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as the spread between the $11.29 average fixed cost per unit
and the $15.51 contribution margin per unit, which is $4.22
average profit per unit. Of course, the amount of profit for the
year (earnings before income tax) is the same as for the two
computation methods explained previously.
Suppose the business had sold only 421,242 units (its
breakeven volume). The average fixed expenses per unit sold
would have been much higher. In fact, it would have been
$15.51 per unit ($6,534,250 total fixed expenses · 421,242
units breakeven volume = $15.51 average fixed cost per unit).
In this hypothetical situation the average fixed cost per unit
would equal the average contribution margin per unit. So the
business would have made precisely zero profit per unit. In
other words, profit would be zero.

Because a business has fixed expenses, it has to worry about
its breakeven point”which is determined by dividing its total


fixed expenses for the period by its contribution profit margin
per unit. The breakeven point is that precise sales volume at
which the business™s sales revenue would equal its total
expenses and thus would experience exactly zero profit. The
only advantage of breaking even is that the business would
have no income tax to pay. At breakeven, the company™s
bottom-line net income is zero. Of course, a business does
not deliberately try to earn zero profit.
This chapter examines the nature of fixed expenses, espe-
cially the depreciation expense component of fixed expenses,
noting that fixed expenses are not really 100 percent fixed
and unchangeable, but are treated as if they were over the
short run for breakeven analysis and for examining the path-
ways to profit. The chapter demonstrates the three different
ways to compute profit, each of which has unique advantages
for management analysis. The manager may find one more
useful than the others in a given situation or for explaining
the profit strategy of his or her business to others.


Sales Volume Changes

Business managers face constant change in the pursuit of
profit. All profit factors are subject to change”due to both
external changes beyond the control of the business and
changes initiated by the managers themselves. Many manage-
ment decisions are triggered by change. Indeed, managers are
often characterized as change agents.
Its suppliers may increase the purchase costs of the prod-
ucts sold by the business. Or the cost of manufacturing prod-
ucts may change, as may the productivity performance of its
manufacturing operations. The company may raise wages for
some or all of its employees, or wage rates might actually be
reduced by employee givebacks or downsizing. The landlord
may raise the rent; competitors may drop their sales prices
and the business may have to follow suit. Managers may
decide to raise sales prices. And so on.
One basic function of managers is to keep a close watch
on all relevant changes and know how to deal with those
changes. Changes set in motion a new round of profit-making
decisions. This chapter is the first of four that analyze the
impact of changes in the factors that drive profit. The basic
factors are changed to determine the resulting change in
profit. For example, if you sold 10 percent more units, would
your profit be 10 percent higher? Nope, it™s not as simple as
this, and managers should know why.


By and large, previous chapters take a macro, or business-as-
a-whole, approach to profit analysis techniques that business
managers need to understand. This chapter shifts gears and
takes more of a micro and focused point of view. The typical
business consists of many different profit pieces, or profit
modules, as I prefer to call them. A profit module is a separate
identifiable source of sales and profit of a business. A product
line is a typical example of a profit module.
One product by itself could be a profit module if the product
stands alone and generates a significant amount of sales rev-
enue and profit. A separate store location or each branch of a
business could be operated as a separate segment of the busi-
ness and, accordingly, be accounted for as a profit module.
Organizational units that have profit responsibility are also
called profit centers.
A profit center may consist of two or more profit modules.
A brand generally covers too broad a range of different prod-
ucts to be just one profit module, although in some cases a
brand might be a profit module. Managers have to figure out
the best way to organize their sales activities into separate
and distinguishable profit modules, which are the constituent
profit members of the whole business. For each one of these
organizational slices of the total business, a meaningful mea-
sure of profit is adopted that is appropriate for that particular
management unit of the organization. Certain designated
managers plan and control each profit module, which is nec-
essary to achieve the overall profit goals of the business.
Figure 9.1 presents management profit reports for three
contrasting profit modules of a business. Each is a basic prod-
uct line of the business. The generic product line is an exam-
ple of high volume and low unit margin. The business™s
premier product line is at the opposite end of the how-to-
make-profit spectrum”low volume and high unit margin. Its
standard product line falls in the middle”moderate volume
and moderate unit margin. Each product line generated a $1
million profit for the year just ended.
I designed these three examples so that profit is $1 million
for each module. This makes it easier to compare the impacts
caused by changes in profit factors between the three product


