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None of this is news to experienced business managers.

The business world is one of trade-offs among profit factors.

In most cases, a change in one profit factor causes, or is in response to, a change in another factor.

Chapters 9 and 10 analyze profit factor changes one at a time; the other profit factors are held constant. (To be technically correct here, I should note that sales price changes cause revenue-driven expenses to change in proportion.) In the real world of business, seldom can you change just one thing at a time. This chapter analyzes the interaction of changes in two or more profit factors.

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SHAVING SALES PRICES TO BOOST SALES VOLUME

The example of the three profit modules introduced in Chapter 9 and carried through in Chapter 10 continues in this chapter.

Instead of the management profit report format used in the previous two chapters, however, this chapter uses a profit model for each product line. Figure 11.1 presents the profit models for each product line. A profit model is essentially a condensed version, or thumbnail sketch, of the profit reports.

Suppose the managers in charge of these three profit modules are seriously considering decreasing their sales prices 10 percent, which they predict would increase sales volume 10 percent. Of course, competitors may reduce their prices 10

percent, so the sales volume increase may not materialize. But the managers don’t think their competitors will follow suit.

The company’s products are differentiated from the competition. (Brand names, customer service, and product specifications are types of differentiation.) There always has been some amount of sales price spread between the business’s products and the competition. A 10 percent price cut should not trigger price reductions by competition, in the opinion of the managers.

One reason for reducing sales prices is that the business is not selling up to its full capacity. This is not unusual; many businesses have some slack or untapped sales capacity provided by their fixed expenses. In this example, assume that the fixed expenses of each product line provide enough space and personnel to handle a 20 to 25 percent larger sales volume. Spreading total fixed expenses over a larger number of units sold seems like a good idea. Rather than downsizing, which would require cutting fixed expenses, the first thought is to increase sales volume and thus take better advantage of the sales capacity provided by fixed expenses.

Of course, the managers are very much aware that sales DANGER!

volume may not respond to the reduction in sales price as much as they predict. On the other hand, sales volume may increase more than 10 percent. In any case, they would closely monitor the reaction of customers. Obviously there is a serious risk here. Suppose sales volume doesn’t increase; they may not be able to reverse directions quickly. The managers may not be able to roll back the sales price decrease without losing customers, who may forget the sales price decreases and see the reversal only as price increases.

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Before the managers make a final decision, wouldn’t it be a good idea to see what would happen to profit? Managers should run through a quick analysis of the consequences of the sales price decision before moving ahead. Otherwise they are operating in the dark and hoping for the best, which may
Standard Product Line

Sales price

$100.00

Product cost

$65.00

Revenue-driven expenses

$8.50

Unit-driven expenses

$6.50

Unit margin

$20.00

Sales volume

100,000

Contribution margin

$2,000,000

Fixed operating expenses

$1,000,000

Profit

$1,000,000

Generic Product Line

Sales price

$75.00

Product cost

$57.00

Revenue-driven expenses

$3.00

Unit-driven expenses

$5.00

Unit margin

$10.00

Sales volume

150,000

Contribution margin

$1,500,000

Fixed operating expenses

$500,000

Profit

$1,000,000

Premier Product Line

Sales price

$150.00

Product cost

$80.00

Revenue-driven expenses

$11.25

Unit-driven expenses

$8.75

Unit margin

$50.00

Sales volume

50,000

Contribution margin

$2,500,000

Fixed operating expenses

$1,500,000

Profit

$1,000,000

FIGURE 11.1
Profit models for three product lines (data from
Figure 9.1).

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actually turn out to be the worst. Figure 11.2 presents the analysis of the sales price reduction plan.

Whoops! Cutting sales prices would be nothing short of a disaster. Assuming the sales volume predictions turn out to be correct, the sales price reduction would push the generic product line into the red and cause substantial profit deterioration in the other two product lines. Why is there such a devastating impact on profit? Why would things turn out so badly? For each product line sales price, revenue-driven expenses and sales volume change 10 percent. But the key change is the percent decrease in unit margin for each product. For instance, the standard product unit margin would go down a huge 46

percent, from $20.00 to $10.85 (see Figure 11.2). Thus contribution margin drops 40 percent and profit drops 81 percent.

The puny 10 percent gain in sales volume is not nearly enough to overcome the 46 percent plunge in unit margin.

You can’t give up almost half your unit contribution margin and make it back with a 10 percent sales volume increase. In fact, any trade-off that lowers sales price on the one side with an equal percent increase in sales volume on the other side pulls the rug out from under profit.

Yet frequently we see sales price reductions of 10 percent or more. What’s going on? First of all, many sales price reductions are from list prices that no one takes seriously as the final price—such as sticker prices on new cars. List prices are only a point of departure for getting to the real price. Everyone wants a discount. I’m sure you’ve heard people say, “I can get it for you wholesale.”

The example is based on real prices, or the sales revenue per unit actually received by the business. Can a business cut its real sales price 10 percent and increase profit? Sales volume would have to increase much more than 10 percent, which I explain shortly. Would trading a 10 percent sales price cut for a 10 percent sales volume increase ever be a smart move? It would seem not; we have settled this point in the preceding analysis, haven’t we? Well, there is one exception that brings out an important point.

