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brand names plus one product sold as a generic product (no
brand name is associated with the product) to a supermarket
chain. Figure 17.2 presents your management profit report
for the most recent year.

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Products Product Line Totals
Generic Economy Standard Deluxe Premier Units Dollars
Sales price $28.25 $42.50 $60.00 $75.00 $95.00 $5,261,000
Product cost ($20.05) ($26.65) ($32.00) ($36.00) ($40.60) ($2,886,500)
Variable expenses ($1.13) ($6.80) ($11.80) ($16.50) ($21.15) ($922,390)
Unit margin $7.07 $9.05 $16.20 $22.50 $33.25 $1,452,110
% of sales price 25% 21% 27% 30% 35% 28%

Sales volume 28,000 18,000 35,000 10,000 9,000 100,000
% of total sales volume 28% 18% 35% 10% 9% 100%

Contribution margin $197,960 $162,900 $567,000 $225,000 $299,250 $1,452,110
% of contribution margin 14% 11% 39% 15% 21% 100%
Fixed expenses ? ? ? ? ? ($766,000)
Profit ? ? ? ? ? $686,110


The question is whether or not to allocate the total fixed expenses among the five
products to determine profit attributable to each product line.

FIGURE 17.2 Management profit report.




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All five products are earning a contribution margin”though
these unit profit margins vary in dollar amount and by percent
of sales price across the five products. The premier product
has the highest percent of profit margin (35 percent), as well
as the highest dollar amount of unit margin ($33.25). You
might notice that the generic model has a higher percent of
contribution margin and generates more total contribution
margin than the economy model.
Production costs are cut to the bone on the generic product,
and no advertising or sales promotion of any type is done on
the product”the variable expenses are mainly delivery costs.
Product cost is highest for the premier product because the best
raw materials are used and additional labor time is required to
produce top-of-the-line quality. Also, variable advertising and
sales promotion costs are very heavy for this product; variable
expenses are 22 percent of sales price for this product ($21.15
variable expenses · $95.00 sales price = 22%).
Y
The economy model accounts for 18 percent of sales vol-
FL
ume but only 11 percent of total contribution margin. The
premier model accounts for only 9 percent of sales volume but
yields 21 percent of total contribution margin. Which brings
AM


up the very important issue of determining the best, or opti-
mal, sales mix. The comparative information presented in Fig-
ure 17.2 is very useful for making marketing decisions. Shifts
TE




in sales mix and trade-offs among the products are important
to understand.
The marketing strategy of many businesses is to encourage
their customers to trade up, or move up to the higher-priced
items in their product line. As a rule, higher-priced products
have higher unit margins. This general rule applies mainly to
mature products, which are those products in the middle-age
or old phases of their life cycles.

Newer products in the infant and adolescent stages of their life
cycles often have a competitive advantage. During the early
phases of their life cycle, new products may enjoy high profit
margins until competition catches up and forces sales price
and/or sales volume down. In fact, the CEO of Kodak made this
very point a few years ago in an article in the New York Times.
Compare the following two products: standard versus
deluxe. You make a $6.30 higher unit contribution profit
margin on the deluxe product ($22.50 deluxe ’ $16.20

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MANAGEMENT CONTROL


standard = $6.30). Giving up one unit of standard in trade-
off for one unit of deluxe would increase total contribution
margin without any change in your total fixed expenses.
Marketing strategies should be based on contribution margin
information such as that presented in Figure 17.2.
The position of the economy model is interesting because
its contribution margin is by far the lowest of the company-
brand products and not much more than the generic model.
The economy model may be in the nature of a loss leader or,
more accurately, a minimum-profit leader”a product on
which you don™t make much margin but one that is necessary
to get the attention of customers and that serves as a spring-
board or stepping-stone for customers to trade up to higher-
priced products.
But the opposite may happen. In tough times, many cus-
DANGER!
tomers may trade down from higher-priced models and
buy products that yield lower profit margins. Large num-
bers of customers may trade down to the standard or the
economy models. Dealing with this downscaling is a challeng-
ing marketing problem. Perhaps the sales prices on the lower-
end products could be raised to increase their unit margins;
perhaps not.
Should you be making and selling the generic product? On
the one hand, this product brings in 28 percent of your total
sales volume and 14 percent of total contribution margin. On
the other hand, these units may be taking sales away from
your other four products”though this is hard to know for cer-
tain. This question has to be answered by market research.
If the generic product were not available in supermarkets,
would these customers buy one of your other models? If all
these customers would buy the economy model, you would be
better off; you™d be giving up sales on which you make a unit
contribution profit margin of $7.07 for replacement sales on
which you would earn $9.05, or almost $2.00 more per unit. If
customers shifted to the standard or higher models you would
be ahead that much more, though it would seem that customers
who tend to buy generic products are not likely to trade up.
Many different marketing questions can be raised. Indeed,
the job of the manager is to consider the whole range of mar-
keting strategies, including the positioning of each product,
setting sales prices, the most effective means of advertising,
and so on. Deciding on sales strategy requires information on

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contribution profit margins and sales mix such as that pre-
sented in Figure 17.2. The exhibit is a good tool of analysis for
making marketing decisions regarding the optimal sales mix.

