Marketing Management and Revenue Accounting Chapter 13 Marketing Metrics From the Operating Statement and Balance Sheet

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1 Marketing Management and Revenue Accounting Chapter 13 Marketing Metrics From the Operating Statement and Balance Sheet Learning Goals 1) To understand and use various marketing metrics drawn from the firm s operating statement and balance sheet to measure marketing performance 2) To appreciate the role that some key concepts and terms used in managerial accounting and financial management play in marketing management 3) To introduce terms and definitions that are new to marketing management such as: the marketing contribution, the return on marketing effort, and the marketing return on sales. 4) To reconcile some managerial accounting terms and economic concepts that are defined or interpreted differently by marketers than they are by financial managers, accountants and economists. 5) To reinforce the philosophy that the primary goal of marketing is to maximize profits and to remind the reader that attempts to maximize secondary objectives such as sales, revenues, market share, return on marketing, etc. will not necessarily maximizing the firm s profits. Key Metrics and Terms Students should know the definitions of the following metrics and how to solve basic problems involving them: Quantity of Units Sold, Q Sales Revenue, R Selling Price per Unit, P Total Cost, TC Net Profit, Z Breakeven Price, BEP Return on Sales, ROS Variable Cost per Unit, V Cost of Goods Sold, COGS Learning Curve Fixed Costs or Period Costs, F Marketing Expenses for the Period Marketing Expenses to Sales Ratio Marketing Overheads Breakeven Quantity, BEQ Dollar Markup or Unit Margin, P- V Markup on Cost per Unit Sold, Mv Markup on Price per Unit Sold, Mp Converting Markup on Cost to Markup on Price Breakeven Revenue, BER Breakeven Markup, BEMp Gross Contribution or Gross Margin, G Gross Return on Sales 1

2 Marketing Contribution or Profit After Marketing Expenses Marketing Return on Sales Marketing Return on Investment or Return on Marketing Expense Detailing the Marketing Expenses Advertising Expenses Consumer Promotions Sales Force Expenses Dealer Promotions Percentage of Advertising to Sales Revenue Percentage of Consumer Promotion to Sales Percentage of Sales Force Expense to Sales Percentage of Dealer Promotion to Sales Return on Individual Marketing Expenses Balance Sheet metrics Asset Turnover Return on Assets Inventory Turnover Return on Inventory Marketing Assets Not Recorded on the Balance Sheet Brand Equity Product Quality Customer Satisfaction Customer Retention and Loss Rates Life Span of the Average Account Market Share Share of Voice Share of Mind Share of Heart Share of Wallet The topics in this chapter are organized into 8 parts: Part 1 Elements of a Simple Cost- Based Performance Report Part 2: Basic Types of Costs in the Operating Statement Part 3: Detailing the Marketing Expenses for the Period Part 4: Classic Rates and Ratios Part 5: Basic Types of Profit and Ratios of Profitability Part 6: Detailing the Marketing Expenses in the Operating Statement Part 7: Marketing Assets for a Balance Sheet Part 8: Marketing Assets Not Recorded on the Balance Sheet 2

3 Part 1: The Elements of a Simple Cost- Based Performance Report Income Statement The Income Statement is the single most important description of a firm s financial performance. It is at the heart of the firm s financial reporting and describes all the firm s revenues, costs and profits over a specific period of time. The audience for the income statement is normally the firm s shareholders and other financial stakeholders. Operating Statement The Operating Statement is similar to the Income Statement but its purpose and its audience is different. The primary audience for the Operating Statement is the firm s managers and its primary purpose is to help in day- to- day decisions and strategy formulation. The Operating Statement may be written to describe the performance of the firm s total activities in all markets, or it may be written to describe the firm s performance in a single market with a single product or single customer. A very simple operating statement for a sample firm with only the most minimal information is illustrated in Figure 1-1. It is always written to describe costs and revenues over relatively short periods of time, such as weeks or months. Figure 1-1 A Very Simple Operating Statement for Sample Firm Twelve Months Ending March 31, 2011 Percentage of Sales Revenue Quantity of Units Sold, Q 5,000 Selling Price per Unit, P $100 Sales Revenue, R = P x Q $500,000 Total Costs, TC $475,000 Net Profit, Z $25,000 Return on Sales = Z/R = 5% Many of the terms used by accountants to describe costs and revenues are common to accounting, finance, operations and marketing. However, some terms in the operating statement are interpreted in very different ways. For example, accountants will refer to the cost of the things purchased as the price of things that were purchased. Marketing managers try to reserve the word price to mean the selling price per unit that they charge the firm s customers and reserve the word cost to mean the expenditures needed to create the sales revenues. The following definitions are designed to be as internally consistent as possible and still retain an acceptable interpretation to the largest number of audiences. For example, the author will avoid the term Return on Marketing Investment, ROMI, in favor of the term Return on Marketing Expense, ROME. The term return will be used to describe ratios and rates of profitability rather than the term margin 3

