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lower or higher). In short, a business nets only $.98 or $.96
from each dollar of credit card sales. The credit card discount
expense comes right off the top of the sales dollar.
Sales commissions are another common example of sales
revenue-dependent expenses. As you probably know, many
retailers and other businesses pay their sales representatives
on a commission basis, usually a certain percent of the total
sales amount such as 5 or 10 percent. The salespersons may
also receive a base salary, which would be the fixed floor of the

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SALES PRICE AND COST CHANGES


expense; only the commission over and above the fixed base
would be variable. (This requires the separation of the fixed
part and the variable part in the management profit report.)
Many businesses extend short-term credit to their cus-
tomers, especially when selling to other businesses. No matter
how carefully a business screens them before extending credit,
a few customers never pay their accounts. Eventually, after
making repeated collection efforts, the business ends up having
to write off all or some of these receivables™ balances as uncol-
lectible. These losses are called bad debts and are a normal
expense of doing business on credit. This expense depends on
the sales amount, not sales volume (number of units sold).
Another example of an expense that varies with sales rev-
enue is one you might not suspect”rent. Companies often
sign lease agreements that call for rental amounts based on
gross sales. There may be a base amount or fixed minimum
monthly rent. In addition, there may be a variable amount
equal to a percent of total sales revenue. This is common for
retailers renting space in shopping centers. There are several
other examples of expenses that vary with total sales revenue,
such as franchise fees based on gross sales.
Summing up, sales revenue increases 10 percent for the
three product lines (see Figure 10.1), but the incremental rev-
enue is partially offset by the increase in the sales revenue-
driven expenses. Thus the increases in contribution margins
are less than the increases in sales revenue. In Figure 10.1 it is
assumed that the fixed operating expenses of the profit mod-
ules do not change at the higher sales price levels. Thus, the
contribution margin increases flow down to the profit lines.

Increasing sales volume 10 percent increases total contribu-
tion margin only 10 percent because the contribution margin
per unit remains the same. And fixed operating expenses may
have to be increased to support the higher sales volume. (In
the examples, these fixed costs are held constant at the higher
sales volume.) Increasing sales prices 10 percent improves
contribution margin per unit much more than 10 percent, and
total contribution margin rises accordingly. Note the standard
product line, for instance (Figure 10.1). The contribution mar-
gin per unit increases $9.15, which is a 46 percent jump over
the $20.00 figure before the sales price increase. Thus, total
contribution margin increases $915,000, or 46 percent, at the

143
PROFIT AND CASH FLOW ANALYSIS


higher sales price. And fixed operating expenses should not
be affected by the higher sales price.
Frankly, a 10 percent increase in sales price with no
increase in the product cost and no increase in the other
expenses of the company is not too likely to happen. It is pre-
sented here to illustrate the powerful impact of a sales price
increase and to contrast it with a 10 percent increase in sales
volume (see Figure 10.2 again). Also, I should mention here
that the cash flow impact of a 10 percent sales price increase
differs from that of a sales volume increase like day from
night (see Chapter 13).


WHEN SALES PRICES HEAD SOUTH
Like it or not, business managers sometimes have to cut
DANGER!
sales prices just to hang onto the present sales volume they
have. They know that profit will suffer, but competitive pres-
Y
sures force them to cut sales prices, at least temporarily. Or
FL
they decide to cut prices to boost sales volume, but the number
of units sold in fact remains the same, and later they have to
nudge sales prices back up to previous levels. A 10 percent
AM


sales price cut would be the negative mirror image of the
effects caused by the 10 percent sales price increase. Just put
negative signs in front of the changes you see in Figure 10.1. If
TE




this happened, all the profit and then some would be wiped out
on the generic product line, over 90 percent of the profit on the
standard product line would evaporate, and the business would
give up over 69 percent of its profit from the premier products.
To illustrate the serious profit damage from even a rela-
tively small decrease in the average sales price of products
over a period of time, assume that during the year just ended
the business had to cut sales prices at times during the year
such that, on average, the sales prices of the products sold in
the three product lines suffered by 4 percent. This may not
sound like too much of a catastrophe, but look at the results
shown in Figure 10.3 for this scenario. Sales prices and sales
revenue drop by 4 percent, but profit plunges from 28 to 43
percent, depending on the product line.
The reason for the lower drop in profit for the premier
product line is that the unit margin of these products is a
much larger percent of sales price, so a 4 percent cut in sales
price doesn™t take such a big bite out of the unit margin. For

144
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
’4%
Sales revenue $100.00 $10,000,000 ($4.00) ($400,000)
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 ($0.34) ($ 34,000)
Unit-driven expenses $ 6.50 $ 650,000
($366,000) ’18%
Contribution margin $ 20.00 $ 2,000,000 ($3.66)
Fixed operating expenses $ 10.00 $ 1,000,000
($366,000) ’37%
Profit $ 10.00 $ 1,000,000 ($3.66)

Generic Product Line
150,000 units sold No change
Per Unit Totals Per Unit Totals
’4%
Sales revenue $ 75.00 $11,250,000 ($3.00) ($450,000)
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 ($0.12) ($ 18,000)
Unit-driven expenses $ 5.00 $ 750,000
($432,000) ’29%
Contribution margin $ 10.00 $ 1,500,000 ($2.88)
Fixed operating expenses $ 3.33 $ 500,000
($432,000) ’43%
Profit $ 6.67 $ 1,000,000 ($2.88)

Premier Product Line
50,000 units sold No change
Per Unit Totals Per Unit Totals
’4%
Sales revenue $150.00 $ 7,500,000 ($6.00) ($300,000)
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 ($0.45) ($ 22,500)
Unit-driven expenses $ 8.75 $ 437,500
($277,500) ’11%
Contribution margin $ 50.00 $ 2,500,000 ($5.55)
Fixed operating expenses $ 30.00 $ 1,500,000
($277,500) ’28%
Profit $ 20.00 $ 1,000,000 ($5.55)
FIGURE 10.3 4 percent lower sales prices.




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PROFIT AND CASH FLOW ANALYSIS


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
DANGER!
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

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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%
($715,000) ’36%
Contribution margin $ 20.00 $ 2,000,000 ($7.15)
Fixed operating expenses $ 10.00 $ 1,000,000 $0.80 $ 80,000 8%
($795,000) ’80%
Profit $ 10.00 $ 1,000,000 ($7.95)

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%
($930,000) ’62%
Contribution margin $ 10.00 $ 1,500,000 ($6.20)
Fixed operating expenses $ 3.33 $ 500,000 $0.27 $ 40,000 8%
($970,000) ’97%
Profit $ 6.67 $ 1,000,000 ($6.47)

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%
($443,750) ’18%
Contribution margin $ 50.00 $ 2,500,000 ($8.88)
Fixed operating expenses $ 30.00 $ 1,500,000 $2.40 $120,000 8%
($563,750) ’56%
Profit $ 20.00 $ 1,000,000 ($11.28)
FIGURE 10.4 Higher costs.


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