The Fast Forward MBA in Finance_8 potx

145 SALES PRICE AND COST CHANGES Standard Product Line Original Scenarios (see Figure 9.1) Changes 100,000 units sold No change Per Unit Totals Per Unit Totals Sales revenue $100.00 $10,000,000 ($4.00) ($400,000) −4% Cost of goods sold $ 65.00 $ 6,500,000 Gross margin $ 35.00 $ 3,500,000 Revenue-driven expenses @ 8.5% $ 8.50 $ 850,000 ($0.34) ($ 34,000) Unit-driven expenses $ 6.50 $ 650,000 Contribution margin $ 20.00 $ 2,000,000 ($3.66) ($366,000) −18% Fixed operating expenses $ 10.00 $ 1,000,000 Profit $ 10.00 $ 1,000,000 ($3.66) ($366,000) −37% Generic Product Line 150,000 units sold No change Per Unit Totals Per Unit Totals Sales revenue $ 75.00 $11,250,000 ($3.00) ($450,000) −4% Cost of goods sold $ 57.00 $ 8,550,000 Gross margin $ 18.00 $ 2,700,000 Revenue-driven expenses @ 4.0% $ 3.00 $ 450,000 ($0.12) ($ 18,000) Unit-driven expenses $ 5.00 $ 750,000 Contribution margin $ 10.00 $ 1,500,000 ($2.88) ($432,000) −29% Fixed operating expenses $ 3.33 $ 500,000 Profit $ 6.67 $ 1,000,000 ($2.88) ($432,000) −43% Premier Product Line 50,000 units sold No change Per Unit Totals Per Unit Totals Sales revenue $150.00 $ 7,500,000 ($6.00) ($300,000) −4% Cost of goods sold $ 80.00 $ 4,000,000 Gross margin $ 70.00 $ 3,500,000 Revenue-driven expenses @ 7.5% $ 11.25 $ 562,500 ($0.45) ($ 22,500) Unit-driven expenses $ 8.75 $ 437,500 Contribution margin $ 50.00 $ 2,500,000 ($5.55) ($277,500) −11% Fixed operating expenses $ 30.00 $ 1,500,000 Profit $ 20.00 $ 1,000,000 ($5.55) ($277,500) −28% FIGURE 10.3 4 percent lower sales prices. comparison, the 4 percent (or $3.00) sales price cut for the generic products, net of the decrease in the revenue-driven expenses, represents a 29 percent reduction in the unit mar- gin on these products. For the premier products, the 4 percent (or $6.00) price cut (net of the decrease in its revenue-driven expenses) is only an 11 percent reduction in the unit margin. CHANGES IN PRODUCT COST AND OPERATING EXPENSES In most cases, changes in sales volume and sales prices have the biggest impact on profit performance. Product cost proba- bly would rank as the next most critical factor for most busi- nesses (except for service businesses that do not sell products). A retailer needs smart, tough-nosed, sharp-pencil, aggressive purchasing tactics to control its product costs. On the other hand, it can be carried to an extreme. I knew a purchasing agent (a neighbor when I lived in Cali- fornia some years ago) who was a real tiger. For instance, George would even return new calendars sent by vendors at the end of the year with a note saying, “Don’t send me this calendar; give me a lower price.” This may be overkill, though George eventually became general manager of the business. Even with close monitoring and relentless control, both the variable and fixed operating expenses of a business may increase. Salaries, rent, insurance, utility bills, and audit and legal fees—virtually all operating expenses—are subject to inflation. To illustrate this situation, consider the scenario in which sales prices and sales volume remain the same but the company’s product costs and its variable and fixed operating expenses increase. In particular, assume that the business’s product costs and its unit-driven variable expenses increase 10 percent. Fixed costs increase only, say, 8 percent, because the depreciation expense component of total fixed expenses remains unchanged. Depreciation is based on the original cost of fixed assets and is not subject to the general inflationary pressures on operating expenses. Revenue-driven variable expenses, being a certain percent of sales revenue, do not change, because in this scenario sales revenue does not change (sales volumes and sales prices for each product line don’t change). Figure 10.4 presents the effects for this cost inflation DANGER! PROFIT AND CASH FLOW ANALYSIS 146 147 SALES PRICE AND COST CHANGES Standard Product Line Original Scenarios (see Figure 9.1) Changes 100,000 units sold No change Per Unit Totals Per Unit Totals Sales revenue $100.00 $10,000,000 Cost of goods sold $ 65.00 $ 6,500,000 $6.50 $650,000 10% Gross margin $ 35.00 $ 3,500,000 Revenue-driven expenses @ 8.5% $ 8.50 $ 850,000 Unit-driven expenses $ 6.50 $ 650,000 $0.65 $ 65,000 10% Contribution margin $ 20.00 $ 2,000,000 ($7.15) ($715,000) −36% Fixed operating expenses $ 10.00 $ 1,000,000 $0.80 $ 80,000 8% Profit $ 10.00 $ 1,000,000 ($7.95) ($795,000) −80% Generic Product Line 150,000 units sold No change Per Unit Totals Per Unit Totals Sales revenue $ 75.00 $11,250,000 Cost of goods sold $ 57.00 $ 8,550,000 $5.70 $855,000 10% Gross margin $ 18.00 $ 2,700,000 Revenue-driven expenses @ 4.0% $ 3.00 $ 450,000 Unit-driven expenses $ 5.00 $ 750,000 $0.50 $ 75,000 10% Contribution margin $ 10.00 $ 1,500,000 ($6.20) ($930,000) −62% Fixed operating expenses $ 3.33 $ 500,000 $0.27 $ 40,000 8% Profit $ 6.67 $ 1,000,000 ($6.47) ($970,000) −97% Premier Product Line 50,000 units sold No change Per Unit Totals Per Unit Totals Sales revenue $150.00 $ 7,500,000 Cost of goods sold $ 80.00 $ 4,000,000 $8.00 $400,000 10% Gross margin $ 70.00 $ 3,500,000 