4 Quantity of Units Sold The quantity of units sold in a period, Q, is often referred to as the sales volume. It is measured in a number of different ways such as in SKU s, e.g., stock keeping units or statistical units. Often the measurement is complicated by the need for metrics that make volumes comparable. Sales Revenue Sales revenue is the amount of money, R, which has been earned by the firm s marketing efforts with its customers in a single period. For a retailer, it can be as simple as counting the sales receipts at the end of the day. For a manufacturer, calculating the actual revenue earned in a period can be extremely difficult to estimate. The sales revenue does not include all of the firm s potential income streams. For example, investment revenue, the sale of patents, obsolete equipment, etc. are not generated by the firm s marketing efforts. The total marketing effort is the summarized total of the firm expenditures in promoting, distributing and producing products and services for the customer. Selling Price per Unit The selling price per unit, P, is better known as the price and it is defined as the amount of money the customer pays for the product. However, accountants will often record the selling price as the average revenue per unit sold and calculate it as the ratio of the sales revenue over the quantity sold, P = R/Q. Economists think of the price per unit as being the incremental revenue earned by the sale of an additional product. In the example (Figure 1-1), the selling price per unit is calculated as P = R/Q = $5,00,000/5,000 units = $100 per unit In practice, the amount of money a customer pays for a product can be extremely difficult to identify because coupons, special discounts, rebates, trade- ins, etc. distort the actual price that customers pay. Total Cost Total cost, TC, is the sum of the entire dollar expenditures incurred in the period for creating sales and covering overheads. In accounting there are many artificial allocations of depreciation and sunk costs are seldom used in the reports needed by marketing managers. The total costs are invariably decomposed into different types of costs such as variable costs and fixed costs. Net Profit The term net profit, Z, is defined as the difference between the sales revenue, R, and the total cost, TC, and is often identified as the firm s earnings before interest and taxes (EBIT). In the example of the very simple operating statement (Figure 1-1), the net profit is calculated as Z = R TC = $500,000 $475,000 = $25,000 There are many costs involved in running a business. Maximizing net profit is the overall goal of a business and all the various departments of a business firm, including the marketing department. Marketing expenditures are designed to make 4

