Learning Objectives s8

Appendix 2 Marketing by the Numbers

Learning Objectives

1. Conduct pricing, breakeven, and margin analysis. 2. Estimate demand, develop a pro forma and actual profit-and-loss statement, and calculate various marketing performance measures. 3. Conduct financial analyses of marketing tactics.

Appendix Overview

This appendix provides a basic introduction to measuring marketing financial analysis and is built around a hypothetical manufacturer of high-definition consumer electronics products—HDX-treme. This company is launching a new product (a high-definition DVD player), and we discuss and analyze the various decisions HDX-treme’s marketing managers must make before and after launch.

The appendix is organized into three sections, and while the HDX-treme scenario is carried throughout all sections, instructors can select one or more sections at their discretion. At the end of each section, quantitative exercises provide students with an opportunity to apply the concepts in that section to contexts beyond the HDX-treme example. The sections are broken down as follows:

1. Pricing, Breakeven, and Margin Analysis. This section covers pricing considerations and break-even and margin analysis assessments that guide the introduction of HDX-treme’s new product launch. 2. Demand Estimates, the Marketing Budget, and Marketing Performance Measures. This section begins with a discussion of estimating market potential and company sales. It then introduces the marketing budget, as illustrated through a pro forma profit-and-loss statement followed by the actual profit-and-loss statement. Next, the section discusses marketing performance measures, with a focus on helping marketing managers to better defend their decisions from a financial perspective. 3. Financial Analysis of Marketing Tactics. The final section analyzes the financial implications of various marketing tactics, such as increasing advertising expenditures, adding sales representatives to increase distribution, lowering price, or extending the product line.

In this manual, solutions to the quantitative exercises follow the outline of the section in which each set of exercises appears. Additionally, fifteen additional quantitative exercises similar to those in the appendix are provided at the end of the material for this manual. These may be used in lectures, for additional student practice, or for exams.

I. Pricing, Breakeven, and Margin Analysis

A. Pricing Considerations

1. The limiting factors are demand and costs.

2. Determining Costs a) Fixed costs do not vary with production or sales (e.g., rent, interest, depreciation, clerical and managerial salaries). b) Variables costs vary directly with the level of production (e.g., cost of goods sold and many marketing costs). c) Total costs are the sum of the fixed and variable costs.

3. Setting Price Based on Costs a) Cost-plus pricing (or markup pricing) simply adds a standard markup to the cost of the product. (1) Unit cost for HDX-treme:

fixed costs $20,000,000 Unit cost = variable cost + —————— = $250 + ————— = $270 unit sales 1,000,000

(2) If HDX-treme desires a 25% markup on sales:

unit cost $270 Markup price = ——————————— = ——— = $360 (l - desired return on sales) l - 0.25

b) Relevant costs are those that will occur in the future and that will vary across the alternatives being considered. c) Sunk costs are past costs that will not reoccur in the future and should not be considered. d) Break-even price is the price at which unit revenue (price) equals unit cost and profit is zero. (1) For HDX-treme: breakeven price equals $270, which is the unit cost determined above. e) Return on investment (ROI) pricing is determined by multiplying the desired return on investment by the investment and adding this figure to the fixed costs. (1) If HDX-treme desires a 30% return on an initial $10 million investment:

4. Setting Price Based on External Factors a) Manufacturers do not have the final say concerning the final price to consumers–retailers do, so HDX-treme must start with its suggested retail price (MSRP) and work back through reseller margins to determine the price at which to sell the product to wholesalers. b) Dollar markup is the difference between a company’s selling price for a product and its cost to manufacture or purchase it:

Dollar markup = selling price – cost

c) Markups are usually expressed as a percentage, and there are two different ways to compute markups–on cost or on selling price: dollar markup Markup percentage on cost = cost

dollar markup Markup percentage on selling price = selling price

Teaching Note: Sometimes a retailer wants to convert markups based on selling price to markups based on cost, and vice versa. The formulas are:

markup percentage on cost Markup percentage on selling price = 100% + markup percentage on cost

markup percentage on selling price Markup percentage on cost = 100% - markup percentage on selling price Suppose a retailer uses a markup of 25% based on selling price and found that his competitor was using a markup of 30% based on cost and wanted to know what this would be as a percentage of selling price. The calculation is:

30% 30% = = 23% 100% + 30% 130%

Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 3 Because the retailer is using a 25% markup on selling price for similar products, his markup is comparable with that of the competitor.

See additional quantitative exercise 6 for another application.

d) Value-based pricing uses buyers’ perceptions of value and not the seller’s cost to determine the MSRP. e) HDX-treme example: MSRP = $599.99, but $600 is used in calculations for simplicity; retailer’s margin is 30% and wholesaler’s is 20%, both based on their selling prices. (1) Thus, the markup chain is:

Suggested retail price: $600 minus retail margin (30%):  $180 Retailer’s cost/wholesaler’s price: $420 minus wholesaler’s margin (20%):  $ 84 Wholesaler’s cost/HDX-treme’s price: $336

Teaching Note: Students should also be able to calculate prices when cost and markup information is known. For example, suppose a retailer knew his cost ($12) and desired markup on price (25%) for a product and wanted to compute the selling price. Substituting (selling price – cost) for dollar markup in the equation for markup percentage on selling price given previously and solving for selling price gives the following formula for determining the selling price: cost Selling price = 1 - markup

$12 Selling price = = $16 0.75 See quantitative exercise 1.4 and additional quantitative exercises 4 and 5 for more applications of this equation.

B. Break-Even and Margin Analysis

1. Determining Breakeven Unit Volume and Dollar Sales a) Break-even analysis determines the unit volume and dollar sales needed to be profitable given a particular price and cost structure. b) Formula for determining break-even unit volume:

fixed costs Break-even volume = ——————————— price  unit variable cost

4 Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall c) The denominator (price unit variable cost) is called unit contribution (sometimes called contribution margin) and represents the amount that each unit contributes to covering fixed costs. d) HDX-treme’s break-even unit volume is:

fixed cost $20,000,000 Break-even volume = ———————— = ————— = 232,558.1 units price  variable cost $336  $250

So HDX-treme will break-even at 232,559 units.

e) Break-even dollar sales can be determined by multiplying unit breakeven volume by selling price:

BE sales = BEvol  price = 232,559 units  $336 = $78,139,824

f) Another way to calculate break-even sales is to use the percentage contribution margin (hereafter referred to as contribution margin), which is the unit contribution divided by the selling price:

price - variable cost $336  $250 Contribution margin = ———————— = —————— = 0.256 or 25.6% price $336

fixed costs $20,000,000 Break-even sales = ———————— = —————— = $78,125,000 contribution margin 0.256

(1) Note: the difference between the two break-even sales calculations is due to rounding. g) Contribution margin can also be calculated as follows:

total sales – total variable costs Contribution margin = ——————————— total sales

h) Another way to determine contribution margin for any sales level is by setting sales equal to 100% and subtracting the percentage of variable costs from sales. For HDX-treme variable costs represent 74% of sales (which can be determined by dividing unit variable costs by price, or $250  $336), so contribution margin can be determined as follows:

2. Determining “Break-even” for Profit Goals a) While break-even analysis is useful, most companies are more interested in making a profit. b) When profit is expressed as an absolute amount, simply add the profit figure to fixed costs and again divide by the unit contribution to determine unit sales (HDX-treme would like to realize a $5 million profit in the first year):

fixed cost  profit goal $20,000,000 + $5,000,000 Unit volume = —————————— = —————————— = 290,697.7 units price  variable cost $336  $250

Dollar sales = 290,698 units  $336 = $97,674,528

fixed cost  profit goal $20,000,000 + $5,000,000 Sales = —————————— = —————————— = $97,656,250 contribution margin 0.256

Again, note that the difference in the sales calculations is due to rounding.

c) Profit can also be stated as a return on investment goal. Determine the absolute profit goal by multiplying the investment by the desired ROI (HDX-treme wants a 30% return on its $10 million investment ($10,000,000  0.30)):

fixed cost  profit goal $20,000,000 + $3,000,000 Unit volume = ————————— = —————————— = 267,442 units price  variable cost $336  $250

