-FARAH CHOUDHARY

-EHSAN UL HAQ
 OVERVIEW
 In many companies product managers assume
the role of mini-CEOs.

 Thus, they should have the complete profit and

loss responsibility for their product.

 To be a part of firm’s overall decision making,

product manager must understand the
financial implication of their decision.
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KINDS OF FINANCIAL ANALYSIS
 SALES ANALYSIS

 PROFITABILITY ANALYSIS

 CAPITAL BUDGETING

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SALES ANALYSIS
 It is defined as “the gathering,
classifying, comparing and studying of
company sales data”

 It measures & evaluates actual sales in

relationship to the goals.

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MAJOR COMPONENTS OF SALES
ANALYSIS
 How sales are defined?
 In what units can sales be analyzed?
 In what categories or classification can the
sales data be placed?
 What are the appropriate standards against
which the sales can be compared?

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TOOLS FOR SALES ANALYSIS:
Sales-variance analysis
 It measures the relative contribution of different factors to
a gap in sales performance.
 Suppose the annual plan called for selling 4,000 units in
the 1st quarter at Rs. 1 per unit, for total revenue of
Rs.4000. At quarter’s end only 3,000 units were sold for
Rs. 0.80 per unit, for total revenue of Rs.2400. Now:
 Variance due to price decline = (Rs.1.00-Rs.0.80 ) (3,000)
= Rs. 600 37.5%
 Variance due to volume decline = (Rs.1.00)(4000-3000)
= Rs. 1000 62.5%
= Rs. 1600 100%
 Almost 2/3rd of the variance is due to failure to achieve the volume
target 6
TOOL FOR SALES ANALYSIS:
Microsales Analysis
 It looks at specific products, territories, and so forth that failed to
produce expected sales.
 Suppose the company sells in three territories, and expected sales
were 1,500 units,500 units, and 2,000 units respectively. Actual
volumes were 1,400 units, 525 units, and 1,075 units, respectively.
 Thus territory 1 showed a 7% shortfall in terms of expected sales;
territory 2, a 5% improvement over expectations; and territory 3,
a 46% short-fall.
 Territory 3 is causing most of the trouble. Maybe territory
3’s sales rep is underperforming; a major competitor has entered
etc.

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ROADBLOCKS
1. Information systems are not designed by
product management in mind.

2. Financial and accounting personnel

have quite different mindsets and
perspectives than marketing personnel.

3. Lack of internal marketing on the

part of product management. 8
PROFITABILITY ANALYSIS
 Companies can benefit from deeper financial
analysis & should measure the profitability of
their products, territories, customer groups,
segments, trade channels, and order size.

 This information can help management

determine whether to expand, reduce, or
eliminate any or marketing activities.

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STEPS FOR PROFITABILITY
ANALYSIS
STEP 1: Identifying Functional Expenses

STEP 2: Assigning Functional Expenses to

Marketing Entities.

STEP 3: Preparing a Profit-and-Loss

Statement for Each Marketing
Entity.
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Conventional Product Profit
Accounting
Product: New Call
Income Statements, December 31, 2005
(000’s)
Revenue (2M units@ $5) $10,000
Less: Direct Labor 2,500
Direct Supervision 500
Social Security 255
Materials 5
Operational Overhead 840
Expenses From Operations 4,100
Operating or gross margin 5,900
Less: Advertising $ 700
Promotions 200
Field sales 1,700
Product Management 25
Marketing Management 250
Product Development 150
Marketing Management 175
Customer Service 1,500
Testing 300
General & Administration 1,000
Total Expenses 6,000
Operation Profit (100)

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Conventional Product Profit
Accounting
 This approach to computing profits is called
full-costing approach.

 In this all costs associated with a product or

service, including corporate overhead, are
subtracted from revenues

 This is the most popular approach to

product profitability analysis.
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Strength &Weakness of conventional Product
Profit Accounting
Strength: All cost of the operation are covered
by the product.

