Financial Aspects of

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Chapter 2
Financial Aspects of Marketing Management
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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

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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

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Types of Cost
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Variable Costs are

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

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THERE ARE TWO CATEGORIES OF VARIABLE COSTS

• Cost of Goods Sold
• Other Variable Costs

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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

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Other Variable Costs

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

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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

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THERE ARE TWO CATEGORIES OF FIXED COSTS

• Programmed costs
• Committed costs

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Fixed Costs Programmed Costs

• Result from attempts to generate sales volume
• Examples include
• Advertising, sales promotion, and sales salaries

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Fixed Costs Committed Costs

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

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Relevant and Sunk Costs
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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

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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

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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.
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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

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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

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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
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Trade Margin (Markup)
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Trade Margin
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Net Profit Margin(before taxes)
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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 Kello
ggs 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
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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 between unit selling price and
  unit variable cost

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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
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Break-even Analysis Chart
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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
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Applications of Contribution Analysis

• Sensitivity Analysis
• Profit Impact
• Market Size
• Performance Measurement
• Assessment of Cannibalization

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Liquidity

• Refers to a companys ability to meet short-term
  financial obligations
• Very important for a companys day-to-day
  operations
• A key factor is Working Capital Current Assets
  minus Current Liabilities

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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.

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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

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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

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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.
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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

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Preparing a pro forma Income Statement

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

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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 40,000 300,000 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
155,000 Net profit before (income) tax
45,000
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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

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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