Dollar sales = 267,442 units  $336 = $89,860,512

fixed cost  profit goal $20,000,000 + $3,000,000 Dollar sales = ————————— = —————————— = $89,843,750 contribution margin 0.256

6 Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall d) Profit goals can also be expressed as a percentage of sales. In this case, we incorporate the profit goal into the unit contribution as an additional variable cost (HDX-treme wants a 25% return on sales):

fixed cost fixed cost Unit volume = ——————————— or —————————— price  variable cost  (0.25  price) (0.75  price)  variable cost

So,

$20,000,000 Unit volume = ————————— = 10,000,000 units (0.75  $336)  $250

Dollar sales necessary = 10,000,000 units  $336 = $3,360,000,000

C. Marketing by the Numbers Exercise Set One

1.1. Sanborn, a manufacturer of electric roof vents, realizes a cost of $55 for every unit it produces. Its total fixed costs equal $2 million. If the company manufactures 500,000 units, compute the following: a. unit cost b. markup price if the company desires a 10% return on sales c. ROI price if the company desires a 25% return on an investment of $1 million

Answer:

fixed costs $2,000,000 a.) Unit cost = variable cost + —————— = $55 + ————— = $59 unit sales 500,000

unit cost $59 b.) Markup price = ————————————— = ——— = $65.56 (l  desired return on sales) (l  0.1)

ROI  investment (0.25  $1,000,000)

1.2. An interior decorator purchases items to sell in her store. She purchases a lamp for $125 and sells it for $225. Determine the following: a. dollar markup b. markup percentage on cost c. markup percentage on selling price

Answer:

a.) Dollar markup = selling price  cost = $225  $125 = $100

dollar markup $100 b.) Markup percentage on cost = ——————— = ——— = 0.8 = 80% cost $125

dollar markup $100 c.) Markup percentage on price = ——————— = ——— = 0.44 = 44% price $225

1.3. A consumer purchases a toaster from a retailer for $60. The retailer’s markup is 20%, and the wholesaler’s markup is 15%, both based on selling price. For what price does the manufacturer sell the product to the wholesaler?

Answer: price  cost Markup percentage on price = —————— price so, Cost at each level = price  (price  markup%)

The retailer’s cost = $60  ($60  0.2) = $48, which is the price the wholesaler sells it to the retailer.

The wholesaler’s cost = $48  ($48  0.15) = $40.80, which is the price the manufacturer sells the product to the wholesaler.

Another way to compute this is:

Retail price: $60.00 minus retail margin (20%):  $12.00 Retailer’s cost/wholesaler’s price: $48.00 minus wholesaler’s margin (15%):  $ 7.20 Wholesaler’s cost/manufacturer’s price $40.80

8 Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 1.4. A vacuum manufacturer has a unit cost of $50 and wishes to achieve a margin of 30% based on selling price. If the manufacturer sells directly to a retailer who then adds a set margin of 40% based on selling price, determine the retail price charged to consumers.

Answer:

price  cost Markup percentage on price = —————— price So, at any level in the chain: cost price = ————— (1 markup)

cost $50 Manufacturer’s price = ————— = ————— = $71.43 (1 markup) (1 0.3)

cost $71.43 Retailer’s price = ————— = ————— = $119.05 (1 markup) (1 0.4)

1.5. Advanced Electronics manufactures DVDs and sells them directly to retailers who typically sell them for $20. Retailers take a 40% margin based on the retail selling price. Advanced’s cost information is as follows:

DVD package and disc $2.50/DVD Royalties $2.25/DVD Advertising and promotion $500,000 Overhead $200,000

Calculate the following: a. contribution per unit and contribution margin b. break-even volume in DVD units and dollars c. volume in DVD units and dollar sales necessary if Advanced’s profit goal is 20% profit on sales. d. net profit if 5 million DVDs are sold

Answer:

a.) Unit contribution = selling price  unit variable cost

Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 9 To determine Advanced’s selling price, we must subtract the retailer’s margin from the retail price: Advanced’s price = retail price  (retail price  percentage retailer margin) = $20  ($20  0.4) = $12.

To determine Advanced’s variable cost, we must add up the variable costs. Unit variable costs = $2.50 + $2.25 = $4.75

Therefore, the contribution per unit = $12  $4.75 = $7.25

unit contribution $7.25 Contribution margin = ———————— = ———— = 0.604 or 60.4% price $12

fixed costs $700,000 b.) Breakeven volume = ———————— = ———— = 96,552 units unit contribution $7.25

Breakeven sales = breakeven volume  price = 96,552 units  $12 = $1,158,624 or fixed costs $700,000 Breakeven sales = ———————— = ———— = $1,158,940 contribution margin 0.604

The difference between the two calculations for breakeven sales is due to rounding.

fixed costs c.) Unit volume = —————————————— price  variable cost  (0.2  price)

$700,000 = —————————— = 144,330 units $12  $4.75  (0.2  $12)

Sales necessary = 144,330 units  $12 = $1,731,960

(Note: The new contribution margin is 40% (i.e., $4.85  $12), so sales can also be calculated as $700,000  0.4 = $1,750,000, with the difference due to rounding.)

Total revenue if 5 million units are sold = 5,000,000  $12 = $60 million

Total cost is equal to TFC + TVC, so if 5 million units are sold:

Total cost = $700,000 + ($4.75  5,000,000) = $24,450,000

Net profit = $60,000,000  $24,450,000 = $35,550,000

(Note: Students may merely subtract the fixed costs from the total contribution: ($7.25  5,000,000 units)  $700,000 = $35,550,000.)

II. Demand Estimates, The Marketing Budget, and Marketing Performance Measures

A. Market Potential and Sales Estimates

1. While determining sales needed to break even or attain various profit goals is useful, companies need more information regarding demand in order to assess the feasibility of attaining the needed sales levels.

2. Total market demand for a product or service is the total volume that would be bought by a defined consumer group in a defined geographic area in a defined time period in a defined marketing environment under a defined level of mix of industry marketing effort.

3. The upper limit of market demand is called market potential.

4. One practical method for estimating total market demand uses three variables: a) number of prospective buyers b) quantity purchased by an average buyer per year c) price of an average unit d) Market demand can be determined as follows:

Q = n  q  p

where Q = total market demand n = number of buyers in the market

5. A variation of this approach is the chain ratio method, which involves multiplying a base number by a chain of adjusting percentages. a) HDX-treme can estimate U.S. demand using a chain of calculations like the following:

Total number of U.S. households × The percentage of U.S. households owning a high definition television × The percentage of these households willing and able to buy a high-definition DVD player b) Industry and company research estimates the following: 110 million U.S. TV households; 38% of TV households will own HDTVs by the end of 2007; 44.5% of HDTV households are willing and able to buy a high-definition DVD player. So the total number of potential households is: 110 million households  0.38  0.445 = 18.6 million households. c) Households typically only own one HDTV, so the quantity of high-definition DVD players purchased by an average buyer is one. d) Average retail price across all brands is $750. e) Estimating total market demand for high-definition DVD players can be calculated as: 18.6 million households  1 DVD player per household  $750 = $14 billion. f) As can be seen, this estimate of market potential relies heavily on assumptions regarding adjusting percentages, average quantity, and average prices. Thus, companies must make certain that its assumptions are reasonable and defendable. g) Because market potential sales estimates can vary given the average price used, HDX-treme uses unit sales potential to determine its sales estimate for next year. HDX-treme expects to attain 2% market share (which is comparable to its share of the HDTV market) in the first year after launching this product, resulting in a forecasted unit sales of 18.6 million units  0.02 = 372,000 units. At a price of $336 per unit, estimated sales are $124.99 million (372,000 units  $336 per unit). For simplicity, further analyses use forecasted sales of $125 million.

B. The Profit-and-Loss Statement and Marketing Budget

12 Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 1. A pro forma (or projected) profit-and-loss statement (also called an income statement or operating statement) shows projected revenues less budgeted expenses and estimates the projected net profit for an organization, product, or brand during a specific planning period, typically a year.