Weakness:
 At first glance, it appears the company would
be $100,000 more profitable by eliminating
the product new call?
 It is difficult to use full-costing approach to
obtain answers for straightforward questions.
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Alternative Accounting System
We can classify accounting systems into 3
groups:
1. Financial or custodial: Useful for external
constituents who may care only about the overall
financial performance of the company.
2. Performance based: Looks at today's
performance based on variance from budgets.
3. Contribution based system: Emphasis on
the cost the product manager can control. There is a
clear distinction between variable and fixed
cost. 14
Contribution Oriented System
 2nd notion of profitability is called
contribution margin.

 Contribution margin is the amount of

money left over after accounting for
variable costs that goes toward covering
fixed costs.

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Contribution Oriented System
 Variable Costs:- They are those costs that
vary directly with total volume of sales
or production. Such costs normally
include materials and direct labour, etc.

 Fixed Costs:- A cost that is fixed if it does

not vary in amount with the volume
of sales or production.
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 Contribution Oriented System
COST CLASSIFICATION:

Category Total Cost Variable Fixed

Operating expenses($000)
Direct Labor $2500 2500
Direct Supervision 500 500
Social Security 255 255
Materials 5 5
Operational overhead 840 200 640
Subtotal: $ 4,100 3,460 640
Non operating expenses
Advertising $ 700 700
Promotion 200 200
Field Sales 1,700 200 1,500
Product management 25 25
Marketing Management 250 250
Marketing research 175 175
Customer Service 1,500 240 1,260
Testing 300 300
General & administration 1,000 1,000
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Subtotal $ 6,000 $ 440 $5,560
Total $ 10,100 3,900 6,200
Contribution Margin Statement
Product: New Call
Income Statements, December 31, 2005
(000’s)
Revenue (2M units@ $5) $10,000
Variable Costs
Direct Labor $2,500
Direct Supervision 500
Social Security 255
Sales force commission 200
Customer Service 240
Materials 5
Operational Overhead 200
Total variable costs 3,900
Contribution margin (61%) 6,100

Fixed Costs
Operational Overheads 640
Advertising 700
Promotions 200
Field sales 1,500
Product Management 25
Marketing Management 250
Product Development 150
Marketing Research 175
Customer Service 1,260
Testing 300
General & Administration 1,000
Total Fixed costs 6,200 18
Operation Profit (Loss) (100)
 Contribution Margin Rate
Breakeven in units = Fixed Costs
Variable Margin per Unit

Breakeven in dollars = Fixed Costs

Variable Margin Rate
Safety factor =(Current Sales Volume –
Break Even Volume)/ Current
Volume
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Break-Even Analysis
 Break-even analyses => Short term oriented as the
calculations are based on one’s results.
 Overreliance on break-even analysis can result in the
company making myopic decisions.
 But, they are useful benchmarks when used
conservatively.
 It can also be applied to any incremental change in
fixed cost
 Target profit breakeven = (Target + Fixed
Cost)/Contribution Rate

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 Businesses which are more fixed cost-intensive, suffer
when sales drop.
 Example of Airline Industry (why price-war?)
 Products characterized by different variable margin
rates have different strategic problems.
 Variable costs are high and CMR is low=> price
needs to be kept high to make profitability high
 Fixed costs are high and Variable costs are low =>
price needs to be kept high to serve the
Fixed costs.

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 FIXED COSTS
 Programmed Direct Fixed Costs-
Controlled by managers and are usually
expended for a specific planning period.
(Eg. Advertising)

 Programmed Indirect Fixed Costs-

Controlled by management but cover
several products. (Eg. Corporate
Umbrella Advertising)
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 Standby Direct Fixed Costs- Don’t change
significantly without a major change in
operations, Generally not controlled by
Product Manager in the short run. (Eg. A
facility dedicated to a specific project)

 Standby Indirect Fixed Costs- Corporate

Overheads (Eg. CEO’s Salary). They are not
directly related to any specific product

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Product Manager’s Responsibility
 His primary responsibility is to make a
profit by generating revenues in excess of
variable costs that cover the fixed cost
attributable to his/her product.
 In other words, the product manager
should be responsible for making a profit
based on costs that would exist only if the
product existed.

