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Chapter 2

Financial Aspects of
Marketing Management

In this chapter, you will


learn about
1. Variable and Fixed Costs
2. Relevant and Sunk Costs
3. Margins
Gross Margin
Trade Margin
Net Profit Margin (Before Taxes)
4. Contribution Analysis
Break-even Analysis
Sensitivity Analysis
Contribution Analysis and Profit
Impact

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

Types of Cost

Costs

Fixed
Costs

Variable
Costs

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

1. Cost of Goods Sold


2. 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

1. Programmed costs
2. 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 years 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%

Cost of Goods Sold

- 40

Gross Profit Margin

$ 60

60%

Unit Sales Price

$1.00

100%

Unit Cost of Goods Sold

- 0.40

- 40

Unit Gross Profit Margin

$0.60

- 40

Unit Gross Margin

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)
Net Sales
Cost of Goods Sold
Gross Profit Margin

Dollar Amount

Percentage

$ 100,000

100%

- 30,000
$ 70,000

- 30
70%

Selling Expenses

- 20,000

- 20

Fixed Expenses

- 40,000

- 40

Net Profit Margin

$ 10,000

10%

Kelloggs Cereal Margins at a Price


of $2.72 per box
Kelloggs 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
Kelloggs 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 organizations break-even sales
volume:
Total Revenue = Total Cost

Break-even Analysis Chart


Dollars

Total Revenue
BE Point
PROFIT

Total Cost

Variable Cost

LOSS

Fixed Cost

Unit Volume

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 companys ability to meet
short-term financial obligations
Very important for a companys day-today 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 businesss 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 Flow


Example
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 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
Cost of goods sold
Gross margin
Marketing expenses
Sales expenses
$170,000
Advertising expenses
90,000
Freight or delivery expenses
40,000
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
5,000
Net profit before (income) tax

$1,000,000
500,000
500,000

300,000

155,000
$45,000

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

Preparing a pro forma


Income 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