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caused by the cost increase. It takes a large increase in sales
volume to make up for the drop in the unit margin.
There is more bad news. More capital would be needed at
the higher sales volume level; the capital invested in assets
would be higher due mainly to increases in accounts receiv-
able and inventory. The impact on cash flow at the higher
sales volume level is explained in Chapter 13.


BETTER PRODUCT AND SERVICE PERMITTING
HIGHER SALES PRICE
The alternative to selling more units to overcome the cost
increases is to sell the same number of units at a higher sales
price. Figure 12.2 presents the higher sales price that would
keep profit the same as before, given the 4 percent higher
product cost and 4 percent higher unit-driven variable
expenses. In this scenario the cost increase is loaded into the
sales price and is not reflected in a sales volume increase.
Following this strategy, the sales price would be increased
to $103.13 (rounded).* In this case the business improved the
product and the service to its customers. There is no increase
in profit. This product upgrade would be customer-driven”if

*The required sales price is computed as follows: ($67.60 product cost +
$6.76 unit-driven cost + $20.00 unit margin) · (1.000 ’ 0.085) = $103.13
sales price (rounded). In other words, the sales price, net of the revenue-
driven cost per unit as a percent of sales price, must cover the product cost
and the sales volume“driven expense per unit and provide the same unit
margin as before.

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PROFIT AND CASH FLOW ANALYSIS




Standard Product Line
Before After Change
Sales price $100.00 $103.13 3.1%
Product cost $65.00 $67.60 4.0%
Revenue-driven expenses $8.50 $8.77
Unit-driven expenses $6.50 $6.76 4.0%
Unit margin $20.00 $20.00
Sales volume 100,000 100,000
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 12.2 Higher sales price required for a 4 percent cost increase




the company failed to improve its product and/or service, then
it might lose sales, because the customers want the improve-
ments and are willing to pay. This may seem to be a strange
state of affairs, but you see examples every day where the cus-
tomer wants a better product and/or service and is willing to
pay more for the improvements.


LOWER COSTS: THE GOOD AND BAD
Suppose a business were able to lower its unit product costs
and its variable expenses per unit. On the one hand, such cost
savings could be true efficiency or productivity gains. Sharper
bargaining may reduce purchase costs, for example, or better
manufacturing methods may reduce labor cost per unit pro-
duced. Wasteful fixed overhead costs could be eliminated or
slashed. The key question is whether the company™s products
remain the same, whether the products™ perceived quality
remains the same, and whether the quality of service to cus-
tomers remains the same.
Maybe not. Product cost decreases may represent quality
degradations, or possibly reduced sizes such as smaller candy
bars or fewer ounces in breakfast cereal boxes. Reducing vari-
able operating expenses may adversely affect the quality of
service to customers”for instance, by spreading fewer per-
sonnel over the same number of customers.

166
COST/VOLUME TRADE-OFFS


Lower Costs and Higher Unit Margin
If the company can lower its costs and still deliver the same
product and the same quality of service, then sales volume
should not be affected (everything else remaining the same, of
course). Customers should see no differences in the products
or service. In this case the cost savings would improve unit
margins and profit would increase accordingly.
Improvements in the unit margins are very powerful; these
increases have the same type of multiplier effect as the oper-
ating leverage of selling more units. For example, suppose
that because of true efficiency gains the business is able to
lower product costs and unit-driven expenses such that unit
margin on its standard product line is improved, say, $1.00
per unit. Now this may not seem like much, but remember
that the business sells 100,000 units during the year.
Therefore, the $1.00 improvement in unit margin would
add $100,000 to the contribution margin line, which is a 5
percent gain on its original $2 million contribution margin.
Lowering product cost and the unit-driven operating costs
should not cause fixed costs to change, so all of the $100,000
contribution margin gain would fall to profit. The $100,000
gain in profit is a 10 percent increase on the $1 million origi-
nal profit, or double the 5 percent gain in contribution margin.
Total quality management (TQM) is getting a lot of press
today, indicated by the fact that it has been reduced to an
acronym. Clearly, managers have always known that product
quality and quality of service to customers are absolutely criti-
cal factors, though perhaps they lost sight of this in pursuit of
short-term profits. Today, however, managers obviously have
been made acutely aware of how quality conscious customers
are (though I find it surprising that today™s gurus are preach-
ing this gospel as if it were just discovered).