2. A profit-and-loss statement typically consists of several major components (see Table and Spreadsheet A2.1 at the end of this material):

Use Table A2.1 and Spreadsheet A2.1 here.

a) Net sales–gross sales revenue minus returns and allowances (e.g., trade, cash, quantity, and promotion allowances). HDX-treme’s net sales for 2007 are estimated to be $125 million, as determined in the previous analysis. b) Cost of goods sold (sometimes called cost of sales)–the actual cost of the merchandise sold by a manufacturer or reseller and includes the cost of inventory, purchases, and other costs associated with making the goods. For HDX- treme, it is estimated to be 50% of net sales, or $62.5 million. c) Gross margin (or gross profit)–the difference between net sales and cost of goods sold. For HDX-treme, it is estimated to be $62.5 million ($125 million  $62.5 million). d) Operating expenses–the expenses incurred while doing business and include all other expenses beyond the cost of goods sold. In the HDX-treme example, expenses are presented as marketing expenses and general and administrative expenses: (1) Marketing expenses include sales expenses, promotion expenses, and distribution expenses. (a) Sales expenses include $5 million for sales salaries (fixed cost) plus 10% commission on sales (variable cost). Thus, total budgeted sales expense is $17.5 million ($5 million plus 10% of $125 million). (b) Promotion expenses include $10 million budgeted for advertising and promotion (fixed cost) plus 4% of sales ($5 million) for cooperative advertising allowances to retailers (variable cost) for a total of $15 million. (c) Distribution expenses include freight and delivery charges that are budgeted at 10% of

Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 13 sales (variable cost) for a total of $12.5 million (10% of $125 million). (d) Total marketing expenses are estimated to be $45 million ($17.5 million  $15 million  $12.5 million). (2) General and administrative expenses are estimated at $5 million (fixed cost), broken down into $2 million for managerial salaries and expenses for the marketing function and $3 million of indirect overhead allocated to this product by the corporate accountants. e) Net profit before taxes–profit earned after all costs are deducted. HDX-treme’s estimated net profit is $12.5 million.

3. Table A2.1 (and Table A2.2) also indicates the percentage of sales that each component of the profit-and-loss statement represents. These percentages are determined by dividing the cost figure by net sales.

C. Marketing Performance Measures

1. Whereas the pro forma profit-and-loss statement shows projected financial performance, the statement given in Table A2.2 shows HDX-treme’s actual financial performance based on actual sales, cost of goods sold, and expenses during the past year.

Use Table A2.2 and Spreadsheet A2.2 here.

2. Why did HDX-treme lose $1 million rather than make the $12.5 million projected profit? a) Net sales were only $100 million, which is $25 million short of estimated sales. b) Cost of goods sold as a percentage of sales exceeded expectations (55% rather than the 50% budgeted). c) Allocated indirect overhead was $5 million rather than the estimated $3 million.

3. At what level of sales would HDX-treme have broken even? a) Contribution margin was 21% rather than the estimated 26% (variable cost represented 79% of sales, so contribution margin = 1  0.79 = 0.21 = 21%). b) Break-even sales can be calculated:

4. Industry sales fell short of forecasted sales and were $2.5 billion, so HDX-treme’s market share was 4% ($100 million  $2.5 billion = 0.04 = 4%).

5. Analytic Ratios a) Operating ratios are the ratios of selected operating statement items to net sales. b) Gross margin percentage indicates the percentage of net sales remaining after cost of goods sold that can contribute to operating expenses and net profit before taxes. (1) For HDX-treme:

gross margin $45,000,000 Gross margin percentage = —————— = —————— = 0.45 = 45% net sales $100,000,000

(2) If there was previous history for this product and this ratio was declining, management should examine it more closely to determine why it has decreased (i.e., decrease in sales volume or price, an increase in costs, or a combination of these). c) Net profit percentage shows the percentage of each sales dollar going to profit. (1) For HDX-treme:

net profit $1,000,000 Net profit percentage = ————— = —————— = 0.01 = 1.0% net sales $100,000,000

d) Operating expense percentage indicates the portion of net sales going to operating expenses. (1) For HDX-treme:

total expenses $46,000,000 Operating expense percentage = —————— = —————— = 0.46 = 46% net sales $100,000,000

e) Inventory turnover rate (also called stockturn rate for resellers) is the number of times an inventory turns over or is sold during a specified time period (often one year).

Teaching Note: It may be computed on a cost, selling price, or a unit basis. The formulas are:

Selling price of goods sold Stockturn rate = ——————————— Avg. selling price of inventory

or Sales in units Stockturn rate = ——————————— Average inventory in units

(1) Assuming HDX-treme’s beginning and ending inventories were $30 million and $20 million, respectively, the inventory turnover rate computed on a cost basis is:

$55,000,000 $55,000,000 Inventory turnover rate = ——————————— = —————— = 2.2 ($30,000,000 + $20,000,000)/2 $25,000,000

(2) The higher the turnover rate, the higher the management efficiency and company profitability, but this rate should be compared to industry averages, competitors’ rates, and past performance. f) Return on investment (ROI) is used to measure managerial effectiveness and efficiency. (1) It is the ratio of net profits to total investment, which includes capital investments in land, buildings, and equipment plus inventory costs. (2) For HDX-treme, total investment includes the initial $10 million to refurbish the manufacturing facility plus average inventory ($25 million determined in the previous inventory turnover rate calculation):

net profit before taxes $1,000,000 Return on investment = ———————= —————— = .0286 = 2.86% investment $35,000,000

6. Marketing Profitability Metrics a) If HDX-treme drops this product, the profits of the total organization will decrease by $4 million!

16 Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall b) Net Marketing Contribution (NMC). Measures marketing profitability. (1) Does not include operating expenses not under marketing’s control (e.g., allocated indirect overhead). (2) NMC = net sales  cost of goods sold  marketing expenses (3) For HDX-treme, NMC = $100 million  $55 million  $41 million = $4 million (a) Marketing expenses include sales expenses ($15 million), promotion expenses ($14 million), freight expenses ($10 million), and the managerial salaries and expenses of the marketing function ($2 million), which total $41 million. (b) The DVD player contributed $4 million to HDX-treme’s overall company profits. (c) If the DVD player is dropped, the $5 million in fixed overhead expenses will not disappear–it will simply have to be allocated elsewhere, but the $4 million in NMC will disappear. c) Marketing Return on Sales and Investment (1) Marketing return on sales (ROS) shows the net sales attributable to the net marketing contribution. (a) For HDX-treme:

net marketing contribution $4,000,000 Marketing ROS = ——————————— = —————— = 0.04 = 4% net sales $100,000,000

(2) Marketing ROI measures the marketing productivity of a marketing investment. (a) For HDX-treme:

net marketing contribution $4,000,000 Marketing ROI = ——————————— = —————— = 0.0976 = 9.76% marketing expenses $41,000,000

(b) Marketing ROI could be greater than 100%, which can be achieved by attaining a higher net marketing contribution and/or a lower total marketing expense.

D. Marketing by the Numbers Exercise Set Two

Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 17 2.1. Determine the market potential for a product that has 50 million prospective buyers who purchase an average of 3 per year and price averages $25. How many units must a company sell if it desires a 10% share of this market?

Answer:

Q = n  q  p where Q = total market demand n = number of buyers in the market q = quantity purchased by an average buyer per year p = price of an average unit

The upper limit of market demand is called market potential. It’s a straightforward calculation:

Q = 50,000,000 buyers  3 units per buyer  $25 per unit = $3.75 billion

Market share = (50,000,000 buyers  3 units per buyer)  0.1 = 15 million units

2.2. Develop a profit-and-loss statement for the Westgate division of North Industries. This division manufactures light fixtures sold to consumers through home improvement and hardware stores. Cost of goods sold represents 40% of net sales. Marketing expenses include selling expenses, promotion expenses, and freight. Selling expenses include sales salaries totaling $3 million per year and sales commissions (5% of sales). The company spent $3 million on advertising last year, and freight costs were 10% of sales. Other costs include $2 million for managerial salaries and expenses for the marketing function and another $3 million for indirect overhead allocated to the division. a. Develop the profit-and-loss statement if net sales were $20 million last year. b. Develop the profit-and-loss statement if net sales were $40 million last year. c. Calculate Westgate’s breakeven sales.

