Profit Dynamics - PowerPoint Presentation

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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 FarrisMarketing Metrics Reference: Chapter 3© 2011 Paul Farris and Management by the Numbers, Inc.Slide2

Breakeven Review

2Breakeven Review

MBTN | Management by the NumbersDefinitionsBE (units) = Fixed Costs / (Selling Price – Variable Cost) or Fixed Costs / Unit MarginBE ($) = 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

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 costsSlide3

Target Profits

3Target Profits

MBTN | Management by the NumbersDefinitionsTarget 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

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.

But What About Profits?Slide4

Target Profit: Examples

4Target Profit: Examples

MBTN | Management by the NumbersQuestion 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:

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.Slide5

Target Profit: Examples

5Target Profit: Examples

MBTN | Management by the NumbersQuestion 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:

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 Slide6

Review

6Review

MBTN | Management by the NumbersThe 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 . . .Summarizing Target Profit and Target Volume...Slide7

Contribution: Sample Problems

7Target Profit: Sample Problems

MBTN | Management by the NumbersQuestion 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 in-flight 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?

Answer:

We know that

Target Volume (units) = (FC + Profit Objective) / (SP - VC)

From the problem,

Variable Costs = 5 + 15 + 10 = 30

Euros per watchTherefore, substituting in our values:

Target Volume (units) = (100,000 + 40,000) / (50 – 30) = 140,000 / 20

= 7,000 watches Slide8

Contribution: Sample Problems

8Target Profit: Sample Problems

MBTN | Management by the NumbersQuestion 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:

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 + ProfitProfit = $18,000! That’s a lot of donuts!

[Alt. Calculation] Profit = 100,000 * (.25 - .05) - $2,000 = $18,000Slide9

Contribution: Sample Problems

9Target Profit: Sample Problems

MBTN | Management by the NumbersQuestion 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:

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 Slide10

Price – Volume Interactions

10Price – Volume Interactions

MBTN | Management by the NumbersWhile 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.But the world is not static...Slide11

Price – Volume Interactions: Examples

11Price – Volume Interaction: Examples

MBTN | Management by the NumbersQuestion 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: 1,000 units

Sales Price per hat: $75

Variable Cost per hat: $20

Unit Contribution

:

$55

Year 1 Total Contribution: $55,000

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?Slide12

Price – Volume Interactions: Examples

12Price – Volume Interaction: Examples

MBTN | Management by the NumbersAnswer: 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: $55,000Year 1 Volume: 1,000

Year 2 (New) Unit Contribution: $80

Year 2 (New) Target Volume: 688 [$55,000 / $80]

Percentage Decrease: 31.2% [(1000 – 688) / (1000)]

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%] Slide13

Price – Volume Interactions: Examples

13Price – Volume Interaction: Examples

MBTN | Management by the NumbersQuestion 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: 700 units

Variable Cost per hat: $20

Total Contribution Goal: 110% of Sam’s Year 1

(110% of $55,000)

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?Slide14

Price – Volume Interactions: Examples

14Price – Volume Interaction: Examples

MBTN | Management by the NumbersAnswer: Lena must cover her contribution goal and her billboard advertising expense with her cowgirl hat sales:Contribution goal: $60,500 [$55,000 x 110%]Billboard advertising: $5,000 [Fixed Cost]Total Goal: $65,500

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: $93.57 ($65,500 / 700 hats)

Variable Costs: $20

Necessary Sales Price: $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 = $113.57Slide15

Price – Volume Interactions: Examples

15Price – Volume Interaction: Examples

MBTN | Management by the NumbersQuestion 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:

$20,000

Cowgirl hat unit sales price: $100

Total contribution goal

:

$100,000What percentage increase in sales must Lena achieve to meet her Year 2 goals?Slide16

Price – Volume Interactions: Examples

16Price – Volume Interaction: Examples

MBTN | Management by the NumbersAnswer: Lena needs to cover her increased advertising expense and her higher contribution goal with a lower unit contribution margin:Total Advertising: $20,000Total Contribution Goal: $100,000Total FC + Contribution Goal: $120,000

Unit Contribution: $80 (SP of $100 – VC of $20)

Necessary Sales: 1,500 ($120,000 / $80)

Percentage Increase: 114% [((1,500 – 700) / 700) x 100]

Lena would need her total sales to more than double to meet her goals!

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!Slide17

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.Breakeven – Further Reference17Profit Dynamics - Further Reference

MBTN | Management by the Numbers