Prentice Hall's one-day MBA in finance & accounting (39 page)

In Closing

I would like to show you examples of management control reports. But control reports are highly confidential; companies are not willing to release them outside the business. In some situations, control reports contain proprietary information that a business is not willing to give out without payment (e.g., customer lists). Management control reports are like income tax returns in this regard—neither is open for public inspection.

However, you may be able to get your hands on one type of management control report—those that are required in a franchise contract between the franchisee and the parent company that owns the franchise name. These contracts usually require that certain accounting reports be prepared and sent to the home office of the company that operates the chain. These reports are full of management control information that is very interesting. Perhaps you could secure a blank form of such an accounting control report.

Last, I should point out that management control reports vary a great deal from business to business. Compare in your mind, if you would, the following types of businesses—a gambling casino, a grocery store, an auto manufacturer, an electric utility, a bank, a hotel, and an airline. Each type of business is unique in the types of control information its
261

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managers need. The preceding comments offer general observations and suggestions for management control reports without going into the many details for particular industries.

SALES MIX ANALYSIS AND ALLOCATION

OF FIXED COSTS

Typically, two or more products share a common base of fixed operating expenses. For instance, consider the sales of a department store in one building. There are many building occupancy expenses, including rent (or depreciation), utilities, property taxes, fire and hazard insurance, and so on. All products sold in the store benefit from the fixed expenses. Or consider a sales territory managed by a sales manager whose salary and other office costs cover all the products sold in the territory. Should such fixed expenses be allocated among the different products?

Allocation may appear to be logical. The more basic question is whether or not allocation really helps management decision making and control. Allocation is a controversial issue, especially where product lines (or other product groupings) are organized as separate profit centers for which different managers have profit responsibility (and whose compensation may depend, in part at least, on the profit performance of the organizational unit).

If a company sold only one product, there would be no cost allocation problems between products—although there may be common costs extending over two or more separate sales regions (territories). The main concern in the following discussion is the allocation of fixed expenses among products.

Sales Mix Analysis

Suppose you’re the general manager of a business’s major division, which is one of the several autonomous profit centers in the organization. (I treat this as a profit module in the following discussion.) Your division sells one basic product line consisting of four products sold under the company’s brand names plus one product sold as a generic product (no brand name is associated with the product) to a supermarket chain. Figure 17.2 presents your management profit report for the most recent year.

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M A N A G E M E N T C O N T R O L

28%

otals

Dollars

$686,110

$5,261,000

($922,390)

($766,000)

($2,886,500)

$1,452,110

$1,452,110

Product Line T

Units

100%

100%

100,000

35%

9%

21%

?

?

$95.00

$33.25

9,000

Premier

($40.60)

($21.15)

$299,250

30%

10%

15%

?

?

Deluxe

$75.00

($36.00)

($16.50)

$22.50

10,000

$225,000

27%

35%

39%

$60.00

?

?

($32.00)

($11.80)

$16.20

35,000

Products

Standard

$567,000

mine profit attributable to each product line.

21%

18%

11%

?

?

$42.50

$9.05

($26.65)

($6.80)

18,000

Economy

$162,900

products to deter

25%

28%

14%

$28.25

($1.13)

$7.07

28,000

?

?

Generic

($20.05)

The question is whether or not to allocate the total fixed expenses among the five $197,960

Management profit report.

Sales price

Product cost

Variable expenses

Unit margin

% of sales price

Sales volume

% of total sales volume

Contribution margin

% of contribution margin

Fixed expenses

Profit

FIGURE 17.2

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All five products are earning a contribution margin—though these unit profit margins vary in dollar amount and by percent of sales price across the five products. The premier product has the highest percent of profit margin (35 percent), as well as the highest dollar amount of unit margin ($33.25). You might notice that the generic model has a higher percent of contribution margin and generates more total contribution margin than the economy model.

Production costs are cut to the bone on the generic product, and no advertising or sales promotion of any type is done on the product—the variable expenses are mainly delivery costs.

Product cost is highest for the premier product because the best raw materials are used and additional labor time is required to produce top-of-the-line quality. Also, variable advertising and sales promotion costs are very heavy for this product; variable expenses are 22 percent of sales price for this product ($21.15

variable expenses ÷ $95.00 sales price = 22%).

The economy model accounts for 18 percent of sales vol-

ume but only 11 percent of total contribution margin. The premier model accounts for only 9 percent of sales volume but yields 21 percent of total contribution margin. Which brings up the very important issue of determining the best, or opti-

mal, sales mix. The comparative information presented in Fig-

ure 17.2 is very useful for making marketing decisions. Shifts in sales mix and trade-offs among the products are important to understand.

TEAMFLY

The marketing strategy of many businesses is to encourage their customers to trade up, or move up to the higher-priced items in their product line. As a rule, higher-priced products have higher unit margins. This general rule applies mainly to mature products, which are those products in the middle-age or old phases of their life cycles.