Teaching Note: The profit-and-loss statements can be developed using Spreadsheet A2.1 or A2.2, but the equations in some cells will need to be changed to reflect the percentages for this problem.

Sales $20,000,000 Cost of goods sold 8,000,000 Gross Margin $12,000,000

Marketing Expenses Sales expenses $4,000,000 Promotion expenses 3,000,000 Freight 2,000,000 9,000,000

General and Administrative Expenses Managerial salaries and expenses $2,000,000 Indirect overhead 3,000,000 5,000,000 Net profit before income tax ($2,000,000) where,

Cost of goods sold = 40% of $20 million sales = $8,000,000

Gross margin = net sales  cost of goods sold = $20,000,000  $8,000,000 = $12,000,000

Sales expenses = $3 million for salaries + 5% of $20 million sales = $3,000,000 +

$1,000,000 = $4,000,000

Promotion expenses = $3,000,000 (fixed cost)

Freight = 10% of $20 million sales = $2,000,000

Managerial salaries and expenses = $2,000,000 (fixed cost)

Indirect overhead = $3,000,000 (fixed cost)

Net profit before taxes = gross margin  marketing expenses  general and administrative expenses = $12,000,000  $9,000,000  $5,000,000 = $2,000,000

Net Sales $40,000,000 Cost of goods sold 16,000,000 Gross Margin $ 24,000,000

Marketing Expenses Sales expenses $5,000,000 Promotion expenses 3,000,000 Freight 4,000,000 12,000,000

General and Administrative Expenses Managerial salaries and expenses $2,000,000 Indirect overhead 3,000,000 5,000,000 Net profit before income tax $7,000,000 where,

Cost of goods sold = 40% of $40 million sales = $16,000,000

Gross margin = net sales  cost of goods sold = $40,000,000  $16,000,000 =

$24,000,000

Sales expenses = $3 million for salaries + 5% of $40 million sales = $3,000,000 +

$2,000,000 = $5,000,000

Promotion expenses = $3,000,000 (fixed cost)

Freight = 10% of $40 million sales = $4,000,000

Managerial salaries and expenses = $2,000,000 (fixed cost)

Indirect overhead = $3,000,000 (fixed cost)

Net profit before taxes = gross margin  marketing expenses  general and administrative expenses = $24,000,000  $12,000,000  $5,000,000 = $7,000,000

fixed costs Break-even sales = —————————— contribution margin

Total fixed costs = sales salaries + advertising + managerial salaries and expenses + indirect overhead = $3,000,000 + $3,000,000 + $2,000,000 + $3,000,000 = $11,000,000

Variable costs make up 55% of sales (i.e., COGS = 40%, commissions = 5%, and freight

= 10% of sales). So,

Contribution margin = 1  0.55 = 0.45

Therefore,

fixed costs $11,000,000 Break-even sales = ——————————— = —————— = $24,444,444 contribution margin 0.45

Reality check: Breakeven sales should be between $20 million and $40 million because Westgate did not realize a profit at $20 million but did at $40 million. Plus, breakeven sales should be closer to $20 million because the company only realized a $2 million loss at that sales level but experienced a $7 million profit at sales of $40 million.

2.3. Using the profit-and-loss statement you developed in question 2.2b, and assuming that Westgate’s beginning inventory was $11 million, ending inventory was $7 million, and total investment was $20 million including inventory, determine the following: a. gross margin percentage b. net profit percentage c. operating expense percentage d. inventory turnover rate e. return on investment (ROI) f. net marketing contribution g. marketing return on sales (marketing ROS) h. marketing return on investment (marketing ROI) i. Is the Westgate division doing well? Explain your answer.

gross margin $24,000,000 a.) Gross margin percentage= ——————— = —————— = 60% net sales $40,000,000

net profit $7,000,000 b.) Net profit percentage = ——————— = —————— = 17.5% net sales $40,000,000

total expenses $17,000,000 c.) Operating expense percentage = ——————— = —————— = 42.5% net sales $40,000,000

cost of goods sold d.) Inventory turnover rate = ——————————— average inventory at cost

$16,000,000 $16,000,000 = ——————————— = —————— = 1.78 ($11,000,000 + $7,000,000)/2 $9,000,000

net profit before taxes $7,000,000 e.) Return on investment = ————————— = —————— = 35% investment $20,000,000 f.) NMC = net sales  cost of goods sold  marketing expenses

where,

marketing expenses = selling expenses + promotion + freight + managerial

salaries and expenses = $5,000,000 + $3,000,000 + $4,000,000 + $2,000,000 =

$14,000,000

so,

NMC = $40,000,000  $16,000,000  $14,000,000 = $10,000,000

net marketing contribution $10,000,000 g.) Marketing ROS = ——————————— = —————— = 25% net sales $40,000,000

22 Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall net marketing contribution $10,000,000 h.) Marketing ROI = ——————————— = —————— = 71.4% marketing expenses $14,000,000 i.) Students’ responses will vary on this question. However, it should be noted that these ratios should be compared to previous ratios for the division, other divisions of the company, competitors, and industry averages.

III. Financial Analysis of Marketing Tactics

A. Increase Advertising Expenditures

1. What if HDX-treme increases national advertising by 50% to $15 million (assume no change in the variable cooperative component of promotional expenditures)? 2. What increase in sales will be needed to break even on this $5 million increase in fixed costs? 3. A quick way to answer this question is to divide the increase in fixed cost by the contribution margin (which was found in a previous analysis to be 21%):

increase in fixed cost $5,000,000 Increase in sales = ————————— = —————— = $23,809,524 contribution margin 0.21

Teaching Note: This is the increase in sales necessary to break even on this increase in fixed costs. Recall, however, that HDX-treme did not break even last year, so this increase in sales is in addition to the $5 million increase HDX-treme needs to break even.

B. Increase Distribution Coverage 1. HDX-treme currently employs 60 sales representatives who earn an average of $50,000 in salary plus 10% commission on sales. 2. DVD player is currently sold through 1,875 retail outlets, and HDX-treme wants to increase that to 2,500 outlets. 3. How many additional salespeople will HDX-treme need, and what level of sales will be necessary to break even on the increased cost? a) The workload method uses the following formula to determine the salesforce size:

NC  FC  LC NS = ———————— TA

NS = number of salespeople NC = number of customers FC = average frequency of customer calls per customer LC = average length of customer call TA = time an average salesperson has available for selling per year

(1) HDX-treme reps typically call on accounts an average of 20 times per year for about 2 hours per call, the average available time per sales rep per year is 1,250 hours (50 weeks  25 hours per week devoted to selling). (2) So the number of sales reps HDX-treme will need to cover 2,500 retail accounts is:

2,500  20  2 NS = ——————— = 80 salespeople 1,250

(3) So HDX-treme will need to hire 20 more salespeople. The cost to hire these reps will be $1 million (20 salespeople  $50,000 salary per rep). b) What increase in sales will be required to break even on this increase in fixed costs? As seen in the previous analysis, divide the increase in fixed cost by the contribution margin (which remains unchanged at 21% because the 10% commission was already accounted for):

increase in fixed cost $1,000,000 Increase in sales = —————————— = —————— = $4,761,905 contribution margin 0.21

c) Since the average revenue generated per outlet is $53,333 ($100 million in sales  1,875 outlets), HDX-treme would need about 90 new outlets ($4,761,905  $53,333 = 89.3 outlets). d) This seems reasonable given that current reps cover about 31 outlets apiece (1,875 outlets divided by 60 reps) and new reps would only need to acquire about 4.5 outlets for HDX-treme to break even on this proposal (89.3 outlets  20 reps).

