Prentice Hall's one-day MBA in finance & accounting (21 page)

Per Unit Totals

Per Unit Totals

Sales revenue

$ 75.00

$11,250,000

($1,125,000)

Cost of goods sold

$ 57.00

$ 8,550,000

($ 855,000)

Gross margin

$ 18.00

$ 2,700,000

($ 270,000)

Revenue-driven expenses @ 4.0% $ 3.00

$

450,000

($

45,000)

Unit-driven expenses

$ 5.00

$

750,000

($

75,000)

Contribution margin

$ 10.00

$ 1,500,000

($ 150,000) −10%

Fixed operating expenses

$ 3.33

$

500,000

$0.37

$

0

Profit

$ 6.67

$ 1,000,000 ($0.37) ($ 150,000) −15%

Premier Product Line

50,000 units sold

5,000 additional units

Per Unit Totals

Per Unit Totals

Sales revenue

$150.00

$ 7,500,000

($ 750,000)

Cost of goods sold

$ 80.00

$ 4,000,000

($ 400,000)

Gross margin

$ 70.00

$ 3,500,000

($ 350,000)

Revenue-driven expenses @ 7.5% $ 11.25

$

562,500

($

56,250)

Unit-driven expenses

$ 8.75

$

437,500

($

43,750)

Contribution margin

$ 50.00

$ 2,500,000

($ 250,000) −10%

Fixed operating expenses

$ 30.00

$ 1,500,000

$3.33

$

0

Profit

$ 20.00

$ 1,000,000 ($3.33) ($ 250,000) −25%

FIGURE 9.3
10 percent lower sales volumes.

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miums) would not be any different if sales volume had been 1

or 2 percent higher or lower, or even 5, 10, or 20 percent different in either direction. But at some point a business will have to increase its fixed costs to provide additional capacity on the upside or will have to cut fixed costs on the downside.

In the preceding analysis, the assumption is made that each product line has enough capacity to take on 10 percent additional sales volume without any increase in the direct fixed costs of the profit module. Keep in mind, however, that one or more fixed operating expenses might have to increase to support a higher sales volume. For instance, the business might have to rent more retail floor space, hire more salaried employees, or purchase additional equipment on which depreciation is recorded. For a moderate increase in sales volume, fixed expenses generally hold steady and don’t increase, as a general rule, unless the business already is running at virtually 100 percent of its capacity.

Faced with moderate decreases in sales volume, businesses generally hold off and delay any serious reduction in capacity that would require laying off employees. Employees usually have been trained and have valuable experience to offer a business. It may be difficult to reduce many fixed expenses, at least in the short run. Some fixed expenses can be adjusted downward in short order. But if you had time to look at the typical fixed costs of a business, I think you would find that unwinding from many of the expenses would take time and would have serious consequences to the business.

Finally, I would mention that in dire circumstances, such as when a business goes into bankruptcy, all bets are off. A business may have to slash many fixed costs under pressures from creditors or by court order. Also, in takeover situations, in which one business buys out another business, often a key element of the takeover strategy is to drastically reduce the fixed costs of the acquired business. This often means laying off hundreds of thousands of employees and selling off assets.

s

END POINT

All profit factors are subject to change. Management neglect or ineptitude can lead to profit deterioration, sometimes very quickly. Increases in product cost as well as increases in vari-

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able and fixed expenses can do serious damage to profit performance. But managers may not be able to significantly improve certain factors. Fixed expenses may already be cut to the bone. One vendor may control product costs, or alternative vendors may offer virtually the same prices. Competition may put a fairly tight straitjacket on sales prices. Customers are sensitive to sales price increases. Sales volume is the key success factor for most businesses, which explains why managers are so concerned about market share. Market share is mentioned often in later chapters.

137

C H A P T E R 10

1

Sales Price and

Cost Changes

BBefore we go any further, let me ask you a basic question.

Suppose you could have one or the other, but not both, which would you prefer—a 10 percent sales volume increase or a 10

percent sales price increase? In most cases, there’s a huge difference between the two. This chapter contrasts the difference between sales volume and sales price changes. You may be surprised. In any case, you should be very certain about the differences!

SALES PRICE CHANGES

Setting sales prices is one of the most perplexing decisions facing business managers. Competition normally dictates the basic range of sales prices. But usually there is some room for deviation from your competitors’ prices because of product differentiation, brand loyalty, location advantages, and/or quality of service, to cite only a few of the many reasons that permit you to charge higher sales prices than your competition.

Fixed operating expenses are insensitive to sales price increases. In contrast, sales volume increases may very well require increases in fixed operating expenses, especially when the company’s capacity is crowded. Very few fixed expenses are directly affected by raising sales prices, even if the company
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is operating at full capacity. Advertising (a fixed cost once spent) might be stepped up to persuade customers that the hike in sales prices is necessary or beneficial. Other than this, it’s hard to find many fixed operating expenses that are tied directly to sales price increases.

The same three profit module examples used in Chapter 9

for analyzing sales volume changes are used in this chapter to analyze sales price changes. This allows the comparison of the differences between the profit impacts of selling more or fewer units versus selling the same number of units but at higher or lower sales prices. With this in mind, consider the hypothetical scenario in which the business could have sold the same number units of each product line at 10 percent higher sales prices. Figure 10.1 presents this scenario for the three profit modules examples.

Profit more than doubles on the generic product line; and profit increases 92 percent and 69 percent on the standard and premier product lines, respectively (see Figure 10.1).

