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ucts and attract a more upscale clientele who are quite willing
to pay the higher price. Or sales may drop more than 25 per-
cent because customers search for better prices elsewhere.
How much could sales volume fall and keep total contribu-
tion margin the same? This sales volume is computed for the
standard product line as follows:
$2,000,000 contribution margin target
= 68,611 units
$29.15 higher unit margin
Sales volume would have to drop more than 30 percent (from
100,000 units in the original scenario to less than 70,000
units at the higher sales prices). Sales may not drop off this
much, at least in the short run. And fixed operating expenses
probably could be reduced at the lower sales volume level.
Given a choice, my guess is that the large majority of busi-
ness managers would prefer keeping their market share and
not giving up any sales volume, even though profit could be
maximized with higher sales prices and lower sales volumes.
Protecting sales volume and market share is deeply ingrained
in the thinking of most business managers.
Any loss of market share is taken very seriously. By and
large, you™ll find that successful companies have built their
success on getting and keeping a significant market share so
that they are a major player and dominant force in the mar-
ketplace.
True, some companies don™t have a very large market
share”they carve out a relatively small niche and build their
business on low sales volume at premium prices. The preced-
ing analysis for the premier product line demonstrates the
profit potential of this niche strategy, which is built on higher
unit margins that more than make up for smaller sales vol-
ume.



s
END POINT
Seldom does one profit factor change without changing or
being changed by one or more other profit factors. The inter-

159
PROFIT AND CASH FLOW ANALYSIS


action effects of the changes should be carefully analyzed
before making final decisions or locking into a course of
action that might be difficult to reverse. Managers should keep
their attention riveted on unit margin. Profit performance is
most responsive to changes in the unit margin.
Basically, there are only two ways to improve unit margin:
(1) increase sales price or (2) decrease product cost and/or
other variable operating expenses per unit (see Chapter 12).
The sales price is the most external or visible part of the
business”the factor most exposed to customer reaction. In
contrast, product cost and variable expenses are more inter-
nal and invisible. Customers may not be aware of decreased
expenses unless such cost savings show up in lower product
quality or worse service.
Last, the importance of protecting sales volume and market
share is mentioned in the chapter. Marketing managers know
what they™re talking about on this point, that™s for sure.
Recapturing lost market share is not easy. Once gone, cus-
tomers may never return.




160
12
CHAPTER




Cost/Volume
Trade-Offs and
Survival Analysis


I
It might seem simple enough. Suppose your unit product cost
goes up. Then all you have to do is to raise sales price by the
same amount to keep the contribution margin the same, true?
Not exactly. Sales volume might be affected by the higher
price, of course. Even if sales volume remained the same, the
higher sales price causes revenue-driven expenses to increase.
So it™s more complicated than it might first appear.


PRODUCT COST INCREASES: WHICH KIND?
There are two quite different reasons for product cost
increases. First is inflation, which can be of two sorts. General
inflation is widespread and drives up costs throughout the
economy, including those of the products sold by the business.
Or inflation may be localized on particular products”for
example, problems in the Middle East may drive up oil and
other energy costs; floods in the Midwest may affect corn and
soybean prices. In either situation, the product is the same
but now costs more per unit.
The second reason for higher product costs is quite differ-
ent than inflation. Increases in unit product costs may reflect
either quality or size improvements. In this situation the prod-
uct itself is changed for the better. Customers may be willing
to pay more for the improved product, with the result that the

161
PROFIT AND CASH FLOW ANALYSIS


company would not suffer a decrease in sales volume. Or, if
the sales price remains the same on the improved product,
then sales volume may increase.
Customers tend to accept higher sales prices if they per-
ceive that the company is operating in a general inflationary
market environment, when everything is going up. On a com-
parative basis, the product does not cost more relative to price
increases of other products they purchase. Sales volume may
not be affected by higher sales prices in a market dominated
by the inflation mentality. On the other hand, if customers™
incomes are not rising in proportion to sales price increases,
demand would likely decrease at the higher sales prices.
If competitors face the same general inflation of product
costs, the company™s sales volume may not suffer from pass-
ing along product cost increases in the form of higher sales
prices because the competition would be doing the same
thing. The exact demand sensitivity to sales price increases
cannot be known except in hindsight. Even then, it™s difficult
to know for sure, because many factors change simultane-
ously in the real world.