C. Decrease Price 1. What increase in sales would be necessary to break even on a 10% decrease in price? That is, what increase in sales will be needed to

24 Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall maintain the total contribution that HDX-treme realized at the higher price? a) Current total contribution = contribution margin  sales = 0.21  $100 million = $21 million. b) Unit variable costs do not change, however, and can be determined by multiplying the unit price by the percentage represented by variable costs (recall that variable costs represented 79% of sales). Thus, unit variable costs equal $265.44 ($336  0.79). c) Price changes result in changes in unit contribution and contribution margin, so we must calculate the new contribution margin to determine the sales necessary to break even on this price reduction. d) New unit contribution and contribution margin can be calculated as follows:

Old New (reduced 10%) Price $336 $302.40  Unit variable cost $265.44 $265.44 = Unit contribution $70.56 $36.96 Contribution margin $70.56/$336 = 0.21 or 21% $36.96/$302.40 = 0.12 or 12%

e) To determine the sales level needed to break even on this price reduction, calculate the level of sales that must be attained at the new contribution margin to achieve the original total contribution of $21 million:

New contribution margin  new sales level = original total contribution

So,

original contribution $21,000,000 New sales level = —————————— = —————— = $175,000,000 new contribution margin 0.12

f) Sales must increase by $75 million, and the marketing manager must assess whether or not this is a reasonable goal.

D. Extend the Product Line 1. HDX-treme is considering introducing a lower-price model in addition to the original DVD player. 2. Cannibalization is the situation in which one product sold by a company takes a portion of its sales from other company products.

Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 25 a) If the new product has a lower contribution than the original product, the company’s total contribution will decrease on cannibalized sales. b) However, if the new product can generate enough new volume, it is worth considering. c) To assess cannibalization, we must look at the incremental contribution gained by having both products available. 3. Assume the first model offered by HDX-treme is called HD1 and the new, lower-priced model is HD2. 4. HD2 will retail for $400 and resellers take the same markup percentages on price as they do with HD1, so the markup chain is:

Retail price: $400 minus retail margin (30%):  $120 Retailer’s cost/wholesaler’s price: $280 minus wholesaler’s margin (20%):  $ 56 Wholesaler’s cost/HDX-treme’s price $224

5. HD1's unit contribution is about $70 ($336  $265.44). Recall that price and unit variable costs were determined in previous analyses. 6. HD2's variable costs are estimated to be $174, which gives a unit contribution of $50 ($224  $174). a) Thus, for every unit that HD2 cannibalizes from HD1, the company will lose $20 in contribution toward fixed costs and profit. b) The original estimate for next year’s sales of HD1 was 600,000 units. But with the introduction of HD2, it is estimated that 200,000 of those sales will be cannibalized by HD2. This results in a loss of contribution of $4 million (200,000 units  ($20) per cannibalized unit). c) It is estimated that HD2 will generate an additional 500,000 unit sales, resulting in an additional contribution of $25 million (500,000 units  $50 per unit). 7. The net effect is that HDX-treme will gain $21 million in total contribution by introducing HD2. 8. This can be seen by comparing the total contribution with and without the introduction of HD2:

HD1 only HD1 and HD2 HD1 contribution 600,000 units  $70 = $42,000,000 400,000 units  $70 = $28,000,000 HD2 contribution 0 700,000 units  $50 = $35,000,000 Total Contribution $42,000,000 $63,000,000

E. Marketing by the Numbers Exercise Set Three

3.1. Kingsford, Inc. sells small plumbing components to consumers through retail outlets. Total industry sales for Kingsford’s relevant market last year were $80 million, with Kingsford’s sales representing 10% of that total. Contribution margin is 25%. Kingsford’s sales force calls on retail outlets and each sales rep earns $45,000 per year plus 1% commission on all sales. Retailers receive a 40% margin on selling price and generate average revenue of $10,000 per outlet for Kingsford. a. The marketing manager has suggested increasing consumer advertising by $300,000. By how much would dollar sales have to increase to break even on this expenditure? What increase in overall market share does this represent? b. Another suggestion is to hire three more sales representatives to gain new consumer retail accounts. How many new retail outlets would be necessary to break even on the increased cost of adding three sales reps? c. A final suggestion is a make a 20% across-the-board price reduction. By how much would dollar sales have to increase to maintain Kingsford’s current contribution? (See endnote 12 to calculate the new contribution margin.) d. Which suggestion do you think Kingsford should implement? Explain your recommendation.

Answer: a.) Increase advertising by $300,000:

An increase in advertising of $300,000 represents an increase in fixed costs by that amount. Therefore, the increase in sales necessary to breakeven on this increase in fixed costs can be calculated by dividing by the contribution margin:

increase in fixed costs $300,000 Increase in sales = ——————————— = —————— = $1,200,000 contribution margin 0.25

1 share point = 1% of total market sales. So 1% of $80,000,000 = $800,000. Kingsford would have to realize a 1.5 share point increase in market share (i.e., $1,200,000 increase in sales  $800,000 per point = 1.5 share points), resulting in a market share of 11.5% required. Another way to determine this: increase in sales $1,200,000

Thus, Kingsford would need to increase market share 1.5 percentage points (i.e., increase from 10% market share to 11.5% market share). Still another way to determine this: new sales $9,200,000 New market share = ———————— = ————— = 0.115 = 11.5% total market sales $80,000,000 So the increase is 1.5 percentage points (from 10% to 11.5% market share). b.) Add three sales representatives: Each sales rep earns $45,000 in salary, so the increase in fixed cost = $135,000 (i.e., 3 reps  $45,000). As we did in part a with the increase in advertising expenditure, the $135,000 is an increase in fixed costs. Therefore, we can determine the increase in sales necessary to break even on this increase in fixed cost by dividing by the contribution margin:

increase in fixed costs $135,000 Increase in sales = ——————————— = —————— = $540,000 contribution margin 0.25

Retail outlets generate average revenue of $10,000 per outlet for Kingsford, so the number of outlets necessary to break even on the increased cost of adding three sales reps can be determined by: increase in sales $540,000 Increase in outlets = ——————————— = ———— = 54 outlets revenue per outlet $10,000

Therefore, Kingsford must obtain distribution through 54 more outlets to break even on this recommendation. c.) Decrease price by 20%:

We must determine the current total contribution and the new contribution margin.

Knowing that Kingsford’s market share is 10% of the total $80 million, therefore:

Current sales = 10% of $80 million = $8 million Therefore,

28 Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall Current total contribution = contribution margin  sales = 0.25  $8 million = $2 million Though we do not know prices, we can base our analyses on 100% or price = $1.00. Because we know the current contribution margin is 25%, the unit contribution will equal $0.25 and unit variable costs will equal $0.75. Thus, we can see the effect on unit contribution and contribution margin when price is decreased to $0.80:

Old New (reduced 20% ) Price $1.00 $0.80  Unit variable cost $0.75 $0.75 = Unit contribution $0.25 $0.05 Contribution margin $0.25/$1.00 = 0.25 or 25% $0.05/$0.80 = 0.0625 or 6.25 %

As can be seen, a 20% reduction in price resulted in a decrease of the contribution margin from 25% to 6.25%. To determine the level of sales necessary to break even on this price reduction, we calculate the level of sales that must be attained at the new contribution margin to achieve the same original total contribution of $2 million:

New contribution margin  new sales level = original total contribution

So,

original contribution $2,000,000 New sales level = ——————————— = —————— = $32,000,000 new contribution margin .0625

Thus, the absolute increase in sales to merely break even on a 20% reduction in price equals $24 million (i.e., $32 million  $8 million). d.) Students’ recommendations will vary. However, it appears that the suggestion to reduce price by 20% is the least attractive alternative.

