Monitoring Costs
A multi-product company cannot get the information it requires from the
conventional profit and loss statement. Instead, it needs to track costs for
the company and for each product. Without product-specific information, it
cannot tell which products are doing well and which need additional
marketing support. To gather all the relevant information, a company needs
to track two types of costs:
•
Variable costs
(direct costs of manufacturing): costs specific to the manufacturing of the
particular good or service under scrutiny (i.e., labor, raw materials and
supplies)
•
Fixed costs:
ongoing costs that occur whether a business is shut down for a period of
time or in full production (i.e., depreciation, insurance, taxes, selling
and administration costs, utilities, and other costs)
Contribution Analysis
Contribution analysis
studies how the final selling price will contribute to fixed costs. Ideally,
a product would cover all the fixed costs and contribute a new profit, but this does not
always happen. Many products in a company’s
business only cover their variable costs and part of the fixed costs. A
company must decide if these products are worth continuing (i.e., whether
the product is necessary to the product line). Fixed costs exist whether the
product is
produced or not. The question that must be answered: "Is it better to
produce a product that pays for itself and part of
the overhead, or do nothing (i.e., not produce it) and cover none of the
overhead?”
If a company has excess capacity, it would be better to keep the products
that are covering only part of the costs. If capacity is full, selling a
product with low or negative total contribution may not be a
dvisable. If
resources and sales
are going to the low-contribution product instead of higher contribution
products, a company is not maximizing
profitability. Salaries can be split according to hours spent on a product
or some other reasonable basis. Rent and utilities can be split on the basis
of volume allocation.
Company advertising and generaland administrative overhead cannot be
allocated to specific products, so are
non-traceable fixed costs. Determining which products should receive
additional support becomes clearer after we calculate the percentage
variable contribution margin.
PVCM = selling price-variable costs selling price
PVCM shows which products contribute the greatest amount to overhead and
profit for each additional dollar spent to increase sales.
Setting Prices
Two tools that are important for setting prices are:
• break-even analysis
• cost-volume relationships
Break-even Analysis
Break-even analysis
can be used as a tool for initially setting a product’s price or for
calculating the effects of a price change. It helps the owner/- manager understand that for certain
prices, different levels of production are required to break even (i.e.,
covering all variable and fixed costs). The break-even point is where total
revenue equals total cost. Below breakeven, losses are incurred. Above
breakeven, profits are realized.
“Sunk” costs, such as research and development, should be ignored. Use
equipment depreciation, rather than
deducting full equipment costs.
Cost-Volume-Profit Relationships
Economies of scale
measure the impact of changes in volume on fixed costs. In many cases, a
company’s ability to increase the volume of output allows them to decrease the per
unit cost. The experience curve effect is where variable costs decline as volume
increases. This can cause better results
from increasing the volume of products.
The following table shows an example of a break-even analysis
for five different prices of one product.
Unit Selling Price $21.95
$23.95
$25.95
$27.95 $29.95
Unit Variable Cost $ 7.95
$ 7.95
$ 7.95
$ 7.95
$ 7.95
Unit Contribution(A) $14.00
$16.00
$18.00 $20.00
$22.00
Estimated Sales 27,500
27,500
25,000
20,000
18,000
Revenue
$603,625 $646,650
$648,750
$559,000
$539,100
Fixed Costs(B) $400,000
$400,000
$400,000
$400,000
$400,000
Variable Costs $218,625
$214,650
$198,750
$159,000
$143,100
Profit (loss) ($15,000)
$ 32,000
$ 50,000
$ 0
($4,000)
Break-even (units)(C) $28,571
$ 25,000
$ 22,222
$ 20,000
$ 18,182
Experience curves may be due to:
• more efficient production processes
• higher discounts due to greater volumes of purchases
• workers becoming more efficient
Calculating Mark-Ups
When setting prices, companies must take into account their own costs as
well as the various mark-ups required as a product moves toward the
consumer. In the food business, markups are usually calculated from the
retail price working back, rather than from the cost working up. As a rule
of thumb, retailers’ margins average around 30% with distributors’ margins
being as high as 30%, depending on what services are being provided. The
approach is similar when dealing with food service distributors such as
Associated Food Distributors, but with allowances made for volume rebates.
Volume rebate schedules are stepped with higher volumes, which means a
higher percentage volume rebate is payable by the processor. The processor
must build in anticipated costs, which will be invoiced to the company at
year-end for the rebate, based on the processor’s total sales to the food
service distributors. The processor should not jump into a volume rebate
schedule without first calculating the impact of the increased
volumes in the form of lower per-unit costs. Many processors offer a volume
rebate schedule that reduces profit
ability because the volume rebate is greater than the cost savings of the
increased output.
Experience curves may be due to:
• more efficient production processes
• higher discounts due to greater volumes of purchases
• workers becoming more efficient
Calculating Mark-Ups
When setting prices, companies must take into account their own costs as
well as the various mark-ups required as a product moves toward the
consumer. In the food business, markups are usually calculated from the
retail price working back, rather than from the cost working up. As a rule
of thumb, retailers’ margins average around 30% with distributors’ margins
being as high as 30%, depending on what services are being provided. The
approach is similar when dealing with food service distributors such as
Associated Food Distributors, but with allowances made for volume rebates.
Volume rebate schedules are stepped with higher volumes, which means a
higher percentage volume rebate is payable by the processor. The processor
must build in anticipated costs, which will be invoiced to the company at
year-end for the rebate, based on the processor’s total sales to the food
service distributors. The processor should not jump into a volume rebate
schedule without first calculating the impact of the increased
volumes in the form of lower per-unit costs. Many processors offer a volume
rebate schedule that reduces profit ability because the volume rebate is
greater than the cost savings of the increased output.
Product 1
2000
Units 4000 Units
Unit Variable Cost $40
$40
Total Variable Cost 80,000
160,000
Total Traceable Fixed Costs 240,000
240,000
Total Direct Cost 320,000
400,000
Divided by Volume 2000
4000
Average Unit Cost $160/unit
$100/unit
Increases in volume have the greatest impact on products with high PVCM
because
most of the costs are fixed for these products.
Break-Even
═
Total Fixed Costs (B)
Point (C) Unit Contribution
(A)
Other features of the marketing program to consider when setting prices:
1. A minimum delivery size is set to capitalize on freight. Minimum Order
Size for freight prepaid shipments is 2300 pounds or more. An industry
standard for minimum order size is 30% contribution..
2. New Store opening. In the case of a new store or a change of ownership,
15% off invoice for a period of seven days, with a case allotment of 15
cases per checkout.
3. “Deal prices.” It is important to recognize that “deal” periods are set
by retailers in December, so the processor has to have the year’s promotion
program agreed to by the store prior to December 31 for the following 12
months. Most processors have some type of maximum order volume to avoid the
wholesaler/retailer stocking up on the product while “on deal.”
4. Floor stock protection is a contentious area whereby the store asks that
any downward adjustment in price apply to the wholesaler’s/ retailer’s
inventory of a product. Most processors do not offer floor stock protection
in the
belief that it is up to the store to control its inventory.
5.Some businesses charge prices according to “rules of thumb,” such as price
is twice labor plus materials, or price is materials and labor plus 20% for
fixed costs and 25% for profit. These methods for setting prices are not
recommended, as calculating actual costs is the only sure means of ensuring
that prices cover costs.