Understanding Business Accounting For Dummies, 2nd Edition (71 page)

Impact of 5% Lower Sales Price on Profit

Contribution margin per unit decrease £4.60

× Units sold during year
520,000

Equals: Decrease in earnings before tax £2,392,000

Hold on! Earnings before tax would drop from £2,800,000 at the £100 sales price (refer to Figure 9-2) to only £408,000 at the £95 sales price - a plunge of 85 per cent. What could cause such a drastic dive in profit?

The sales price drops £5 per unit - a 5 per cent decrease of the £100 sales price. But, contribution margin per unit does not drop by the entire £5 because the variable operating expense per unit (sales commissions in this example) would also drop 5 per cent, or £40 per unit - for a net decrease of £4.60 per unit in the contribution margin per unit. (This is one reason for identifying the expenses that depend on sales revenue - as shown in the management profit and loss account in Figure 9-2.) For this what-if scenario that examines the case of the company selling all units at a 5 per cent lower sales price than it did, the company's contribution margin would have been only £27.40 per unit. Such a serious reduction in its contribution margin per unit would have been intolerable.

At the lower sales price, the company's contribution margin would be £27.40 per unit (£32.00 in the original example minus the £4.60 decrease = £27.40). As a result, the break-even sales volume would be much higher, and the company's 520,000 sales volume for the year would have been only 14,891 units over its break-even point. So, the lower £27.40 contribution margin per unit would yield only £408,000 profit before tax.

The moral of the story is to protect contribution margin per unit above all else. Every pound of contribution margin per unit that's lost - due to decreased sales prices, increased product cost, or increases in other variable costs - has a tremendously negative impact on profit. Conversely, if you can increase the contribution margin per unit without hurting sales volume, you reap very large profit benefits, as described next.

Improving profit

The preceding sections explore the downside of things - that is, what would've happened to profit if sales volume or sales prices had been lower. The upside - higher profit - is so much more pleasant to discuss and analyse, don't you think?

Profit improvement boils down to the three critical profit-making factors, listed in order from the most effective to the least effective:

Increasing the contribution margin per unit

Increasing sales volume

Reducing fixed expenses

Say you want to improve your bottom-line profit from the £1,900,000 net income you earned the year just ended to £2,110,000 next year. How can you pump up your net income by £210,000? (By the way, this is the only place in the chapter we bring the tax factor into the analysis.)

First of all, realise that to increase your net income
after taxes
by £210,000, you need to increase your before-tax profit by much more - to provide for the amount that goes to tax. Your accountant calculates that you would need a £312,000 increase in earnings before tax next year because your tax increase would be about £102,000 on the £312,000 increase in pre-tax earnings. So, you have to find a way to increase earnings, before tax, by £312,000.

You should also take into account the possibility that fixed costs and interest expense may rise next year, but for this example we're assuming that they won't. We're also assuming that the business can't cut any of its fixed operating expenses without hurting its ability to maintain and support its present sales level (and a modest increase in the sales level). Of course, in real life, every business should carefully scrutinise its fixed expenses to see if some of them can be cut.

Okay, so how can you increase your business's before-tax profit by £312,000? You have two choices (well, actually three choices). Take another look at Figure 9-2 and study these options:

Increase your contribution margin per unit by £0.60, which would raise the total contribution margin by £312,000, based on a 520,000 units sales volume (£0.60 × 520,000 = £312,000).

Sell 9,750 additional units at the current contribution margin per unit of £32, which would raise the total contribution margin by £312,000 (9,750 × £32 = £312,000).

Use a combination of these two approaches: Increase both the margin per unit and the sales volume.