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However, this assumes sales volume would remain the same at the higher sales price. Sales volume might decrease at the higher sales price unless customers accept the increase as a general inflationary-driven increase. Sales volume might be sensitive to even small sales price increases. Many customers keep a sharp eye on prices, as you know. The business should probably allow for some decrease in sales volume when sales prices are raised.

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SURVIVAL ANALYSIS

As I recall, many years ago there was a series in a magazine called “Can This Marriage Be Saved?” Which is not a bad way to introduce the situation in which any business can find itself from time to time—selling a product or product line that is losing money hand over fist. Perhaps the entire business is in dire straits and can’t make money on any of its products.

Before throwing in the towel, the manager in charge should at least do the sort of analysis explained in this chapter to determine what would have to be done to salvage the product or keep the business going.

Profile of a Loser

A successful formula for making profit can take a wrong turn anytime. Every step on the pathway to profit is slippery and requires constant attention. Managers have to keep a close watch on all profit factors, continuously looking for opportunities to improve profit. Nothing can be taken for granted. A popular term these days is
environmental scan,
which is a good term to use here. Managers should scan the profit radar to see if there are any blips on the screen that signal trouble.

Suppose you’re the manager in charge of a product line, territory, division, or some other major organization unit of a large corporation. You are responsible for the profit performance of your unit, of course. A brief summary of your most recent annual profit report is presented in Figure 12.4, which is titled the Bad News Profit Report to emphasize the loss for the year. This report is shown in a condensed format to limit attention to absolutely essential profit factors. Only one variable operating expense is included (which is unit-driven). The examples in this and previous chapters also include revenue-driven variable operating expenses, but this distinction takes a backseat in the following analysis.

In addition to sales volume, note that the example also includes annual capacity and breakeven volume for the year just ended.

You have taken a lot of heat lately from headquarters for the $145,000 loss. Your job is to turn things around—and fairly fast. Your bonus next year, and perhaps even your job, depends on moving your unit into the black.

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Annual sales 100,000 units

Annual breakeven 120,000 units

Annual capacity 150,000 units

Per Unit

Total

Sales revenue

$50.00

$5,000,000

Product cost

($32.50)

($3,250,000)

Variable expenses

($10.25)

($1,025,000)

Contribution margin

$ 7.25

$ 725,000

Fixed operating expenses

($ 870,000)

Profit (loss)

($ 145,000)

Breakeven is computed by dividing $870,000 fixed

expenses by $7.25 contribution margin per unit.

Annual capacity is new information given here in the example.

FIGURE 12.4
Bad news profit report.

First Some Questions about Fixed Expenses

One thing you might do first is to take a close look at your $870,000 fixed operating expenses. Your fixed expenses may include an allocated amount from a larger pool of fixed expenses generated by the organizational unit to which your profit module reports, or they may include a share of fixed expenses from corporate headquarters. Any basis of allocation is open to question; virtually every allocation method is somewhat arbitrary and can be challenged on one or more grounds.

For instance, consider the legal expenses of the corporation. Should these be allocated to each profit responsibility unit throughout the organization? On what basis? Relative sales revenue, frequency of litigation of each unit, or according to some other formula? Likewise, what about the costs of centralized data processing and accounting expenses of the business? Many fixed expenses are allocated on some arbitrary basis, which is open to question.

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It’s not unusual for many costs to be allocated across different organizational units; every manager should be aware of the methods, bases, or formulas that are used to allocate costs. It is a mistake to assume that there is some natural or objective basis for cost allocation. Most cost allocation schemes are arbitrary and therefore subject to manipulation.

Chapter 17 discusses cost allocation schemes in more detail.

Questions about the proper method of allocation should be settled before the start of the year. Raising such questions after the fact—after the profit performance results are reported for the period—is too late. In any case, if you argue for a smaller allocation of fixed expenses to your unit, then you are also arguing that other units should be assessed a greater proportion of the organization’s fixed expenses—which will initiate a counterargument from those units, of course. Also, it may appear that you’re making excuses rather than fixing the problem.

Another question to consider is this: Is a significant amount of depreciation expense included in the fixed expenses total?

Accountants treat depreciation as a fixed expense, based on generally accepted methods that allocate original cost over the estimated useful economic lives of the assets. For instance, under current income tax laws, buildings are depreciated over 39 years and cars and light trucks over 5 years. Just because accountants adopt such methods doesn’t mean that depreciation is, in fact, a fixed expense.

Contrast depreciation with, for example, annual property taxes on buildings and land (real estate). Property tax is an actual cash outlay each year. Whether or not the business made full use of the building and land during the year, the entire amount of tax should be charged to the year as fixed expense. There can be no argument about this. On the other hand, depreciation raises entirely different issues.

Suppose your loss is due primarily to sales volume that is well below your normal volume of operations. You can argue that less depreciation expense should be charged to the year and more shifted to future years. The reasoning is that the assets were not used as much—the machines were not operated as many hours, the trucks were not driven as many miles, and so on. On the other hand, depreciation may be truly caused by the passage of time. For instance, depreciation of computers is based on their expected technological life.

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Using the computers less probably doesn’t delay the date of replacing the computers.

Generally speaking, arguing for less depreciation is not going to get you very far. Most businesses are not willing to make such a radical change in their depreciation policies (i.e., to slow down recorded depreciation when sales volume takes a dip). Also, this would look suspicious—the business would appear to be choosing expense methods to manipulate reported profit.

What’s the Problem?

