Understand The Financial Implications Of Your Decisions With What-If Analysis using the Cost Volume Profit Relationships
If you’ve worked your way this this Pillar 1 Module 3 systematically, then with what you know so far, you can start to look at the financial implications of some quite complex decisions.
Previously you’d rely on gut feel to make and worry about the possible consequences.
Now you can start looking at the facts and key assumptions and make a considered judgement, just like senior managers do in big businesses with full accounting and financial management support teams.
Decisions To Make Your Business More Profitable
Let’s imagine you want to grow your business and make it more profitable…that’s not hard, is it?
Your business is big enough to have its own sales representative and you have regular contact with an advertising rep. You ask both for ideas on how you can grow.
Your sales rep proposes that if you reduce your prices by 10% – because he is convinced you over charge and it costs you business – you could sell 20% more volume.
Your advertising rep comes up with the idea that if you spend an extra £1,000 in advertising each month, you will get another 20% of sales.
Both sound like interesting ideas and give you the growth you want…so what do you do?
Well first we need to establish our base case and I’m going to stay with our previous example because the numbers are so easy.
At the moment imagine you sell 100 units at £100 per unit and make a contribution of 40% or £40 per unit.
Fixed costs are £2,000.
Contribution is therefore £4,000 (100 units at £40) and profit £2,000 after the £2,000 fixed costs are deducted.
This Is Where It Gets Exciting
In my finance training classes, this is where things get really excited and I hear comments like:
“That makes a lot of sense” and
“Wow! That’s so easy.”
So let’s get into the numbers.
Evaluating The Sales Proposal
We’ll start by evaluating the proposal from the sales rep.
If you remember, the suggestion was 20% more sales for a 10% price cut.
Sales units will increase from 100 units to 120 units if the 20% volume increase happens.
Price will reduce by 10% from £100 to £90 per unit…a £10 reduction.
Unfortunately, it means contribution per unit also reduces by £10 because variable costs haven’t changed so contribution which was £40 per unit is now £30.
The total contribution for the 120 units sold is £3,600 (120 multiplied by 30)
And with fixed costs at £2,000, profit is now £1,600.
That’s down £400 from our starting position of £2,000.
The sales rep’s idea doesn’t look so hot now but remember these are only estimates.
What if the price reduction could lead to a 25% or 30% increase in sales volume? Does that make it worthwhile?
What Is Needed To Make The Sales Proposal Pay-off?
Well you could keep trying numbers and calculating the profit or you could take the short cut and use the break even point logic.
We know that to keep profits the same, we need contribution to be £4000 (the original £40 per unit multiplied by 100 units).
If we divide the new contribution rate of £30 per unit (after the 10% price cut) into £4,000, we discover we need sales of 133.3 units.
Since we can’t sell 0.3 of a unit, we need at least 34 extra units to be sold to just stand still.
To make the price reduction worthwhile… and to cover the risks of it going wrong… we need to be thinking in terms of whether …a 50% to 60% increase in sales units is possible.
Alternatively, could extra volume be won without such a drastic price reduction? Perhaps the sales rep is right that price is a problem because your product is too much of a commodity but he overestimates how much of a price reduction it would take to unleash the extra business.
What if price was reduced by 5% and volume could increase by 20%?
Can you calculate whether that makes sense financially.
If you can, have a go by yourself and you’ll be able to check yourself against my answer at the bottom of the page.
Let’s see if the advertising proposal makes sense.
The idea was to spend £1,000 extra on advertising each month to increase sales by 20%…an increase from 100 to 120 units sold.
No sales price reduction this time.
The idea is more people will see your offer, contact your business and be persuaded to buy.
The sales price stays at £100 and contribution per unit remains £40.
But what has happened is that fixed costs have increased from £2,000 to £3,000.
If you are thinking that advertising and sales are linked and advertising is a variable cost you’ve got the cause and effect the wrong way around.
We sell more because we advertise more – advertising is the cause and more sales is the effect. Even if we don’t sell more we still have the advertising cost.
If we paid commission to agents to promote our business it would be different. We would pay more commissions because sales increase but if sales didn’t increase we wouldn’t pay more commission, making agents commission a variable cost.
I hope that’s clear.
Back to our advertising proposal and the increase in fixed costs to £3,000.
We can calculate our new contribution – 120 units at 40 equals £4,800.
And because our fixed costs are £3,000, profit is £1,800 – down £200 from our base case.
What Will Make The Advertising Proposal Pay-off?
Again we can calculate the sales needed to break even on the increased advertising.
We want £2,000 profit plus the fixed costs of £3,000 to be covered.
In total contribution we need a contribution of £5,000.
And at £40 of contribution per unit… it means 125 units need to be sold… an increase of 25% and not the 20% originally suggested.
A New Growth Strategy
We get the sales rep and advertising rep together and tell them that neither idea will work to our satisfaction.
The sales rep is adamant that prices need to reduce by 10% …a 5% reduction won’t make any impact on customers who are saying No.
You ask if the sales rep will put his job on the line and commit to a 40% increase …(remember you need 34% to stand still) but he says “No way”.
Your advertising rep comes up with another proposal because more advertising can help to increase brand perceptions and raise the price customers are willing to pay.
Advertising Proposal 2
This time, the idea is to spend £1,400 per month to increase the perceived value so customers are willing to pay £120 each.
It means a bigger advertisement with more room to emphasis what’s special about the product and to provide proof through testimonials.
The extra price means contribution increases from £40 to £60 per unit.
Fixed costs increase by £1,400 to £3,400.
This proposal is different because it’s not targeting sales growth.
We can calculate our sales needed for this third proposal to break even with the base case.
We need contribution of £5,400 – that’s the £2,000 base profit plus £3,400 fixed costs.
And at £60 contribution it means 90 units need to be sold (5,400 divided by 60)
If we still sell 100 units we make more profit – contribution of £6,000 less fixed costs of £3,400 means £2,600 profit…or £600 more.
The Power Of What If Analysis
Can you see the power these few numbers give you to manage your business for more profit?
You can start operating in the light instead of working in the dark and hoping things are OK.
If you run any kind of promotional campaign, you know exactly what you need and you can monitor whether it works or not.
Calculating the numbers ahead of time doesn’t guarantee your results improve but it means you stop things quickly if they are not going to work:
- At the idea stage on the sales reps suggestion or
- After one or two market tests for the advertising.
And if things do work, you can do it more often and take advantage of the opportunity while it exists.
The Answer – The Effect Of A 5% Price Cut
Earlier, I challenged you to work out for yourself if cutting prices by 5% for a 20% increase in volumes could make sense.
Fixed costs are still £2,000 but contribution reduces from £100 per unit to £35 per unit.
This new break even point volume is 2000/95 = 57.15 units when we previously broke even at 50 units. That’s a 14.3% increase in volume.
I hope you tried to do it yourself and you got it right. It’s only by doing exercises like this where you can check the answers that you’ll build up the confidence to do this type of thinking in your business in real life.
Return to P1M3 How Profit Is Created
Get To Know Me