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tomers have to be won over. Once established, sales volume
can never be taken for granted. Sales are vulnerable to compe-
tition, shifts in consumer preferences and spending decisions,


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PROFIT AND CASH FLOW ANALYSIS


and general economic conditions both domestically and
globally.
Thinking more positively, sales volume growth is the most
realistic way to increase profit. In most cases, sales price
increases are met with some degree of customer resistance as
well as a response from competitors. Indeed, demand may be
extremely sensitive to sales prices. Cost containment and
expense control are important, to be sure, but are more of a
defensive tactic than a profit growth strategy as such.
Suppose that for all three product lines the business sold 10
percent more units during the year just ended. What amount
of profit would have been earned from each product line? Of
course, there™s no such thing as a free lunch. An experienced
manager would ask how the business could increase its sales
volume. Would customers buy 10 percent more without any
increase in advertising, without any sales price incentives,
without some product improvements or other inducements?
Not too likely. Increasing sales volume usually requires some
stimulant such as more advertising.

Another question an experienced manager might ask is
whether the business has enough capacity to handle 10 per-
cent additional sales. It™s always a good idea to run a capacity
check whenever looking at sales volume increases. Fixed
expenses may have to be increased to enlarge the capacity
needed to accommodate the additional sales volume. How-
ever, assume that the manager of each profit module had
enough untapped capacity to take on 10 percent additional
sales volume without having to increase any of his or her
fixed operating expenses.
Figure 9.2 presents the profit results for the 10 percent
higher sales scenario for each product line. Sales prices, unit
product costs, and variable expenses per unit remain the
same in each of the three profit modules. And, the direct fixed
costs of each product line remain the same. Therefore, at the
higher sales volume the average fixed cost per unit is lower.
For instance, consider the standard product line. At the origi-
nal 100,000 units sales volume, the $1 million in fixed costs
average out to $10.00 per unit. At the higher 110,000 units
sales volume, the average fixed costs per unit drop $.91 per
unit, so the business makes $10.91 profit per unit. The driv-
ing force behind the $200,000 increase in profit is selling

130
SALES VOLUME CHANGES




Standard Product Line
Original Scenarios (see Figure 9.1) Changes
100,000 units sold 10,000 additional units
Per Unit Totals Per Unit Totals
Sales revenue $100.00 $10,000,000 $1,000,000
Cost of goods sold $ 65.00 $ 6,500,000 $ 650,000
Gross margin $ 35.00 $ 3,500,000 $ 350,000
Revenue-driven expenses @ 8.5% $ 8.50 $ 850,000 $ 85,000
Unit-driven expenses $ 6.50 $ 650,000 $ 65,000
Contribution margin $ 20.00 $ 2,000,000 $ 200,000 10%
Fixed operating expenses $ 10.00 $ 1,000,000 ($0.91) $ 0
Profit $ 10.00 $ 1,000,000 $0.91 $ 200,000 20%

Generic Product Line
150,000 units sold 15,000 additional units
Per Unit Totals Per Unit Totals
Sales revenue $ 75.00 $11,250,000 $1,125,000
Cost of goods sold $ 57.00 $ 8,550,000 $ 855,000
Gross margin $ 18.00 $ 2,700,000 $ 270,000
Revenue-driven expenses @ 4.0% $ 3.00 $ 450,000 $ 45,000
Unit-driven expenses $ 5.00 $ 750,000 $ 75,000
Contribution margin $ 10.00 $ 1,500,000 $ 150,000 10%
Fixed operating expenses $ 3.33 $ 500,000 ($0.30) $ 0
Profit $ 6.67 $ 1,000,000 $0.30 $ 150,000 15%

Premier Product Line
50,000 units sold 5,000 additional units
Per Unit Totals Per Unit Totals
Sales revenue $150.00 $ 7,500,000 $ 750,000
Cost of goods sold $ 80.00 $ 4,000,000 $ 400,000
Gross margin $ 70.00 $ 3,500,000 $ 350,000
Revenue-driven expenses @ 7.5% $ 11.25 $ 562,500 $ 56,250
Unit-driven expenses $ 8.75 $ 437,500 $ 43,750
Contribution margin $ 50.00 $ 2,500,000 $ 250,000 10%
Fixed operating expenses $ 30.00 $ 1,500,000 ($2.73) $ 0
Profit $ 20.00 $ 1,000,000 $2.73 $ 250,000 25%
FIGURE 9.2 10 percent higher sales volumes.




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PROFIT AND CASH FLOW ANALYSIS


10,000 additional units at a $20.00 unit margin, not the
decrease in average fixed cost per unit. This decrease is sim-
ply one result of the higher sales volume.
In all three cases, contribution margin improves exactly 10
percent, the same as the percent of sales volume increase.
This is straightforward: Selling 10 percent more units with no
change in unit margin drives up contribution margin exactly
10 percent. But please note the difference in the amounts of
the contribution margin increases:

Contribution Margin Increases for Each Product Line
5,000 units increase — $50.00 unit margin =
Premier
$250,000
Standard 10,000 units increase — $20.00 unit margin =
$200,000
15,000 units increase — $10.00 unit margin =
Generic
$150,000
Selling 10 percent more premier units would bring in a
$50,000 higher contribution margin than would selling 10
percent more standard units. And selling 10 percent more
standard units would make $50,000 more profit than selling
10 percent generic units.


