cost

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Chapter 2

Financial Aspects of Marketing Management

Types of Cost

Costs Fixed Costs Variable Costs

2-2

Variable Costs are…

Expenses that are uniform per unit of output within a relevant time period As volume increases, total variable costs increase 2-3

THERE ARE TWO CATEGORIES OF VARIABLE COSTS 1. Cost of Goods Sold 2. Other Variable Costs 2-4

Variable Costs – Cost of Goods Sold

For Manufacturer or Provider of Service  Covers materials, labor and factory overhead applied directly to production For Reseller (Wholesaler or Retailer)  Covers primarily the cost of merchandise 2-5

Other Variable Costs

Expenses not directly tied to production but vary directly with volume Examples include:  Sales commissions, discounts, and delivery expenses 2-6

Fixed Costs

Expenses that do not fluctuate with output volume within a relevant time period They become progressively smaller per unit of output as volume increases No matter how large volume becomes, the absolute size of fixed costs remains unchanged 2-7

THERE ARE TWO CATEGORIES OF FIXED COSTS 1. Programmed costs 2. Committed costs 2-8

Fixed Costs – Programmed Costs

Result from attempts to generate sales volume Examples include:  Advertising, sales promotion, and sales salaries 2-9

Fixed Costs – Committed Costs

Costs required to maintain the organization Examples include nonmarketing expenditures, such as:  rent, administrative cost, and clerical salaries 2-10

Relevant and Sunk Costs

2-11

Relevant Costs are…

Future expenditures unique to the decision alternatives under consideration.

Expected to occur in the future as a result of some marketing action Differ among marketing alternatives being considered In general, opportunity costs are considered relevant costs 2-12

Sunk Costs are…

The direct opposite of relevant costs.

Past expenditures for a given activity Typically irrelevant in whole or in part to future decisions Examples of sunk costs: Past marketing research and development expenditures Last year’s advertising expense 2-13

Sunk Cost Fallacy

When marketing managers attempt to incorporate sunk costs into future decisions, they often fall prey to the

Sunk Cost Fallacy

– that is, they attempt to recoup spent dollars by spending even more dollars in the future.

Example: Continuing to advertise a failing product heavily in an attempt to recover what has already been spent on it.

2-14

Margins

The difference between the selling price and the “cost” of a product or service Margins are expressed in both dollar terms or as percentages on:  a total volume basis, or  an individual unit basis 2-15

Gross Margin or Gross Profit

On a total volume basis: The difference between total sales revenue and total cost of goods sold On a per-unit basis: The difference between unit selling price and unit cost of goods sold 2-16

Gross Margin

Total Gross Margin Dollar Amount Percentage

Net Sales Cost of Goods Sold

Gross Profit Margin

$100 - 40

$ 60

100% - 40

60%

Unit Gross Margin

Unit Sales Price Unit Cost of Goods Sold $1.00

- 0.40

Unit Gross Profit Margin $0.60

100% - 40

60%

2-17

Trade Margin (Markup)

Suppose a retailer purchases an item for $10 and sells it at $20.

Retailer Margin as a percentage of cost is:

($10 / $10) x 100 = 100 %

Retailer Margin as a percentage of selling price is:

($10 / $20) x 100 = 50 %

2-18

Trade Margin

Manufacturer $2.00

Wholesaler Retailer Consumer

Unit Cost of Goods Sold Unit Selling Price Gross Margin as a % of Selling Price

$2.88

$3.60

$6.00

$2.88

$3.60

$6.00

30.6% 20.0% 40.0% 2-19

Net Profit Margin (before taxes)

Dollar Amount Percentage

Net Sales $ 100,000 Cost of Goods Sold - 30,000 Gross Profit Margin $ 70,000 100% - 30 70% Selling Expenses Fixed Expenses Net Profit Margin - 20,000 - 40,000 $ 10,000 - 20 - 40 10% 2-20

