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Financial Aspects of Marketing Management

Chapter 2

by Subbu SivaramakrishnanUniversity of Manitoba

In this chapter, you will learn about…

1. Variable and Fixed Costs2. Relevant and Sunk Costs3. Margins

Gross MarginTrade MarginNet Profit Margin (Before Taxes)

4. Contribution AnalysisBreak-even AnalysisSensitivity AnalysisContribution Analysis and Profit Impact

In this chapter, you will learn about…

4. Contribution Analysis (contd.)Contribution Analysis and Market SizeContribution Analysis and Performance MeasurementAssessment of Cannibalization

5. Liquidity6. Operating Leverage7. Discounted Cash Flow8. Preparing a pro forma Income

Statement

Costs

FixedCosts

Variable Costs

Types of Cost

Expenses that are uniform per unit of output within a relevant time period

As volume increases, total variable costs increase

Variable Costs are…

THERE ARE TWO CATEGORIES OFVARIABLE COSTS

1. Cost of Goods Sold

2. Other Variable Costs

For Manufacturer or Provider of Service Covers materials, labor and factory

overhead applied directly to production

For Reseller (Wholesaler or Retailer) Covers primarily the cost of

merchandise

Variable Costs – Cost of Good Sold

Other Variable Costs

Expenses not directly tied to production but vary directly with volume

Examples include:

Sales commissions, discounts, and delivery expenses

Expenses that do not fluctuate with output volume within a relevant time period

They become progressively smaller per unit of output as volume increases

No matter how large volume becomes, the absolute size of fixed costs remains unchanged

Fixed Costs

THERE ARE TWO CATEGORIES OFFIXED COSTS

1. Programmed costs2. Committed costs

Result from attempts to generate sales volume

Examples include: Advertising, sales promotion, and

sales salaries

Fixed Costs – Programmed Costs

Costs required to maintain the organization

Examples include nonmarketing expenditures such as: rent, administrative cost, and

clerical salaries

Fixed Costs – Committed Costs

Relevant andSunk Costs

Future expenditures unique to the decision alternatives under consideration.

Expected to occur in the future as a result of some marketing actionDiffer among marketing alternatives being consideredIn general, opportunity costs are considered relevant costs

Relevant Costs are…

The direct opposite of relevant costs.

Past expenditures for a given activityTypically irrelevant in whole or in part to future decisions

Examples of sunk costs:Past marketing research and development expendituresLast year’s advertising expense

Sunk Costs are…

When marketing managers attempt to incorporate sunk costs into future decisions, they often fall prey to the Sunk Cost Fallacy – that is, they attempt to recoup spent dollars by spending even more dollars in the future.

Example: Continuing to advertise a failing product heavily in an attempt to recover what has already been spent on it.

Sunk Cost Fallacy

Margins

The difference between the selling price and the “cost” of a product or service

Margins are expressed in both dollar terms or as percentages on:

a total volume basis, or an individual unit basis

Gross Margin or Gross Profit

On a total volume basis:The difference between total sales revenue and total cost of goods sold

On a per-unit basis:The difference between unit selling price and unit cost of goods sold

Gross MarginTotal Gross Margin Dollar Amount Percentage

Net Sales $100 100%

Cost of Goods Sold - 40 - 40

Gross Profit Margin $ 60 60%

Unit Gross Margin

Unit Sales Price $1.00 100%

Unit Cost of Goods Sold - 0.40 - 40

Unit Gross Profit Margin $0.60 60%

Trade Margin (Markup)

Suppose a retailer purchases an item for

$10 and sells it at $20.