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Income Statement: Direct vs. Indirect Fixed Costs

Revenues 10,000
Variable Costs (Direct Labor, Supervision, Customer 3,900 3,900
Service, Materials, Operations Overhead etc.)
Contribution Margin 6,100
Fixed Costs-
Programmed Direct (Advertising, Promotion, Field 3,025 3,075
Sales, Product Mgmt, Mktng Research etc.)
Standby Direct (Operations Overhead, Testing, 1,240 1,835
General & Administrative)
Programmed Indirect (Advertising, Mktng Mgmt, 1,235
Product Development etc.)
Standby Indirect (General & Administrative) 700
Total Indirect Costs 1935
Operating profit (100) 25
 Subtracting both programmed & standby direct
fixed costs, Newcall shows a ‘profit’ of $1.835 m.
 Only after subtracting costs over which the
product manager has no control, the product
shows loss.
 In fact despite showing loss, the Company will be
worse off dropping this money-losing product,
as it is generating $1.835 m which is
covering indirect fixed costs.

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In Sum….
 Full Costing Statement- Top Management &
External Constituents.
 Contribution Margin Statement- Easy to read
and shows quickly the money going to cover
the fixed costs, but doesn’t differentiate
between Indirect and Direct fixed costs.
 Statement breaking down Fixed Costs- Most
relevant for Product Management as it clearly
states how the product is performing.

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Strategic Framework For Control-
VARIANCE ANALYSIS
 Variance- A discrepancy between a
planned figure/objective and the actual
outcome
 Used for control
 Major benefit => Identification of
potential problem areas, not diagnosing
the causes of the problems

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 An Example Of Variance Analysis: Product
Alpha
Item Planned Actual Variance
Revenues

Sales (Rs) 20,000,000 22,000,000 2,000,000

Price per lb. ($) 0.5000 0.4773 0.2270
Revenues ($) 10,000,000 10,500,000 500,000
Total Mkt (lbs.) 40,000,000 50,000,000 10,000,000

Share of Mkt 50% 44% 6%

Costs
Variable cost per lb. ($) 30 30 --
Contribution per lb. ($) 0.2000 0.1773 0.0227
Total ($) 4,000,000 3,900,000 (100,000) 29
Price-Quantity Decomposition
S = Share, M = Total Market Size,
Q = Quantity sold in units,
C = Contribution margin per unit
a = Actual values & p= Planned values

Price/Cost Variance => (Ca - Cp)* Qa

= (0.1773 – 0.2000)* 22,000,000
= -$500,000
This comes from selling too much at a low margin or the product is
penalized heavily for missing the contribution target.

Volume Variance => (Qa - Qp)* Cp

= (22,000,000 – 20,000,000)* 0.20
= 400,000
Sum of the variances => -100,000
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Penetration-Market Size
Decomposition
 Variance in contribution due to market share
=> (Sa - Sp)* Ma* Cp
=(0.44 – 0.50)* 50,000,000* 0.2
= -$600,000

 Offset by the gain from the increased size of the

market =>(Ma - Mp)* Sp* Cp
=(50,000,000 – 40,000,000)* 0.5* 0.2
= $1,000,000
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Summary of the analysis
Planned Profit Contribution $4,000,000
Volume Variance
Share Variance ($600,000)
Market Size Variance 1,000,000
400,000
Price/Cost Variance (500,000)
Actual profit contribution $3,900,000

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Capital Budgeting
 Deals with prioritizing several aspects
to projects within a firm.
 Five discrete steps
1. Generating Investment proposals
2. Estimating Cash Flows for the proposals
3. Evaluating the Cash Flows
4. Selecting projects based on an acceptance
criterion
5. Re evaluating the projects after their
acceptance
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Evaluating the Cash Flows
Five major methods
1. Average Rate of Return (Avg Annual Profit)/ Avg Investment
per year
2. Payback (No. of years to recover the initial investment) Initial
Investment/Annual Cash Flows
3. Internal Rate of Return [A =A /(1+r) + A /(1+r) +…A /(1+r) ]
0 1 2
2
n
n

(n- last period when the cash flows can be expected)

4. Present Value NPV= ∑A /(1+k) t
t

5. Economic Value added After-tax operating income –

(Investments in assets* Weighted Average
Cost of Capital)

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