5 a positive contribution to the firm s net profit. Normally, there are too many non- marketing expenses included in an operating statement for marketers to use the firm s net profit or bottom line as an operational definition of the marketing profit. However, it is the marketing department s primary objective to make a positive contribution to the firm s net profit. Many practitioners think that the primary reason for marketing is to maximize revenue, or other secondary objectives such as brand awareness, customer satisfaction, market share, marketing ROI, etc. There should be no doubt that the primary reason for marketing activity is to maximize marketing s contribution to the firm s net profit. As we shall illustrate in other chapters, there are times when the goal of maximizing profit is inconsistent with secondary objectives such as maximizing revenue (top line), minimizing expenses, maximizing market share, or maximizing marketing ROI. In practical terms, the goal of marketing is to maximize marketing s contribution to the net profit. Breakeven Price The breakeven price, BEP, is defined as the ratio of the firm s total cost in a period, TC, over the number of units sold in the period, Q, That is to say, the breakeven price, BEP, is the selling price that the firm would have to charge its customers just to have a zero profit after paying for all direct and indirect costs for the period. It is better known in accounting as the average cost per unit and is sometimes called the average unit cost or simply the unit cost. In the sample operating statement (Figure 1-1), the breakeven price, BEP, is calculated as BEP = TC/Q = $475,000/5,000 = $95 per unit. The average cost per unit or BEP is often used in cost- based calculations for setting the selling price per unit. Return on Sales The net return on sales, ROS, is the ratio of the net profit, Z, to the sales revenue, R. Financial managers often use the term profit margin as a synonym for return on sales. Return on sales is the rate at which net profits are converted from the sales revenue. The net profit, Z, generated from the sales revenue, R, when the firm s ROS is known can be calculated from Figure 1-1 as Z = ROS x R Z = 5% x $500,000 = $25,000 The net return on sales revenue, ROS, is a classic measure of operating performance and is used in finance and accounting as an indicator of the firm s operating efficiency. Firms with high levels of ROS are seen as very efficient at converting sales revenues into net profits. The interpretation of the ratio, of net profit to sales, as the firm s output over the firm s input is a very mechanical view of the firm s efficiency. In the example (Figure 1-1), the ROS sales is calculated as ROS = Z/R = $25,000/$500,000 = 5% 5

6 Many firms have a traditional level of ROS that the firm is expected to reach and the expected ROS is widely used as the firm s target level of profitability. However, the ROS can be difficult to use as a diagnostic measure of profitability because ROS will increase as the selling price increases and at some point any further increase in price will result in decreased profits. This characteristic of ROS is explored further in other chapters. The target ROS is commonly used in the cost based pricing. The equation for setting a price that will be high enough to cover all normal costs at normal sales volumes for a normal profit. For example, the equation for determining the selling price, P, to cover the average cost per unit (i.e., breakeven price, BEP) and to generate a normal ROS is P = BEP/(1- ROS). If the average cost per unit at the normal sales volume is BEP = $45 and the normal return on sales is ROS = 25%, then the price must be set at $60. P = $45/(1-0.25) = 45/0.75 = $60 Part 2: The Basic Types of Costs in the Operating Statement Most operating statements have more detail on the many different types of costs than the simple example in Figure 1-1. The operating statement in Figure 1-2 is an expanded version of Figure 1-1 and provides a more detailed listing of the variable costs per unit, the fixed marketing expenses and marketing overheads that make up the total costs. A distinction is made between the fixed marketing costs that were designed to have an immediate and direct impact on the sales volume in the period, such as advertising and sales force expenses, and fixed marketing overheads, such as research and product development, that indirectly support the marketing effort over long periods of time. Variable Cost per Unit The two most important types of costs on an operating statement are the fixed costs and the variable costs. Variable costs, V, are those that can be directly traced to the production and sale of products. The total variable cost or total cost of goods sold, by definition, increases in direct proportion to the increasing volume of products sold. For example, traceable variable costs include the direct costs of raw materials, direct labor, supervision, inventory storage costs, sales commissions and coupons. Do not confuse variable costs and discretionary costs. Advertising is a marketing expense that can be varied from month to month on the manager s discretion. However, it is considered a fixed or period cost because it does not automatically change due to changes in sales or production volume. Finance managers structure their capital budgeting problems in terms of cash flows with the fixed costs being paid at the beginning of the period because they are known and they will not change for the period (e.g., rent, salaries, etc.). The variable elements that will not be known until the end of the period (e.g., actual sales 6

