Financial Analysis for Product Management

-Rohan M. Thomas-Nikunj Barnwal

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Overview

• Product Managers have the complete profit and loss responsibility for their product.

• To be a part of firms overall decision making, product manager must understand the financial implication of their decision.

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Two kinds of information are important to marketing decision

making:1. The product manager is to have the profit and

loss responsibility or set short & long term objective, he or she must have a good understanding of how profits are computed.

2. Understanding of financial performance is relevant if there is a product line or many product variant because it analyzes the performance of different product variant.

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Sales Analysis

• Defined as “the gathering, classifying, comparing and studying of company sales data”

• Sales analysis is a powerful tool in the hands of a product manager.

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Major component of sales analysis

1. How sales are defined?2. In what units can sales be

analyzed?3. In what categories or classification

can the sales data be placed?4. What are the appropriate

standards against which the sales can be compared?

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Roadblocks

1. Information systems are not designed by product management in mind.

2. Financial and accounting personnel have quite different mindsets and perspective than marketing personnel.

3. Lack of internal marketing on the part of product management.

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Profitability AnalysisProduct: New Call

Income Statements, December 31, 2005(000’s)

Revenue (2M units@ $5) $10,000Less: Direct Labor 2,500 Direct Supervision 500 Social Security 255 Materials 5 Operational Overhead 840Expenses From Operations 4,100Operating or gross margin 5,900Less: Advertising $ 700 Promotions 200 Field sales 1,700 Product Management 25 Marketing Management 250 Product Development 150 Marketing Management 175 Customer Service 1,500 Testing 300 General & Administration 1,000Total Expenses 6,000

Operation Profit (100)

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Strength &Weakness of conventional Product Profit

AccountingStrength: All cost of the operation are covered

by the product.

Weakness: At first glance, it appears the company

would be $100,000 more profitable by eliminating

the product new call?It is difficult to use full-costing approach to

obtain answers for straightforward questions.

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Alternative Accounting System

We can classify accounting systems into 3 groups:

1. Financial or custodial: Useful for external constituents who may care only about the overall financial performance of the company.

2. Performance based: Looks at today's performance based on budget.

3. Contribution based system: Emphasis on the cost the product manager can control. There is a clear distinction between variable and fixed cost.

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Contribution Oriented System

Category Total Cost Variable Fixed

Operating expenses($000)Direct Labor $2500 2500Direct Supervision 500 500Social Security 255 255Materials 5 5Operational overhead 840 200 640Subtotal: $ 4,100 3,460 640Non operating expensesAdvertising $ 700 700Promotion 200 200Field Sales 1,700 200 1,500Product management 25 25Marketing Management 250 250Marketing research 175 175Customer Service 1,500 240 1,260 Testing 300 300General & administration 1,000 1,000Subtotal $ 6,000 $ 440 $5,560Total $ 10,100 3,900 6,200

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Contribution Margin Rate

Breakeven in units = Fixed Costs Variable Margin per

UnitBreakeven in dollars = Fixed Costs

Variable Margin Rate

Safety factor = (Current Sales Volume – Break Even Volume)/Current Volume

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Break-Even Analysis

• Break-even analyses => Short term oriented

• Example of a new product…• What if some fixed cost undergo

incremental change?Re 1/0.33 = Rs 3

• Target profit breakeven = (Target + Fixed Cost)/Contribution Rate

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• Businesses which are more fixed cost-intensive, suffer when sales drop.– Example of Airline Industry (why price-war?)

• Products characterized by different variable margin rates have different strategic problems.– Variable costs are high and CMR is

low=> price needs to be kept high to make profitability high

– Fixed costs are high and Variable costs are low => price needs to be kept high to serve the Fixed costs

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Fixed Costs

• Programmed Direct Fixed Costs- Controlled by managers and are usually expended for a specific planning period. (Eg. Advertising)

• Programmed Indirect Fixed Costs- Controlled by management but cover several products. (Eg. Corporate Umbrella Advertising)

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• Standby Direct Fixed Costs- Don’t change significantly without a major change in operations, Generally not controlled by Product Manager in the short run. (Eg. A facility dedicated to a specific project)

• Standby Indirect Fixed Costs- Corporate Overheads (Eg. CEO’s Salary)

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Product Manager’s Responsibility

• Is his primary responsibility to make a profit by generating revenues in excess of variable costs that cover the fixed cost attributable to her product?

