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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)
($ 150,000) ’10%
Contribution margin $ 10.00 $ 1,500,000
Fixed operating expenses $ 3.33 $ 500,000 $0.37 $ 0
($ 150,000) ’15%
Profit $ 6.67 $ 1,000,000 ($0.37)

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)
250,000) ’10%
Contribution margin $ 50.00 $ 2,500,000 ($
Fixed operating expenses $ 30.00 $ 1,500,000 $3.33 $ 0
250,000) ’25%
Profit $ 20.00 $ 1,000,000 ($3.33) ($
FIGURE 9.3 10 percent lower sales volumes.




135
PROFIT AND CASH FLOW ANALYSIS


miums) would not be any different if sales volume had been 1
or 2 percent higher or lower, or even 5, 10, or 20 percent dif-
ferent in either direction. But at some point a business will
have to increase its fixed costs to provide additional capacity
on the upside or will have to cut fixed costs on the downside.

In the preceding analysis, the assumption is made that each
product line has enough capacity to take on 10 percent addi-
tional sales volume without any increase in the direct fixed
costs of the profit module. Keep in mind, however, that one or
more fixed operating expenses might have to increase to sup-
port a higher sales volume. For instance, the business might
have to rent more retail floor space, hire more salaried
employees, or purchase additional equipment on which
depreciation is recorded. For a moderate increase in sales vol-
ume, fixed expenses generally hold steady and don™t increase,
as a general rule, unless the business already is running at
virtually 100 percent of its capacity.
Faced with moderate decreases in sales volume, businesses
generally hold off and delay any serious reduction in capacity
that would require laying off employees. Employees usually
have been trained and have valuable experience to offer a
business. It may be difficult to reduce many fixed expenses, at
least in the short run. Some fixed expenses can be adjusted
downward in short order. But if you had time to look at the
typical fixed costs of a business, I think you would find that
unwinding from many of the expenses would take time and
would have serious consequences to the business.
Finally, I would mention that in dire circumstances, such as
when a business goes into bankruptcy, all bets are off. A busi-
ness may have to slash many fixed costs under pressures from
creditors or by court order. Also, in takeover situations, in
which one business buys out another business, often a key
element of the takeover strategy is to drastically reduce the
fixed costs of the acquired business. This often means laying
off hundreds of thousands of employees and selling off assets.



s END POINT
All profit factors are subject to change. Management neglect
or ineptitude can lead to profit deterioration, sometimes very
quickly. Increases in product cost as well as increases in vari-

136
SALES VOLUME CHANGES


able and fixed expenses can do serious damage to profit per-
formance. But managers may not be able to significantly
improve certain factors. Fixed expenses may already be cut to
the bone. One vendor may control product costs, or alterna-
tive vendors may offer virtually the same prices. Competition
may put a fairly tight straitjacket on sales prices. Customers
are sensitive to sales price increases. Sales volume is the key
success factor for most businesses, which explains why man-
agers are so concerned about market share. Market share is
mentioned often in later chapters.




137
10
CHAPTER




Sales Price and
Cost Changes



B
Before we go any further, let me ask you a basic question.
Suppose you could have one or the other, but not both, which
would you prefer”a 10 percent sales volume increase or a 10
percent sales price increase? In most cases, there™s a huge dif-
ference between the two. This chapter contrasts the difference
between sales volume and sales price changes. You may be
surprised. In any case, you should be very certain about the
differences!


SALES PRICE CHANGES
Setting sales prices is one of the most perplexing decisions
facing business managers. Competition normally dictates the
basic range of sales prices. But usually there is some room for
deviation from your competitors™ prices because of product
differentiation, brand loyalty, location advantages, and/or
quality of service, to cite only a few of the many reasons that
permit you to charge higher sales prices than your competi-
tion.