7 revenue, actual cost of making and selling the product sold) are paid at the end of the period. The finance manager looks at the operating statement with a view to calculating net cash flows and the actual bill for the cost of goods sold will not be known until the end of the period because the size of the bill varies with the amount manufactured and sold. Accountants have strong traditional focus on the costs of production and seldom pay any attention to the variable costs involved in selling products. However, the size of the total expenditures needed to pay for sales commissions, shipping, etc. varies directly with the volume of product being sold and this makes these types selling costs of a variable costs. In many business models the variable of production are dwarfed by the variable selling costs. Traditional accounting practices make many variable selling costs difficult to trace and as modern accounting procedures evolve to become more useful to marketing managers, then more variable selling costs will be included in the firm s operating statements. The total variable costs are defined as variable because they vary directly with the number of goods sold in the period. In companies where modern accounting systems are in tune with the needs of modern marketing management, then COGS will include both the total variable selling costs and, not just, the traditional production costs. If more products are sold, then the total cost of goods sold increases. In the example (Figure 1-2), the variable cost per unit is $30 per unit and the quantity sold is 5,000 units. The cost of the goods sold is calculated as COGS = V x Q = $30 x 5,000 = $15,000 Figure 1-2 Operating Statement for Sample Firm with an Expanded Listing of Various Costs Twelve Months Ending December 31, 2011 % of Sales Selling price per Unit, P $100 Quantity of Units Sold, Q 5,000 Sales Revenue, R = P x Q $500,000 Variable Cost per Unit, V $30 Cost of Goods Sold, COGS = V x Q $150,000 Gross Profit, G = R - COGS $350,000 G/R = 70% Marketing Expenses, ME $200,000 E/R = 40% Marketing Contribution to Profit, M $150,000 M/R =30% Marketing Overhead and other General $125,000 Overhead Expenses for the period, OH Net Profit, Z $25,000 Z/R = 5% 7

8 Basic Profit Equation The basic profit equation presents the basic operating statement (Table 1-2) in its many variants as an algebraic equation. Z = (P- V)Q F Z = G F Z = PQ VQ F Z = R COGS F Z = R - TC where Z = the net profit G = (P V)Q = the gross profit P = the selling price per unit V = the variable costs per unit Q = the quantity of units sold F = the fixed costs for the period R = PQ = the sales revenue COGS = VQ = the total cost of goods sold TC = VQ + F =the cost for the period The basic profit equation is the starting point from which many classic marketing metrics and benchmarks are derived. Learning Curve The Learning Curve phenomena are also called Experience Curves and they have a direct effect on lowering the variable costs over time. It is the empirical observation that the direct costs of production, such as labor, raw materials, etc. decrease as a firm gains more and more experience in the production of the product. The variable cost is usually considered a constant cost per unit per period; however, the variable cost per unit can decrease from period to period as learning accumulates with the cumulative production of the product. The reduction in the variable cost due to the learning curve is often framed in terms cumulative production. For example, it might be stated that the variable cost per unit is dropping by 25% every time the history of the production volume doubles. That is to say, if the product s variable cost was $40 per unit when the production history had reached 300,000 units, then the variable cost per unit will have dropped by 25% to $30 per unit when production has accumulated a history of 600,000 units. For operational purposes, a 25% learning curve is described as a function of the cumulative quantity, Q, and the variable cost per unit at 600,000 units is calculated as V = 7500 Q = 7,500(600, ) = 7,500(0.004) = $30. The learning curve can play a crucial role in the cost- based calculations for pricing of new products. Fixed Costs Fixed costs are sometimes called period costs because they are defined as costs that do not vary with volume of sales from period to period. In theory, if the reporting period is long enough, then all costs will vary with the volume of sales and production as firms grow and decline. However, for practical purposes the reporting 8

