Prentice Hall's one-day MBA in finance & accounting (24 page)

P R O F I T A N D C A S H F L O W A N A L Y S I S

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

184,332

84%

Contribution margin

$2,000,000

$2,000,000

Fixed operating expenses

$1,000,000

$1,000,000

Profit

$1,000,000

$1,000,000

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

535,714

257%

Contribution margin

$1,500,000

$1,500,000

Fixed operating expenses

$500,000

$500,000

Profit

$1,000,000

$1,000,000

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

69,204

38%

Contribution margin

$2,500,000

$2,500,000

Fixed operating expenses

$1,500,000

$1,500,000

Profit

$1,000,000

$1,000,000

FIGURE 11.3
Sales volumes needed to offset 10 percent sales price cuts.

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The average profit margin for the year depends on how often the item goes on sale.

In any case, the same basic analysis also applies to limited, short-term sales price reductions. The manager should calculate, or at least estimate, how much additional sales volume would be needed on the sale items just to remain even with the profit that would have been earned at normal sales prices. Complicating the picture are sales of other products (not on sale) that would not have been made without the increase in sales traffic caused by the sale items. Clearly, the additional sales made at normal profit margins are a big factor to consider, though this may be very hard to estimate with any precision.

THINKING IN REVERSE: GIVING UP SALES

VOLUME FOR HIGHER SALES PRICES

Suppose the general managers of the three product lines are thinking of a general 10 percent sales price increase, knowing that sales volume probably would decrease. In fact, they predict the number of units sold will drop at least 10 percent.

Sales managers generally are very opposed to giving up any sales volume, especially a loss of market share that could be difficult to recapture later. Any move that decreases sales volume has to be considered very carefully. But for the moment let’s put aside these warnings. Would a 10 percent sales price hike be a good move if sales volume dropped only 10 percent?

The profit analysis for this trade-off is shown in Figure 11.4. However, before you look at it, what would you expect?

An increase in profit? Yes, but would you expect the profit increases to be as large as shown in Figure 11.4? The unit margins on each product line would increase substantially, from 28 percent on the premier products to 72 percent on the generic products. These explosions in unit margins would more than offset the drop in sales volumes and would make for dramatic increases in profit. Fixed expenses wouldn’t go up with the decrease in sales volume. If anything, some of the fixed operating costs possibly could be reduced at the lower sales volume level.

The big jumps in profit reported in Figure 11.4 are based on the prediction that sales volume would drop only 10 percent. But actual sales might fall 15, 20, or even 25 percent.

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Before

After

Change

Standard Product Line

Sales price

$100.00

$110.00

10%

Product cost

$65.00

$65.00

Revenue-driven expenses

$8.50

$9.35

10%

Unit-driven expenses

$6.50

$6.50

Unit margin

$20.00

$29.15

46%

Sales volume

100,000

90,000

−10%

Contribution margin

$2,000,000

$2,623,500

31%

Fixed operating expenses

$1,000,000

$1,000,000

Profit

$1,000,000

$1,623,500

62%

Generic Product Line

Sales price

$75.00

$82.50

10%

Product cost

$57.00

$57.00

Revenue-driven expenses

$3.00

$3.30

10%

Unit-driven expenses

$5.00

$5.00

Unit margin

$10.00

$17.20

72%

Sales volume

150,000

135,000

−10%

Contribution margin

$1,500,000

$2,322,000

55%

Fixed operating expenses

$500,000

$500,000

Profit

$1,000,000

$1,822,000

82%

Premier Product Line

Sales price

$150.00

$165.00

10%

Product cost

$80.00

$80.00

Revenue-driven expenses

$11.25

$12.38

10%

Unit-driven expenses

$8.75

$8.75

Unit margin

$50.00

$63.87

28%

Sales volume

50,000

45,000

−10%

Contribution margin

$2,500,000

$2,874,375

15%

Fixed operating expenses

$1,500,000

$1,500,000

Profit

$1,000,000

$1,374,375

37%

FIGURE 11.4
10 percent higher sales prices and 10 percent lower sales
volumes.

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Profit can be calculated for any particular sales volume decrease prediction, of course. No one knows how sales volume might respond to a 10 percent sales price increase. Sales may not decrease at all. For instance, the higher prices might enhance the prestige or upscale image of the standard products and attract a more upscale clientele who are quite willing to pay the higher price. Or sales may drop more than 25 percent because customers search for better prices elsewhere.

How much could sales volume fall and keep total contribution margin the same? This sales volume is computed for the standard product line as follows:

$2,000,000 contribution margin target

ᎏᎏᎏᎏᎏ = 68,611 units

$29.15 higher unit margin

Sales volume would have to drop more than 30 percent (from 100,000 units in the original scenario to less than 70,000

units at the higher sales prices). Sales may not drop off this much, at least in the short run. And fixed operating expenses probably could be reduced at the lower sales volume level.