Retailer Margin as a percentage of cost is:

($10 / $10) x 100 = 100 %

Retailer Margin as a percentage of selling price is:

($10 / $20) x 100 = 50 %

Trade Margin

Unit Cost of Goods Sold

Unit Selling Price

Gross Margin as a % of

Selling Price

Manufacturer $2.00 $2.88 30.6%

Wholesaler $2.88 $3.60 20.0%

Retailer $3.60 $6.00 40.0%

Consumer $6.00

Net Profit Margin(before taxes)

Dollar Amount Percentage

Net Sales $ 100,000 100%

Cost of Goods Sold - 30,000 - 30

Selling Expenses - 20,000 - 20

Fixed Expenses - 40,000 - 40

Gross Profit Margin $ 70,000 70%

Net Profit Margin $ 10,000 10%

Kellogg’s Cereal Margins at a Price of $2.72 per box

Kellogg’s Direct Unit Manufacturing CostGrain $.18Other Ingredients .23Packaging .31Labor .18Mfg. Overheads .34Cost of Goods Sold $1.24 ––––––– 54.4% Gross Margin

($2.72 - $1.24)/$2.72Promotions (excluding Advertising + .20Total Unit Variable Cost $1.44Manufacturer Contribution to Fixed Cost and Profit $1.28 ––- 47% Contribution Margin

($2.72-$1.44)/$2.72Kellogg’s Selling Price to Grocery Store $2.72Grocery Store Margin .68 ––- 20% Trade Margin

($3.40 - $2.72)/$3.40Grocery Store Selling Price $3.40

Contribution Analysis

Contribution is…

The difference between total sales

revenue and total variable costs

OR on a per-unit basis

The difference between unit selling price

and unit variable cost

Break-even point is the unit or dollar

sales at which an organization neither

makes a profit nor a loss.

At the organization’s break-even sales

volume:

Total Revenue = Total Cost

Break-Even Analysis

LOSS

PROFIT

Total Revenue

Fixed Cost

BE PointTotal Cost

Variable Cost

Unit Volume

Dollars

0

Break-even Analysis Chart

Break-even AnalysisExample

Fixed Costs = $50,000Price per unit = $5Variable Cost = $3Contribution = $5 - $3 = $2Breakeven Volume = $50,000 $2

= 25,000 unitsBreakeven Dollars = 25,000 x $5

= $125,000

Applications of Contribution Analysis

Sensitivity Analysis

Profit Impact

Market Size

Performance Measurement

Assessment of Cannibalization

Liquidity

Refers to a company’s ability to meet

short-term financial obligations

Very important for a company’s day-to-

day operations

A key factor is Working Capital = Current

Assets minus Current Liabilities

Operating LeverageExtent to which fixed costs and variable costs are used in the production and marketing of products and services.

Firms with high total fixed costs relative to total variable costs are defined as having high operating leverage.

Higher operating leverage results in a faster increase in profit once sales exceed break-even volume. The same happens with losses when sales fall below break-even volume.

Discounted Cash Flow

Discounted cash flows are future cash flows expressed in terms of their present valueIncorporates the time value of moneyBased on the premise that a dollar received tomorrow is worth less than a dollar todayUseful in determining a business’s net cash flows

The interest or discount rate is often defined as…

The opportunity cost of capital, which is the cost of earnings opportunities forgone by investing in a business with its attendant risk as opposed to investing in risk-free securities.

Preparing a pro forma Income Statement

A pro forma income statement is a projected income statementIncludes:

Projected RevenuesBudgeted ExpensesEstimated Net Profit

Pro Forma Income Statement – ExampleSales

$1,000,000Cost of goods sold

500,000Gross margin

500,000Marketing expenses

Sales expenses $170,000Advertising expenses 90,000Freight or delivery expenses 40,000 300,000

General and administrative expensesAdministrative salaries $120,000Depreciation on buildings and equipment 20,000Interest expense 5,000Property taxes and insurance 5,000Other administrative expenses 5,000 155,000

Net profit before (income) tax $45,000


Sales – forecasted unit volume times selling price

Cost of goods sold – costs incurred in buying or producing products and services

Gross margin – represents the remainder after cost of goods sold has been subtracted from sales

Marketing Expenses – programmed expenses to be spent on increasing sales

General & Administrative Expenses – fixed costs (often referred to as overheads)

Net Income before Taxes – sales revenues minus all costs


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