9 periods are usually short and many overhead costs for the period such as the weekly salaries, monthly rent, etc. remain the same from period to period. Costs that do not vary with the production or sales volumes are called fixed or period costs. Examples of fixed or period costs include expenditures on advertising, consumer promotions, dealer promotions, sales force salaries, product development and testing, market research and general overheads. Marketing managers can choose to vary the advertising expense from period to period, but advertising is not defined to be a variable cost. Advertising is defined to be a fixed cost for the time period in question. Marketing expenditures, such as advertising and promotion expenses are often called discretionary expenses because they may vary from period to period due to changes in the marketing strategy. However, if the marketing expenses do not vary directly with changes in the sales or production volume, then they are considered fixed or period costs. Sometimes fixed costs such as advertising or overheads costs are discussed in terms of averages, such as the average cost of advertising per unit sold is $10 per unit and this makes the average fixed cost per unit sound like a variable cost. However variable costs per unit can be traced directly to an individual product in the production or selling process. Part 3: Detailing the Marketing Expenses for the Period Expenditures on any marketing effort that is designed to have a direct and an immediate impact on the firm s sales volume in the period is considered to be a marketing expense, ME. For example, expenditures on advertising, sales force and sales promotion expenses are defined as marketing expenses because they are designed to have an immediate impact on the sales volume in the period. In managerial accounting, it is common for cost accountants to think of marketing expenditures such as advertising as cost drives. However, marketing managers know that marketing expenditures such as advertising are revenue drivers and should be discussed as investments rather than expenses. Accountants and Finance Managers never think of advertising expenses as investments or profit creating assets. Marketing Expenses to Sales Ratio The ratio of marketing expenses to sales revenue, ME/R, is commonly reported in the operating statement. The ratio is often used for setting marketing budgets and controlling marketing expenses. For example, accountants will often report the firm s advertising to sales ratio and the firm s sales force expense to sales ratio. In the sample operating statement (Figure 1-2), the ratio of the total marketing expense to the revenue is ME/R = $200,000/$500,000 = 40%. Unfortunately, the ratio ME/R is commonly used as a budgeting method and constraint. That is to say, it is common for accountants, using marketing as a cost driver, to assume that a forecasted revenue should determine the size of the marketing budget. For example, if the traditional advertising to sales ratio is 40% 9

10 and the forecasted revenue for the next period is $450,000, then the advertising budget would be reduced from $200,000 to $180,000 by the calculation Marketing Budget = (ME/R) x Forecasted Revenue = 40% x $450,000 = $180,000 The budgeting implication, that sales revenues cause marketing is, of course, fundamentally flawed and misleading because it is the marketing expenditures that create sales and drive revenues. If sales are falling, then the accountants implied advice to reduce advertising expenditures to establish a budgeted advertising to sales ration may be completely wrong and it might be more profitable to increase advertising. Marketing Overheads There are many marketing expenditures that are not directly linked to sales or designed to have an immediate impact on sales or customers. Marketing expenditures that support marketing efforts but can t be directly traced to specific sales or that are designed to have long- term impacts are considered marketing overheads. Marketing Overheads would include expenditures on market research, product research, product development and market testing, distribution and warehousing facilities, marketing salaries, public relations campaigns, and customer retention programs. In many cases, Marketing Overheads are listed with the firm s general overheads. Part 4: Classic Rates and Ratios Markup The term markup is business slang to shorten the phrase percentage of the dollar markup over the selling price. The term markup should not be used to mean the percentage of the dollar markup over the cost of the product. In this text any reference to the term markup meaning the markup on cost will explicitly include the word cost. Any reference to the term markup meaning the dollar markup will explicitly include the word dollar. We will avoid using the term markup and if it is used, then it will be slang for the percentage of the unit contribution over the selling price. Unit Contribution or Dollar Markup per Unit Sold The term unit contribution or unit profit contribution is defined as the difference between the variable cost per unit, V, and the selling price per unit, P. Accountants will sometimes refer to the profit contributed by sale of a unit of inventory as the unit margin. However, in this text we use the unit contribution to be the dollar profit or dollar markup on the cost of each unit sold. In the example (Figure 1-2), the unit contribution is calculated as Unit Contribution = (P- V) = $100 - $70 = $30 per unit The dollar markup or unit contribution is a dominant metric in the calculation of breakeven quantities. 10

