Problem Recognition/Evaluation
Recently I tried engaging in a business that produces different types of consumer products. After carrying out an extensive market research, i was faced with an economic problem of knowing which business enterprise would give me a higher return on investment within a year.
The root cause analysis for this problem showed that:
· Previous similar undertaking lacked clarity in understanding how these products would be affected by demand.
· There were lots of factors imposing some degree of limitation upon the actions of buyers or sellers and this increases the difficulty in comprehending the uncertainties and risks associated. Some of these risks and uncertainties includes:
o variations from business or economic assumptions
o variations in the cost estimates despite a fixed configuration baseline
o variations from problems associated with technology maturity or availability
o Any events that changes the schedule: stretching it out thereby increasing funding requirements, delays delivery and reduce mission benefits
o Rapid changes in government laws and regulations
o Risks associated with support programs like software which causes cost growth from overly optimistic assumptions about software productivity, underestimated integration effort, to mention a few.
· My products have substitutes that can replace them for use by consumers thereby making the market more competitive.
Development of Feasible Alternatives/Solutions
Examination of three feasible business ventures is used.
In carrying out this analysis, an assumption is that the time value of money is not a factor because comparisons of alternatives are being done for only one year.
Alternative 1-
First Venture results in Produce A
Alternative 2 –
Second Venture results in Produce B
Alternative 3-
Third Venture results in Produce C
Probable Outcomes of Alternatives / Solutions.
A number of meetings were held with various key financial players already in the respective business ventures including some government regulators in order to know the limitations involved.
Costs used are factored but have same equivalence with original for the purpose of showing the final result.
Alternative 1 – Venture 1
This venture has fixed cost calculated to be $50,000 per month and a variable cost of $70 per unit. The price per unit that would result in no demand is $180, with a 2% increase in demand for each unit decrease in price.
Alternative 2 – Venture 2
Here the fixed cost is about $35,000 per month with a variable cost of $90 per unit. The price per unit resulting in no demand is $180, with a 2% increase in demand for each unit decrease in price.
Alternative 3 – Venture 3
The fixed cost is cheapest with this venture having an amount of $20,000 per month. The variable cost here is much higher at about $120 per unit. The amount by which demand increases for each unit decrease in price is 0.02 and the price per unit resulting in no demand is $180.
Selection Criteria in determining the solution
1. The business venture should have a wide range of profitable demand.
2. The venture should have a capability of earning the maximum profit.
Analysis and Comparison of the alternatives
The price per unit that will result in no demand (a), and the percentage increase in demand for each unit decrease in price (b), were assumed constant for all alternatives inorder to fairly carry out the analysis.
Another assumption is that all units produced are defect free.
Also, in this analysis, an assumption is that demand is a function of price and can be expressed as a linear function.
p = a – b*D..................................................................................Equation 1
In order for profit to occur, the analysis is based on the following conditions:
· the price per unit resulting in no demand (a) is greater than the variable cost (cv)
· the Total Revenue (TR) must exceed Total Cost (CT)
The formulars below were used in determining the optimal value of demand (D) that maximises profit and the range of profitable demand (D’1 and D’2)
D = a – cv
2b......................................................................................Equation 2
D’ = - (a-cv) +/- [(a – cv) 2 – 4(-b) (-cf)]1/2........................................Equation 3
2(-b)
Other formulars were
TR = D * P.......................................................................................Equation 4
CT = cv * D........................................................................................Equation 5
Where:
D = optimal demand at which maximum profit will occur.
a = price per unit that will result in no demand
cv = variable cost per unit
CF = Fixed cost
b = amount by which demand increases for each unit decrease in price
p = selling price per unit
D’1 & D’2 = Breakeven points (TR= CT)
D = demand
TR = Total Revenue
CT = Total Cost
With the above conditions for a profit satisfied, the breakeven points D’1 and D’2 would be real positive unequal values.
