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Another example of an expense that varies with sales revenue is one you might not suspect—rent. Companies often sign lease agreements that call for rental amounts based on gross sales. There may be a base amount or fixed minimum monthly rent. In addition, there may be a variable amount equal to a percent of total sales revenue. This is common for retailers renting space in shopping centers. There are several other examples of expenses that vary with total sales revenue, such as franchise fees based on gross sales.

Summing up, sales revenue increases 10 percent for the three product lines (see Figure 10.1), but the incremental revenue is partially offset by the increase in the sales revenue-driven expenses. Thus the increases in contribution margins are less than the increases in sales revenue. In Figure 10.1 it is assumed that the fixed operating expenses of the profit modules do not change at the higher sales price levels. Thus, the contribution margin increases flow down to the profit lines.

Increasing sales volume 10 percent increases total contribution margin only 10 percent because the contribution margin per unit remains the same. And fixed operating expenses may have to be increased to support the higher sales volume. (In the examples, these fixed costs are held constant at the higher sales volume.) Increasing sales prices 10 percent improves contribution margin per unit much more than 10 percent, and total contribution margin rises accordingly. Note the standard product line, for instance (Figure 10.1). The contribution margin per unit increases $9.15, which is a 46 percent jump over the $20.00 figure before the sales price increase. Thus, total contribution margin increases $915,000, or 46 percent, at the
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higher sales price. And fixed operating expenses should not be affected by the higher sales price.

Frankly, a 10 percent increase in sales price with no increase in the product cost and no increase in the other expenses of the company is not too likely to happen. It is pre-

sented here to illustrate the powerful impact of a sales price increase and to contrast it with a 10 percent increase in sales volume (see Figure 10.2 again). Also, I should mention here that the cash flow impact of a 10 percent sales price increase differs from that of a sales volume increase like day from night (see Chapter 13).

WHEN SALES PRICES HEAD SOUTH

Like it or not, business managers sometimes have to cut DANGER!

sales prices just to hang onto the present sales volume they have. They know that profit will suffer, but competitive pres-

sures force them to cut sales prices, at least temporarily. Or they decide to cut prices to boost sales volume, but the number of units sold in fact remains the same, and later they have to nudge sales prices back up to previous levels. A 10 percent sales price cut would be the
negative
mirror image of the effects caused by the 10 percent sales price increase. Just put negative signs in front of the changes you see in Figure 10.1. If this happened, all the profit and then some would be wiped out on the generic product line, over 90 percent of the profit on the TEAMFLY

standard product line would evaporate, and the business would give up over 69 percent of its profit from the premier products.

To illustrate the serious profit damage from even a rela-

tively small decrease in the average sales price of products over a period of time, assume that during the year just ended the business had to cut sales prices at times during the year such that, on average, the sales prices of the products sold in the three product lines suffered by 4 percent. This may not sound like too much of a catastrophe, but look at the results shown in Figure 10.3 for this scenario. Sales prices and sales revenue drop by 4 percent, but profit plunges from 28 to 43

percent, depending on the product line.

The reason for the lower drop in profit for the premier product line is that the unit margin of these products is a much larger percent of sales price, so a 4 percent cut in sales price doesn’t take such a big bite out of the unit margin. For
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S A L E S P R I C E A N D C O S T C H A N G E S

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 ($4.00)

($400,000)

−4%

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 ($0.34)

($ 34,000)

Unit-driven expenses

$ 6.50

$

650,000

Contribution margin

$ 20.00

$ 2,000,000 ($3.66)

($366,000) −18%

Fixed operating expenses

$ 10.00

$ 1,000,000

Profit

$ 10.00

$ 1,000,000 ($3.66)

($366,000) −37%

Generic Product Line

150,000 units sold

No change

Per Unit Totals

Per Unit Totals

Sales revenue

$ 75.00

$11,250,000 ($3.00)

($450,000)

−4%

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 ($0.12)

($ 18,000)

Unit-driven expenses

$ 5.00

$

750,000

Contribution margin

$ 10.00

$ 1,500,000 ($2.88)

($432,000) −29%

Fixed operating expenses

$ 3.33

$

500,000

Profit

$ 6.67

$ 1,000,000 ($2.88)

($432,000) −43%

Premier Product Line

50,000 units sold

No change

Per Unit Totals

Per Unit Totals

Sales revenue

$150.00

$ 7,500,000 ($6.00)

($300,000)

−4%

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 ($0.45)

($ 22,500)

Unit-driven expenses

$ 8.75

$

437,500

Contribution margin

$ 50.00

$ 2,500,000 ($5.55)

($277,500) −11%

Fixed operating expenses

$ 30.00

$ 1,500,000

Profit

$ 20.00

$ 1,000,000 ($5.55)

($277,500) −28%

FIGURE 10.3
4 percent lower sales prices.

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comparison, the 4 percent (or $3.00) sales price cut for the generic products, net of the decrease in the revenue-driven expenses, represents a 29 percent reduction in the unit margin on these products. For the premier products, the 4 percent (or $6.00) price cut (net of the decrease in its revenue-driven expenses) is only an 11 percent reduction in the unit margin.

