Chapter 2

Financial Aspects of
Marketing Management
In this chapter, you will
learn about…
1. Variable and Fixed Costs
2. Relevant and Sunk Costs
3. Margins
Gross Margin
Trade Margin
Net Profit Margin (Before Taxes)
4. Contribution Analysis
Break-even Analysis
Sensitivity Analysis
Contribution Analysis and Profit
Impact
2-2
In this chapter, you will
learn about…
4. Contribution Analysis (contd.)
Contribution Analysis and Market
Size
Contribution Analysis and
Performance Measurement
Assessment of Cannibalization
5. Liquidity
6. Operating Leverage
7. Discounted Cash Flow
8. Preparing a pro forma Income
Statement
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 Types of Cost

Costs

Fixed Variable
Costs Costs

2-4
Variable Costs are…

Expenses that are uniform per unit of

output within a relevant time period

As volume increases, total variable

costs increase

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THERE ARE TWO CATEGORIES OF
VARIABLE COSTS

1. Cost of Goods Sold

2. Other Variable Costs

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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

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Other Variable Costs

Expenses not directly tied to

production but vary directly with
volume

Examples include:

 Sales commissions, discounts,

and delivery expenses

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 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
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THERE ARE TWO CATEGORIES OF
FIXED COSTS

1. Programmed costs
2. Committed costs

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Fixed Costs – Programmed
Costs

Result from attempts to generate sales

volume

Examples include:

 Advertising, sales promotion, and

sales salaries

2-11
Fixed Costs – Committed
Costs
Costs required to maintain the
organization

Examples include nonmarketing

expenditures, such as:

 rent, administrative cost, and

clerical salaries

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Relevant and
Sunk Costs

2-13
 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

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 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
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 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.
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 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

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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
2-18
 Gross Margin
Total Gross Margin Dollar Amount Percentage

Net Sales $100 100%

Cost of Goods Sold - 40 - 40

Gross Profit Margin $ 60 60%

Unit Gross Margin

Unit Sales Price $1.00 100%

Unit Cost of Goods Sold - 0.40 - 40

Unit Gross Profit Margin $0.60 60%

2-19
 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 %

2-20
 Trade Margin

Unit Cost of Unit Gross Margin

Goods Sold Selling Price as a % of
Selling Price

Manufacturer $2.00 $2.88 30.6%

Wholesaler $2.88 $3.60 20.0%

Retailer $3.60 $6.00 40.0%

Consumer $6.00

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 Net Profit Margin
(before taxes)
Dollar Amount Percentage

Net Sales $ 100,000 100%

Cost of Goods Sold - 30,000 - 30

Gross Profit Margin $ 70,000 70%

Selling Expenses - 20,000 - 20

Fixed Expenses - 40,000 - 40

Net Profit Margin $ 10,000 10%

2-22
 Kellogg’s Cereal Margins at a Price
of $2.72 per box
Kellogg’s Direct Unit Manufacturing Cost
Grain $.18
Other Ingredients .23
Packaging .31
Labor .18
Mfg. Overheads .34
Cost of Goods Sold $1.24 ––––––– 54.4% Gross Margin
($2.72 - $1.24)/$2.72
Promotions (excluding Advertising) + .20
Total Unit Variable Cost $1.44
Manufacturer Contribution to Fixed Cost
and Profit $1.28 ––- 47% Contribution
Margin
($2.72-$1.44)/$2.72
Kellogg’s Selling Price to Grocery Store $2.72
Grocery Store Margin .68 ––- 20% Trade Margin
($3.40 - $2.72)/$3.40
Grocery Store Selling Price $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

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 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

2-25
Break-even Analysis Chart
Dollars
Total Revenue

BE Point
Total Cost
PROFIT

Variable Cost

LOSS Fixed Cost

0 Unit Volume
2-26
 Break-even Analysis
Example

Fixed Costs = $50,000

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

Sensitivity Analysis

Profit Impact

Market Size

Performance Measurement

Assessment of Cannibalization

2-28
 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

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 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.
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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
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Discounted Cash Flow

The discount rate can be

expressed as follows:

Discount factor = ___1___

n
(1 + r)

Where the r in the denominator

is the interest rate and n is the
number of years

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The interest or discount rate is
often defined as…

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.

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 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

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 Preparing a pro forma
Income Statement

A pro forma income statement is a

projected income statement

Includes:

Projected Revenues

Budgeted Expenses

Estimated Net Profit

2-35
Pro Forma Income Statement – Example
Sales
$1,000,000
Cost of goods sold
500,000
Gross margin
500,000
Marketing expenses
Sales expenses $170,000
Advertising expenses 90,000
Freight or delivery expenses 40,000
300,000
General and administrative expenses
Administrative salaries $120,000
Depreciation on buildings and equipment 20,000
Interest expense 5,000
Preparing a pro forma
Income Statement

Sales – forecasted unit volume

times selling price

Cost of goods sold – costs incurred

in buying or producing products
and services

Gross margin – represents the

remainder after cost of goods sold
has been subtracted from sales
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Preparing a pro forma
Income Statement

Marketing Expenses – programmed

expenses to be spent on increasing
sales

General & Administrative Expenses

– fixed costs (often referred to as
overheads)

Net Income before Taxes – sales

revenues minus all costs
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