Financial Aspects of Marketing Management

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CHAPTER
Financial Aspects of Marketing Management
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AFTER READING THIS CHAPTERYOU SHOULD BE ABLE TO

• Define accounting and financial concepts useful
  in marketing management.

• Describe how pro forma income statements are
  prepared.

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CHAPTER 2 FINANCIAL ASPECTS OF MARKETING
MANAGEMENT
VARIABLE ANDFIXED COSTS
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TYPES OF COSTS
Variable/FixedCosts
VariableCosts
FixedCosts
OtherVariableCosts
Cost of Goods Sold
Programmed Costs
CommittedCosts
SellingExpenses
Materials
Overhead
Advertising
Rent
Salary
Labor
SalesCommissions
SalesPromotion
Administrative/Clerical
Commission/Bonus
Discounts
Others
Others
Others
Others
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TYPES OF COSTS
Variable Costs

• Are expenses that are uniform per unit of output
  within a relevant time period (i.e. budget year).

• Fluctuate in direct proportion to the number of
  units produced.

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TYPES OF COSTS
Variable Costs
Are divided into two categories
Materials, labor, and overhead tied directly to
production.
Cost of Goods Sold
Variable expenses not tied to production but do
vary with volume. Includes sales commissions,
discounts, etc.
OtherVariableCosts
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TYPES OF COSTS
Fixed Costs

• Are expenses that do not fluctuate with output
  volume within a budget year.

• On a per-unit basis, decrease as the number of
  units over which they are allocated increase.

• Remain unchanged regardless of the number of
  units produced.

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TYPES OF COSTS
Fixed Costs
Are divided into two categories
Those that generate sales. Includes marketing
costs such as advertising, sales promotion,
salesforce salaries, etc.
Programmed Costs
Those that maintain the organization. Includes
rent, administrative/clerical salaries, etc.
CommittedCosts
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TYPES OF COSTS
Variable/Fixed Costs
Some costs have both a variable and fixed
component. Example

• Fixed component salary

SellingExpenses

• Variable component commission or bonus

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CHAPTER 2 FINANCIAL ASPECTS OF MARKETING
MANAGEMENT
RELEVANT ANDSUNK COSTS
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RELEVANT COSTS
Relevant costs are expenditures that

• Are expected to occur in the future as a result
  of some marketing action.

• Differ among marketing alternatives being
  considered.

• Include opportunity costs, the forgone benefits
  from an alternative not chosen.

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SUNK COSTS
Sunk costs are past expenditures for a given
activity and are typically irrelevant in whole or
in part to future decisions.

• Are the opposite of relevant costs.

• Include past RD, test marketing, and advertising
  expenses.

• Sunk cost fallacy Recoup spent dollars by
  spending still more dollars in the future.

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CHAPTER 2 FINANCIAL ASPECTS OF MARKETING
MANAGEMENT
MARGINS
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MARGIN
Margin refers to the difference between the
selling price and the cost of a product or
service.

• Is expressed on a total volume or individual
  basis, dollar terms, or percentages.

• Consists of three types

Profit Margin
Gross Margin
Trade Margin
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GROSS MARGIN
Gross margin (or gross profit) is

• The difference between total sales revenue and
  total cost of goods sold or

• On a per-unit basis, the difference between unit
  selling price and unit cost of goods sold.

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GROSS MARGIN
Gross margin is expressed in dollars or percent
Dollar Amount
Percentage
Total Gross Margin
Unit Gross Margin
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TRADE MARGIN
Trade margin is

• The difference between unit sales price and unit
  cost at each level of a marketing channel
  (manufacturer?wholesaler?retailer).

• Frequently referred to as a markup or mark-onby
  channel members, expressed as a percentage.

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TRADE MARGIN
Example Selling Price 20 Cost 10 Margin
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Retailer Margin as aPercent of Cost
Retailer Margin as aPercent of Selling Price

• Differences in margin percentages show the
  importance of knowing the base (cost or selling
  price).

• Trade margin percents are usually based on
  selling price.

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TRADE MARGIN

• Managers must work backward from the
  consumerretail selling price through the
  marketing channel to arrive at the manufacturers
  products selling price.

• Example

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NET PROFIT MARGIN (BEFORE TAXES)

• Net profit margin is the remainder after cost of
  goods sold, other variable costs, and fixed costs
  have been subtracted from sales revenue.

• Example Net profit margin in an income statement

Dollar Amount
Percentage
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CHAPTER 2 FINANCIAL ASPECTS OF MARKETING
MANAGEMENT
CONTRIBUTION ANALYSIS
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CONTRIBUTION ANALYSIS

• Contribution is

• The difference between total sales revenue and
  total variable costs or

• On a per-unit basis, the difference betweenunit
  selling price and unit variable cost

• Contribution analysis is used to assess the
  relationship between costs, prices, volume, and
  profit.