Quantitative analysis of the alternatives
In the figures below, a display of the spreadsheet solution for the 3 alternatives are shown.
This spread sheet calculates profit for a range of demand values (shown in column A).
For each specific value of demand, price per unit is calculated in column B by using Equation 1.
Total Revenue (TR) = demand (D) x Price (P).
Total cost CT = CF + cv * D
Profit (column E) = Total Revenue – Total Cost.
Venture 1 | Column A | Column B | Column C | Column D | Column E |
S/N | Monthly Demand | Price per Unit | Total Revenue | Total Expense | Profit |
1 | 0 | $ 180.00 | $ - | $ 50,000.00 | $ (50,000.00) |
2 | 250 | $ 175.00 | $ 43,750.00 | $ 67,500.00 | $ (23,750.00) |
3 | 500 | $ 170.00 | $ 85,000.00 | $ 85,000.00 | $ - |
4 | 750 | $ 165.00 | $ 123,750.00 | $ 102,500.00 | $ 21,250.00 |
5 | 1,000 | $ 160.00 | $ 160,000.00 | $ 120,000.00 | $ 40,000.00 |
6 | 1,250 | $ 155.00 | $ 193,750.00 | $ 137,500.00 | $ 56,250.00 |
7 | 1,500 | $ 150.00 | $ 225,000.00 | $ 155,000.00 | $ 70,000.00 |
8 | 1,750 | $ 145.00 | $ 253,750.00 | $ 172,500.00 | $ 81,250.00 |
9 | 2,000 | $ 140.00 | $ 280,000.00 | $ 190,000.00 | $ 90,000.00 |
10 | 2,250 | $ 135.00 | $ 303,750.00 | $ 207,500.00 | $ 96,250.00 |
11 | 2,500 | $ 130.00 | $ 325,000.00 | $ 225,000.00 | $ 100,000.00 |
12 | 2,750 | $ 125.00 | $ 343,750.00 | $ 242,500.00 | $ 101,250.00 |
13 | 3,000 | $ 120.00 | $ 360,000.00 | $ 260,000.00 | $ 100,000.00 |
14 | 3,250 | $ 115.00 | $ 373,750.00 | $ 277,500.00 | $ 96,250.00 |
15 | 3,500 | $ 110.00 | $ 385,000.00 | $ 295,000.00 | $ 90,000.00 |
16 | 3,750 | $ 105.00 | $ 393,750.00 | $ 312,500.00 | $ 81,250.00 |
17 | 4,000 | $ 100.00 | $ 400,000.00 | $ 330,000.00 | $ 70,000.00 |
18 | 4,250 | $ 95.00 | $ 403,750.00 | $ 347,500.00 | $ 56,250.00 |
19 | 4,500 | $ 90.00 | $ 405,000.00 | $ 365,000.00 | $ 40,000.00 |
20 | 4,750 | $ 85.00 | $ 403,750.00 | $ 382,500.00 | $ 21,250.00 |
21 | 5,000 | $ 80.00 | $ 400,000.00 | $ 400,000.00 | $ - |
22 | 5,250 | $ 75.00 | $ 393,750.00 | $ 417,500.00 | $ (23,750.00) |
23 | 5,500 | $ 70.00 | $ 385,000.00 | $ 435,000.00 | $ (50,000.00) |
Fig 1- Venture 1. Showing a table of profit values for a range of demand values in Alternative 1
Venture 2 | Column A | Column B | Column C | Column D | Column E |
S/N | Monthly Demand | Price per Unit | Total Revenue | Total Expense | Profit |
1 | 0 | $ 180.00 | $ - | $ 35,000.00 | $ (35,000.00) |
2 | 250 | $ 175.00 | $ 43,750.00 | $ 57,500.00 | $ (13,750.00) |
3 | 500 | $ 170.00 | $ 85,000.00 | $ 80,000.00 | $ 5,000.00 |
4 | 750 | $ 165.00 | $ 123,750.00 | $ 102,500.00 | $ 21,250.00 |
5 | 1,000 | $ 160.00 | $ 160,000.00 | $ 125,000.00 | $ 35,000.00 |
6 | 1,250 | $ 155.00 | $ 193,750.00 | $ 147,500.00 | $ 46,250.00 |