Your first thought might be that sales volume is the main problem since it is below your breakeven point (see Figure 12.4). To review briefly, the breakeven point is determined as follows: $870,000 fixed expenses

ᎏᎏᎏ = 120,000 units breakeven volume

$7.25 unit margin

To reach breakeven (the zero profit and zero loss point) you would have to sell an additional 20,000 units, which would add $145,000 additional contribution margin at a $7.25 unit margin. By the way, notice that breakeven is 80 percent of capacity (120,000 units sold ÷ 150,000 units capacity = 80%).

By almost any standard, this is far too high. Anyway, just reaching the breakeven point is not your ultimate goal, though it would be better than being in the red.

Suppose you were able to increase sales volume beyond the breakeven point, all the way up to sales capacity of 150,000

units, an increase of 50,000 units from the actual sales level of 100,000 units. A 50 percent increase in sales volume may not be very realistic, to say the least. At any rate, your annual profit report would appear as shown in Figure 12.5.

Even if your sales volume could be increased to full capacity, profit would be only $217,500, which equals only 2.9 percent of sales revenue. For the large majority of businesses—the only exceptions being those with very high inventory turnover ratios—a meager 2.9 percent return on sales is seriously inadequate. Your return-on-sales profit goal probably should be in the range of 10 to 15 percent.

In short, increasing sales volume is not the entire answer.

You have two other basic options: Reduce fixed expenses or improve unit margin.

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Annual sales 150,000 units

Annual breakeven 120,000 units

Annual capacity 150,000 units

Per Unit

Total

Sales revenue

$50.00

$7,500,000

Product cost

($32.50)

($4,875,000)

Variable expenses

($10.25)

($1,537,500)

Contribution margin

$ 7.25

$1,087,500

Fixed operating expenses

($ 870,000)

Profit (loss)

$ 217,500

Notice that even at full capacity, profit is only 2.9 percent of sales revenue, which in almost all industries is far too low.

FIGURE 12.5
Sales at full capacity profit report.

There may be flab in your fixed expenses. It goes without saying that you should cut the fat. The more serious question is whether to downsize (reduce fixed operating expenses and capacity). For instance, assume you could slash fixed expenses by one-third ($290,000) but that this would reduce capacity by one-third, down to 100,000 units. If no other fac-

TEAMFLY

tors change, your profit performance would be as shown in Figure 12.6.

Your profit would be $145,000, which is better than a loss. But profit would still be only 2.9 percent of sales rev-

enue, which is much too low as already explained. Keep in mind that making profit requires a substantial amount of capital invested in the assets needed to carry on profit-

making operations. The capital invested in assets is supplied by debt and equity sources and carries a cost (as discussed in Chapter 6).

Suppose, to illustrate this cost-of-capital point, that the $5

million sales revenue level requires investing $2 million in assets—one-half from debt at 8.0 percent annual interest and one-half from equity on which the annual ROE target is 15.0

percent. The interest expense is $80,000 ($1 million debt ×

8.0%), leaving only $65,000 earnings before tax. Net income
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Team-Fly®

C O S T / V O L U M E T R A D E - O F F S

Annual sales 100,000 units

Annual breakeven 80,000 units

Annual capacity 100,000 units

Per Unit

Total

Sales revenue

$50.00

$5,000,000

Product cost

($32.50)

($3,250,000)

Variable expenses

($10.25)

($1,025,000)

Contribution margin

$ 7.25

$ 725,000

Fixed operating expenses

($ 580,000)

Profit (loss)

$ 145,000

Notice that even if fixed expenses are reduced by one-third, profit is only 2.9 percent of sales revenue, which in almost all industries is far too low.

FIGURE 12.6
Profit at one-third less fixed costs and capacity.

after income tax is not enough to meet the company’s ROE

goal, which would be the $1 million owners’ equity capital times 15.0 percent, or $150,000 net income.

By cutting fixed operating expenses you have removed any room for growth, because sales volume would be at capacity.

In summary, it’s fairly clear that your main problem is a unit contribution margin that is too low.

Improving Unit Margin

Now for the tough question: How would you improve unit margin? Is sales price too low? Are product cost and variable expenses too high? Do all three need improving? Answering these questions strikes at the essence of the manager’s function. Managers are paid for knowing what to do, what has to be changed, and how to make the changes. Analysis techniques don’t provide the final answers to these questions. But the analysis methods certainly help the manager size up and quantify the impact of changes in factors that determine unit contribution margin.

One useful approach is to set a reasonably achievable profit
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goal—say $500,000—and load all the needed improvement on each factor to see how much change would be needed in each.

To move from $145,000 loss to $500,000 profit is a $645,000

swing. If sales volume stays the same at 100,000 units, then achieving this improvement would require that the unit margin be increased $6.45 per unit, which is a tall order. You could compare the $6.45 unit margin increase to each profit factor; doing this shows that the following improvement percents would be needed:

Unit Margin Improvement as Percent of Each Profit Factor

$6.45 ÷ $50.00 sales price = 13 percent increase

$6.45 ÷ $32.50 product cost = 20 percent decrease

$6.45 ÷ $10.25 variable expenses = 63 percent decrease Making changes of these magnitudes would be very tough, to say the least.

Raising sales prices 13 percent would surely depress DANGER!

demand. Lowering product cost 20 percent is not realistic in most situations. And lowering variable expenses 63 percent may be just plain impossible. A combination of improvements would be needed instead of loading all the improvement on just one factor. Also, sales volume probably would have to be increased.