<<

. 27
( 55 .)



>>

Sales volume 50,000 55,000 10%
’21%
Contribution margin $2,500,000 $1,986,875
Fixed operating expenses $1,500,000 $1,500,000
’51%
Profit $1,000,000 $486,875
FIGURE 11.2 10 percent lower sales prices and 10 percent higher sales
volumes.




153
PROFIT AND CASH FLOW ANALYSIS


changes in the product cost per unit for the product lines. This
seems to be a reasonable assumption. To have products for
sale, the business either has to buy (or make) them at this unit
cost or, if already in inventory, has to incur this cost to replace
units sold. This is the normal situation, of course. But it may
not be true in certain unusual and nontypical cases.
A business may not replace the units sold; it may be at the
end of the product™s life cycle. For instance, the product may
be in the process of being phased out and replaced with a
newer model. In this situation the historical, original account-
ing cost of inventory becomes a sunk cost, which means that
it™s water over the dam; it can™t be reversed.

Suppose the units held in inventory will not be replaced, that
the business is at the end of the line on these units and is sell-
ing off its remaining stock. In this situation the book value of
Y
the inventory (the recorded accounting cost) is not relevant.
What the business paid in the past for the units should be dis-
FL
regarded.* For all practical purposes the unit product cost can
be set to zero for the units held in stock. The manager should
AM


ignore the recorded product cost and find the highest sales
price that would move all the units out of inventory.
TE




VOLUME NEEDED TO OFFSET SALES PRICE CUT
In analyzing sales price reductions, managers should deter-
mine just how much sales volume increase would be needed
to offset the 10 percent sales price cut. In other words, what
level of sales volume would keep contribution margin the
same? For the moment, assume that the fixed expenses would
remain the same”that the additional sales volume could be
taken on with no increase in fixed costs. The sales volumes
needed to keep profit the same for each product line are com-
puted by dividing the contribution margins of each product

*The original cost (book value) of products that will not be replaced when
sold should be written down to a lower value (possibly zero) under the
lower-of-cost-or-market (LCM) accounting rule. This write-down is based on
the probable disposable value of the products. If such products have not yet
been written down, the manager should make the accounting department
aware of this situation so that the proper accounting adjusting entry can be
recorded.

154
PRICE/VOLUME TRADE-OFFS


line at the original sales prices by the unit margins at the
lower sales prices:

Product Contribution Margin · Lower Unit Margin = Required Sales Volume
Standard $2,000,000 · $10.85 = 184,332 units
$1,500,000 · $2.80 = 535,714 units
Generic
Premier $2,500,000 · $36.12 = 69,204 units
Figure 11.3 summarizes the effects of these higher sales
volumes and shows that the number of units sold would have
to increase by rather large percents”from a 257 percent
increase for the generic product line to a 38 percent increase
for the premier product line. Would such large sales volume
gains be possible? Doubtful, to say the least. And to achieve
such large increases in sales volume, fixed expenses would
have to be increased, probably by quite large amounts. Also,
interest expense would increase because more debt would be
used to finance the increase in operating assets needed to
support the higher sales volume.

The moral of the story, basically, is that a 10 percent sales
price cut usually takes such a big bite out of unit contribution
margin that it would take a huge increase in sales volume to
stay even (i.e., to earn the same profit as before the price cut).
Managers should think long and hard before making sales
price reductions.

Short-Term and Limited Sales
The preceding analysis applies the sales price reduction to all
sales for the entire year. However, many sales price reductions
are limited to a relatively few items and are short-lived, per-
haps for only a day or weekend. Furthermore, the sale may
bring in customers who buy other items not on sale. Profit
margin is sacrificed on selected items to make additional sales
of other products at normal profit margins.

Indeed, many retailers seem to have some products on sale
virtually every day of the year. In this case the normal profit
margin is hard to pin down, since almost every product takes
its turn at being on sale. In short, every product may have two
profit margins”one when not on sale and one when on sale.