11 Breakeven Quantity The term breakeven quantity, BEQ, is the number of units that must be sold to pay for a given fixed cost for the period. The BEQ is defined as the ratio of a fixed cost to the unit contribution or dollar markup, BEQ = F/(P- V). The BEQ can be calculated for a single expense, such as the quantity a sales person must sell to cover his/her salary, or it may be calculated for the entire fixed costs of an operation. For the example in Table 1-2, the sample firm must sell 4,643 units in a period to cover the total fixed costs for the period, BEQ = F/(P- V) = $325,000/($100- $30) = 4,643 units However, the firm need only sell an additional 1,429 units to breakeven on an additional advertising expenditure of $100,000. BEQ = F/(P- V) = $100,000/($100 - $30) = 1,429 units Markup on Cost per Unit Sold The term markup on cost, Mv, is defined as the ratio of the dollar markup or the unit contribution over the variable cost per unit, Mv = (P- V)/V, and is usually stated as a percentage. In the example (Figure 1-2), the markup on cost is Mv = (P- V)/V = ($100- $30)/$30 = 2.33 = 233% Some managers use the markup on cost to calculate the profit being returned on inventory. Markup on cost might be more accurately called the return on the unit cost. For example, a markup on cost of 233% per item would imply that the amount of profit earned by selling one item is 233% of the item s cost. It should be noted that the percentage markup on cost can be greater than 100%, whereas the percentage markup on price is always less than 100%. Many students enter business school with an intuitive understanding that the term markup means the dollar markup over cost per unit. However, markup over cost is seldom used in the analysis of marketing problems. The markup on price is used far more commonly than markup on cost, thus students often confuse the slang markup to mean the markup on cost when it is the markup on price that is being discussed. When marketing managers want to talk about the percentage markup over cost, then they will invariably be explicit by incorporating the words on cost, into the discussion. If the markup being discussed in a situation does not explicitly mention on cost, then it should be assumed that the discussion is about markup on price. Markup on Price per Unit Sold Markup on price is probably the most important and most widely used ratio in marketing. The formal definition of the term markup on price, Mp, is the ratio of the unit contribution, P- V, divided by the unit s selling price, P, and is usually discussed as percentage. The ratio of markup on price, Mp, is calculated in the example (Figure 1-2) with a selling price of P = $100 and variable cost per unit of V = $30 Mp = (P- V)/P = ($100- $30)/$100 = 70% 11

12 The most obvious difference between markup on cost and markup on price is that the markup on price ratio can never be larger than 100%. Special deals and seasonal sales are never advertised as having a discount greater than 100% because retailers use the markup on price and not the markup on cost. Managers use the ratio of markup on price far more often than markup on cost in their calculations. For example, the markup on price is used in calculations associated with cost based pricing, gross profit maintenance, breakeven revenue, elasticities, minimum order quantities, markdowns, operating and channel efficiencies. Students are always on safe ground to assume the slang term markup means the percentage markup on price. If the problem does not explicitly say markup on cost assume that it is markup on price. In modern supply chain management and retailing, the terms markup and markup on price are being replaced by terms such as Discount off Manufacturer s Suggested List Price, or Discount off List. To avoid confusion, some textbooks refer to the markup on price ratio as the profit- volume or PV ratio. The markup on price can be thought of as the return on the selling price per unit. For students having difficulty remembering that markup is slang for markup on price, it helps to think of markup as a cousin to the term, sales commission. No one intuitively thinks of the ratio of the salesman s commission as a percentage of the seller s cost. Sales commissions, like markup, are always calculated based on the selling price, not the unit s cost. A percentage markup can be thought of as the obverse of a markdown. A markdown is the percentage that is taken off the original selling price to give customers a discounted sale price. Markdowns, like markups, are always calculated as percentages of the selling price and not as percentages of original cost to the retailer. Markup on price, Mp, has several interesting interpretations and useful properties. Markup on price is sometimes seen as a ratio of output (unit profit) over input (unit cost) and is often interpreted as a measure of the firm s efficiency at converting the selling price per unit into the profit per unit. For example, the operating statement in Figure 1-2 implies that the firm is 70% efficient at converting the price per unit, P, into the unit s profit contribution, (P- V). Unit contribution = Mp x price = 70% x $100 = $70 per unit Declining returns and profits are considered an important diagnostic of a firm s operating health. The difficulty in using the markup on price as a measure of operating efficiency is that the Mp = (P- V)/P will always increase when the cost per unit is constant and the selling price increases. The nature of this characteristic is discussed in more detail in other chapters. The ratio of markup on price is used by retailers as a target profit to ensure that the gross profit is high enough to cover normal operating overheads and generate a normal net profit. For example, if a retailer needs a normal gross profit generated by 12