Whenever sales prices are increased due to increases in prod-
uct costs”whether because of general or specific inflation or
product improvements”managers cannot simply tack on the
product cost increase to sales price. They should carefully
take into account variable expenses that are dependent on
(driven by) sales revenue.
To illustrate this point, consider the standard product line
example from previous chapters. The sales price and per-unit
costs for the product are as follows (from Figure 9.1).


Standard Product
Sales price $100.00
Product cost $ 65.00
Revenue-driven expenses @ 8.5% $ 8.50
Unit-driven expenses $ 6.50
Unit margin $ 20.00


Suppose, for instance, that the company™s unit product cost
goes up $9.15, from $65.00 to $74.15 per unit. (This is a

162
COST/VOLUME TRADE-OFFS


rather large jump in cost, of course.) The manager shouldn™t
simply raise the sales price by $9.15. In the example, the
revenue-driven variable operating expenses are 8.5 percent
of sales revenue. So the necessary increase in the sales price
is determined as follows:
$9.15 product cost increase
= $10.00 sales price increase
0.915
Dividing by 0.915 recognizes that only 91.5 cents of a sales
dollar is left over after deducting revenue-driven variable
expenses, which equal 8.5 cents of the sales dollar. Only 91.5
cents on the dollar is available to provide for the increase in
the unit product cost. If the business raises its sales price
exactly $10.00 (from $100.00 to $110.00), the unit margin for
the standard product would remain exactly the same, which is
shown as follows:


Standard Product Sales Price for Higher Product Cost
Sales price $110.00
Product cost $ 74.15
Revenue-driven expenses @ 8.5% $ 9.35
Unit-driven expenses $ 6.50
Unit margin $ 20.00


Therefore the company™s total contribution margin would
be the same at the $110.00 sales price, assuming sales vol-
ume remains the same, of course.


VARIABLE COST INCREASES AND SALES VOLUME
As just mentioned, one basic type of product cost increase
occurs when the product itself is improved. These quality
improvements may be part of the marketing strategy to stim-
ulate demand by giving customers a better product at the
same sales price. In addition to product cost, one or more of
the specific variable operating expenses could be deliber-
ately increased to improve the quality of the service to cus-
tomers.
For example, faster delivery methods such as overnight
Federal Express could be used, even though this would cost

163
PROFIT AND CASH FLOW ANALYSIS


more than the traditional delivery methods. This would
increase the volume-driven expense. The company could
increase sales commissions to improve the personal time and
effort the sales staff spends with each customer, which would
increase the revenue-driven expense.
In our example, suppose the general manager of the stan-
dard product line is considering a new strategy for product
and service quality improvements that would increase product
cost and unit-driven operating expenses 4 percent. Revenue-
driven variable expenses would be kept the same, or 8.5 per-
cent of sales revenue. Tentatively, she has decided not to
increase sales prices because in her opinion the improved
products and service would stimulate demand for these prod-
ucts. It goes without saying that customers would have to be
aware of and convinced that the product has improved.
Before making a final decision, she asks the critical question:
What increase in sales volume would be necessary just to
Y
keep profit the same?
FL
Figure 12.1 presents this even-up, or standstill, scenario
in which product cost and unit-driven variable expenses
increase 4 percent but sales price remains the same. Fixed
AM


expenses are held constant, as is the variable revenue-driven
operating expenses. Sales volume would have to increase
16,686 units, or 16.7 percent. By the way, the required sales
TE




Standard Product Line
Before After Change
Sales price $100.00 $100.00
Product cost $65.00 $67.60 4.0%
Revenue-driven expenses $8.50 $8.50
Unit-driven expenses $6.50 $6.76 4.0%
’14.3%
Unit margin $20.00 $17.14
Sales volume 100,000 116,686 16.7%
Contribution margin $2,000,000 $2,000,000
Fixed operating expenses $1,000,000 $1,000,000
Profit $1,000,000 $1,000,000
FIGURE 12.1 Sales volume required for a 4 percent cost increase.



164
COST/VOLUME TRADE-OFFS


volume for this scenario of higher cost and lower unit margin
can be computed directly as follows:

Required Sales Volume at Higher Costs
$2,000,000 contribution margin target
$17.14 lower unit margin
= 116,686 sales volume

The relatively large increase in sales volume needed to offset
the relatively minor 4 percent cost increase is because the cost
increase causes a 14.3 percent drop in unit margin. So a 16.7
percent jump in sales volume would be needed to keep profit
at the same level. The key point is the drop in the unit margin

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