Given a choice, my guess is that the large majority of business managers would prefer keeping their market share and not giving up any sales volume, even though profit could be maximized with higher sales prices and lower sales volumes.

Protecting sales volume and market share is deeply ingrained in the thinking of most business managers.

Any loss of market share is taken very seriously. By and large, you’ll find that successful companies have built their success on getting and keeping a significant market share so that they are a major player and dominant force in the marketplace.

True, some companies don’t have a very large market share—they carve out a relatively small niche and build their business on low sales volume at premium prices. The preceding analysis for the premier product line demonstrates the profit potential of this niche strategy, which is built on higher unit margins that more than make up for smaller sales volume.

s

END POINT

Seldom does one profit factor change without changing or being changed by one or more other profit factors. The inter-

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action effects of the changes should be carefully analyzed before making final decisions or locking into a course of action that might be difficult to reverse. Managers should keep their attention riveted on unit margin. Profit performance is most responsive to changes in the unit margin.

Basically, there are only two ways to improve unit margin: (1) increase sales price or (2) decrease product cost and/or other variable operating expenses per unit (see Chapter 12).

The sales price is the most external or visible part of the business—the factor most exposed to customer reaction. In contrast, product cost and variable expenses are more internal and invisible. Customers may not be aware of decreased expenses unless such cost savings show up in lower product quality or worse service.

Last, the importance of protecting sales volume and market share is mentioned in the chapter. Marketing managers know what they’re talking about on this point, that’s for sure.

Recapturing lost market share is not easy. Once gone, customers may never return.

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C H A P T E R12

1

Cost/Volume

Trade-Offs and

Survival Analysis

IIt might seem simple enough. Suppose your unit product cost goes up. Then all you have to do is to raise sales price by the same amount to keep the contribution margin the same, true?

Not exactly. Sales volume might be affected by the higher price, of course. Even if sales volume remained the same, the higher sales price causes revenue-driven expenses to increase.

So it’s more complicated than it might first appear.

PRODUCT COST INCREASES: WHICH KIND?

There are two quite different reasons for product cost increases. First is inflation, which can be of two sorts. General inflation is widespread and drives up costs throughout the economy, including those of the products sold by the business.

Or inflation may be localized on particular products—for example, problems in the Middle East may drive up oil and other energy costs; floods in the Midwest may affect corn and soybean prices. In either situation, the product is the same but now costs more per unit.

The second reason for higher product costs is quite different than inflation. Increases in unit product costs may reflect either quality or size improvements. In this situation the product itself is changed for the better. Customers may be willing to pay more for the improved product, with the result that the
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company would not suffer a decrease in sales volume. Or, if the sales price remains the same on the improved product, then sales volume may increase.

Customers tend to accept higher sales prices if they perceive that the company is operating in a general inflationary market environment, when everything is going up. On a comparative basis, the product does not cost more relative to price increases of other products they purchase. Sales volume may not be affected by higher sales prices in a market dominated by the inflation mentality. On the other hand, if customers’

incomes are not rising in proportion to sales price increases, demand would likely decrease at the higher sales prices.

If competitors face the same general inflation of product costs, the company’s sales volume may not suffer from passing along product cost increases in the form of higher sales prices because the competition would be doing the same thing. The exact demand sensitivity to sales price increases cannot be known except in hindsight. Even then, it’s difficult to know for sure, because many factors change simultaneously in the real world.

Whenever sales prices are increased due to increases in product costs—whether because of general or specific inflation or product improvements—managers cannot simply tack on the product cost increase to sales price. They should carefully take into account variable expenses that are dependent on (driven by) sales revenue.

To illustrate this point, consider the standard product line example from previous chapters. The sales price and per-unit costs for the product are as follows (from Figure 9.1).

Standard Product

Sales price

$100.00

Product cost

$ 65.00

Revenue-driven expenses @ 8.5%

$ 8.50

Unit-driven expenses

$ 6.50

Unit margin

$ 20.00

Suppose, for instance, that the company’s unit product cost goes up $9.15, from $65.00 to $74.15 per unit. (This is a
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rather large jump in cost, of course.) The manager shouldn’t simply raise the sales price by $9.15. In the example, the revenue-driven variable operating expenses are 8.5 percent of sales revenue. So the necessary increase in the sales price is determined as follows:

$9.15 product cost increase

ᎏᎏᎏᎏ = $10.00 sales price increase

0.915

Dividing by 0.915 recognizes that only 91.5 cents of a sales dollar is left over after deducting revenue-driven variable expenses, which equal 8.5 cents of the sales dollar. Only 91.5