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Summing up, each of the three profit modules in the example (see Figure 9.1) earned $1 million for the year just ended.

These are profit amounts prior to taking into account the indirect fixed expenses of the business and the interest expense and income tax expense of the business. The general manager of each product line is held accountable for its profit performance, of course.

SELLING MORE UNITS

Business managers, quite naturally, are sales oriented. No sales, no business; it’s as simple as that. As they say in marketing—nothing happens until you sell it. Many businesses do not make it through their start-up phase because it’s very difficult to build up and establish a sales base. Customers have to be won over. Once established, sales volume can never be taken for granted. Sales are vulnerable to competition, shifts in consumer preferences and spending decisions,
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and general economic conditions both domestically and globally.

Thinking more positively, sales volume growth is the most realistic way to increase profit. In most cases, sales price increases are met with some degree of customer resistance as well as a response from competitors. Indeed, demand may be extremely sensitive to sales prices. Cost containment and expense control are important, to be sure, but are more of a defensive tactic than a profit growth strategy as such.

Suppose that for all three product lines the business sold 10

percent more units during the year just ended. What amount of profit would have been earned from each product line? Of course, there’s no such thing as a free lunch. An experienced manager would ask how the business could increase its sales volume. Would customers buy 10 percent more without any increase in advertising, without any sales price incentives, without some product improvements or other inducements?

Not too likely. Increasing sales volume usually requires some stimulant such as more advertising.

Another question an experienced manager might ask is whether the business has enough
capacity
to handle 10 percent additional sales. It’s always a good idea to run a capacity check whenever looking at sales volume increases. Fixed expenses may have to be increased to enlarge the capacity needed to accommodate the additional sales volume. However, assume that the manager of each profit module had enough untapped capacity to take on 10 percent additional sales volume without having to increase any of his or her fixed operating expenses.

Figure 9.2 presents the profit results for the 10 percent higher sales scenario for each product line. Sales prices, unit product costs, and variable expenses per unit remain the same in each of the three profit modules. And, the direct fixed costs of each product line remain the same. Therefore, at the higher sales volume the average fixed cost per unit is lower.

For instance, consider the standard product line. At the original 100,000 units sales volume, the $1 million in fixed costs average out to $10.00 per unit. At the higher 110,000 units sales volume, the average fixed costs per unit drop $.91 per unit, so the business makes $10.91 profit per unit. The driving force behind the $200,000 increase in profit is selling
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Standard Product Line

Original Scenarios (see Figure 9.1)

Changes

100,000 units sold 10,000 additional units

Per Unit Totals

Per Unit Totals

Sales revenue

$100.00

$10,000,000

$1,000,000

Cost of goods sold

$ 65.00

$ 6,500,000

$ 650,000

Gross margin

$ 35.00

$ 3,500,000

$ 350,000

Revenue-driven expenses @ 8.5% $ 8.50

$

850,000

$

85,000

Unit-driven expenses

$ 6.50

$

650,000

$

65,000

Contribution margin

$ 20.00

$ 2,000,000

$ 200,000

10%

Fixed operating expenses

$ 10.00

$ 1,000,000 ($0.91)

$

0

Profit

$ 10.00

$ 1,000,000

$0.91

$ 200,000

20%

Generic Product Line

150,000 units sold 15,000 additional units

Per Unit Totals

Per Unit Totals

Sales revenue

$ 75.00

$11,250,000

$1,125,000

Cost of goods sold

$ 57.00

$ 8,550,000

$ 855,000

Gross margin

$ 18.00

$ 2,700,000

$ 270,000

Revenue-driven expenses @ 4.0% $ 3.00

$

450,000

$

45,000

Unit-driven expenses

$ 5.00

$

750,000

$

75,000

Contribution margin

$ 10.00

$ 1,500,000

$ 150,000

10%

Fixed operating expenses

$ 3.33

$

500,000 ($0.30)

$

0

Profit

$ 6.67

$ 1,000,000

$0.30

$ 150,000

15%

Premier Product Line

50,000 units sold

5,000 additional units

Per Unit Totals

Per Unit Totals

Sales revenue

$150.00

$ 7,500,000

$ 750,000

Cost of goods sold

$ 80.00

$ 4,000,000

$ 400,000

Gross margin

$ 70.00

$ 3,500,000

$ 350,000

Revenue-driven expenses @ 7.5% $ 11.25

$

562,500

$

56,250

Unit-driven expenses

$ 8.75

$

437,500

$

43,750

Contribution margin

$ 50.00

$ 2,500,000

$ 250,000

10%

Fixed operating expenses

$ 30.00

$ 1,500,000 ($2.73)

$

0

Profit

$ 20.00

$ 1,000,000

$2.73

$ 250,000

25%

FIGURE 9.2
10 percent higher sales volumes.

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10,000 additional units at a $20.00 unit margin, not the decrease in average fixed cost per unit. This decrease is simply one result of the higher sales volume.

In all three cases, contribution margin improves exactly 10

percent, the same as the percent of sales volume increase.

This is straightforward: Selling 10 percent more units with no change in unit margin drives up contribution margin exactly 10 percent. But please note the difference in the amounts of the contribution margin increases:

Contribution Margin Increases for Each Product Line

Premier

5,000 units increase × $50.00 unit margin =

$250,000

Standard 10,000 units increase × $20.00 unit margin =

$200,000

Generic

15,000 units increase × $10.00 unit margin =

$150,000

Selling 10 percent more premier units would bring in a $50,000 higher contribution margin than would selling 10

percent more standard units. And selling 10 percent more standard units would make $50,000 more profit than selling 10 percent generic units.

