Understanding Business Accounting For Dummies, 2nd Edition (72 page)

The second approach is obvious - you just need to set a sales goal of increasing the number of products sold by 9,750 units. (How you motivate your already overworked sales staff to accomplish that sales volume goal is up to you.) But how do you go about the first approach, increasing the contribution margin per unit by £0.60?

The simplest way to increase contribution margin per unit by £0.60 would be to decrease your product cost per unit by £0.60. Or you could attempt to reduce sales commissions from £8 per £100 of sales to £7.40 per £100 - which may adversely affect the motivation of your sales force, of course. Or you could raise the sales price about £0.65 (remember that 8 per cent comes off the top for the sales commission, so only £0.60 would remain from that £0.65 to improve the unit contribution margin). Or you could combine two or more such changes so that your unit contribution next year would increase £0.60. However you do it, the improvement would increase your earnings before tax the desired amount:

Impact of £0.60 Higher Unit Contribution Margin on Profit

Contribution margin per unit increase £0.60

× Units sold during year
520,000

Equals: Increase in earnings before tax £312,000

Cutting prices to increase sales volume: A very tricky game to play!

A word of warning: Be sure to
run the numbers
(accountant speak for using a profit model) before deciding to drop sales prices in an effort to gain more sales volume. Suppose, for example, you're convinced that if you decrease sales prices by 5 per cent your sales volume will increase by 10 per cent. Seems like an attractive trade-off, one that would increase both profit performance and market share. But are you sure that those positive changes are the results you'll get?

The impact on profit may surprise you. Get a piece of notepaper and do the computation for this lower sales price and higher sales volume scenario:

Lower Sales Price and Higher Sales Volume Impact on Profit

New sales price (lower) £95.00

Less: Product cost per unit (same) £60.00

Less: Variable operating expenses (lower)
£7.60

Equals: New unit contribution margin (lower) £27.40

× Sales volume (higher)
572,000

Equals: Total contribution margin £15,672,800

Less: Previous total contribution margin
£16,640,000

Equals: Decrease in total contribution margin £967,200

Your total contribution margin would not go up; instead, it would go down £967,200! In dropping the sales price by £5, you would give up too much of your contribution margin per unit. The increase in sales volume would not make up for the big dent in unit contribution margin. You may gain more market share, but would pay for it with a £967,200 drop in earnings before tax.

To keep profit the same, you would have to increase sales volume more than 10 per cent. By how much? Divide the total contribution margin for the 520,000 units situation by the contribution margin per unit for the new scenario:

£16,640,000 ÷ £27.40 = 607,300 units


In other words, just to keep your total contribution margin the same at the lower sales price, you would have to increase sales volume to 607,300 units - an increase of 87,300 units, or a whopping 17 per cent. That would be quite a challenge, to say the least.

Cash flow from improving profit margin versus improving sales volume

This chapter discusses increasing profit margin versus increasing sales volume to improve bottom-line profit. Improving your profit margin is the better way to go, compared with increasing sales volume. Both actions increase profit, but the profit margin tactic is much better in terms of cash flow. When sales volume increases, so does stock. On the other hand, when you improve profit margin (by raising the sales price or by lowering product cost), you don't have to increase stock - in fact, reducing product cost may actually cause stock to decrease a little. In short, increasing your profit margin yields a higher cash flow from profit than does increasing your sales volume.

The SCORE Web site offers a downloadable Excel spreadsheet that enables you to do as many ‘what if' calculations as you like (go to
www.score.org
and click on ‘Business Tools', ‘Template Gallery', and ‘Breakeven Analysis'). You can push your selling price up and down, add in and strip out costs, and see what your break-even point will be. By adding in your target profit as a ‘fixed cost' at the last line where you're asked for the ‘Owner's Draw' (in other words, what money the shareholder(s) expects), you can work out break-even volumes to meet those profit goals.

A Final Word or Two

Recently, some friends pooled their capital and opened an up-market off-licence in a rapidly growing area. The business has a lot of promise. We can tell you one thing they should have done before going ahead with this new venture - in addition to location analysis and competition analysis, of course. They should have used the basic profit model (in other words, the management profit and loss account) discussed in this chapter to figure out their break-even sales volume - because we're sure they have rather large fixed expenses. And they should have determined how much more sales revenue over their break-even point that they will need to earn a satisfactory return on their investment in the business.

During their open house for the new shop we noticed the very large number of different beers, wines, and spirits available for sale - to say nothing of the different sizes and types of containers many products come in. Quite literally, the business sells thousands of distinct products. The shop also sells many products like soft drinks, ice, corkscrews, and so on. Therefore, the company does not have a single sales volume factor (meaning the number of units sold) to work with in the basic profit model. So, you have to adapt the profit model to get along without the sales volume factor.

The trick is to determine your
average contribution margin as a percentage of sales revenue
. We'd estimate that an off-licence's average gross margin (sales revenue less cost of goods sold) is about 25 per cent. The other variable operating expenses of the shop probably run about 5 per cent of sales. So, the average contribution margin would be 20 per cent of sales (25 per cent gross margin less 5 per cent variable operating expenses). Suppose the total fixed operating expenses of the shop are about £100,000 per month (for rent, salaries, electricity, and so on), which is £1.2 million per year. So, the shop needs £6 million in sales per year just to break even:

£1.2 million fixed expenses ÷ 20% average contribution margin = £6 million annual sales to break even


Selling £6 million of product a year means moving a lot of booze. The business needs to sell another £1 million to provide £200,000 of operating earnings (at the 20 per cent average contribution margin) - to pay interest expense, tax, and leave enough net income for the owners who invested capital in the business and who expect a good return on their investment.

By the way, some disreputable off-licence owners are known (especially to HM Revenue and Customs) to engage in
sales skimming
. This term refers to not recording all sales revenue; instead, some cash collected from customers is put in the pockets of the owners. They don't report the profit in their tax returns or in the profit and loss accounts of the business. Our friends who started the off-licence are honest businessmen, and we're sure they won't engage in sales skimming - but they do have to make sure that none of their store's employees skim off some sales revenue.