Lower Costs Causing Lower Sales Volume
Cost savings may cause degradation in the quality of the prod-
uct or service to customers. It would be no surprise, therefore,
if sales volume would decrease. The unit margin would
improve, but sales volume may drop as some customers aban-
don the business because of poorer product quality. Still, a
business might adopt the strategy of deliberately knocking
down the quality of its products (or some of its products) and

167
PROFIT AND CASH FLOW ANALYSIS


the general level of service to its customers to boost unit mar-
gin, gambling that the higher unit margin will more than offset
the loss of sales volume. (Of course, this brings up the loss-of-
market-share problem again, which I won™t go into here.)
To illustrate this scenario of lower cost and lower sales vol-
ume, suppose the business could lower the product costs in its
standard product line from $65.00 to $60.00 per unit, but this
cost savings results in lesser-grade materials, cheaper trim,
and so forth. And the company could save on its shipping
costs and reduce its unit-driven variable costs from $6.50 to
$5.00 per unit, but in exchange delivery time to the customers
would take longer. The combined $6.50 cost savings would
increase unit margin by the same amount. The general man-
ager of this profit module knows that many customers will be
driven off by the changes in product quality and delivery
times. She wants to know just how far sales volume would
have to fall to offset the $6.50 gain in unit margin.
Figure 12.3 shows that if sales volume fell to 75,472 units,
profit would be the same. In other words, selling 75,472 units
at a $26.50 unit margin each would generate the same con-
tribution margin as before. If sales fell by only 10,000 or
15,000 units, profit would be more than before. And, cer-
tainly, fixed costs would not go up at the lower sales volume.
If anything, fixed costs probably could be reduced at the
lower sales volume.




Standard Product Line
Before After Change
Sales price $100.00 $100.00
’7.7%
Product cost $65.00 $60.00
Revenue-driven expenses $8.50 $8.50
’23.1%
Unit-driven expenses $6.50 $5.00
Unit margin $20.00 $26.50 32.5%
’24.5%
Sales volume 100,000 75,472
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 12.3 Lower costs causing lower sales volume.



168
COST/VOLUME TRADE-OFFS



This sort of profit strategy goes against the grain of many
managers. Of course, the business could lose more than 25
percent of sales volume, in which case its profit would be
lower than before. Once a product becomes identified as a
low-cost/low-quality brand, it™s virtually impossible to reverse
this image in the minds of most customers. Thus, it™s no sur-
prise why many managers take a dim view of this profit strat-
egy.


SUBTLE AND NOT-SO-SUBTLE CHANGES
IN FIXED COSTS
Why do fixed operating expenses increase? The increase may
be due to general inflationary trends. For instance, utility bills
and insurance premiums seem to drift relentlessly upward;
they hardly ever go down. In contrast, fixed operating
expenses may be deliberately increased to expand capacity.
The business could rent a larger space or hire more employ-
ees on fixed salaries.
And there™s a third reason: Fixed expenses may be
increased to improve the sales value of the present location.
The business could invest in better furnishings and equipment
(which would increase its annual depreciation expense). Fixed
expenses could decrease for the opposite reasons, of course.
But, we™ll focus on increases in fixed expenses.
Suppose in the company example that total fixed operating
expenses were to increase due to general inflationary trends.
There were no changes in the capacity of the business or in
the retail space or appearance (attractiveness) of the space. As
far as customers can tell there have been no changes that
would benefit them. The company could attempt to increase
its sales price”the additional fixed expenses could be spread
over its present sales volume.
However, this assumes sales volume would remain the
same at the higher sales price. Sales volume might decrease
at the higher sales price unless customers accept the increase
as a general inflationary-driven increase. Sales volume might
be sensitive to even small sales price increases. Many cus-
tomers keep a sharp eye on prices, as you know. The business
should probably allow for some decrease in sales volume
when sales prices are raised.

169
PROFIT AND CASH FLOW ANALYSIS


SURVIVAL ANALYSIS
As I recall, many years ago there was a series in a magazine
called “Can This Marriage Be Saved?” Which is not a bad way
to introduce the situation in which any business can find itself
from time to time”selling a product or product line that is
losing money hand over fist. Perhaps the entire business is in
dire straits and can™t make money on any of its products.
Before throwing in the towel, the manager in charge should at
least do the sort of analysis explained in this chapter to deter-
mine what would have to be done to salvage the product or
keep the business going.


Profile of a Loser
A successful formula for making profit can take a wrong turn
anytime. Every step on the pathway to profit is slippery and
requires constant attention. Managers have to keep a close
watch on all profit factors, continuously looking for opportuni-
ties to improve profit. Nothing can be taken for granted. A
popular term these days is environmental scan, which is a
good term to use here. Managers should scan the profit radar
to see if there are any blips on the screen that signal trouble.
Suppose you™re the manager in charge of a product line,
territory, division, or some other major organization unit of a
large corporation. You are responsible for the profit perform-
ance of your unit, of course. A brief summary of your most
recent annual profit report is presented in Figure 12.4, which
is titled the Bad News Profit Report to emphasize the loss for
the year. This report is shown in a condensed format to limit
attention to absolutely essential profit factors. Only one vari-
able operating expense is included (which is unit-driven). The
examples in this and previous chapters also include revenue-
driven variable operating expenses, but this distinction takes
a backseat in the following analysis.
In addition to sales volume, note that the example also
includes annual capacity and breakeven volume for the year
just ended.
You have taken a lot of heat lately from headquarters for
the $145,000 loss. Your job is to turn things around”and
fairly fast. Your bonus next year, and perhaps even your job,
depends on moving your unit into the black.


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