A Special Case: Sunk Costs

Notice in Figure 11.1 that the unit costs for the products remain the same at the lower sales price; there are no
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Before

After

Change

Standard Product Line

Sales price

$100.00

$90.00

−10%

Product cost

$65.00

$65.00

Revenue-driven expenses

$8.50

$7.65

−10%

Unit-driven expenses

$6.50

$6.50

Unit margin

$20.00

$10.85

−46%

Sales volume

100,000

110,000

10%

Contribution margin

$2,000,000

$1,193,500

−40%

Fixed operating expenses

$1,000,000

$1,000,000

Profit

$1,000,000

$193,500

−81%

Generic Product Line

Sales price

$75.00

$67.50

−10%

Product cost

$57.00

$57.00

Revenue-driven expenses

$3.00

$2.70

−10%

Unit-driven expenses

$5.00

$5.00

Unit margin

$10.00

$2.80

−72%

Sales volume

150,000

165,000

10%

Contribution margin

$1,500,000

$462,000

−69%

Fixed operating expenses

$500,000

$500,000

Profit (Loss)

$1,000,000

($38,000)

−104%

Premier Product Line

Sales price

$150.00

$135.00

−10%

Product cost

$80.00

$80.00

Revenue-driven expenses

$11.25

$10.13

−10%

Unit-driven expenses

$8.75

$8.75

Unit margin

$50.00

$36.12

−28%

Sales volume

50,000

55,000

10%

Contribution margin

$2,500,000

$1,986,875

−21%

Fixed operating expenses

$1,500,000

$1,500,000

Profit

$1,000,000

$486,875

−51%

FIGURE 11.2
10 percent lower sales prices and 10 percent higher sales
volumes.

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changes in the product cost per unit for the product lines. This seems to be a reasonable assumption. To have products for sale, the business either has to buy (or make) them at this unit cost or, if already in inventory, has to incur this cost to replace units sold. This is the normal situation, of course. But it may not be true in certain unusual and nontypical cases.

A business may not replace the units sold; it may be at the end of the product’s life cycle. For instance, the product may be in the process of being phased out and replaced with a newer model. In this situation the historical, original account-

ing cost of inventory becomes a
sunk cost,
which means that it’s water over the dam; it can’t be reversed.

Suppose the units held in inventory will not be replaced, that the business is at the end of the line on these units and is sell-

ing off its remaining stock. In this situation the book value of the inventory (the recorded accounting cost) is not relevant.

What the business paid in the past for the units should be dis-

regarded.* For all practical purposes the unit product cost can be set to zero for the units held in stock. The manager should ignore the recorded product cost and find the highest sales price that would move all the units out of inventory.

VOLUME NEEDED TO OFFSET SALES PRICE CUT

TEAMFLY

In analyzing sales price reductions, managers should deter-

mine just how much sales volume increase would be needed to offset the 10 percent sales price cut. In other words, what level of sales volume would keep contribution margin the same? For the moment, assume that the fixed expenses would remain the same—that the additional sales volume could be taken on with no increase in fixed costs. The sales volumes needed to keep profit the same for each product line are com-

puted by dividing the contribution margins of each product

*The original cost (book value) of products that will not be replaced when sold should be written down to a lower value (possibly zero) under the lower-of-cost-or-market (LCM) accounting rule. This write-down is based on the probable disposable value of the products. If such products have not yet been written down, the manager should make the accounting department aware of this situation so that the proper accounting adjusting entry can be recorded.

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Team-Fly®

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line at the original sales prices by the unit margins at the lower sales prices:

Product Contribution Margin
÷
Lower Unit Margin
=
Required Sales Volume

Standard $2,000,000 ÷ $10.85 = 184,332 units

Generic

$1,500,000 ÷ $2.80 = 535,714 units

Premier

$2,500,000 ÷ $36.12 = 69,204 units

Figure 11.3 summarizes the effects of these higher sales volumes and shows that the number of units sold would have to increase by rather large percents—from a 257 percent increase for the generic product line to a 38 percent increase for the premier product line. Would such large sales volume gains be possible? Doubtful, to say the least. And to achieve such large increases in sales volume, fixed expenses would have to be increased, probably by quite large amounts. Also, interest expense would increase because more debt would be used to finance the increase in operating assets needed to support the higher sales volume.

The moral of the story, basically, is that a 10 percent sales price cut usually takes such a big bite out of unit contribution margin that it would take a huge increase in sales volume to stay even (i.e., to earn the same profit as before the price cut).

Managers should think long and hard before making sales price reductions.

Short-Term and Limited Sales

The preceding analysis applies the sales price reduction to all sales for the entire year. However, many sales price reductions are limited to a relatively few items and are short-lived, perhaps for only a day or weekend. Furthermore, the sale may bring in customers who buy other items not on sale. Profit margin is sacrificed on selected items to make additional sales of other products at normal profit margins.

Indeed, many retailers seem to have some products on sale virtually every day of the year. In this case the normal profit margin is hard to pin down, since almost every product takes its turn at being on sale. In short, every product may have two profit margins—one when not on sale and one when on sale.

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