155
PROFIT AND CASH FLOW ANALYSIS




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 100,000 184,332 84%
Contribution margin $2,000,000 $2,000,000
Fixed operating expenses $1,000,000 $1,000,000
Profit $1,000,000 $1,000,000

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 150,000 535,714 257%
Contribution margin $1,500,000 $1,500,000
Fixed operating expenses $500,000 $500,000
Profit $1,000,000 $1,000,000

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
Sales volume 50,000 69,204 38%
Contribution margin $2,500,000 $2,500,000
Fixed operating expenses $1,500,000 $1,500,000
Profit $1,000,000 $1,000,000
FIGURE 11.3 Sales volumes needed to offset 10 percent sales price cuts.




156
PRICE/VOLUME TRADE-OFFS


The average profit margin for the year depends on how often
the item goes on sale.
In any case, the same basic analysis also applies to limited,
short-term sales price reductions. The manager should calcu-
late, or at least estimate, how much additional sales volume
would be needed on the sale items just to remain even with
the profit that would have been earned at normal sales
prices. Complicating the picture are sales of other products
(not on sale) that would not have been made without the
increase in sales traffic caused by the sale items. Clearly, the
additional sales made at normal profit margins are a big fac-
tor to consider, though this may be very hard to estimate with
any precision.


THINKING IN REVERSE: GIVING UP SALES
VOLUME FOR HIGHER SALES PRICES
Suppose the general managers of the three product lines are
thinking of a general 10 percent sales price increase, knowing
that sales volume probably would decrease. In fact, they pre-
dict the number of units sold will drop at least 10 percent.
Sales managers generally are very opposed to giving up any
sales volume, especially a loss of market share that could be
difficult to recapture later. Any move that decreases sales vol-
ume has to be considered very carefully. But for the moment
let™s put aside these warnings. Would a 10 percent sales price
hike be a good move if sales volume dropped only 10 percent?
The profit analysis for this trade-off is shown in Figure
11.4. However, before you look at it, what would you expect?
An increase in profit? Yes, but would you expect the profit
increases to be as large as shown in Figure 11.4? The unit
margins on each product line would increase substantially,
from 28 percent on the premier products to 72 percent on the
generic products. These explosions in unit margins would
more than offset the drop in sales volumes and would make
for dramatic increases in profit. Fixed expenses wouldn™t go
up with the decrease in sales volume. If anything, some of the
fixed operating costs possibly could be reduced at the lower
sales volume level.
The big jumps in profit reported in Figure 11.4 are based
on the prediction that sales volume would drop only 10 per-
cent. But actual sales might fall 15, 20, or even 25 percent.

157
PROFIT AND CASH FLOW ANALYSIS




Before After Change
Standard Product Line
Sales price $100.00 $110.00 10%
Product cost $65.00 $65.00
Revenue-driven expenses $8.50 $9.35 10%
Unit-driven expenses $6.50 $6.50
Unit margin $20.00 $29.15 46%
’10%
Sales volume 100,000 90,000
Contribution margin $2,000,000 $2,623,500 31%
Fixed operating expenses $1,000,000 $1,000,000
Profit $1,000,000 $1,623,500 62%

Generic Product Line
Sales price $75.00 $82.50 10%
Product cost $57.00 $57.00
Revenue-driven expenses $3.00 $3.30 10%
Unit-driven expenses $5.00 $5.00
Unit margin $10.00 $17.20 72%
’10%
Sales volume 150,000 135,000
Contribution margin $1,500,000 $2,322,000 55%
Fixed operating expenses $500,000 $500,000
Profit $1,000,000 $1,822,000 82%

Premier Product Line
Sales price $150.00 $165.00 10%
Product cost $80.00 $80.00
Revenue-driven expenses $11.25 $12.38 10%
Unit-driven expenses $8.75 $8.75
Unit margin $50.00 $63.87 28%
’10%
Sales volume 50,000 45,000
Contribution margin $2,500,000 $2,874,375 15%
Fixed operating expenses $1,500,000 $1,500,000
Profit $1,000,000 $1,374,375 37%
FIGURE 11.4 10 percent higher sales prices and 10 percent lower sales
volumes.




158
PRICE/VOLUME TRADE-OFFS


Profit can be calculated for any particular sales volume
decrease prediction, of course. No one knows how sales vol-
ume might respond to a 10 percent sales price increase. Sales
may not decrease at all. For instance, the higher prices might
enhance the prestige or upscale image of the standard prod-

<<

. 27
( 55 .)



>>