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goods-sold expense or gross margin (sales revenue less cost of
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Team-Fly®

S E R V I C E B U S I N E S S E S

Standard Service

100,000 units

Per Unit

Totals

Sales revenue

$100.00

$10,000,000

Revenue-driven expenses @ 8.5%

$ 8.50

$

850,000

Unit-driven expenses

$ 6.50

$

650,000

Contribution margin

$ 85.00

$ 8,500,000

Fixed operating expenses

$ 75.00

$ 7,500,000

Profit

$ 10.00

$ 1,000,000

Basic Service

150,000 units

Per Unit

Totals

Sales revenue

$ 75.00

$11,250,000

Revenue-driven expenses @ 4.0%

$ 3.00

$

450,000

Unit-driven expenses

$ 5.00

$

750,000

Contribution margin

$ 67.00

$10,050,000

Fixed operating expenses

$ 60.33

$ 9,050,000

Profit

$ 6.67

$ 1,000,000

Premier Service

50,000 units

Per Unit

Totals

Sales revenue

$150.00

$ 7,500,000

Revenue-driven expenses @ 7.5%

$ 11.25

$

562,500

Unit-driven expenses

$ 8.75

$

437,500

Contribution margin

$130.00

$ 6,500,000

Fixed operating expenses

$110.00

$ 5,500,000

Profit

$ 20.00

$ 1,000,000

FIGURE 16.2
Management profit reports for service business example.

goods sold). Note that each service profit module earned $1

million for the year just ended. The purpose of this is twofold.

The three sources of sales added together provide $3 million profit, which is approximately equal to the earnings before interest and income tax shown in the income statement in Figure 16.1. The main reason for showing three different
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E N D T O P I C S

profit modules, however, is to contrast and compare the effects from changes in profit factors among the three.

The amount of the cost-of-goods-sold expense amounts shown in Figure 9.1 for the product-based business are moved to fixed operating expenses in this example for the three service profit modules. In other words, the entire amount of the cost-of-goods-sold expense amount is moved down to the fixed operating expense account, which is the largest expense for each service line. Notice the relatively high amounts of fixed costs for each module in Figure 16.2.

By definition, a service business sells services and not products. Even so, incidental products are often sold along with the services. For example, a copying business (such as Kinko’s) sells paper to its customers. Of course, the main thing sold is the copying service, not the paper. Airlines sell transportation but also provide in-flight food and beverages. Hotels are not really in the business of selling towels and ashtrays, but they know that many guests take these with them on the way out. Many personal and professional service firms (e.g., CPA and architect firms) sell no product at all. (Although come to think of it, our architect charged us a small amount for blueprint copies of our home remodeling project.)

Some expenses of a service business vary with total sales revenue. Credit card discounts and sales commissions come to mind. Service businesses also have some expenses that vary with sales volume—for example, the number of passengers flown by an airline. The number of hotel guests directly affects certain variable expenses of this business.

Most service businesses are saddled with large annual fixed expenses. Service takes people to render it: Most service businesses have a large number of employees on fixed salaries or who are paid fixed hourly rates based on a 40-hour workweek. Also, many service businesses, such as gas and electric utilities and airlines, make large capital investments in buildings and equipment and record large depreciation expense each year. Therefore, the service business example includes a large amount of fixed expenses for each of the three profit modules.

In contrast to product-based businesses, the contribution margins of service-based businesses are relatively large per-

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S E R V I C E B U S I N E S S E S

cents of their sales revenue. For the service business example shown in Figure 16.1, the contribution margins are as follows: Standard

service

$85.00 unit margin ÷ $100.00 sales price = 85%

Basic

service

$67.00 unit margin ÷ $75.00 sales price = 89%

Premier

service

$130.00 unit margin ÷ $150.00 sales price = 87%

The annual sales volumes in the three profit modules are expressed in
units of service,
whatever these units might be—billable hours for a law firm, number of tickets for a movie theater, or passenger miles for an airline. For a long-distance trucking company it is ton-miles hauled. Most service businesses adopt a common denominator to measure their sales volume activity.

SALES PRICE AND VOLUME CHANGES

The profit impacts of increasing sales prices 10 percent versus increasing sales volumes 10 percent are compared in Figure 16.3. Please keep in mind that the baseline profit for each of the three profit modules is $1 million. The amount of the profit increase is divided by $1 million to determine the percentage increases shown in Figure 16.3. For all three service lines, note the relatively small difference in profit increase between the sales volume and the sales price increase scenarios.

Looking back at the profit effects for a product-based business (refer to Figure 10.2), there is a huge advantage to increasing sales price versus increasing sales volume by the same percent. But as Figure 16.3 shows, this is not true for a service business because price increases on top of the relatively high unit margins of a service business don’t pack the same wallop as price increases for a product business.