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BREAK-EVEN ANALYSIS

• Breakeven analysis identifies the unit or dollar
  sales volume at which an organization neither
  makes a profit nor incurs a loss.

• Break-even is shown by this equation

TotalVariable Costs
TotalFixed Costs
TotalRevenue


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BREAK-EVEN ANALYSIS
Break-even requires the following

• An estimate of unit variable costs.

• An estimate of the relevant total dollar fixed
  costs to produce and market the product or
  service unit.

• The selling price for each product or service
  unit.

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BREAK-EVEN ANALYSIS
Break-even formula
TotalFixed Costs
UnitBreak-EvenVolume

UnitVariable Costs
UnitSelling Price

Denominator contribution per unit
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BREAK-EVEN ANALYSIS
Unit Break-Even Volume Example Unit Selling
Price 5 Unit Variable Costs 2 Total Fixed
Costs 30,000
UnitBreak-EvenVolume
30,000

5 2
UnitBreak-EvenVolume
10,000 units

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BREAK-EVEN ANALYSIS
Dollar Break-Even Volume Example Unit Selling
Price 5 Unit Variable Costs 2 Total Fixed
Costs 30,000
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CONTRIBUTION MARGIN
Contribution margin formula
UnitVariable Costs
UnitSelling Price

ContributionMargin

UnitSelling Price
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CONTRIBUTION MARGIN
Contribution Margin Example Unit Selling Price
5Unit Variable Costs 2
5 2
ContributionMargin
ContributionMargin

60


5
TotalFixed Costs
DollarBreak-EvenVolume
30,000



50,000
0.60
ContributionMargin
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EXHIBIT 2.1 BREAK-EVEN ANALYSIS CHART
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SENSITIVITY ANALYSIS
Break-even points can change if there are
changesin selling price, variable costs, and/or
fixed costs.
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CONTRIBUTION ANALYSIS AND PROFIT IMPACT

• A modified break-even analysis is used to
  incorporate a profit goal since profits are
  necessary for the continued operation of an
  organization.

• To incorporate a profit goal in the break-even
  formula, treat it as an additional fixed cost.

TotalFixed Costs
Dollar Profit Goal

Unit Volumeto AchieveProfit Goal

ContributionPer Unit
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CONTRIBUTION ANALYSIS AND PROFIT IMPACT
Profit Goal Example Unit Selling Price
25Unit Variable Costs 10 Total Fixed Costs
200,000 Profit Goal 20,000
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CONTRIBUTION ANALYSIS AND PROFIT IMPACT

• A profit goal can also be specified as a
  percentage of sales rather than as a dollar
  amount Profit goal 20 on sales.

• To incorporate a profit goal in the break-even
  formula, subtract the profit goal from the
  contribution per unit.

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CONTRIBUTION ANALYSIS AND PROFIT IMPACT
Profit Goal Example Unit Selling Price (P)
25Unit Variable Costs (UVC) 10 Total Fixed
Costs (FC) 200,000 Profit Goal 20 of Unit
Selling Price (P)Contribution per Unit (CU)
P- UVC
Dollar Profit Goal (P Profit Goal Percent
on Sales) 25 20 25 .20 5
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CONTRIBUTION ANALYSIS AND MARKET SIZE

• A manager can assess the feasibility of a venture
  by comparing the break-even volume with market
  size and market-capture percentage.

• Example Market potential is 100,000 units
  andunit volume break-even point is 50,000 units.
  Therefore, a firms product or service needs a50
  percent market share to break even.

• Marketing implication Can such a percentage can
  be achieved?

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CONTRIBUTION ANALYSIS AND PERFORMANCE MEASUREMENT
Product Y(20,000 units)
Total(30,000 units)
Product X(10,000 units)

• Which product is more profitable?

• Which product is more profitable on a
  unit-contribution basis?

• Should Product X or Product Y be dropped? Why or
  why not?

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ASSESSMENT OF CANNIBALIZATION
Cannibalization occurs when a firm obtains
revenue by diverting sales from one product or
service to another.
Brand YNew Gel Toothpaste
Brand XExisting OpaqueWhite Toothpaste

• Which product has the higher unit contribution?

• Why is this important?

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ASSESSMENT OF CANNIBALIZATION

• Example Estimate of Brand X sold 1,000,000
  unitsEstimate of Brand Y sold
  1,000,000Cannibalization effect

• Loss of 500,000 units of Brand X sales diverted
  to Brand Y

• Loss of 0.10 per unit of Brand X for each unit
  of Brand Y sold

• How will the introduction of Brand Y affect the
  total contribution dollars of Brand X?