3.2. PepsiCo sells its soft drinks in approximately 400,000 retail establishments, such as supermarkets, discount stores, and convenience stores. Sales representatives call on each retail account weekly, which means each account is called on by a sales rep 52 times per year. The average length of a sales call is 75 minutes (or 1.25 hours). While an average salesperson works 2,000 hours per year (50 weeks per year  40 hours per week), each spends ten hours a week on nonselling activities, such as administrative tasks and travel. How many sales people does PepsiCo need? Answer:

NC  FC  LC NS = ———————— TA

where,

NS = number of salespeople

NC = number of customers (400,000)

FC = frequency of customer calls (52)

LC = length of customer call (1.25)

TA = time an average salesperson has available for selling per year

(50 weeks  30 hours per week = 1,500 hours)

400,000  52  1.25 NS = ———————— = 17,333 1,500

Thus, PepsiCo needs 17,333 salespeople to carry out the selling function.

3.3. Hair Zone manufactures a brand of hair styling gel. It is considering adding a modified version of the product—a foam that provides stronger hold. Hair Zone’s variable costs and prices to wholesalers are: Current hair gel New foam product Unit selling price 2.00 2.25 Unit variable costs .85 1.25

Hair Zone expects to sell 1 million units of the new styling foam in the first year after introduction, but it expects that 60% of those sales will come from buyers who normally purchase Hair Zone’s styling gel. Hair Zone estimates that it would sell 1.5 million units of the gel if it did not introduce the foam. If the fixed cost of launching the new foam will be $100,000 during the first year, should Hair Zone add the new product to its line? Why or why not?

Answer:

Unit contribution = price  unit variable costs Unit contribution for the gel product = $2.00  $0.85 = $1.15 Unit contribution for the foam product = $2.25  $1.25 = $1.00

One way to analyze this is to assess the incremental contribution gained (or lost) by adding the new product. Hair Zone estimates that next year’s sales of the new foam product would be 1 million units, but 600,000 (60% of 1 million) will be cannibalized from the original gel product Thus, Hair Zone will lose $0.15 in contribution for every unit cannibalized:

Contribution lost due to cannibalization = 600,000 units  ($0.15) = $90,000 However, it is estimated that the foam product will generate an additional 400,000 unit sales (1 million units  600,000 cannibalized units). Thus, Contribution due to net new volume = 400,000 units  $1 per unit = $400,000 The net effect is that Hair Zone will gain $310,000 in contribution by introducing the foam product (incremental contribution = $400,000  $90,000 = $310,000). This increase in total contribution is greater than the $100,000 increase in fixed costs to introduce this product, so Hair Zone should consider this option favorably.

gel only gel and foam gel contribution 1,500,000 units  $1.15 = $1,725,000 900,000 units  $1.15 = $1,035,000 foam contribution 0 1,000,000 units  $1.00 = $1,000,000 Total Contribution $1,725,000 $2,035,000

Notice that the difference in the total contribution is a net gain of $310,000 ($2,035,000  $1,725,000 = $310,000), which we found using the incremental method. Again, because the increase in total contribution is greater than the increase in fixed cost, Hair Zone should go ahead with this product introduction.

Pro Forma Profit-and-Loss Statement for the 12-Month Period Ended December 31, 2007 % of sales Net Sales $125,000,000 100% Cost of goods sold 62,500,000 50% Gross Margin $ 62,500,000 50%

Marketing Expenses Sales expenses $17,500,000 Promotion expenses 15,000,000 Freight 12,500,000 45,000,000 36%

General and Administrative Expenses Managerial salaries and expenses $2,000,000 Indirect overhead 3,000,000 5,000,000 4% Net profit before income tax $12,500,000 10%

Table A2.2

Profit-and-Loss Statement for the 12-Month Period Ended December 31, 2007 % of sales Net Sales $100,000,000 100% Cost of goods sold 55,000,000 55% Gross Margin $ 45,000,000 45%

Marketing Expenses Sales expenses $15,000,000 Promotion expenses 14,000,000 Freight 10,000,000 39,000,000 39%

General and Administrative Expenses Managerial salaries and expenses $2,000,000 Indirect overhead 5,000,000 7,000,000 7% Net profit before income tax ($1,000,000) -1%

Pro Forma Profit-and-Loss Statement for the 12-Month Period Ended December 31, 2007

% of sales Net Sales $ 125,000,000 100% Cost of Goods Sold $ 62,500,000 50% Gross Margin $ 62,500,000 50%

Marketing Expenses Sales Expenses $ 17,500,000 Promotion Expenses $ 15,000,000 Feight $ 12,500,000 $ 45,000,000 36%

General and Administration Expenses Managerial salaries and expenses $ 2,000,000 Indirect Overhead $ 3,000,000 $ 5,000,000 4% Net Profit $ 12,500,000 10%

Teaching Note: Note that the absolute amount for the cost of goods sold was entered in that cell because the percentage of sales that cost of goods sold represents was estimated to represent 50% of sales when developing the pro forma statement, but it represented 55% of actual sales. Either one of these spreadsheets can be used to develop the spreadsheets for quantitative exercise 2.2, but students will have to change equations in the cells to calculate the correct expenses.

Spreadsheet A2.2

Profit-and-Loss Statement for the 12-Month Period Ended December 31, 2007

% of sales Net Sales $ 100,000,000 100% Cost of Goods Sold $ 55,000,000 55% Gross Margin $ 45,000,000 45%

Marketing Expenses Sales Expenses $ 15,000,000 Promotion Expenses $ 14,000,000 Feight $ 10,000,000 $ 39,000,000 39%

General and Administration Expenses Managerial salaries and expenses $ 2,000,000 Indirect Overhead $ 5,000,000 $ 7,000,000 7% Net Profit (1,000,000) -1%

1. Chill Out, a manufacturer of outdoor patio heaters, realizes a cost of $75 for every heater it produces. Total fixed costs equal $3 million. If the company manufactures 1 million heaters, compute the following: a. unit cost b. markup price if the company desires a 15% return on sales c. ROI price if the company desires a 20% return on an investment of $10 million

Answer:

fixed costs $3,000,000 a.) Unit cost = variable cost + —————— = $75 + ————— = $78 unit sales 1,000,000

unit cost $78 b.) Markup price = ————————————— = ——— = $91.76 (l  desired return on sales) l  0.15

ROI  investment (0.20  $10,000,000) c.) ROI price = unit cost + ——————— = $78 + —————— = $80.00 unit sales 1,000,000

2. A women’s apparel retailer purchases items to sell in the store. If the retailer purchases a blouse for $30 and sells it for $45, determine the following: a. dollar markup b. markup percentage on cost c. markup percentage on selling price

Answer:

a.) Dollar markup = selling price  cost = $45  $30 = $15

dollar markup $15 b.) Markup percentage on cost = ——————— = ——— = 0.5 = 50% cost $30

dollar markup $15 c.) Markup percentage on price = ——————— = ——— = 0.333 = 33.3% price $45

Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 35 3. A consumer purchases a lawn mower from Home Depot for $225. Home Depot’s markup is 30%, and the wholesaler’s is 20%, both based on selling price. For what price does the manufacturer sell the product to the wholesaler?

Answer:

price  cost Markup percentage on price = —————— price so, Cost at each level = price  (price  markup%)

Home Depot’s cost = $225  ($225  0.30) = $157.50, which is the price the wholesaler sells it to Home Depot.

The wholesaler’s cost = $157.50  ($157.50  0.20) = $126, which is the price the manufacturer sells the product to the wholesaler.

Another way to compute this is:

Retail price: $225.00 minus retail margin (30%):  $ 67.50 Retailer’s cost/wholesaler’s price: $157.50 minus wholesale margin (20%):  $ 31.50 Wholesaler’s cost/manufacturer’s price $ 126.00

4. A bicycle manufacturer has a unit cost of $75 and wishes to achieve a margin of 40% based on selling price. If the manufacturer sells directly to a retailer who then adds a set margin of 30% based on selling price, determine the retail price charged to consumers.