13 a 40% markup, Mp=40%, and the variable cost per unit (i.e., invoice cost) is V=$10, then the selling price, P, must be set at $25. P = V/(1- Mp) = $10/(1-0.40) = $10/0.4 = $25 In the retail industry, the markups and markdowns are both ratios based on the selling price and the two work in harmony when retail prices are being adjusted up and down for seasonal specials, etc. It would be very awkward and confusing if retail markups were calculated as percentages of cost and markdowns were calculated as percentages of price. If a product was marked up at 50% of its cost, then displayed on the shelf for a special sale with a 50% markdown on price, then the product would be sold at a loss. For example, a product is bought for V =$10 and is originally sold with a 50% markup on cost, then the original selling price is P = V + 50%(V) = $ ($10) = $15 When the price is marked down by 50% from the original selling price as seasonal special, then the discount price, Pd, is Pd = P (discount rate)(p) = $ ($15) = $15 $7.50 = $7.50 The discount price of $7.50 gives the retailer a loss of $2.50 on every unit sold. We can avoid bankruptcy by using markup on price for setting the original price. As we shall see in other chapters, there is also a rule of thumb for an optimal markup that can be established by working with the market s sensitivity to price changes (i.e., price elasticity) such that maximum profit is achieved when the markup on price is set equal to the inverse of the price elasticity. Mp = - 1/E where the price elasticity is a constant over the relevant range and more negative than - 1, (i.e., E - 1). Using Channel Markup as a Measure of Channel Efficiency Using markup on price is far more convenient than markup on cost. The convenience of using markup on price is illustrated when measuring the efficiency of channels of distribution. When a manufacturer is choosing between two national retailers that provide identical coverage and services, etc., then the percentage markup (percentage discount off the suggested consumer list price) is the determining factor in the choice. The lower the markup the retailer charges on the suggested list price, the more the manufacturer earns per sale. A more efficient distribution system can charge a lower markup. For example, if two retailers, A and B, have identical distribution coverage and functions, and Retailer A charges a 40% markup and Retailer B charges a 30% markup. The manufacturer s suggested list price to the consumer is $80. Retailer A keeps 40% of the $80 list price for his services. Retailer A s dollar markup = % markup x suggested list price Retailer A s dollar markup = 40% x $80 = $32 per unit sold 13

14 The manufacturer when using channel A earns a selling price equal to 60% of the suggested list price of $80. Manufacturer s selling price = (1- A s markup) x Suggested List Price Manufacturer s selling price = (1-40%) x $80 = 60% x $80 = $48 per unit Retailer B keeps 30% of the $80 list price for his services. Retailer B s dollar markup = % markup x suggested list price Retailer B s dollar markup = 30% x $80 = $24 per unit sold The manufacturer when using channel B earns a selling price equal to 70% of the suggested list price of $80. Manufacturer s selling price = (1- B s markup) x Suggested List Price Manufacturer s selling price = (1-30%) x $80 = 70% x $80 = $56 per unit The manufacturer in the example can easily see that he earns higher selling price using Retailer B and Channel B is more efficient with 30% markup than channel A with a 40% markup. However, channels of distribution are seldom simple and seldom have identical services or efficiency. The total markup charged by a distribution system can be easily calculated using the suggested list price and the markup on price charged by each member of the distribution channel. For example, a channel of distribution involves the manufacturer who sells to a level of distributors, the distributors sell to a level of wholesalers and the wholesalers sell to a level of retailers, and the retailer s sell to the final consumers a product with a suggested final selling price of $60 each. The retailer has an agreed markup of 40%, the wholesaler has a markup of 10%, the distributor has a markup of 5%. The chain of markup on price is often represented on invoices as $60/40/10/5. The manufacturer s selling price to the distributors is calculated as Manufacturer s price per unit = $60 x (1- Distributor s markup) x (1- Wholesaler s markup) x (1- Retailer s markup) Manufacturer s price per unit = $60 x (1-40%) x(1-10%) x (1-5%) Manufacturer s price per unit = $60 x (0.6) x(0.9)x (0.95) = $30.78 The total cost of the channel functions being purchased through the markups is Total Dollar Markup in the channel = Suggested List Price Manufacturer s Selling Price Total Dollar Markup in the channel = $60 - $30.78 = $29.44 The percentage markup for the channel is calculated as Markup for Total Channel = (List price- Channel Cost per unit)/(list price) Markup for Total Channel = ($60- $29.44)/($60) = 48.7% The markup on list price for the total channel is a measure of the channel s efficiency at performing distribution functions. Using the markup on price to calculate the efficiency of the marketing channel is more convenient than using the markup on cost. 14

