Financial Aspects of

Marketing Management

Chapter 2

2-2

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

2-3

In this chapter, you will learn about…

4. Contribution Analysis (contd.)

Contribution Analysis and Market

Size

Contribution Analysis and

Performance Measurement

Assessment of Cannibalization

5. Liquidity

6. Operating Leverage

7. Discounted Cash Flow

8. Preparing a pro forma Income

Statement

2-4

Costs

FixedCosts

Variable Costs

Types of Cost

2-5

Expenses that are uniform per unit of

output within a relevant time period

As volume increases, total variable

costs increase

Variable Costs are…

2-6

THERE ARE TWO CATEGORIES OF

VARIABLE COSTS

1. Cost of Goods Sold

2. Other Variable Costs

2-7

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 Goods Sold

2-8

Other Variable Costs

Expenses not directly tied to

production but vary directly with

volume

Examples include:

Sales commissions, discounts,

and delivery expenses

2-9

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

2-10

THERE ARE TWO CATEGORIES OF

FIXED COSTS

1. Programmed costs

2. Committed costs

2-11

Result from attempts to generate sales

volume

Examples include:

Advertising, sales promotion, and

sales salaries

Fixed Costs – Programmed Costs

2-12

Costs required to maintain the

organization

Examples include nonmarketing

expenditures, such as:

rent, administrative cost, and

clerical salaries

Fixed Costs – Committed Costs

2-13

Relevant and

Sunk Costs

2-14

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

Relevant Costs are…

2-15

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 Costs are…

2-16

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

2-17

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

2-18

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

2-19

Gross Margin

Total 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%

2-20

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 %

2-21

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

2-22

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

2-24

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

2-25

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

2-26

LOSS

PROFIT

Total Revenue

Fixed Cost

BE PointTotal Cost

Variable Cost

Unit Volume

Dollars

0

Break-even Analysis Chart

2-27

Break-even AnalysisExample

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

2-28

Applications of Contribution Analysis

Sensitivity Analysis

Profit Impact

Market Size

Performance Measurement

Assessment of Cannibalization

2-29

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

2-30

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.

2-31

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

2-32

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

2-33

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.

2-34

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:

1PV = ———— X $1,000,000 = $620,921.32

(1 + 0.10)5

2-35

Preparing a pro forma Income 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 expensesSales 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

2-37

Preparing a pro forma Income 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

2-38

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

Preparing a pro forma Income Statement