Financial Aspects of Marketing Management

Chapter 2 Financial Aspects of Marketing Management

In this chapter, you will learn about… • Variable and Fixed Costs • Relevant and Sunk Costs • Margins • Gross Margin • Trade Margin • Net Profit Margin (Before Taxes) • Contribution Analysis • Break-even Analysis • Sensitivity Analysis • Contribution Analysis and Profit Impact

In this chapter, you will learn about… • Contribution Analysis (contd.) • Contribution Analysis and Market Size • Contribution Analysis and Performance Measurement • Assessment of Cannibalization • Liquidity • Operating Leverage • Discounted Cash Flow • Preparing a pro forma Income Statement

Costs Fixed Costs Variable Costs Types of Cost

Variable Costs are… • Expenses that are uniform per unit of output within a relevant time period • As volume increases, total variable costs increase

THERE ARE TWO CATEGORIES OF VARIABLE COSTS • Cost of Goods Sold • Other Variable Costs

Variable Costs – Cost of Goods Sold • 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

Other Variable Costs • Expenses not directly tied to production but vary directly with volume • Examples include: • Sales commissions, discounts, and delivery expenses

Fixed Costs • 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

THERE ARE TWO CATEGORIES OF FIXED COSTS • Programmed costs • Committed costs

Fixed Costs – Programmed Costs • Result from attempts to generate sales volume • Examples include: • Advertising, sales promotion, and sales salaries

Fixed Costs – Committed Costs • Costs required to maintain the organization • Examples include nonmarketing expenditures, such as: • rent, administrative cost, and clerical salaries

Relevant and Sunk Costs

Relevant Costs are… • Future expenditures unique to the decision alternatives under consideration. • Expected to occur in the future as a result of some marketing action • Differ among marketing alternatives being considered • In general, opportunity costs are considered relevant costs

Sunk Costs are… • The direct opposite of relevant costs. • Past expenditures for a given activity • Typically irrelevant in whole or in part to future decisions • Examples of sunk costs: • Past marketing research and development expenditures • Last year’s advertising expense

Sunk Cost Fallacy 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.

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 Margin Total Gross Margin Dollar Amount Percentage Net Sales $100 100% - 40 Cost of Goods Sold - 40 Gross Profit Margin $ 60 60% Unit Gross Margin Unit Sales Price $1.00 100% - 0.40 Unit Cost of Goods Sold - 40 Unit Gross Profit Margin $0.60 60%

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 (Markup)

Gross Margin as a % of Selling Price Unit Selling Price Unit Cost of Goods Sold Manufacturer $2.00 $2.88 30.6% Wholesaler $2.88 $3.60 20.0% Retailer $3.60 $6.00 40.0% Consumer $6.00 Trade Margin

Dollar Amount Percentage Net Sales $ 100,000 100% Cost of Goods Sold - 30,000 - 30 Gross Profit Margin $ 70,000 70% Selling Expenses - 20,000 - 20 Fixed Expenses - 40,000 - 40 Net Profit Margin $ 10,000 10% Net Profit Margin(before taxes)

Kellogg’s Cereal Margins at a Price of $2.72 per box • Kellogg’s Direct Unit Manufacturing Cost • Grain $.18 • Other Ingredients .23 • Packaging .31 • Labor .18 • Mfg. Overheads .34 • Cost of Goods Sold $1.24–––––––54.4% Gross Margin • ($2.72 - $1.24)/$2.72 • Promotions (excluding Advertising) + .20 • Total Unit Variable Cost $1.44 • Manufacturer Contribution to Fixed Cost • and Profit $1.28––-47% Contribution Margin • ($2.72-$1.44)/$2.72 • Kellogg’s Selling Price to Grocery Store $2.72 • Grocery Store Margin .68––-20% Trade Margin • ($3.40 - $2.72)/$3.40 • Grocery 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 Analysis 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

Dollars Total Revenue BE Point Total Cost PROFIT Variable Cost Fixed Cost LOSS 0 Unit Volume Break-even Analysis Chart

Break-even Analysis Example Fixed Costs = $50,000 Price per unit = $5 Variable Cost = $3 Contribution = $5 - $3 = $2 Breakeven Volume = $50,000  $2 = 25,000 units Breakeven 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 Leverage • Extent 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 value • Incorporates the time value of money • Based on the premise that a dollar received tomorrow is worth less than a dollar today • Useful in determining a business’s net cash flows

Discounted Cash Flow The 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 FlowExample Suppose 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: 1 PV = ———— X $1,000,000 = $620,921.32 (1 + 0.10)5

Preparing a pro formaIncome Statement A pro forma income statement is a projected income statement Includes: • Projected Revenues • Budgeted Expenses • Estimated Net Profit

Pro Forma Income Statement – Example Sales $1,000,000 Cost of goods sold 500,000 Gross margin 500,000 Marketing expenses Sales expenses $170,000 Advertising expenses 90,000 Freight or delivery expenses 40,000300,000 General and administrative expenses Administrative salaries $120,000 Depreciation on buildings and equipment 20,000 Interest expense 5,000 Property taxes and insurance 5,000 Other administrative expenses 5,000155,000 Net profit before (income) tax $45,000

Preparing a pro formaIncome Statement • 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

Preparing a pro formaIncome Statement • 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

Financial Aspects of Marketing Management