Fixed operating expenses are insensitive to sales price
increases. In contrast, sales volume increases may very well
require increases in fixed operating expenses, especially when
the company™s capacity is crowded. Very few fixed expenses
are directly affected by raising sales prices, even if the company
139
PROFIT AND CASH FLOW ANALYSIS


is operating at full capacity. Advertising (a fixed cost once
spent) might be stepped up to persuade customers that the
hike in sales prices is necessary or beneficial. Other than this,
it™s hard to find many fixed operating expenses that are tied
directly to sales price increases.
The same three profit module examples used in Chapter 9
for analyzing sales volume changes are used in this chapter to
analyze sales price changes. This allows the comparison of
the differences between the profit impacts of selling more or
fewer units versus selling the same number of units but at
higher or lower sales prices. With this in mind, consider the
hypothetical scenario in which the business could have sold
the same number units of each product line at 10 percent
higher sales prices. Figure 10.1 presents this scenario for the
three profit modules examples.
Profit more than doubles on the generic product line; and
profit increases 92 percent and 69 percent on the standard
and premier product lines, respectively (see Figure 10.1).
Would this be realistic? Only to the extent that a 10 percent
sales price increase would be realistic. Assume that the busi-
ness could have sold all units during the year at the higher
sales prices. The advantages of selling at 10 percent higher
sales prices compared with selling 10 percent more sales vol-
ume are summarized in Figure 10.2.
In this scenario only one variable operating expense would
increase”the one driven by sales revenue. Note that cost-of-
goods-sold expense does not increase because the volume sold
remains the same. In the sales volume increase situation
(Chapter 9), the sales revenue increase is offset substantially
by the increase in cost-of-goods-sold expense. In contrast,
consider the standard product line here in the sales price
increase case: $915,000 of the $1 million incremental sales
revenue flows through to profit.
Chapter 3 introduces the format and logic of an internal
management profit report. One key point is that expenses
should be classified and reported according to their behavior,
or what drives them.* Some operating expenses depend


*Cost driver is a popular term these days. This refers to the specific factors
that determine, or push, or drive a particular cost. Identifying cost drivers is
the key step in the method of cost analysis and allocation called activity-
based costing (ABC). Cost allocation is discussed in Chapter 18.

140
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 $10.00 $1,000,000 10%
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 $ 0.85 $ 85,000
Unit-driven expenses $ 6.50 $ 650,000
Contribution margin $ 20.00 $ 2,000,000 $ 9.15 $ 915,000 46%
Fixed operating expenses $ 10.00 $ 1,000,000
Profit $ 10.00 $ 1,000,000 $ 9.15 $ 915,000 92%

Generic Product Line
150,000 units sold No change
Per Unit Totals Per Unit Totals
Sales revenue $ 75.00 $11,250,000 $ 7.50 $1,125,000 10%
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 $ 0.30 $ 45,000
Unit-driven expenses $ 5.00 $ 750,000
Contribution margin $ 10.00 $ 1,500,000 $ 7.20 $1,080,000 72%
Fixed operating expenses $ 3.33 $ 500,000
Profit $ 6.67 $ 1,000,000 $ 7.20 $1,080,000 108%

Premier Product Line
50,000 units sold No change
Per Unit Totals Per Unit Totals
Sales revenue $150.00 $ 7,500,000 $15.00 $ 750,000 10%
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 $ 1.12 $ 56,250
Unit-driven expenses $ 8.75 $ 437,500
Contribution margin $ 50.00 $ 2,500,000 $13.88 $ 693,750 28%
Fixed operating expenses $ 30.00 $ 1,500,000
Profit $ 20.00 $ 1,000,000 $13.88 $ 693,750 69%
FIGURE 10.1 10 percent higher sales prices.




141
PROFIT AND CASH FLOW ANALYSIS




10 Percent Sales 10 Percent Sales
Volume Increase Price Increase
(see Figure 9.2) (see Figure 10.1)

Standard Product Line
Contribution margin $200,000 10% $ 915,000 46%
Profit $200,000 20% $ 915,000 92%

Generic Product Line
Contribution margin $150,000 10% $1,080,000 72%
Profit $150,000 15% $1,080,000 108%

Premier Product Line
Contribution margin $250,000 10% $ 693,750 28%
Profit $250,000 25% $ 693,750 69%
FIGURE 10.2 Comparison of 10 percent higher sales prices versus 10 per-
cent higher sales volumes.




directly on the dollar amounts of sales, not the quantity of
products sold. As total sales revenue (dollars) increases, these
expenses increase directly in proportion. In short, one more
dollar of sales revenue causes these expenses to increase by a
certain amount of cents on the dollar.
Most retailers accept national credit cards (Visa, Master-
Card, Discover, American Express, Diners Club, etc.). The
credit card charge slips are deposited daily with a local partic-
ipating bank. The bank then discounts the total amount and
credits the net balance in the business™s checking account.
Discount rates vary between 2 and 4 percent (sometimes

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