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cents on the dollar is available to provide for the increase in the unit product cost. If the business raises its sales price exactly $10.00 (from $100.00 to $110.00), the unit margin for the standard product would remain exactly the same, which is shown as follows:

Standard Product Sales Price for Higher Product Cost
Sales price

$110.00

Product cost

$ 74.15

Revenue-driven expenses @ 8.5%

$ 9.35

Unit-driven expenses

$ 6.50

Unit margin

$ 20.00

Therefore the company’s total contribution margin would be the same at the $110.00 sales price, assuming sales volume remains the same, of course.

VARIABLE COST INCREASES AND SALES VOLUME

As just mentioned, one basic type of product cost increase occurs when the product itself is improved. These quality improvements may be part of the marketing strategy to stimulate demand by giving customers a better product at the same sales price. In addition to product cost, one or more of the specific variable operating expenses could be deliberately increased to improve the quality of the service to customers.

For example, faster delivery methods such as overnight Federal Express could be used, even though this would cost
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more than the traditional delivery methods. This would increase the volume-driven expense. The company could increase sales commissions to improve the personal time and effort the sales staff spends with each customer, which would increase the revenue-driven expense.

In our example, suppose the general manager of the stan-

dard product line is considering a new strategy for product and service quality improvements that would increase product cost and unit-driven operating expenses 4 percent. Revenue-

driven variable expenses would be kept the same, or 8.5 per-

cent of sales revenue. Tentatively, she has decided not to increase sales prices because in her opinion the improved products and service would stimulate demand for these prod-

ucts. It goes without saying that customers would have to be aware of and convinced that the product has improved.

Before making a final decision, she asks the critical question: What increase in sales volume would be necessary just to keep profit the same?

Figure 12.1 presents this even-up, or standstill, scenario in which product cost and unit-driven variable expenses increase 4 percent but sales price remains the same. Fixed expenses are held constant, as is the variable revenue-driven operating expenses. Sales volume would have to increase 16,686 units, or 16.7 percent. By the way, the required sales TEAMFLY

Standard Product Line

Before

After

Change

Sales price

$100.00

$100.00

Product cost

$65.00

$67.60

4.0%

Revenue-driven expenses

$8.50

$8.50

Unit-driven expenses

$6.50

$6.76

4.0%

Unit margin

$20.00

$17.14

−14.3%

Sales volume

100,000

116,686

16.7%

Contribution margin

$2,000,000

$2,000,000

Fixed operating expenses

$1,000,000

$1,000,000

Profit

$1,000,000

$1,000,000

FIGURE 12.1
Sales volume required for a 4 percent cost increase.

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volume for this scenario of higher cost and lower unit margin can be computed directly as follows:

Required Sales Volume at Higher Costs

$2,000,000 contribution margin target

ᎏᎏᎏᎏᎏ

$17.14 lower unit margin

= 116,686 sales volume

The relatively large increase in sales volume needed to offset the relatively minor 4 percent cost increase is because the cost increase causes a 14.3 percent drop in unit margin. So a 16.7

percent jump in sales volume would be needed to keep profit at the same level. The key point is the drop in the unit margin caused by the cost increase. It takes a large increase in sales volume to make up for the drop in the unit margin.

There is more bad news. More capital would be needed at the higher sales volume level; the capital invested in assets would be higher due mainly to increases in accounts receivable and inventory. The impact on cash flow at the higher sales volume level is explained in Chapter 13.

BETTER PRODUCT AND SERVICE PERMITTING

HIGHER SALES PRICE

The alternative to selling more units to overcome the cost increases is to sell the same number of units at a higher sales price. Figure 12.2 presents the higher sales price that would keep profit the same as before, given the 4 percent higher product cost and 4 percent higher unit-driven variable expenses. In this scenario the cost increase is loaded into the sales price and is not reflected in a sales volume increase.

Following this strategy, the sales price would be increased to $103.13 (rounded).* In this case the business improved the product and the service to its customers. There is no increase in profit. This product upgrade would be customer-driven—if

*The required sales price is computed as follows: ($67.60 product cost +

$6.76 unit-driven cost + $20.00 unit margin) ÷ (1.000 − 0.085) = $103.13

sales price (rounded). In other words, the sales price, net of the revenue-driven cost per unit as a percent of sales price, must cover the product cost and the sales volume–driven expense per unit and provide the same unit margin as before.

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Standard Product Line

Before

After

Change

Sales price

$100.00

$103.13

3.1%

Product cost

$65.00

$67.60

4.0%

Revenue-driven expenses

$8.50

$8.77

Unit-driven expenses

$6.50

$6.76

4.0%

Unit margin

$20.00

$20.00

Sales volume

100,000

100,000

Contribution margin

$2,000,000

$2,000,000

Fixed operating expenses

$1,000,000

$1,000,000

Profit

$1,000,000

$1,000,000

FIGURE 12.2
Higher sales price required for a 4 percent cost increase
the company failed to improve its product and/or service, then it might lose sales, because the customers want the improvements and are willing to pay. This may seem to be a strange state of affairs, but you see examples every day where the customer wants a better product and/or service and is willing to pay more for the improvements.