Would this be realistic? Only to the extent that a 10 percent sales price increase would be realistic. Assume that the business could have sold all units during the year at the higher sales prices. The advantages of selling at 10 percent higher sales prices compared with selling 10 percent more sales volume are summarized in Figure 10.2.

In this scenario only one variable operating expense would increase—the one driven by sales revenue. Note that cost-of-goods-sold expense does not increase because the volume sold remains the same. In the sales volume increase situation (Chapter 9), the sales revenue increase is offset substantially by the increase in cost-of-goods-sold expense. In contrast, consider the standard product line here in the sales price increase case: $915,000 of the $1 million incremental sales revenue flows through to profit.

Chapter 3 introduces the format and logic of an internal management profit report. One key point is that expenses should be classified and reported according to their behavior, or what drives them.* Some operating expenses depend

*
Cost driver
is a popular term these days. This refers to the specific factors that determine, or push, or drive a particular cost. Identifying cost drivers is the key step in the method of cost analysis and allocation called
activity-based costing
(ABC). Cost allocation is discussed in Chapter 18.

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Standard Product Line

Original Scenarios (see Figure 9.1)

Changes

100,000 units sold

No change

Per Unit Totals

Per Unit Totals

Sales revenue

$100.00

$10,000,000 $10.00

$1,000,000

10%

Cost of goods sold

$ 65.00

$ 6,500,000

Gross margin

$ 35.00

$ 3,500,000

Revenue-driven expenses @ 8.5% $ 8.50

$

850,000 $ 0.85

$

85,000

Unit-driven expenses

$ 6.50

$

650,000

Contribution margin

$ 20.00

$ 2,000,000 $ 9.15

$ 915,000

46%

Fixed operating expenses

$ 10.00

$ 1,000,000

Profit

$ 10.00

$ 1,000,000 $ 9.15

$ 915,000

92%

Generic Product Line

150,000 units sold

No change

Per Unit Totals

Per Unit Totals

Sales revenue

$ 75.00

$11,250,000 $ 7.50

$1,125,000

10%

Cost of goods sold

$ 57.00

$ 8,550,000

Gross margin

$ 18.00

$ 2,700,000

Revenue-driven expenses @ 4.0% $ 3.00

$

450,000 $ 0.30

$

45,000

Unit-driven expenses

$ 5.00

$

750,000

Contribution margin

$ 10.00

$ 1,500,000 $ 7.20

$1,080,000

72%

Fixed operating expenses

$ 3.33

$

500,000

Profit

$ 6.67

$ 1,000,000 $ 7.20

$1,080,000 108%

Premier Product Line

50,000 units sold

No change

Per Unit Totals

Per Unit Totals

Sales revenue

$150.00

$ 7,500,000 $15.00

$ 750,000

10%

Cost of goods sold

$ 80.00

$ 4,000,000

Gross margin

$ 70.00

$ 3,500,000

Revenue-driven expenses @ 7.5% $ 11.25

$

562,500 $ 1.12

$

56,250

Unit-driven expenses

$ 8.75

$

437,500

Contribution margin

$ 50.00

$ 2,500,000 $13.88

$ 693,750

28%

Fixed operating expenses

$ 30.00

$ 1,500,000

Profit

$ 20.00

$ 1,000,000 $13.88

$ 693,750

69%

FIGURE 10.1
10 percent higher sales prices.

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10 Percent Sales

10 Percent Sales

(see Figure 9.2)

(see Figure 10.1)

Standard Product Line

Contribution margin

$200,000

10%

$ 915,000

46%

Profit

$200,000

20%

$ 915,000

92%

Generic Product Line

Contribution margin

$150,000

10%

$1,080,000

72%

Profit

$150,000

15%

$1,080,000

108%

Premier Product Line

Contribution margin

$250,000

10%

$ 693,750

28%

Profit

$250,000

25%

$ 693,750

69%

FIGURE 10.2
Comparison of 10 percent higher sales prices versus 10 percent higher sales volumes.

directly on the dollar amounts of sales, not the quantity of products sold. As total sales revenue (dollars) increases, these expenses increase directly in proportion. In short, one more dollar of sales revenue causes these expenses to increase by a certain amount of cents on the dollar.

Most retailers accept national credit cards (Visa, Master-Card, Discover, American Express, Diners Club, etc.). The credit card charge slips are deposited daily with a local participating bank. The bank then discounts the total amount and credits the net balance in the business’s checking account.

Discount rates vary between 2 and 4 percent (sometimes lower or higher). In short, a business nets only $.98 or $.96

from each dollar of credit card sales. The credit card discount expense comes right off the top of the sales dollar.

Sales commissions are another common example of sales revenue-dependent expenses. As you probably know, many retailers and other businesses pay their sales representatives on a commission basis, usually a certain percent of the total sales amount such as 5 or 10 percent. The salespersons may also receive a base salary, which would be the fixed floor of the
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expense; only the commission over and above the fixed base would be variable. (This requires the separation of the fixed part and the variable part in the management profit report.) Many businesses extend short-term credit to their customers, especially when selling to other businesses. No matter how carefully a business screens them before extending credit, a few customers never pay their accounts. Eventually, after making repeated collection efforts, the business ends up having to write off all or some of these receivables’ balances as uncollectible. These losses are called
bad debts
and are a normal expense of doing business on credit. This expense depends on the sales amount, not sales volume (number of units sold).