Kellogg’s Cereal Margins at a Price of $2.72 per box

Kellogg’s Direct Unit Manufacturing Cost Grain $.18

Other Ingredients .23

Packaging Labor Mfg. Overheads Cost of Goods Sold .31

.18

.34

$1.24

––––––– 54.4% Gross Margin ($2.72 - $1.24)/$2.72

Promotions (excluding Advertising) + .20

Total Unit Variable Cost Manufacturer Contribution to Fixed Cost and Profit $1.44

Kellogg’s Selling Price to Grocery Store Grocery Store Margin Grocery Store Selling Price

$1.28

–– 47% Contribution Margin ($2.72-$1.44)/$2.72

$2.72

.68

–– 20% Trade Margin ($3.40 - $2.72)/$3.40

$3.40

Contribution Analysis

Contribution is…

The difference between total sales revenue and total variable costs OR on a per-unit basis The difference between unit selling price and unit variable cost 2-22

Break-Even Analysis

Break-even point is the unit or dollar sales at which an organization neither makes a profit nor a loss. At the organization’s break-even sales volume:

Total Revenue = Total Cost

2-23

Break-even Analysis Chart

Dollars Total Revenue LOSS BE Point Total Cost PROFIT Variable Cost Fixed Cost 0 Unit Volume

2-24

Break-even Analysis

Example

Fixed Costs Price per unit Variable Cost Contribution Breakeven Volume Breakeven Dollars = $50,000 = $5 = $3 = $5 - $3 = $2 = $50,000  $2 = 25,000 units = 25,000 x $5 = $125,000 2-25

Applications of Contribution Analysis

Sensitivity Analysis Profit Impact Market Size Performance Measurement Assessment of Cannibalization 2-26

Liquidity

Refers to a company’s ability to meet short-term financial obligations Very important for a company’s day-to day operations A key factor is Working Capital = Current Assets minus Current Liabilities 2-27

Operating Leverage

Extent to which fixed costs and variable costs are used in the production and marketing of products and services.

Firms with high total fixed costs relative to total variable costs are defined as having high operating leverage.

Higher operating leverage results in a faster increase in profit once sales exceed break-even volume. The same happens with losses when sales fall below break-even volume.

2-28

Discounted Cash Flow

Discounted cash flows are future cash flows expressed in terms of their present value Incorporates the time value of money Based on the premise that a dollar received tomorrow is worth less than a dollar today Useful in determining a business’s net cash flows 2-29

Discounted Cash Flow

The discount rate can be expressed as follows:

Discount factor = ___1___ (1 + r)

n

Where the r in the denominator is the interest rate and n is the number of years 2-30

The

interest

or

discount rate

often defined as… is The

opportunity cost of capital

, which is the cost of earnings opportunities forgone by investing in a business with its attendant risk as opposed to investing in risk-free securities.

2-31

Discounted Cash Flow

Example

Suppose you were to collect $1 million in 5 years. If the discount rate used were 10%, the present value of the $1 million would be:

1 PV = ———— X $1,000,000 = $620,921.32

(1 + 0.10) 5

2-32

Preparing a pro forma Income Statement

A pro forma income statement is a projected income statement Includes: Projected Revenues Budgeted Expenses Estimated Net Profit 2-33

Pro Forma Income Statement – Example

Sales Cost of goods sold Gross margin Marketing expenses Sales expenses Advertising expenses Freight or delivery expenses $170,000 90,000 40,000 General and administrative expenses Administrative salaries Depreciation on buildings and equipment Interest expense $120,000 20,000 5,000 Property taxes and insurance Other administrative expenses 5,000 5,000

Net profit before (income) tax

$1,000,000 500,000 500,000 300,000 155,000

$45,000

Preparing a pro forma Income Statement

Sales

forecasted unit volume times selling price

Cost of goods sold

and services costs incurred in buying or producing products

Gross margin

represents the remainder after cost of goods sold has been subtracted from sales 2-35

Preparing a pro forma Income Statement

Marketing Expenses

sales – programmed expenses to be spent on increasing

General & Administrative Expenses

– fixed costs (often referred to as overheads)

Net Income before Taxes

sales revenues minus all costs 2-36

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