7 | 1,500 | $ 150.00 | $ 225,000.00 | $ 170,000.00 | $ 55,000.00 |
8 | 1,750 | $ 145.00 | $ 253,750.00 | $ 192,500.00 | $ 61,250.00 |
9 | 2,000 | $ 140.00 | $ 280,000.00 | $ 215,000.00 | $ 65,000.00 |
10 | 2,250 | $ 135.00 | $ 303,750.00 | $ 237,500.00 | $ 66,250.00 |
11 | 2,500 | $ 130.00 | $ 325,000.00 | $ 260,000.00 | $ 65,000.00 |
12 | 2,750 | $ 125.00 | $ 343,750.00 | $ 282,500.00 | $ 61,250.00 |
13 | 3,000 | $ 120.00 | $ 360,000.00 | $ 305,000.00 | $ 55,000.00 |
14 | 3,250 | $ 115.00 | $ 373,750.00 | $ 327,500.00 | $ 46,250.00 |
15 | 3,500 | $ 110.00 | $ 385,000.00 | $ 350,000.00 | $ 35,000.00 |
16 | 3,750 | $ 105.00 | $ 393,750.00 | $ 372,500.00 | $ 21,250.00 |
17 | 4,000 | $ 100.00 | $ 400,000.00 | $ 395,000.00 | $ 5,000.00 |
18 | 4,250 | $ 95.00 | $ 403,750.00 | $ 417,500.00 | $ (13,750.00) |
19 | 4,500 | $ 90.00 | $ 405,000.00 | $ 440,000.00 | $ (35,000.00) |
20 | 4,750 | $ 85.00 | $ 403,750.00 | $ 462,500.00 | $ (58,750.00) |
21 | 5,000 | $ 80.00 | $ 400,000.00 | $ 485,000.00 | $ (85,000.00) |
22 | 5,250 | $ 75.00 | $ 393,750.00 | $ 507,500.00 | $(113,750.00) |
23 | 5,500 | $ 70.00 | $ 385,000.00 | $ 530,000.00 | $(145,000.00) |
Fig 2- Venture 2. Showing a table of profit values for a range of demand values in Alternative 2
Venture 3 | Column A | Column B | Column C | Column D | Column E |
S/N | Monthly Demand | Price per Unit | Total Revenue | Total Expense | Profit |
1 | 0 | $ 180.00 | $ - | $ 20,000.00 | $ (20,000.00) |
2 | 250 | $ 175.00 | $ 43,750.00 | $ 50,000.00 | $ (6,250.00) |
3 | 500 | $ 170.00 | $ 85,000.00 | $ 80,000.00 | $ 5,000.00 |
4 | 750 | $ 165.00 | $ 123,750.00 | $ 110,000.00 | $ 13,750.00 |
5 | 1,000 | $ 160.00 | $ 160,000.00 | $ 140,000.00 | $ 20,000.00 |
6 | 1,250 | $ 155.00 | $ 193,750.00 | $ 170,000.00 | $ 23,750.00 |
7 | 1,500 | $ 150.00 | $ 225,000.00 | $ 200,000.00 | $ 25,000.00 |
8 | 1,750 | $ 145.00 | $ 253,750.00 | $ 230,000.00 | $ 23,750.00 |
9 | 2,000 | $ 140.00 | $ 280,000.00 | $ 260,000.00 | $ 20,000.00 |
10 | 2,250 | $ 135.00 | $ 303,750.00 | $ 290,000.00 | $ 13,750.00 |
11 | 2,500 | $ 130.00 | $ 325,000.00 | $ 320,000.00 | $ 5,000.00 |
12 | 2,750 | $ 125.00 | $ 343,750.00 | $ 350,000.00 | $ (6,250.00) |
13 | 3,000 | $ 120.00 | $ 360,000.00 | $ 380,000.00 | $ (20,000.00) |
14 | 3,250 | $ 115.00 | $ 373,750.00 | $ 410,000.00 | $ (36,250.00) |
15 | 3,500 | $ 110.00 | $ 385,000.00 | $ 440,000.00 | $ (55,000.00) |
16 | 3,750 | $ 105.00 | $ 393,750.00 | $ 470,000.00 | $ (76,250.00) |
17 | 4,000 | $ 100.00 | $ 400,000.00 | $ 500,000.00 | $(100,000.00) |
18 | 4,250 | $ 95.00 | $ 403,750.00 | $ 530,000.00 | $(126,250.00) |
19 | 4,500 | $ 90.00 | $ 405,000.00 | $ 560,000.00 | $(155,000.00) |
20 | 4,750 | $ 85.00 | $ 403,750.00 | $ 590,000.00 | $(186,250.00) |
