Financial Aspects of Marketing ManagementChapter 2

In this chapter, you will learn aboutVariable and Fixed CostsRelevant and Sunk CostsMarginsGross MarginTrade MarginNet Profit Margin (Before Taxes)Contribution AnalysisBreak-even AnalysisSensitivity AnalysisContribution Analysis and Profit Impact

In this chapter, you will learn aboutContribution Analysis (contd.)Contribution Analysis and Market SizeContribution Analysis and Performance MeasurementAssessment of CannibalizationLiquidityOperating LeverageDiscounted Cash FlowPreparing a pro forma Income Statement

Types of Cost

Expenses that are uniform per unit of output within a relevant time periodAs volume increases, total variable costs increaseVariable Costs are

THERE ARE TWO CATEGORIES OFVARIABLE COSTSCost of Goods SoldOther Variable Costs

For Manufacturer or Provider of ServiceCovers materials, labor and factory overhead applied directly to productionFor Reseller (Wholesaler or Retailer)Covers primarily the cost of merchandiseVariable Costs Cost of Goods Sold

Other Variable CostsExpenses not directly tied to production but vary directly with volumeExamples include:Sales commissions, discounts, and delivery expenses

Expenses that do not fluctuate with output volume within a relevant time periodThey become progressively smaller per unit of output as volume increasesNo matter how large volume becomes, the absolute size of fixed costs remains unchangedFixed Costs

THERE ARE TWO CATEGORIES OFFIXED COSTSProgrammed costsCommitted costs

Result from attempts to generate sales volumeExamples include:Advertising, sales promotion, and sales salariesFixed Costs Programmed Costs

Costs required to maintain the organizationExamples include nonmarketing expenditures, such as:rent, administrative cost, and clerical salariesFixed 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 costsRelevant Costs are

The direct opposite of relevant costs.Past expenditures for a given activityTypically irrelevant in whole or in part to future decisionsExamples of sunk costs:Past marketing research and development expendituresLast years advertising expenseSunk 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

MarginsThe difference between the selling price and the cost of a product or serviceMargins are expressed in both dollar terms or as percentages on: a total volume basis, or an individual unit basis

Gross Margin or Gross ProfitOn a total volume basis:The difference between total sales revenue and total cost of goods soldOn a per-unit basis:The difference between unit selling price and unit cost of goods sold

Gross MarginTotal Gross MarginDollar AmountPercentageNet Sales$100100%Cost of Goods Sold- 40- 40Gross Profit Margin$ 60 60%Unit Gross MarginUnit Sales Price$1.00100%Unit Cost of Goods Sold- 0.40- 40Unit Gross Profit Margin$0.60 60%

Trade Margin (Markup)

Trade Margin

Net Profit Margin(before taxes)

Kelloggs Cereal Margins at a Price of $2.72 per boxKelloggs Direct Unit Manufacturing CostGrain$.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)/$2.72Kelloggs 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 AnalysisContribution isThe difference between total sales revenue and total variable costsOR on a per-unit basisThe 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 organizations break-even sales volume: Total Revenue = Total CostBreak-Even Analysis

Break-even Analysis Chart

Break-even AnalysisExampleFixed 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 AnalysisSensitivity AnalysisProfit ImpactMarket SizePerformance MeasurementAssessment of Cannibalization

LiquidityRefers to a companys ability to meet short-term financial obligationsVery important for a companys day-to-day operationsA 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 FlowDiscounted 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 businesss net cash flows

Discounted Cash FlowThe discount rate can be expressed as follows:

Discount factor = ___1___ (1 + r)n

Where the r in the denominator is the interest rate and n is the number of years

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.

Discounted Cash FlowExampleSuppose you were to collect $1 million in 5 years. If the discount rate used were 10%, the present value of the $1 million would be: 1PV = X $1,000,000 = $620,921.32 (1 + 0.10)5

Preparing a pro forma Income StatementA 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 expensesSales expenses$170,000Advertising expenses 90,000Freight or delivery expenses 40,000 300,000General and administrative expensesAdministrative salaries$120,000Depreciation on buildings and equipment 20,000Interest expense 5,000Property taxes and insurance 5,000Other administrative expenses 5,000 155,000Net profit before (income) tax $45,000

Preparing a pro forma Income StatementSales forecasted unit volume times selling priceCost of goods sold costs incurred in buying or producing products and servicesGross margin represents the remainder after cost of goods sold has been subtracted from sales

Preparing a pro forma Income StatementMarketing Expenses programmed expenses to be spent on increasing salesGeneral & Administrative Expenses fixed costs (often referred to as overheads)Net Income before Taxes sales revenues minus all costs