Revenue-driven expenses @ 7.5% $ 11.25 $ 562,500 Unit-driven expenses $ 8.75 $ 437,500 $0.88 $ 43,750 10% Contribution margin $ 50.00 $ 2,500,000 ($8.88) ($443,750) −18% Fixed operating expenses $ 30.00 $ 1,500,000 $2.40 $120,000 8% Profit $ 20.00 $ 1,000,000 ($11.28) ($563,750) −56% FIGURE 10.4 Higher costs. PROFIT AND CASH FLOW ANALYSIS 148 scenario. As you can see, it’s not a pretty picture. The com- pany could ill afford to let its product costs and operating expenses get out of control. Virtually all (97 percent) of the profit on the generic product line would be eliminated in this case. The profit on the standard product line would plunge 80 percent, and the profit on the premier product line would suf- fer 56 percent. If the cost increases could not be avoided, then managers would have the unpleasant task of passing the cost increases along to their customers in the form of higher sales prices. s END POINT If you had your choice, the best change is a sales price in- crease, assuming all other profit factors remain the same. A sales price increase yields a much better profit result than a sales volume increase of equal magnitude. Increasing sales volume ranks a distant second behind raising sales prices. Of course, customers are sensitive to sales price increases, and as a practical matter the only course of action to increase profit may be to sell more units at the established sales prices. Sales volume and sales prices are the two big factors driving profit. However, cost factors cannot be ignored, of course. The unit costs of the products sold by the business and vir- tually all its operating costs—both variable and fixed—can change for the worse. Such unfavorable cost shifts would cause devastating profit impacts unless they are counterbal- anced with prompt increases in sales prices. This and other topics are explored in the following chapters. 11 CHAPTER Price/Volume Trade-Offs R 11 Raising sales prices may very well cause sales volume to fall. Cutting sales prices may increase sales volume—unless com- petitors lower their prices also. Higher sales prices may be in response to higher product costs that are passed through to customers. Increasing product costs to improve product qual- ity may jack up sales volume. Increasing sales commissions (a prime revenue-driven expense) may give the sales staff just the incentive needed to sell more units. Spending more on fixed operating expenses—such as bigger advertising budgets, higher rent for larger stores, or more expensive furnishings— may help sales volume. 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 techni- cally 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. 149 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 mod- ules 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 competi- tion. (Brand names, customer service, and product specifica- tions 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 pro- vided 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 vol- ume. 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 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 seri- ous 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. DANGER! PROFIT AND CASH FLOW ANALYSIS 150 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 151 PRICE/VOLUME TRADE-OFFS 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). 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 prod- uct 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 per- cent 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 contri- bution 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 reduc- tions 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. Every- one 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 vol- ume 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 PROFIT AND CASH FLOW ANALYSIS 152 153 PRICE/VOLUME TRADE-OFFS 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. 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 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 PROFIT AND CASH FLOW ANALYSIS 154 *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. TEAMFLY Team-Fly ® [...]... 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... 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... 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... 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... 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. .. 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... 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... 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. .. 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... 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 . 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. If the cost increases could not be avoided, then managers would have the unpleasant task of passing the cost increases along to their customers in the form of higher sales prices. s END POINT If. be correct, the sales price reduction would push the generic prod- uct line into the red and cause substantial profit deterioration in the other two product lines. Why is there such a devastating impact