For instance, consider the standard product line (Figure 9.1) versus the standard service line (Figure 16.2). In both, the sales price is $100.00 per unit. The unit margin for the standard product line is $20.00 versus $85.00 for the standard service line. A 10 percent sales price increase yields a $9.15 unit margin increase (net of revenue-driven variable expenses). This
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Standard Service

Sales Volume Increase

Sales Price Increase

110,000 units

100,000 units

Per Unit

Totals

Per Unit

Totals

Sales revenue

$100.00

$11,000,000

$110.00

$11,000,000

Revenue-driven expenses

@ 8.5%

$ 8.50

$

935,000

$ 9.35

$

935,000

Unit-driven expenses

$ 6.50

$

715,000

$ 6.50

$

650,000

Contribution margin

$ 85.00

$ 9,350,000

$ 94.15

$ 9,415,000

Fixed operating expenses

$ 68.18

$ 7,500,000

$ 75.00

$ 7,500,000

Profit

$ 16.82

$ 1,850,000

$ 19.15

$1,915,000

Profit increase (compared

with Figure 16.2)

85%

92%

Basic Service

165,000 units

150,000 units

Per Unit

Totals

Per Unit

Totals

Sales revenue

$ 75.00

$12,375,000

$ 82.50

$12,375,000

Revenue-driven expenses

@ 4.0%

$ 3.00

$

495,000

$ 3.30

$

495,000

Unit-driven expenses

$ 5.00

$

825,000

$ 5.00

$

750,000

Contribution margin

$ 67.00

$11,055,000

$ 74.20

$11,130,000

Fixed operating expenses

$ 54.85

$ 9,050,000

$ 60.33

$ 9,050,000

Profit

$ 12.15

$ 2,005,000

$ 13.87

$ 2,080,000

Profit increase (compared

with Figure 16.2)

101%

108%

Premier Service

55,000 units

50,000 units

Per Unit

Totals

Per Unit

Totals

Sales revenue

$150.00

$ 8,250,000

$165.00

$ 8,250,000

Revenue-driven expenses

@ 7.5%

$ 11.25

$

618,750

$ 12.37

$

618,750

Unit-driven expenses

$ 8.75

$

481,250

$ 8.75

$

437,500

Contribution margin

$130.00

$ 7,150,000

$143.88

$ 7,193,750

Fixed operating expenses

$100.00

$ 5,500,000

$110.00

$ 5,500,000

Profit

$ 30.00

$ 1,650,000

$ 33.88

$ 1,693,750

Profit increase (compared

with Figure 16.2)

65%

69%

FIGURE 16.3
Comparison of 10 percent increases in sales volume versus
sales price.

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S E R V I C E B U S I N E S S E S

equals a 46 percent leap in unit margin for the product business ($9.15 ÷ $20.00 = 46%), but only an 11 percent gain for the service business ($9.15 ÷ $85.00 = 11%). For a service business, a price increase is better than a volume increase, but the advantage is much less than for a product business.

WHAT ABOUT FIXED COSTS?

One key issue concerns the large amount of fixed

operating expenses for a typical service business. The profit increases shown in Figure 16.3 are based on the premise that fixed costs remain constant at the higher sales volumes. However, if the business were already operating at or close to its capacity limits, its fixed costs probably would have to be increased to enable higher sales volumes. Keep in mind that basically fixed costs provide
capacity,
or the ability to handle a certain level of sales activity during the period.

Capacity for a service business is measured by the total number of hours its employee workforce could turn out during the year, the number of passenger miles that an airline could fly, the number of energy units a utility could deliver over the period, and so on. Always a key question is whether capacity is being fully used or not. Some slack, or unused capacity, is normal, which allows for a modest growth in sales volume.

When sales volume is too far below capacity and top management sees no way to rebuild sales volume, the option is to downsize the capacity of the business.

Looking at Figure 16.3 again, the business could afford to expand capacity and increase its fixed costs to support a 10 percent gain in sales volume for its service lines—but not by more than the projected profit increase. Increasing sales prices generally does not require a business to increase its fixed costs. So the clear advantage is on the side of increasing sales prices. Of course, the key question is whether a business could pass along a 10 percent sales price increase without adversely affecting the demand for its services.

TRADE-OFF DECISIONS

Suppose the business is considering cutting sales prices 10 percent on all three of its service lines. One question the
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E N D T O P I C S

managers should ask is this: How much would the increases in sales volumes have to be simply to maintain the same profit? Of course, the business would really prefer to stimulate demand to
increase
profit, not just keep it the same. But calculating these same-profit sales volumes provides very useful points of reference. Each manager should forecast sales demand at the lower prices and compare the predicted sales volume against the same-profit volumes.

The profit report format presented in Figure 16.4 is a good tool for this sort of analysis. (This is the same profit pathway used in Chapter 11 for analyzing trade-off decisions for a product-based business, except that cost-of-goods-sold expense is deleted.)

Figure 16.5 shows the unit margins at the lower sales prices and the required sales volumes needed just to maintain the same profit. The required sales volumes are determined by dividing the contribution margin targets (from Figure 16.4) by the lower unit margins caused by the lower sales prices.

Fixed costs are held the same, but as previously mentioned, one should be very careful in making this assumption when sales volumes are increased.

What about the opposite trade-off ? Suppose sales prices were increased 10 percent, causing decreases in sales volume.

The same method of analysis can be used to determine how far sales volume could drop and profit remain the same. (If you do these calculations the answers are standard = 9,719 units
Service Line

Standard

Basic

Premier

Sales price

$100.00

$75.00

$150.00

Revenue-driven expenses

$8.50

$3.00

$11.25

Unit-driven expenses

$6.50

$5.00

$8.75

Unit margin

$85.00

$67.00

$130.00

Sales volume

100,000

150,000

50,000

Contribution margin

$8,500,000

$10,050,000

$6,500,000

Fixed operating expenses

$7,500,000

$9,050,000

$5,500,000