LOWER COSTS: THE GOOD AND BAD

Suppose a business were able to lower its unit product costs and its variable expenses per unit. On the one hand, such cost savings could be true efficiency or productivity gains. Sharper bargaining may reduce purchase costs, for example, or better manufacturing methods may reduce labor cost per unit produced. Wasteful fixed overhead costs could be eliminated or slashed. The key question is whether the company’s products remain the same, whether the products’ perceived quality remains the same, and whether the quality of service to customers remains the same.

Maybe not. Product cost decreases may represent quality degradations, or possibly reduced sizes such as smaller candy bars or fewer ounces in breakfast cereal boxes. Reducing variable operating expenses may adversely affect the quality of service to customers—for instance, by spreading fewer personnel over the same number of customers.

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Lower Costs and Higher Unit Margin

If the company can lower its costs and still deliver the same product and the same quality of service, then sales volume should not be affected (everything else remaining the same, of course). Customers should see no differences in the products or service. In this case the cost savings would improve unit margins and profit would increase accordingly.

Improvements in the unit margins are very powerful; these increases have the same type of multiplier effect as the operating leverage of selling more units. For example, suppose that because of true efficiency gains the business is able to lower product costs and unit-driven expenses such that unit margin on its standard product line is improved, say, $1.00

per unit. Now this may not seem like much, but remember that the business sells 100,000 units during the year.

Therefore, the $1.00 improvement in unit margin would add $100,000 to the contribution margin line, which is a 5

percent gain on its original $2 million contribution margin.

Lowering product cost and the unit-driven operating costs should not cause fixed costs to change, so all of the $100,000

contribution margin gain would fall to profit. The $100,000

gain in profit is a 10 percent increase on the $1 million original profit, or double the 5 percent gain in contribution margin.

Total quality management (TQM) is getting a lot of press today, indicated by the fact that it has been reduced to an acronym. Clearly, managers have always known that product quality and quality of service to customers are absolutely critical factors, though perhaps they lost sight of this in pursuit of short-term profits. Today, however, managers obviously have been made acutely aware of how quality conscious customers are (though I find it surprising that today’s gurus are preaching this gospel as if it were just discovered).

Lower Costs Causing Lower Sales Volume

Cost savings may cause degradation in the quality of the product or service to customers. It would be no surprise, therefore, if sales volume would decrease. The unit margin would improve, but sales volume may drop as some customers abandon the business because of poorer product quality. Still, a business might adopt the strategy of deliberately knocking down the quality of its products (or some of its products) and
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the general level of service to its customers to boost unit margin, gambling that the higher unit margin will more than offset the loss of sales volume. (Of course, this brings up the loss-of-market-share problem again, which I won’t go into here.) To illustrate this scenario of lower cost and lower sales volume, suppose the business could lower the product costs in its standard product line from $65.00 to $60.00 per unit, but this cost savings results in lesser-grade materials, cheaper trim, and so forth. And the company could save on its shipping costs and reduce its unit-driven variable costs from $6.50 to $5.00 per unit, but in exchange delivery time to the customers would take longer. The combined $6.50 cost savings would increase unit margin by the same amount. The general manager of this profit module knows that many customers will be driven off by the changes in product quality and delivery times. She wants to know just how far sales volume would have to fall to offset the $6.50 gain in unit margin.

Figure 12.3 shows that if sales volume fell to 75,472 units, profit would be the same. In other words, selling 75,472 units at a $26.50 unit margin each would generate the same contribution margin as before. If sales fell by only 10,000 or 15,000 units, profit would be more than before. And, certainly, fixed costs would not go up at the lower sales volume.

If anything, fixed costs probably could be reduced at the lower sales volume.

Standard Product Line

Before

After

Change

Sales price

$100.00

$100.00

Product cost

$65.00

$60.00

−7.7%

Revenue-driven expenses

$8.50

$8.50

Unit-driven expenses

$6.50

$5.00

−23.1%

Unit margin

$20.00

$26.50

32.5%

Sales volume

100,000

75,472

−24.5%

Contribution margin

$2,000,000

$2,000,000

Fixed operating expenses

$1,000,000

$1,000,000

Profit

$1,000,000

$1,000,000

FIGURE 12.3
Lower costs causing lower sales volume.

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This sort of profit strategy goes against the grain of many managers. Of course, the business could lose more than 25

percent of sales volume, in which case its profit would be lower than before. Once a product becomes identified as a low-cost/low-quality brand, it’s virtually impossible to reverse this image in the minds of most customers. Thus, it’s no surprise why many managers take a dim view of this profit strategy.

SUBTLE AND NOT-SO-SUBTLE CHANGES

IN FIXED COSTS

Why do fixed operating expenses increase? The increase may be due to general inflationary trends. For instance, utility bills and insurance premiums seem to drift relentlessly upward; they hardly ever go down. In contrast, fixed operating expenses may be deliberately increased to expand capacity.

The business could rent a larger space or hire more employees on fixed salaries.

And there’s a third reason: Fixed expenses may be

increased to improve the sales value of the present location.

The business could invest in better furnishings and equipment (which would increase its annual depreciation expense). Fixed expenses could decrease for the opposite reasons, of course.

But, we’ll focus on increases in fixed expenses.

Suppose in the company example that total fixed operating expenses were to increase due to general inflationary trends.

There were no changes in the capacity of the business or in the retail space or appearance (attractiveness) of the space. As far as customers can tell there have been no changes that would benefit them. The company could attempt to increase its sales price—the additional fixed expenses could be spread over its present sales volume.