CHANGES IN PRODUCT COST

AND OPERATING EXPENSES

In most cases, changes in sales volume and sales prices have the biggest impact on profit performance. Product cost probably would rank as the next most critical factor for most businesses (except for service businesses that do not sell products).

A retailer needs smart, tough-nosed, sharp-pencil, aggressive purchasing tactics to control its product costs. On the other hand, it can be carried to an extreme.

I knew a purchasing agent (a neighbor when I lived in Cali-fornia some years ago) who was a real tiger. For instance, George would even return new calendars sent by vendors at the end of the year with a note saying, “Don’t send me this calendar; give me a lower price.” This may be overkill, though George eventually became general manager of the business.

Even with close monitoring and relentless control, both the DANGER!

variable and fixed operating expenses of a business may increase. Salaries, rent, insurance, utility bills, and audit and legal fees—virtually all operating expenses—are subject to inflation. To illustrate this situation, consider the scenario in which sales prices and sales volume remain the same but the company’s product costs and its variable and fixed operating expenses increase. In particular, assume that the business’s product costs and its unit-driven variable expenses increase 10 percent. Fixed costs increase only, say, 8 percent, because the depreciation expense component of total fixed expenses remains unchanged. Depreciation is based on the original cost of fixed assets and is not subject to the general inflationary pressures on operating expenses. Revenue-driven variable expenses, being a certain percent of sales revenue, do not change, because in this scenario sales revenue does not change (sales volumes and sales prices for each product line don’t change).

Figure 10.4 presents the effects for this cost inflation
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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

Cost of goods sold

$ 65.00

$ 6,500,000

$6.50

$650,000

10%

Gross margin

$ 35.00

$ 3,500,000

Revenue-driven expenses @ 8.5% $ 8.50

$

850,000

Unit-driven expenses

$ 6.50

$

650,000

$0.65

$ 65,000

10%

Contribution margin

$ 20.00

$ 2,000,000 ($7.15)

($715,000) −36%

Fixed operating expenses

$ 10.00

$ 1,000,000

$0.80

$ 80,000

8%

Profit

$ 10.00

$ 1,000,000 ($7.95)

($795,000) −80%

Generic Product Line

150,000 units sold

No change

Per Unit Totals

Per Unit Totals

Sales revenue

$ 75.00

$11,250,000

Cost of goods sold

$ 57.00

$ 8,550,000

$5.70

$855,000

10%

Gross margin

$ 18.00

$ 2,700,000

Revenue-driven expenses @ 4.0% $ 3.00

$

450,000

Unit-driven expenses

$ 5.00

$

750,000

$0.50

$ 75,000

10%

Contribution margin

$ 10.00

$ 1,500,000 ($6.20)

($930,000) −62%

Fixed operating expenses

$ 3.33

$

500,000

$0.27

$ 40,000

8%

Profit

$ 6.67

$ 1,000,000 ($6.47)

($970,000) −97%

Premier Product Line

50,000 units sold

No change

Per Unit Totals

Per Unit Totals

Sales revenue

$150.00

$ 7,500,000

Cost of goods sold

$ 80.00

$ 4,000,000

$8.00

$400,000

10%

Gross margin

$ 70.00

$ 3,500,000

Revenue-driven expenses @ 7.5% $ 11.25

$

562,500

Unit-driven expenses

$ 8.75

$

437,500

$0.88

$ 43,750

10%

Contribution margin

$ 50.00

$ 2,500,000 ($8.88)

($443,750) −18%

Fixed operating expenses

$ 30.00

$ 1,500,000

$2.40

$120,000

8%

Profit

$ 20.00

$ 1,000,000 ($11.28)

($563,750) −56%

FIGURE 10.4
Higher costs.

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scenario. As you can see, it’s not a pretty picture. The company could ill afford to let its product costs and operating expenses get out of control. Virtually all (97 percent) of the profit on the generic product line would be eliminated in this case. The profit on the standard product line would plunge 80

percent, and the profit on the premier product line would suffer 56 percent. If the cost increases could not be avoided, then managers would have the unpleasant task of passing the cost increases along to their customers in the form of higher sales prices.

s

END POINT

If you had your choice, the best change is a sales price increase, assuming all other profit factors remain the same. A sales price increase yields a much better profit result than a sales volume increase of equal magnitude. Increasing sales volume ranks a distant second behind raising sales prices. Of course, customers are sensitive to sales price increases, and as a practical matter the only course of action to increase profit may be to sell more units at the established sales prices.

Sales volume and sales prices are the two big factors driving profit. However, cost factors cannot be ignored, of course.

The unit costs of the products sold by the business and virtually all its operating costs—both variable and fixed—can change for the worse. Such unfavorable cost shifts would cause devastating profit impacts unless they are counterbal-anced with prompt increases in sales prices. This and other topics are explored in the following chapters.

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1

Price/Volume

Trade-Offs

RRaising sales prices may very well cause sales volume to fall.

Cutting sales prices may increase sales volume—unless competitors lower their prices also. Higher sales prices may be in response to higher product costs that are passed through to customers. Increasing product costs to improve product quality may jack up sales volume. Increasing sales commissions (a prime revenue-driven expense) may give the sales staff just the incentive needed to sell more units. Spending more on fixed operating expenses—such as bigger advertising budgets, higher rent for larger stores, or more expensive furnishings—may help sales volume.