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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.




148
11
CHAPTER




Price/Volume
Trade-Offs



R
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
PROFIT AND CASH FLOW ANALYSIS


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
DANGER!
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.
150
PRICE/VOLUME TRADE-OFFS



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



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).


151
PROFIT AND CASH FLOW ANALYSIS


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

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PRICE/VOLUME TRADE-OFFS




Before After Change
Standard Product Line
’10%
Sales price $100.00 $90.00
Product cost $65.00 $65.00
’10%
Revenue-driven expenses $8.50 $7.65
Unit-driven expenses $6.50 $6.50
’46%
Unit margin $20.00 $10.85
Sales volume 100,000 110,000 10%
’40%
Contribution margin $2,000,000 $1,193,500
Fixed operating expenses $1,000,000 $1,000,000
’81%
Profit $1,000,000 $193,500

Generic Product Line
’10%
Sales price $75.00 $67.50
Product cost $57.00 $57.00
’10%
Revenue-driven expenses $3.00 $2.70
Unit-driven expenses $5.00 $5.00
’72%
Unit margin $10.00 $2.80
Sales volume 150,000 165,000 10%
’69%
Contribution margin $1,500,000 $462,000
Fixed operating expenses $500,000 $500,000
’104%
Profit (Loss) $1,000,000 ($38,000)

Premier Product Line
’10%
Sales price $150.00 $135.00
Product cost $80.00 $80.00
’10%
Revenue-driven expenses $11.25 $10.13
Unit-driven expenses $8.75 $8.75
’28%
Unit margin $50.00 $36.12

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