Operating Leverage

Note in Figure 9.2 that even though contribution

margin increases 10 percent for each product line

because of the 10 percent higher sales volume levels, the percent increases in profit are 1.5 to 2.5 times greater. For instance, profit on the standard product line would be 20 percent higher, or two times the 10 percent sales volume increase.

The $200,000 increase in contribution margin equals 10 percent gain, but the $200,000 gain is 20 percent on the profit figure. In short, the 10 percent sales volume increase has a doubling effect on the percent increase in profit. The multiplier, or compounding effect is called
operating leverage.

The additional 10,000 units sold equal 10 percent of the total units sold, but they equal 20 percent of the units sold in excess of the product line’s breakeven point. The profit pile, or units sold in excess of breakeven, expands by 20 percent. This
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analysis is summarized as follows for the standard product line (data from Figure 9.2):

Analysis of Operating Leverage Effect

$1,000,000 fixed costs ÷ $20.00 unit margin = 50,000 units breakeven

100,000 units sales volume − 50,000 units breakeven =

50,000 units over breakeven

10,000 additional units sold ÷ 50,000 units over breakeven =

20% increase

So profit would increase 20 percent by increasing sales volume just 10 percent, as shown in Figure 9.2. In like manner, the percent of gain in profit (15 percent for generic products and 25 percent for premier products) can be calculated.

The nub of operating leverage is that the swing in profit is more than the sales volume swing. Operating leverage means that profit percent changes are a multiple of sales volume percent changes. There’s hardly ever a 1:1 percent relationship.

This rule is based on fixed expenses remaining constant at the higher sales level. If fixed expenses increase 10 percent right along with the sales volume increase (i.e., if fixed operating expenses increase 10 percent as well), then profit would go up only 10 percent.

Operating leverage reflects the fact that the business has not been fully using the capacity provided by its fixed costs. When capacity is reached, and sooner or later it will be as sales volume grows, fixed expenses will have to be increased to provide more capacity. If the company had already been selling at its maximum capacity, then its fixed expenses would have had to be increased. This points out the importance of knowing where you are presently relative to the company’s capacity.

SALES VOLUME SLIPPAGE

Suppose that the sales volumes had been 10 percent
lower
during the year just ended across the board for all three product lines. The effects of this downside scenario are presented in Figure 9.3, which is basically the negative mirror image of the 10 percent sales volume increase scenario. It’s a good idea for the managers of each product line to keep this lower sales
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volume, or worst-case scenario, in mind so they know just how sensitive profit is to a falloff in sales volume.

The combined impact for all three product lines would have been a profit drop-off of $600,000, from $3 million in the original scenario to only $2.4 million profit in the 10 percent lower sales volume.

When faced with a falloff in sales volume, managers should be very concerned, of course, and they should probe into the reasons for the decrease. More competition? Are people switching to substitute products? Are hard times forcing cus-

tomers to spend less? Is the location deteriorating? Has ser-

vice to customers slipped? Are total quality management (TQM) techniques needed to correct the loss of sales?

Sales volume losses are one of the most serious problems confronting any business. Unless they are quickly reversed, the business has to make extremely wrenching decisions regarding how to downsize (laying off employees, selling off fixed assets, shutting down plants, etc.). The late economist Kenneth Boulding has called downsizing the management of decline, which hits the nail on the head, I think. It’s an extremely unpleasant task, to say the very least.

The immediate (short-run) operating profit impact of a 10 percent sales volume decrease would depend heavily on whether the company could reduce its fixed expenses at the lower sales level. Assume not. In Figure 9.3, fixed operating expenses remain the same at the lower sales levels for each TEAMFLY

product line. In the sales decline scenario, operating leverage compounds the felony—profit decreases by a multiple of the 10 percent sales volume decrease in this scenario.

FIXED COSTS AND SALES VOLUME CHANGES

In analyzing the profit impacts of changes in sales volume, there is the question regarding what to do with fixed operat-

ing expenses. The simple expedient is to keep fixed costs the same at the higher or the lower sales volume. However, this is not an entirely satisfactory solution. For very small changes in sales volume, fixed costs do not change. In other words, fixed costs are insensitive to relatively small changes in sales volume.

In the typical situation, most fixed costs (e.g., depreciation expense recorded in the period, labor cost for employees paid monthly fixed salaries, and amounts paid for insurance pre-

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S A L E S V O L U M E C H A N G E S

Standard Product Line

Original Scenarios (see Figure 9.1)

Changes

100,000 units sold 10,000 additional units

Per Unit Totals

Per Unit Totals

Sales revenue

$100.00

$10,000,000

($1,000,000)

Cost of goods sold

$ 65.00

$ 6,500,000

($ 650,000)

Gross margin

$ 35.00

$ 3,500,000

($ 350,000)

Revenue-driven expenses @ 8.5% $ 8.50

$

850,000

($

85,000)

Unit-driven expenses

$ 6.50

$

650,000

($

65,000)

Contribution margin

$ 20.00

$ 2,000,000

($ 200,000) −10%

Fixed operating expenses

$ 10.00

$ 1,000,000

$1.11

$

0

Profit

$ 10.00

$ 1,000,000 ($1.11) ($ 200,000) −20%

Generic Product Line

150,000 units sold 15,000 additional units