Newer products in the infant and adolescent stages of their life cycles often have a competitive advantage. During the early phases of their life cycle, new products may enjoy high profit margins until competition catches up and forces sales price and/or sales volume down. In fact, the CEO of Kodak made this very point a few years ago in an article in the
New York Times.

Compare the following two products: standard versus deluxe. You make a $6.30 higher unit contribution profit margin on the deluxe product ($22.50 deluxe − $16.20

264

Team-Fly®

M A N A G E M E N T C O N T R O L

standard = $6.30). Giving up one unit of standard in trade-off for one unit of deluxe would increase total contribution margin without any change in your total fixed expenses.

Marketing strategies should be based on contribution margin information such as that presented in Figure 17.2.

The position of the economy model is interesting because its contribution margin is by far the lowest of the company-brand products and not much more than the generic model.

The economy model may be in the nature of a loss leader or, more accurately, a
minimum-profit leader—
a product on which you don’t make much margin but one that is necessary to get the attention of customers and that serves as a spring-board or stepping-stone for customers to trade up to higher-priced products.

But the opposite may happen. In tough times, many cus-DANGER!

tomers may trade down from higher-priced models and buy products that yield lower profit margins. Large numbers of customers may trade down to the standard or the economy models. Dealing with this downscaling is a challenging marketing problem. Perhaps the sales prices on the lower-end products could be raised to increase their unit margins; perhaps not.

Should you be making and selling the generic product? On the one hand, this product brings in 28 percent of your total sales volume and 14 percent of total contribution margin. On the other hand, these units may be taking sales away from your other four products—though this is hard to know for certain. This question has to be answered by market research.

If the generic product were not available in supermarkets, would these customers buy one of your other models? If all these customers would buy the economy model, you would be better off; you’d be giving up sales on which you make a unit contribution profit margin of $7.07 for replacement sales on which you would earn $9.05, or almost $2.00 more per unit. If customers shifted to the standard or higher models you would be ahead that much more, though it would seem that customers who tend to buy generic products are not likely to trade up.

Many different marketing questions can be raised. Indeed, the job of the manager is to consider the whole range of marketing strategies, including the positioning of each product, setting sales prices, the most effective means of advertising, and so on. Deciding on sales strategy requires information on
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contribution profit margins and sales mix such as that presented in Figure 17.2. The exhibit is a good tool of analysis for making marketing decisions regarding the optimal sales mix.

Fixed Expenses: To Allocate or Not?

When selling two or more products, inevitably there are fixed operating expenses that cannot be directly matched or coupled with the sales of each product or each separate stream of sales revenue. The unavoidable question is whether or not to allocate the total fixed operating expenses among the products. Refer to Figure 17.2, please; notice that fixed expenses are not allocated. Should these fixed expenses be distributed among the five different products in some manner?

Fixed expenses generally fall into two broad cate-

gories: (1) sales and marketing expenses and

(2) general and administrative expenses. Most fixed operating expenses are
indirect;
the expenses cannot be directly associated with particular products. The example here assumes there are no direct fixed expenses for any of the products. On the other hand, there could be some direct fixed expenses.

For example, an advertising campaign may feature only one product. Suppose you bought a one-time insertion in the
Wall Street Journal
for the premier product. The cost of this one-time ad should be deducted from the contribution margin of the premier product as a direct fixed expense. Typically, however, most fixed expenses are indirect; they cannot be directly matched to any one product.

Indirect fixed expenses can be allocated to products, although the purposes and methods of allocation are open to much debate and differences of opinion. For instance, the allocation can be done on the basis of sales volume, which means each unit sold would be assigned an equal amount of the total fixed expense. Or fixed costs can be allocated on the basis of sales revenue, which means that each dollar of sales revenue would be assigned an equal amount of total fixed expense. Alternatively, fixed costs can be allocated according to a more complex formula.

Figure 17.3 shows two alternative profit reports for the example—one in which total fixed expenses are allocated on
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M A N A G E M E N T C O N T R O L

68,940)

Premier

$855,000

($365,400)

$489,600

($190,350)

$299,250

($

$230,310

Premier

$855,000

($365,400)

$489,600

($190,350)

$299,250

($124,488)

$174,762

Deluxe

76,600)

$750,000

Deluxe

($360,000)

$390,000

($165,000)

$225,000

($

$148,400

$750,000

($360,000)

$390,000

($165,000)

$225,000

($109,200)

$115,800

980,000

413,000)

567,000

268,100)

298,900

980,000

413,000)

567,000

305,759)

261,241

Standard

$2,100,000

Standard

($1,120,000)

$

($

$

($

$

$2,100,000

($1,120,000)

$

($

$

($

$

olume

25,020

51,516

Economy

$765,000

($479,700)

$285,300

($122,400)

$162,900

($137,880)

$

Economy

$765,000

($479,700)

$285,300

($122,400)

$162,900

($111,384)

$

31,640)

16,520)

31,640)

82,791

Generic

$791,000

($561,400)

$229,600

($

$197,960

($214,480)