Answer:

price  cost Markup percentage on price = —————— price So, at any level in the chain: cost price = ————— (1 markup)

cost $75 Manufacturer’s price = ————— = ————— = $125 (1 markup) (1 0.4)

5. Complete the blanks in the following markup chain. All markup percentages are based on selling prices. $ %

Retail selling price $4.00

Retail markup ______50%

Retail cost ______

Wholesale selling price ______

Wholesale markup ______

Wholesale cost ______

Manufacturer’s selling price ______

Manufacturer’s markup ______60%

Manufacturer’s cost $0.48

Answer:

To complete this chain, students need the following equations:

Dollar markup = selling price  cost

price  cost Markup percentage on price = —————— price so, Cost at each level = price  (price  markup%)

price  cost Markup percentage on price = —————— price

To fill in the blanks on this chain, students can begin either at the top or the bottom. If beginning at the top, they can determine the retail dollar markup, followed by the retail cost, which is the wholesale selling price. There is not enough information at that point to continue down the chain, so they will have to work from the bottom to determine the wholesale cost. Working from the bottom, they can first determine the manufacturer’s selling price from the information given, and the difference between the price and the cost is the dollar markup. The manufacturer’s price is the wholesale cost, so now they can work from the top to determine the wholesale selling price (which they would have gotten to if starting at the top). Once these two figures are determined, they can subtract the wholesale cost from the wholesale price to determine the wholesale dollar markup. The only unknown, then, is the percentage wholesale markup, which can be determined by dividing the wholesale dollar markup by the wholesale price.

$ %

Retail selling price $4.00

Retail markup ___$2.00____ 50%

Retail cost ___$2.00____

Wholesale selling price ___$2.00____

Wholesale markup ___$0.80______40%___

Wholesale cost ___$1.20____

Manufacturer’s selling price ___$1.20____

Manufacturer’s markup ___$0.72____ 60%

Manufacturer’s cost $0.48

6. Note: Only use this exercise if the equations given in the teaching note were covered. Suppose a retailer uses a markup of 40% based on price and found that his competitor was using a markup of 50% percent based on cost and wanted to know what this would be as a percentage of selling price. Are these equivalent?

The equations given in the teaching note are:

markup percentage on cost Markup percentage on selling price = 100% + markup percentage on cost

markup percentage on selling price Markup percentage on cost = 100% - markup percentage on selling price

The calculation is:

50% 50% = = 33.3% 100% + 50% 150%

These are not equivalent as the first retailer is using a 40% markup based on price, but the competitor is using a lower markup based on price (33.3%).

7. Seasons, Inc. manufactures holiday wreaths and sells them directly to retailers for $5.00. The manufacturer’s cost information is as follows: Variable cost $3.35/wreath Advertising and promotion $300,000 Overhead $700,000

Calculate the following: a. contribution per unit and contribution margin for the manufacturer b. break-even volume in units and dollars c. volume in units and dollar sales necessary if Seasons’s profit goal is $500,000 d. net profit if 6 million wreaths are sold

Answer:

a.) Unit contribution = selling price  unit variable cost

Therefore, the contribution per unit = $5  $3.35 = $1.65

unit contribution $1.65 Contribution margin = ———————— = ———— = 0.33 or 33% price $5

Breakeven sales = breakeven volume  price = 606,061 units  $5 = $3,030,305 or fixed costs $1,000,000 Breakeven sales = ———————— = ———— = $3,030,303 contribution margin 0.33

The difference between the two calculations for breakeven sales is due to rounding.

fixed costs + profit goal c.) Unit volume = ——————————— price  variable cost

$1,000,000 + $500,000 = —————————— = 909,091 units $5  $3.35

Sales necessary = 909,091 units x $5 = $4,545,455

or fixed costs + profit goal $1,500,000 Breakeven sales = ———————— = ———— = $4,545,455 contribution margin 0.33

d.) Net profit = total revenue  total costs

Total revenue if 6 million units are sold = 6,000,000  $5 = $30 million

Total cost is equal to TFC + TVC, so if 6 million units are sold:

Total cost = $1,000,000 + ($3.35  6,000,000) = $21,100,000

Net profit = $30,000,000  $21,100,000 = $8,900,000

(Note: Students may merely subtract the fixed costs from the total contribution: ($1.65  6,000,000 units)  $1,000,000 = $8,900,000.)

40 Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 8. A company sells its products for $8.50. It has variable costs of $2.50, and fixed costs total $250,000. What must its dollar sales be to break even? How many units must it sell to earn a 20% return on its investment of $100,000?

Answer:

fixed costs $250,000 Breakeven volume = ———————— = ———— = 41,667 units unit contribution $6.00

where unit contribution = price  variable cost = $8.50  $2.50 = $6.00

Breakeven sales = breakeven volume  price = 41,667 units  $8.50 = $354,169.50

or fixed costs $250,000 Breakeven sales = ———————— = ———— = $352,113 contribution margin 0.71 where unit contribution $6.00 Contribution margin = ———————— = ———— = 0.7059 or 71% price $8.50 price $8.50

The difference between the two calculations for breakeven sales is due to rounding.

To determine the unit volume necessary to earn a 20% return on an investment of $100,000, we must first determine the absolute amount of the profit goal. The profit goal is 20% of $100,000, or $20,000 (0.2  $100,000). so fixed costs + profit goal Unit volume = ——————————— unit contribution

$250,000 + $20,000 = —————————— = 45,000 units $6.00

9. Determine the market potential for a product that has 8 million prospective buyers who purchase an average of 2 per year and price averages $50.

Q = n  q  p where Q = total market demand n = number of buyers in the market q = quantity purchased by an average buyer per year p = price of an average unit

The upper limit of market demand is called market potential. It’s a straightforward calculation:

Q = 8,000,000 buyers  2 units per buyer  $50 per unit = $800 million

10. Smithsborough, Inc. had the following profit and loss statement for the year ending 2007:

Sales $50,000,000 Cost of goods sold 10,000,000 Gross Margin $40,000,000

Marketing Expenses Sales expenses $10,000,000 Promotion expenses 4,000,000 14,000,000

General and Administrative Expenses Managerial salaries and expenses for the marketing function $1,000,000 Indirect overhead 6,000,000 7,000,000 Net profit before income tax $19,000,000

Determine the following ratios: a. gross margin percentage b. net profit percentage c. operating expense percentage d. net marketing contribution e. marketing return on sales (marketing ROS) f. marketing return on investment (marketing ROI) g. Is Smithsborough doing well? Explain your answer.

Answer:

gross margin $40,000,000 a.) Gross margin percentage= ——————— = —————— = 0.80 = 80% net sales $50,000,000

total expenses $21,000,000 c.) Operating expense percentage = ——————— = ————— = 0.42 = 42% net sales $50,000,000 d.) NMC = net sales  cost of goods sold  marketing expenses

where,

marketing expenses = selling expenses + promotion + managerial salaries and

expenses for the marketing function = $10,000,000 + $4,000,000 + $1,000,000 =

$15,000,000

so,

NMC = $50,000,000  $10,000,000  $15,000,000 = $25,000,000

net marketing contribution $25,000,000 e.) Marketing ROS = ——————————— = —————— = 0.50 = 50% net sales $50,000,000

net marketing contribution $25,000,000 f.) Marketing ROI = ——————————— = —————— = 1.67 = 167% marketing expenses $15,000,000

This is not a mistake. Marketing ROI can be greater than 100%, which indicates that the company is efficient with its marketing expenditures. In this case, each dollar spent on marketing is generating $1.67 toward general fixed costs and profit. g.) Students’ responses will vary on this question, but most students will agree that Smithsborough is doing well. However, it should be noted that these ratios should be compared to previous ratios for the division, other divisions of the company, competitors, and industry averages.

11. Given the following cost structure, calculate Blendco, Inc.’s breakeven dollar sales:

Cost of goods sold equal to 50% of sales

Advertising expenditures of $500,000

Freight expenses equal 10% of sales

Marketing staff costs equal $250,000 per year

Indirect overhead equals $600,000

Answer:

Breakeven sales can be determined by:

fixed costs Break-even sales = —————————— contribution margin

Total fixed costs = sales salaries + advertising + managerial salaries and expenses + indirect overhead = $1,000,000 + $500,000 + $250,000 + $600,000 = $2,350,000

Variable costs make up 70% of sales (i.e., COGS = 50%, commissions = 10%, and freight = 10% of sales). So,

Contribution margin = 1  0.70 = 0.30

Therefore,

fixed costs $2,350,000 Break-even sales = ——————————— = —————— = $7,833,333 contribution margin 0.30

12. Drake, Inc. manufactures electric welders that it sells to other manufacturers, and sales last year were $45 million. Drake has a 35% contribution margin. The marketing manager has suggested increasing the number of sales representatives by five, which would cause fixed costs to increase by $250,000. Another suggestion is to reduce price by 10%.