Fixed Expenses: To Allocate or Not?
When selling two or more products, inevitably there are fixed
operating expenses that cannot be directly matched or cou-
pled with the sales of each product or each separate stream of
sales revenue. The unavoidable question is whether or not to
allocate the total fixed operating expenses among the prod-
ucts. Refer to Figure 17.2, please; notice that fixed expenses
are not allocated. Should these fixed expenses be distributed
among the five different products in some manner?

Fixed expenses generally fall into two broad cate-
gories: (1) sales and marketing expenses and
(2) general and administrative expenses. Most fixed operat-
ing expenses are indirect; the expenses cannot be directly
associated with particular products. The example here
assumes there are no direct fixed expenses for any of the
products. On the other hand, there could be some direct
fixed expenses.
For example, an advertising campaign may feature only
one product. Suppose you bought a one-time insertion in the
Wall Street Journal for the premier product. The cost of this
one-time ad should be deducted from the contribution margin
of the premier product as a direct fixed expense. Typically,
however, most fixed expenses are indirect; they cannot be
directly matched to any one product.
Indirect fixed expenses can be allocated to products,
although the purposes and methods of allocation are open to
much debate and differences of opinion. For instance, the
allocation can be done on the basis of sales volume, which
means each unit sold would be assigned an equal amount of
the total fixed expense. Or fixed costs can be allocated on the
basis of sales revenue, which means that each dollar of sales
revenue would be assigned an equal amount of total fixed
expense. Alternatively, fixed costs can be allocated according
to a more complex formula.
Figure 17.3 shows two alternative profit reports for the
example”one in which total fixed expenses are allocated on

266
Method A: Fixed Expenses Allocated on Basis of Sales Volume
Generic Economy Standard Deluxe Premier
Sales revenue $791,000 $765,000 $2,100,000 $750,000 $855,000
Cost-of-goods-sold expense ($561,400) ($479,700) ($1,120,000) ($360,000) ($365,400)
Gross margin $229,600 $285,300 $ 980,000 $390,000 $489,600
Variable expenses ($ 31,640) ($122,400) ($ 413,000) ($165,000) ($190,350)
Contribution margin $197,960 $162,900 $ 567,000 $225,000 $299,250
Fixed expenses ($214,480) ($137,880) ($ 268,100) ($ 76,600) ($ 68,940)
Profit (loss) ($ 16,520) $ 25,020 $ 298,900 $148,400 $230,310

Method B: Fixed Expenses Allocated on Basis of Sales Revenue
Generic Economy Standard Deluxe Premier
Sales revenue $791,000 $765,000 $2,100,000 $750,000 $855,000
Cost-of-goods-sold expense ($561,400) ($479,700) ($1,120,000) ($360,000) ($365,400)
Gross margin $229,600 $285,300 $ 980,000 $390,000 $489,600
Variable expenses ($ 31,640) ($122,400) ($ 413,000) ($165,000) ($190,350)
Contribution margin $197,960 $162,900 $ 567,000 $225,000 $299,250
Fixed expenses ($115,169) ($111,384) ($ 305,759) ($109,200) ($124,488)
Profit (loss) $ 82,791 $ 51,516 $ 261,241 $115,800 $174,762
FIGURE 17.3 Two common methods for allocating fixed expenses.




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basis of sales volume (method A), and the second on the basis
of sales revenue of each product (method B). Total profit for
the product line is the same for both, but the operating profit
reported for each product differs between the two allocation
methods.
Both sales volume and sales revenue for allocating fixed
costs have obvious shortcomings; furthermore, both methods
are rather arbitrary. Either method rests on a dubious prem-
ise. Method A assumes that each and every unit has the same
fixed cost. Method B assumes that each and every sales rev-
enue dollar has the same fixed cost. Recent attention has
been focused on the theory of cost drivers to allocate fixed
expenses, which goes under the rubric of activity based cost-
ing (ABC). This approach should really be called activity
based cost allocation, because it™s a method to allocate indi-
rect costs to products.


Activity Based Costing (ABC)
The ABC method challenges the premise that fixed expenses
are truly and completely indirect. Total fixed expenses are
subdivided into separate cost pools; a separate cost pool is
determined for each basic activity or support service. Instead
of lumping all fixed costs into one conglomerate pool of gen-
eral support, each basic type of support activity is identified
with its own separate cost pool. Each product is then analyzed
to determine and measure the usage the product makes of
each activity for which separate fixed-expense pools are
established.
In this example, for instance, all products except the
generic model are advertised, and all advertising is done
through the advertising department of the corporation. The
advertising department is defined as one separate fixed-cost
pool, and its activity is measured according to some common
denominator of activity, such as number of ad pages run in
the print media (newspapers and magazines). Each product is
allocated a share of the total advertising department™s cost
pool based on the number of ad pages run for that product.
The number of ad pages is called a cost driver. This activity
drives, or determines, the amount of the fixed-cost subpool to
be allocated to each product.
Alternatively, different types of advertising (print versus

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electronic media, for example) could be identified and each
product line charged with its share of the advertising depart-
ment™s cost based on two separate cost drivers”one for the
number of print media pages and a second for the number of
minutes on television or radio.
Some fixed expenses are quite indirect and far removed
from particular products. Examples include the accounting
department, the legal department, the annual CPA audit fee,
the cost of security guards, general liability insurance, and
many more. The cost driver concept would get stretched to its

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