Operating Leverage

Note in Figure 9.2 that even though contribution
margin increases 10 percent for each product line
because of the 10 percent higher sales volume levels, the per-
cent increases in profit are 1.5 to 2.5 times greater. For
instance, profit on the standard product line would be 20 per-
cent higher, or two times the 10 percent sales volume increase.
The $200,000 increase in contribution margin equals 10 per-
cent gain, but the $200,000 gain is 20 percent on the profit fig-
ure. In short, the 10 percent sales volume increase has a
doubling effect on the percent increase in profit. The multi-
plier, or compounding effect is called operating leverage.
The additional 10,000 units sold equal 10 percent of the
total units sold, but they equal 20 percent of the units sold in
excess of the product line™s breakeven point. The profit pile, or
units sold in excess of breakeven, expands by 20 percent. This

132
SALES VOLUME CHANGES


analysis is summarized as follows for the standard product
line (data from Figure 9.2):

Analysis of Operating Leverage Effect
$1,000,000 fixed costs · $20.00 unit margin = 50,000 units
breakeven
100,000 units sales volume ’ 50,000 units breakeven =
50,000 units over breakeven
10,000 additional units sold · 50,000 units over breakeven =
20% increase
So profit would increase 20 percent by increasing sales vol-
ume just 10 percent, as shown in Figure 9.2. In like manner,
the percent of gain in profit (15 percent for generic products
and 25 percent for premier products) can be calculated.
The nub of operating leverage is that the swing in profit is
more than the sales volume swing. Operating leverage means
that profit percent changes are a multiple of sales volume per-
cent changes. There™s hardly ever a 1:1 percent relationship.
This rule is based on fixed expenses remaining constant at the
higher sales level. If fixed expenses increase 10 percent right
along with the sales volume increase (i.e., if fixed operating
expenses increase 10 percent as well), then profit would go up
only 10 percent.

Operating leverage reflects the fact that the business has not
been fully using the capacity provided by its fixed costs. When
capacity is reached, and sooner or later it will be as sales vol-
ume grows, fixed expenses will have to be increased to pro-
vide more capacity. If the company had already been selling at
its maximum capacity, then its fixed expenses would have had
to be increased. This points out the importance of knowing
where you are presently relative to the company™s capacity.


SALES VOLUME SLIPPAGE
Suppose that the sales volumes had been 10 percent lower
during the year just ended across the board for all three prod-
uct lines. The effects of this downside scenario are presented
in Figure 9.3, which is basically the negative mirror image of
the 10 percent sales volume increase scenario. It™s a good idea
for the managers of each product line to keep this lower sales

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PROFIT AND CASH FLOW ANALYSIS


volume, or worst-case scenario, in mind so they know just
how sensitive profit is to a falloff in sales volume.
The combined impact for all three product lines would have
been a profit drop-off of $600,000, from $3 million in the
original scenario to only $2.4 million profit in the 10 percent
lower sales volume.
When faced with a falloff in sales volume, managers should
be very concerned, of course, and they should probe into the
reasons for the decrease. More competition? Are people
switching to substitute products? Are hard times forcing cus-
tomers to spend less? Is the location deteriorating? Has ser-
vice to customers slipped? Are total quality management
(TQM) techniques needed to correct the loss of sales?
Sales volume losses are one of the most serious problems
confronting any business. Unless they are quickly reversed,
the business has to make extremely wrenching decisions
regarding how to downsize (laying off employees, selling off
Y
fixed assets, shutting down plants, etc.). The late economist
FL
Kenneth Boulding has called downsizing the management of
decline, which hits the nail on the head, I think. It™s an
extremely unpleasant task, to say the very least.
AM


The immediate (short-run) operating profit impact of a
10 percent sales volume decrease would depend heavily on
whether the company could reduce its fixed expenses at the
TE




lower sales level. Assume not. In Figure 9.3, fixed operating
expenses remain the same at the lower sales levels for each
product line. In the sales decline scenario, operating leverage
compounds the felony”profit decreases by a multiple of the
10 percent sales volume decrease in this scenario.


FIXED COSTS AND SALES VOLUME CHANGES
In analyzing the profit impacts of changes in sales volume,
there is the question regarding what to do with fixed operat-
ing expenses. The simple expedient is to keep fixed costs the
same at the higher or the lower sales volume. However, this is
not an entirely satisfactory solution. For very small changes in
sales volume, fixed costs do not change. In other words, fixed
costs are insensitive to relatively small changes in sales volume.
In the typical situation, most fixed costs (e.g., depreciation
expense recorded in the period, labor cost for employees paid
monthly fixed salaries, and amounts paid for insurance pre-

134
SALES VOLUME CHANGES




Standard Product Line
Original Scenarios (see Figure 9.1) Changes
100,000 units sold 10,000 additional units
Per Unit Totals Per Unit Totals
Sales revenue $100.00 $10,000,000 ($1,000,000)
Cost of goods sold $ 65.00 $ 6,500,000 ($ 650,000)
Gross margin $ 35.00 $ 3,500,000 ($ 350,000)
Revenue-driven expenses @ 8.5% $ 8.50 $ 850,000 ($ 85,000)
Unit-driven expenses $ 6.50 $ 650,000 ($ 65,000)
($ 200,000) ’10%
Contribution margin $ 20.00 $ 2,000,000
Fixed operating expenses $ 10.00 $ 1,000,000 $1.11 $ 0
($ 200,000) ’20%
Profit $ 10.00 $ 1,000,000 ($1.11)

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