44 Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall a. What incremental dollar volume would be necessary to break even on the suggestion to hire five additional sales reps? b. What absolute increase in dollar sales volume would be necessary to maintain Drake’s current contribution if price was reduced by 10%? c. Which suggestion do you think Drake should implement? Explain your recommendation.

Answer: a.) Add five sales representatives: Adding five sale reps would increase fixed cost by $250,000. We can determine the increase in sales necessary to break even on this increase in fixed cost by dividing by the contribution margin:

increase in fixed costs $250,000 Increase in sales = ——————————— = —————— = $714,286 contribution margin 0.35 b.) Decrease price by 10%: We must determine the current total contribution with sales of $45 million and the new contribution margin after price is reduced by 10%. Therefore,

Current total contribution = contribution margin  sales = 0.35  $45 million = $15,750,000 Though we do not know prices, we can base our analyses on 100% or price = $1.00. Because we know the current contribution margin is 35%, the unit contribution will equal $0.35 and unit variable costs will equal $0.65. Thus, we can see the effect on unit contribution and contribution margin when price is decreased to $0.90:

Old New (reduced 10% ) Price $1.00 $0.90  Unit variable cost $0.65 $0.65 = Unit contribution $0.35 $0.25 Contribution margin $0.35/$1.00 = 0.35 or 35% $0.25/$0.90 = 0.278 or 27.8 %

As can be seen, a 10% reduction in price resulted in a decrease of the contribution margin from 35% to 27.8%. To determine the level of sales necessary to break even on this price

Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 45 reduction, we calculate the level of sales that must be attained at the new contribution margin to achieve the same original total contribution of $15,750,000:

New contribution margin  new sales level = original total contribution

So,

original contribution $15,750,000 New sales level = ——————————— = —————— = $56,654,676 new contribution margin 0.278

Thus, the absolute increase in sales to merely break even on a 10% reduction in price equals $11,654,676 (i.e., $56,654,676  $45,000,000). c.) Students’ recommendations will vary. However, it appears that the suggestion to reduce price by 10% is the least attractive alternative.

13. Artco sells framed artwork in approximately 5,000 home decorating stores. Sales representatives call on each store 5 times per year. The average length of a sales call is one hour. While an average salesperson works 2,000 hours per year (i.e., 50 weeks per year  40 hours per week), each spends ten hours a week on nonselling activities, such as administrative tasks and travel. How many sales people does Artco need? Answer: The number of salespeople can be determined by using the workload method:

NC  FC  LC NS = ———————— TA where,

NS = number of salespeople

NC = number of customers (5,000 stores)

FC = frequency of customer calls (5 time per year)

LC = length of customer call (1 hour)

TA = time an average salesperson has available for selling per year (50 weeks 

30 hours per week = 1,500 hours)

14. Avian Electronics, Inc. manufactures a model of portable music players that can play music downloaded from the Internet. It is considering adding a more advanced model of the product that can also download and play video files as well as music files. Avian’s variable costs and prices to wholesalers are:

Current Audio model New Audio/Video model Unit selling price $150.00 $250.00 Unit variable costs $60.00 $120.00

The company expects to sell 2 million units of the new audio/video model in the first year after introduction, but it expects that half of those sales will come from buyers who would have purchased Avian’s current audio model. Avian estimates that it would sell 2.5 million units of the current audio model if it did not introduce the audio/video model. If the fixed cost of launching the new audio/video model will be $800,000 during the first year, should Avian add the new model? Why or why not?

Answer: This is a cannibalization problem. To analyze this problem, we need to determine unit contributions:

Unit contribution = price  unit variable costs Unit contribution for the audio model = $150  $60 = $90 Unit contribution for the audio/video model = $250  $120 = $130 Because the audio/video model has a higher contribution than the audio model, any cannibalized volume will positively impact total contribution. That is, Avian will experience a gain in contribution of $40 for every unit cannibalized from the audio model ($130  $90 = $40). However, we must determine the contribution gained by adding the new model to ensure that it is higher than the $800,000 increase in fixed costs associated with the introduction of the new model.

Contribution gained due to cannibalization = 1 million units  $40 = $40,000,000 No further calculations are necessary because the gain in contribution due to cannibalization alone far exceeds the increase in fixed cost. Avian should introduce the new model. (However, if students did calculate the total incremental contribution, they must determine the contribution generated by the other 1 million units of the audio/video model that are not cannibalized sales: 1 million units  $130 = $130 million. Add that to

Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 47 the contribution due to the cannibalized sales, and we get a total increase in contribution of $170 million.) Another way students might do this problem is to examine the total contributions with and without the new model:

Audio model only Audio and Audio/Video models audio contribution 2,500,000 units  $90 = $225,000,000 1,500,000 units  $90 = $135,000,000 audio/video contribution 0 2,000,000 units  $130 = $260,000,000 Total Contribution $225,000,000 $395,000,000

The difference in the total contribution is a net gain of $170 million ($395 million  $225 million = $170 million), which is greater than the $800,000 increase in fixed costs.

15. Perfam is a manufacturer of fragrances for women. It currently sells two brands, one called Allure, which is sold to wholesalers for $40, and another called Beauty, which is sold to wholesalers for $20. It is considering adding a mid-priced brand called Classy for $30. Perfam’s variable costs and prices to wholesalers for six ounce bottles are:

Allure Beauty Classy (new brand) Unit selling price $40.00 $20.00 $30.00 Unit variable $20.00 $10.00 $15.00 costs

Perfam expects to sell 10,000 bottles of the new Classy brand, but 5,000 of those sales will be cannibalized from Allure and 1,000 will be cannibalized from Beauty. Before Perfam considered the new brand, it had expected to sell 11,000 bottles of Allure and 10,000 bottles of Beauty. Should Perfam launch the new Classy brand? Answer: This is a cannibalization problem. To analyze this problem, we need to determine unit contributions for each brand:

Unit contribution = price  unit variable costs Unit contribution for Allure = $40  $20 = $20 Unit contribution for Beauty = $20  $10 = $10 Unit contribution for Classy = $30  $15 = $15 One way to analyze this is to assess the incremental contribution gained (or lost) by adding the new product. Perfam estimates that next year’s sales of the new Classy brand will be 10,000 bottles, but 5,000 of those will be cannibalized from the Allure brand and 1,000 will be cannibalized from the Beauty brand. Thus, Perfam will lose $5 in

48 Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall contribution for every bottle cannibalized from Allure, but it will gain $5 in contribution for every bottle cannibalized from Beauty:

Contribution lost due to cannibalization from Allure = 5,000 bottles  ($5) = $25,000 Contribution gained due to cannibalization from Beauty = 1,000 bottles  $5 = $5,000 The net effect is a loss in total contribution of $20,000 due to cannibalization. However, it is estimated that Classy will generate an additional 4,000 bottle sales. Thus,

Contribution due to net new volume = 4,000 bottles  $15 per unit = $60,000 The net effect is that Perfam will gain $40,000 in incremental contribution by introducing the new Classy brand (incremental contribution = $60,000  $20,000 = $40,000). Assuming no increases in fixed costs, Perfam should launch this new brand.

Another way to see is to compare Perfam’s total contribution with and without the introduction of the new product:

Allure and Beauty only All three brands Allure contribution 11,000 bottles  $20 = $220,000 6,000 bottles  $20 = $120,000 Beauty contribution 10,000 bottles  $10 = $100,000 9,000 bottles  $10 = $90,000 Classy contribution 0 10,000 bottles  $15 = $150,000 Total Contribution $320,000 $360,000

Notice that the difference in the total contribution is a net gain of $40,000 ($360,000  $320,000 = $40,000), which we found using the incremental method.