21 | 5,000 | $ 80.00 | $ 400,000.00 | $ 620,000.00 | $(220,000.00) |
22 | 5,250 | $ 75.00 | $ 393,750.00 | $ 650,000.00 | $(256,250.00) |
23 | 5,500 | $ 70.00 | $ 385,000.00 | $ 680,000.00 | $(295,000.00) |
Fig 3- Venture 3. Showing a table of profit values for a range of demand values in Alternative 3
Selection of Preferred Alternative
The yellow background in the tables shows the range of profitable demand.
The red fonts in the table shows the maximum profit for an optimal value of demand (D)
Based on the above quantitative analysis and criteria, I recommend ALTERNATIVE 1 because of the following reasons:
· Alternative 1 is 17% more than Alternative 2 in the range of profitable demand
· Alternative 1 is 35% higher in maximum profit than Alternative 2
· Alternative 1 is 50% more than Alternative 3 in the range of profitable demand
· Alternative 1 is 75% higher in maximum profit than Alternative 3
Performance Monitoring/Post Evaluation
This would be monitored by constantly evaluating
· How the demand and price linear relationship actually occurs in practice and the effect on the economic breakeven points (D’1 and D’2).
· How the effect of other risks and uncertainties affects the range of profitable demand.
References
Sullivan, W. G., Wicks, E.M., & Koelling, C.P. (2009). Cost Concepts and Design Economics. In M.J. Horton (Ed.), Engineering economy (15th ed.) (chapter 2) (pp. 20 - 25). New Jersey, NJ: Pearson Education, Inc.
Humphreys, G.C (2002) Introduction to Technical Risk Assessment. Project management using earned value (chapter 3). (pp.67-71). California, CA: Humphreys & Associates, Inc.
United States Government Accountability Office (2009, March). Cost Risk and Uncertainty. GAO Cost Estimating and Assessment Guide. Best Practices for Developing and Managing Capital Program Costs. (chapter 14) (pp.160).Washington, DC: GAO.
AACE International Education Board. (2006). Risk Management. In J.K.Hollmann (Ed), Total cost management framework – A process for applying the Skills & knowledge of cost engineering (1st ed) (chapter 7.6.1) (pp.159-160). Morgantown, West Virginia: AACE International.
AWESOME, SeeGod!!! Simply outstanding.......
ReplyDeleteOne of the best analysis I have seen yet!! Showing a very high level of sophistication and understanding of the tools/techniques we are using.
Keep up the good work, and I would really like to see you playing a more active role in mentoring others in the class..... There are a lot of people who still don't seem to understand what is being expected and/or how to go about doing it, and given Part II of the exams is going to require an analysis just like this, they need to master that skill.
Again, nice work!!
BR,
Dr. PDG, Jakarta