Standard Product Line
100,000 units sold
Per Unit Totals
Sales revenue $100.00 $10,000,000
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
Unit-driven expenses $ 6.50 $ 650,000
Contribution margin $ 20.00 $ 2,000,000
Fixed operating expenses $ 10.00 $ 1,000,000
Profit $ 10.00 $ 1,000,000

Generic Product Line
150,000 units sold
Per Unit Totals
Sales revenue $ 75.00 $11,250,000
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
Unit-driven expenses $ 5.00 $ 750,000
Contribution margin $ 10.00 $ 1,500,000
Fixed operating expenses $ 3.33 $ 500,000
Profit $ 6.67 $ 1,000,000

Premier Product Line
50,000 units sold
Per Unit Totals
Sales revenue $150.00 $ 7,500,000
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
Unit-driven expenses $ 8.75 $ 437,500
Contribution margin $ 50.00 $ 2,500,000
Fixed operating expenses $ 30.00 $ 1,500,000
Profit $ 20.00 $ 1,000,000
FIGURE 9.1 Three contrasting profit modules of a business.


lines. Profit is the same for all three modules, but the sales
prices, unit margins, and fixed operating expenses are quite
different for the three product lines. Note that the business
had to sell three times as many units of its generic products
(150,000 units) as its premier products (50,000 units) to earn
the same profit.

Chapter 8 explains the different ways of analyzing profit,
which I call pathways to profit. The three management profit
reports presented in Figure 9.1 for the three profit modules
follow the layout of the #1 pathway to profit, as follows:

Unit margin — sales volume = contribution margin
’ fixed costs
= profit

The management profit reports in Figure 9.1 also include
data for the #3 pathway to profit. For instance, for the pre-
miere product line the business spread its $1.5 million fixed
costs over 50,000 units, which gives a $30.00 average fixed
cost per unit sold. On this product line, the business makes a
$50.00 unit margin, so its profit is $20.00 per unit, which
multiplied times the 50,000 units sales volume gives $1 mil-
lion profit for the year. The #2 pathway to profit is brought
into play later to explain why the percent change in profit is
greater than the percent change in sales volume.

The three variable expenses per unit reported in Figure 9.1
for each profit module (i.e., product cost, revenue-driven,
and unit-driven) are incremental costs. That is to say, if the
business sells one more unit, then total cost increases by
the per unit amounts shown in Figure 9.1. The total amount
of each of these expenses for the period depends on the
number of units sold (or sales volume). In contrast, the per-
unit amount of fixed operating expenses for each product
line is determined by dividing the total fixed costs for the
period by the number of units sold. If the business had sold
one unit more or one unit less than it did, the total amount
of fixed costs for the period would be the same, but the


average fixed cost per unit would be slightly different
because this is a calculated amount that depends on the
number of units sold.

Defining Profit and the Matter of Fixed Costs
Each profit module (product line) shown in Figure 9.1 is
charged with its direct fixed operating expenses for the year.
These include such costs as the salaries of the managers and
other employees who work exclusively in this area of the busi-
ness, advertising expenditures for the products (except for the
generic product, which is not advertised), depreciation of vari-
ous fixed assets used by each of these profit segments of the
business, and so on. Several fixed costs of the business cannot
be allocated directly to any of its profit modules (the general
legal costs of the business, the compensation of companywide
top-level executives, the cost of its annual independent audit,
charitable contributions made by the business, the cost of
institutional advertising in which the name of the company
but no specific products are promoted, etc.). Every profit mod-
ule is expected to earn a sufficient profit after deducting its
direct fixed costs from its contribution margin.
Summing up, each of the three profit modules in the exam-
ple (see Figure 9.1) earned $1 million for the year just ended.
These are profit amounts prior to taking into account the indi-
rect fixed expenses of the business and the interest expense
and income tax expense of the business. The general manager
of each product line is held accountable for its profit perform-
ance, of course.

Business managers, quite naturally, are sales oriented. No
sales, no business; it™s as simple as that. As they say in
marketing”nothing happens until you sell it. Many busi-
nesses do not make it through their start-up phase because
it™s very difficult to build up and establish a sales base. Cus-


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