products should
be able to estimate them with some degree of accuracy.
Exhibit 12.5 illustrates the analysis. The known factors are the service data (columns 1 and 2) and
the annual data that was calculated earlier (columns 7 and 8). In addition, the high-end and midrange
revenue figures are estimated with some degree of confidence given the investment house report.
What is necessary is to plug in estimates for the variable costs of these two offerings knowing that the
total variable costs of all three offerings must be close to our annual estimate, $374.8. A competitor
with a good sense of the market would probably have little trouble arriving at the figures in the boxes,
26% and 36%, which then yield a total variable cost for the mix very close to the $374.8 figure in
column 7.
Assume that competitive pressures are commoditizing the market, driving the high-end to midrange
mix from 40:60 to 1:2, and Company X is responding to this potential drop in profitability by
aggressively driving its service business with a stated goal of increasing it to 25% of total revenue