Valuable Lessons Learned from the Profit Analysis Template
The profit analysis template shown here offers managers several important lessons. Like most tools, the more you use it the more you learn. The following are some important lessons from the template.
Recognize the leverage effect caused by fixed operating expenses
Suppose sales volume had been 10 percent higher or lower in 2015, holding other profit factors the same. Would profit have been correspondingly 10 percent higher or lower? The intuitive, knee-jerk reaction answer is yes, profit would have been 10 percent higher or lower. Wouldn’t it? Not necessarily. Margin would have been 10 percent higher or lower — $250,000 higher or lower ($25 margin per unit x 10,000 units = $250,000).
The $250,000 change in margin would carry down to operating earnings unless fixed expenses would have been higher or lower at the different sales volume. The very nature of fixed expenses is that these costs do not change with relatively small changes in sales volume. In all likelihood, fixed expenses would have been virtually the same at a 10 percent higher or lower sales level.
Therefore, operating earnings would have been $250,000 higher or lower. On the base profit of $1.5 million, the $250,000 swing equals a 17 percent shift in profit. Thus, a 10 percent swing in sales volume causes a 17 percent swing in profit. This wider swing in profit is called the operating leverage effect. The idea is that a business makes better use of its fixed expenses when sales go up; its fixed expenses don’t increase with the sales volume increase. Of course, the downside is that fixed expenses don’t decrease when sales volume drops.
Don’t underestimate the impact of small changes in sales price
Recall that in the example the sales price is $100, and revenue-driven variable expenses are 8.5 percent of sales revenue. Suppose the business had sold the product for $4 more or less than it did, which is only a 4 percent change — pretty small it would seem. This different sales price would have changed its margin per unit $3.66 net of the corresponding change in the revenue-driven variable expenses per unit. ($4 sales price change x 8.5 percent = $.34 per unit, which netted against the $4 sales price change = $3.66 change in margin per unit.)
Therefore, the business would have earned total margin $366,000 higher or lower than it did at the $100 sales price. ($3.66 change in margin per unit x 100,000 units sales volume = $366,000 shift in margin.) Fixed expenses are not sensitive to sales price changes and would have been the same, so the $366,000 shift in margin would carry down to profit.
The $366,000 swing in profit, compared with the $1.5 million baseline profit in the example, equals a 24 percent swing in profit. A 4 percent change in sales price causes a 24 percent change in profit. Recall that a 10 percent change in sales volume causes just a 17 percent change in profit. When it comes to profit impact, sales price changes dominate sales volume changes.
The moral of the story is to protect margin per unit above all else. Every dollar of margin per unit that’s lost — due to decreased sales prices, increased product cost, or increases in other variable costs — has a tremendously negative impact on profit. Conversely, if you can increase the margin per unit without hurting sales volume, you reap very large profit benefits.
Know your options for improving profit
Improving profit boils down to three critical factors, listed in order from the most effective to the least effective:
Increasing margin per unit
Increasing sales volume
Reducing fixed expenses
Say you want to improve your profit from the $1.5 million you earned in 2015 to $1.8 million next year, which is a $300,000 or 20 percent increase. Okay, so how are you going to increase profit $300,000? Here are your basic options:
Increase your margin per unit $3, which would raise total margin $300,000 based on the 100,000 units sales volume.
Sell 12,000 additional units at the present margin per unit of $25, which would raise your total margin by $300,000. (12,000 additional units x $25 = $300,000 additional margin.)
Use a combination of these two strategies: Increase both the margin per unit and sales volume such that the combined effect is to improve total margin $300,000.
Reduce fixed expenses $300,000.
The last alternative may not be very realistic. Reducing your direct fixed expenses $300,000, on a base of $1,000,000, would be drastic and probably would reduce your capacity to make sales and carry out the operations in your part of the business. Perhaps you could do a little belt-tightening in your fixed expenses area, but in all likelihood you would have to turn to the other alternatives for increasing your profit.
The second approach is obvious — you just need to set a sales goal of increasing the number of products sold by 12,000 units. (How you motivate your already overworked sales staff to accomplish that sales volume goal is up to you.) But how do you go about the first approach, increasing the margin per unit by $3?
The simplest way to increase margin per unit by $3 would be to decrease your product cost per unit $3. Or you could attempt to reduce sales commissions from $8.50 per $100 of sales to $5.50 per $100 — which may hurt the motivation of your sales force, of course. Or you could raise the sales price about $3.38 (remember that 8.5 percent comes off the top for sales commission, so only $3 would remain to improve the unit margin). Or you could combine two or more such changes so that your unit margin next year would increase $3.