• In other words, the product manager should be responsible for making a profit based on costs that would exist only if the product existed.

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Income Statement: Direct vs. Indirect Fixed Costs

(Pg 454)

Revenues 10,000

Variable Costs (Direct Labor, Supervision, Customer Service, Materials, Operations Overhead etc.)

3,900 3,900

Contribution Margin 6,100

Fixed Costs-

Programmed Direct (Advertising, Promotion, Field Sales, Product Mgmt, Mktng Research etc.)

3,025 3,075

Standby Direct (Operations Overhead, Testing, General & Administrative)

1,240 1,835

Programmed Indirect (Advertising, Mktng Mgmt, Product Development etc.)

1,235

Standby Indirect (General & Administrative) 700 1935

(100)

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• In fact despite showing loss, the Company will be worse off dropping this money-losing product, as it is generating $1.835 m which is covering indirect fixed costs.

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• Full Costing Statement- Top Management & External Constituents.

• Contribution Margin Statement- Easy to read and shows quickly the money going to cover the fixed costs, but doesn’t differentiate between Indirect and Direct fixed costs.

• Statement breaking down Fixed Costs- Most relevant for Product Management as it clearly states how the product is performing.

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Variance Analysis

• Variance- A discrepancy between a planned figure/objective and the actual outcome

• Used for control• Major benefit => Identification of

potential problem areas, not diagnosing the causes of the problems

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An Example

Item Planned Actual Variance

Revenues

Sales (Rs) 20,000,000

22,000,000

2,000,000

Price per lb. ($) 0.5000 0.4773 0.2270

Revenues ($) 10,000,000

10,500,000

500,000

Total Mkt (lbs.) 40,000,000

50,000,000

10,000,000

Share of Mkt 50% 44% 6%

Costs

Variable cost per lb. ($)

30 30 --

Contribution per lb. ($)

0.2000 0.1773 0.0227

Total ($) 4,000,000

3,900,000

(100,000)

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Price-Quantity Decomposition

S => Share, M => Total Market Size, Q => Quantity sold in units, C => Contribution margin per unitPrice/Cost Variance =>(Ca - Cp)* Qa = (0.1773 – 0.2000)* 22,000,000 = -500,000Volume Variance =>(Qa - Qp)* Cp = (22,000,000 – 20,000,000)*

0.20 = 400,000Sum of the variances => -100,000

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Penetration-Market Size Decomposition

• Variance in contribution due to market share => (Sa - Sp)* Ma* Cp

(0.44 – 0.50)* 50,000,000* 0.2 = -600,000

• Offset by the gain from the increased size of the market =>(Ma - Mp)* Sp* Cp

(50,000,000 – 40,000,000)* 0.5* 0.2 = 1,000,000

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Summary of the analysis

Planned Profit Contribution $4,000,000

Volume VarianceShare Variance ($600,000)Market Size Variance 1,000,000

400,000Price/Cost Variance

(500,000)Actual profit contribution

$3,900,000

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Capital Budgeting• Deals with prioritizing several

aspects to projects within a firm.• Five discrete steps

1. Generating Investment proposals2. Estimating Cash Flows for the

proposals3. Evaluating the Cash Flows4. Selecting projects based on an

acceptance criterion5. Reevaluating the projects after their

acceptance

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3. Evaluating the Cash Flows

Five major methods1. Average Rate of Return (Avg Annual

Profit)/ Avg Investment per year

2. Payback (No. of years to recover the initial investment) Initial Investment/Annual Cash Flows

3. Internal Rate of Return [A0=A1/(1+r) + A2/(1+r)2 +…An/(1+r)n] (n- last period when the cash flows can be expected)

4. Present Value NPV= ∑At/(1+k)t

5. Economic Value added After-tax operating income – (Investments in assets* Weighted Average Cost of Capital)

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