• Brand X total contribution lost? (0.10 per unit
  lost 500,000 cannibalized units from Brand X to
  Brand Y 50,000)

• Brand Y total contribution gained? (0.70 unit
  contribution 500,000 units of Brand Y
  350,000)

• Financial effect of introducing Brand Y? (Net
  contribution dollars 350,000 50,000
  300,000)

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ASSESSMENT OF CANNIBALIZATION
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LIQUIDITY AND WORKING CAPITAL
Liquidity
A firms ability to meet short-term financial
obligations within a budget year.
WorkingCapital
Consists of cash, accounts receivable,prepaid
expenses, inventory, etc.
CurrentAssets
Consists of short-term accounts payable,income
taxes, etc.
CurrentLiabilities
Managers must be aware of the impact of marketing
actions on working capital.
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OPERATING LEVERAGE

• Operating leverage refers to the extent to which
  fixed costs and variable costs are used in the
  production and marketing of products and services.

HighOperatingLeverage
High total fixed costs relative to total variable
costs. Example Airlines
LowOperatingLeverage
Low total fixed costs relative to total variable
costs. Example Wholesalers

• The higher the operating leverage, the faster
  total profits will rise or fall once sales volume
  rises or falls below break-even volume.

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EXHIBIT 2.2 EFFECT OF OPERATING LEVERAGE ON
PROFIT
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DISCOUNTED CASH FLOW

• Discounted cash flows are future cash flows
  expressed in terms of their present value.

• Incorporates the theory of the time value of
  money or present-value analysis.

• Premise A dollar received next year is worth
  less than a dollar received today because its
  future value is affected by risk, inflation, and
  opportunity cost.

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DISCOUNTED CASH FLOW
DiscountedCash FlowFactors
The cost of earnings opportunities forgone by
investing in a business with its attendant risk
as opposed to investing in risk-free securities
such as U.S. Treasury bills.
Cost ofCapital
The interest or discount rate is defined by the
cost of capital.
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EXHIBIT 2.3 APPLICATION OF DISCOUNTED CASH FLOW
ANALYSIS WITH A 15 PERCENT DISCOUNT FACTOR

• Which business has the larger cumulative cash
  flow? Why is this important?

• Which business has the faster payback? Why is
  this important?

• Which business has the greater discounted cash
  flow? Why is this important?

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CHAPTER 2 FINANCIAL ASPECTS OF MARKETING
MANAGEMENT
CUSTOMER LIFETIME VALUE
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CUSTOMER LIFETIME VALUE
CustomerLifetimeValue(CLV)
The present value of future cash flows from a
customer relationship.
The CLV calculation requires this information
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CUSTOMER LIFETIME VALUE
The customer lifetime value (CLV) formula is
CustomerLifetimeValue(CLV)
1
M


1 i r
Example M 2,000 i 10 and r 80. CLV
is
1
CLV

2,000

1.0 0.1 0.8
CLV

6,666.67
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CUSTOMER LIFETIME VALUE
Example M 2,000 i 10 r 80g
(constant growth rate) 6. CLV is

• Marketing affects the customer margin (M),the
  retention rate (r), and the growth rate (g)but
  not the interest rate (i).

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CHAPTER 2 FINANCIAL ASPECTS OF MARKETING
MANAGEMENT
PREPARING A PRO FORMA INCOME STATEMENT
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PRO FORMA INCOME STATEMENT

• A pro forma income statement displays projected
  revenues, budgeted expenses, and estimated net
  profit for an organization, product, or service
  during a specific planning period, usually a year.

• A pro forma income statement includes a sales
  forecast and a listing of variable and fixed
  costs that can be programmed or committed.

• A pro forma income statement reflects a
  marketers expectations (sales) given certain
  inputs (costs).

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PRO FORMA INCOME STATEMENT DEFINITIONS

• Sales. The forecasted unit volume times unit
  selling price.

• Cost of goods sold. The costs incurred in buying
  or producing offerings, which

• Are constant per unit within certain volume ranges

• Vary with total unit volume

• Gross margin or gross profit. The remainder after
  cost of goods sold has been subtracted from sales.

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PRO FORMA INCOME STATEMENT DEFINITIONS

• Marketing expenses. The programmed expenses
  budgeted to produce sales.

• General and administrative expenses (overhead).
  The committed fixed costs for the planning
  period, which cannot be avoided if the
  organization is to operate.

• Net income before (income) taxes or net profit
  before taxes. The remainder after all costs have
  been subtracted from sales.

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EXHIBIT 2.4 PRO FORMA INCOME STATEMENT FOR THE
12-MONTH PERIOD ENDED DECEMBER 31, 2006