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Profit Dynamics This module reviews breakeven and covers the concepts of target profit and volume and price-volume interaction. Author: Paul Farris Marketing Metrics Reference: Chapter 3 © 2011 Paul Farris and Management by the Numbers, Inc. • The Breakeven Point is selling enough to just cover fixed costs. • Unit Breakeven is unit sales required to cover fixed costs • Revenue Breakeven is sales revenue required to cover fixed costs BREAKEVEN REVIEW Breakeven Review Definitions BE (units) = Fixed Costs / (Selling Price – Variable Cost) or Fixed Costs / Unit Margin BE ($) = Fixed Costs / ((Selling Price – Variable Cost) / Selling Price) or Fixed Costs / Margin % To convert from revenue (currency) to units or vice versa: Revenue Breakeven = Breakeven in Units * Unit Price Breakeven in Units = Revenue Breakeven / Unit Price MBTN | Management by the Numbers 2 But What About Profits? • Companies don’t want to just breakeven on costs, they want to earn profits. • We can calculate how many units have to be sold in order to breakeven on costs and to produce a particular level of profit. TARGET PROFITS Target Profits Definitions Target Volume in Units = (Fixed Costs + Profit Objective) / (SP – VC) Target Volume in Dollars = (Fixed Costs + Profit Objective) / ((SP-VC) / SP) Just as with the breakeven formulas, notice that multiplying the first formula by the selling price yields the second formula. Thus… Target Revenues = Unit Target Volume * Selling Price MBTN | Management by the Numbers 3 Question 1: Mickey’s Mousetraps wants to calculate how many of its “Magic Mouse Trappers” it needs to sell in order to realize a profit objective* of $30,000. The product sells for $20, it costs $5 per unit to make, and the company’s fixed costs are $30,000. Answer: TARGET PROFIT: EXAMPLES Target Profit: Examples We know that Target Volume (units) = (FC + Profit Objective) / (SP - VC) Therefore, substituting in our values: Target Volume (units) = ($30,000 + $30,000) / ($20 - $5) = 4000 mousetraps *Note: A profit objective may sometimes be described as a contribution objective. Generally, a contribution objective will not consider covering fixed costs whereas as a profit objective will. However, depending on the context, they may be used interchangeably, especially if describing the contribution a particular product line makes toward a company’s overall profitability. MBTN | Management by the Numbers 4 Question 2: Now Mickey’s Mousetraps wants to calculate how many dollars worth of its “Deluxe Mighty Mouse Trappers’” it needs to sell in order to realize a profit objective of $60,000. The product sells for $40, it costs $10 per unit to make, and the company’s fixed costs are $30,000. Answer: TARGET PROFIT: EXAMPLES Target Profit: Examples We know Target Volume (Revs) = (FC + Profit Objective) / ((SP - VC) / SP) Therefore, substituting in our values: Target Volume (revenues) = ($30,000 + $60,000) / (($40 - $10) / $40) = ($90,000 / 0.75) = $120,000 = 3000 mousetraps MBTN | Management by the Numbers 5 REVIEW Review Summarizing Target Profit and Target Volume... • The objective of break-even calculations is to determine how many units or dollars worth of a product need to be sold to cover all costs. • The objective of target volume calculations is to determine how many units or dollars worth of a product need to be sold not just to cover costs, but to achieve a certain profit objective as well. • Continue for a few sample problems . . . MBTN | Management by the Numbers 6 Question 1: Swiss entrepreneur Herr Zeitgeist buys watch faces from Italy for 5 Euros, buys watch mechanisms for 15 Euros from Spain, and hires assembly in Portugal for 10 Euros per watch. His only other expense is 100,000 Euros he pays the Zuricher Flughafen ad agency to place ads in inflight magazines to build the Zeitgeist brand. Herr Zeitgeist sells each watch for 50 Euros to airport duty-free shops, that earn an 80% margin on the sale of each watch. If his profit objective is 40,000 Euros, how many watches must he sell? CONTRIBUTION: SAMPLE PROBLEMS Target Profit: Sample Problems Answer: We know that Target Volume (units) = (FC + Profit Objective) / (SP - VC) From the problem, Variable Costs = 5 + 15 + 10 = 30 Euros per watch Therefore, substituting in our values: Target Volume (units) = (100,000 + 40,000) / (50 – 30) = 140,000 / 20 = 7,000 watches MBTN | Management by the Numbers 7 Question 2: Ms. Sprinkle runs a donut shop called “It’s in the hole!” She calculated the cost of the ingredients to be $0.05 per donut. Her rent and other overhead expenses total $2,000 per month. She sells her donuts for $0.25 each. If she sold 100,000 donuts in the last month, what were her profits? Answer: CONTRIBUTION: SAMPLE PROBLEMS Target Profit: Sample Problems We know that Target Volume (units) = (FC + Profit) / (SP - VC) Therefore, substituting in our values: 100,000 units = ($2,000 + Profit) / (0.25 – 0.05) 100,000 units = ($2,000 + Profit) / (0.20) $20,000 = $2000 + Profit Profit = $18,000! That’s a lot of donuts! [Alt. Calculation] Profit = 100,000 * (.25 - .05) - $2,000 = $18,000 MBTN | Management by the Numbers 8 Question 3: Now Ms. Sprinkle wants to know her profits for a particular level of sales revenues. As before, she calculated the cost of the ingredients to be $0.05 per donut. Her rent and other overhead expenses total $2,000 per month. She sells her donuts for $0.25 each. If she sold $10,000 of donuts last month, what were her profits? Answer: CONTRIBUTION: SAMPLE PROBLEMS Target Profit: Sample Problems We know Target Volume (Revs) = (FC + Profit) / ((SP - VC) / SP) Therefore, substituting in our values: $10,000 = ($2,000 + Profit) / ((0.25 – 0.05) / 0.25) $10,000 = ($2,000 + Profit) / (0.80) $8,000 = $2000 + Profit Profit = $6,000 MBTN | Management by the Numbers 9 But the world is not static... • While static relationships like the target volume and target profit equations provide a sound framework for estimating sales targets, price points, and budget allocations, often it is necessary for a manager to test various pieces of these equations in the quest for improving profitability. • Price-volume relationships are elusive to pinpoint. • Continue for a few examples that illustrate these concepts. MBTN | Management by the Numbers PRICE – VOLUME INTERACTIONS Price – Volume Interactions 10 Question 1: Sam moved from Texas to Maine last year and opened a cowboy hat store. The store became quite popular. Sam’s financials for last year were: Year 1 Cowboy Hat Sales: Sales Price per hat: Variable Cost per hat: Unit Contribution: Year 1 Total Contribution: 1,000 units $75 $20 $55 $55,000 PRICE – VOLUME INTERACTIONS: EXAMPLES Price – Volume Interaction: Examples Customers seemed so happy with the “cowboy look” that Sam wondered whether they would pay more for his hats. If, in Year 2, Sam raised the price of his hats to $100 each, how much could his volume drop before he would generate less contribution than in Year 1? MBTN | Management by the Numbers 11 Answer: Sam needs to calculate his Year 2 unit contribution, which is his new selling price [$100] less his variable cost [still $20], or $80. Then he can determine the number of units he needs to sell to meet the same total contribution of $55,000. Year 1 Total Contribution: Year 1 Volume: Year 2 (New) Unit Contribution: Year 2 (New) Target Volume: Percentage Decrease: $55,000 1,000 $80 688 [$55,000 / $80] 31.2% [(1000 – 688) / (1000)] PRICE – VOLUME INTERACTIONS: EXAMPLES Price – Volume Interaction: Examples Therefore, Sam can allow his sales to decline by 31% before his price increase actually hurts his total contribution. The figure can also be obtained by dividing the old unit contribution by the new [$55 / $80 = 0.6875] and subtracting the result from 1 as the percentage increase in contribution is offset by the same percentage decrease in volume. [1 – 0.6875 = 0.3125 = 31.25%] MBTN | Management by the Numbers 12 Question 2: Sam’s sister, Lena, upon hearing of her brother’s success, decided to move to Maine to compete against him. She believes that if she sells “cowgirl” hats, she can eventually achieve higher sales than Sam. Lena has the following first year targets: Total Cowgirl Hat Sales: Variable Cost per hat: Total Contribution Goal: 700 units $20 110% of Sam’s Year 1 (110% of $55,000) PRICE – VOLUME INTERACTIONS: EXAMPLES Price – Volume Interaction: Examples In addition, Lena is spending $5,000 on billboard advertising, so the locals will know that “authentic” Texas headwear isn’t for guys only. Given these costs and goals, what must Lena charge for her cowgirl hats? MBTN | Management by the Numbers 13 Answer: Lena must cover her contribution goal and her billboard advertising expense with her cowgirl hat sales: Contribution goal: Billboard advertising: Total Goal: $60,500 $5,000 $65,500 [$55,000 x 110%] [Fixed Cost] Lena can divide this total goal by the number of hats she hopes to sell to get a contribution per hat, to which she will add her variable costs per hat to arrive at a necessary sales price: Contribution per hat: Variable Costs: Necessary Sales Price: PRICE – VOLUME INTERACTIONS: EXAMPLES Price – Volume Interaction: Examples $93.57 ($65,500 / 700 hats) $20 $113.57 (contribution per hat + VC per hat) Note: One can also obtain the sales price by adding the total goal and the total variable costs, then dividing by the number of units. ($65,500 + $14,000) / 700 = $113.57 MBTN | Management by the Numbers 14 Question 3: Lena managed to meet her goals for the previous year. For Year 2, she believes an advertising blitz will allow her to drastically increase her sales as ‘cowgirl’ hats become even more fashionable. She also plans on doubling her total contribution and slightly cutting her sales price. Lena’ year 2 projections are: Total advertising: Cowgirl hat unit sales price: Total contribution goal: $20,000 $100 $100,000 PRICE – VOLUME INTERACTIONS: EXAMPLES Price – Volume Interaction: Examples What percentage increase in sales must Lena achieve to meet her Year 2 goals? MBTN | Management by the Numbers 15 Answer: Lena needs to cover her increased advertising expense and her higher contribution goal with a lower unit contribution margin: Total Advertising: Total Contribution Goal: Total FC + Contribution Goal: Unit Contribution: Necessary Sales: Percentage Increase: $20,000 $100,000 $120,000 $80 (SP of $100 – VC of $20) 1,500 ($120,000 / $80) 114% [((1,500 – 700) / 700) x 100] Lena would need her total sales to more than double to meet her goals! PRICE – VOLUME INTERACTIONS: EXAMPLES Price – Volume Interaction: Examples Perhaps Lena’s projections are too aggressive? It boils down to whether the increase in advertising and decrease in selling price will more than double demand and estimating the impact of these factors is beyond the scope of this module! MBTN | Management by the Numbers 16 Marketing Metrics by Farris, Bendle, Pfeifer and Reibstein, 2nd edition, pages 65-108 (Chapter 3). - And Pricing I – Linear Demand (advanced MBTN module). This module introduces one approach to estimating the relationship between price and volume. MBTN | Management by the Numbers BREAKEVEN – FURTHER REFERENCE Profit Dynamics - Further Reference 17