15 Converting Markup on Cost to Markup on Price Converting markup on cost, Mc, to the markup on price, Mp, is simple because the two ratios form a mathematical identity such that, (1/Mp) (1/Mv) = 1. For example, 1/20% markup on price minus 1/25% markup on cost is always equal to 1, or 1/Mp - 1/Mv = (1/20%) (1/25%) = (1/0.2) (1/0.25) = 5 4 = 1 However, many students memorize the simple markup on cost to markup on price conversion rule as: assume the percentage of markup on cost is a fraction and add the top part to the bottom part, and re- calculate the fraction. For example, 25% on cost is 25/100, add the top part to the bottom part results in, 25/125 and the new ratio is 20% markup on price. That is to say, the relationship is easy to remember as Mp = Mc/(Mc+1) Mp = 0.25/( ) = 0.25/1.25 = 0.20 or 20% Breakeven Revenue There is a very close relationship between Breakeven Quantity and Breakeven Revenue. Breakeven Revenue is more commonly used than Breakeven Quantity, since most managers can remember the percentage markup on goods easier then the dollar margin on units sold. The conversion from Breakeven Quantity, Q*, to Breakeven Revenue, BER, is Q* = F/(P- V) Multiply both sides by the price, P, and the breakeven revenue, R* = PxQ*, is established as PxQ* = P x F/(P- V) R* = F/((P- V)/P) Where we remember (P- V)/P = Mp =markup on price, and F = fixed costs each period, and the Breakeven Revenue, BER is BER = F/Mp Breakeven Revenue is more likely to be used in estimating the sales of services and tailor- made products than Breakeven Quantity, due to the difficulty of comparing and counting dissimilar products. Breakeven Markup or Discount Off List Price The Breakeven Markup is widely used by retailers to negotiate the size of their discount off the recommended consumer list price that they need from manufacturers. The breakeven markup is closely related to the Breakeven Revenue calculation as follows: BER = F/Mp Breakeven Markup, Mp* = F/BER Retailers find it a convenient benchmark, since they are usually very conscious of the fixed costs of keeping the store open each period and the amount of revenue needed to breakeven each period. Retailers use many version of the Breakeven Revenue and Markup in their performance metrics. 15

16 Part 5: Basic Types of Profit and Ratios of Profitability Gross Profit The term gross profit or gross profit contribution, G, is calculated as the difference between the sales revenue, R, and the total cost of goods sold, COGS. The term gross contribution can be confusing because accountants often call the gross contribution the gross margin and finance managers will often use the term gross margin to mean the gross return on sales. In this text we will avoid using the term margin. The gross profit can also be calculated by multiplying the unit contribution (P- V) times the quantity of units sold, Q. The gross contribution in the operating statement (Figure 1-2) is the gross profit and it is calculated as Gross Contribution = G = R- COGS = PQ- VQ = (P- V)Q = MQ Gross Profit = G = ($100- $30) x 5,000 = $350,000 Gross contribution is a classic metric for use in the analysis of the firm s performance and is at the heart of many profit maximization strategies. Gross Return on Sales The term gross return on sales is the ratio of the gross contribution over the sales revenue, G/R. Finance managers prefer the simpler term, gross margin to mean the rate of gross profit to sales; however for reasons of consistency, this text uses the term gross return on sales, GROS. The gross return on sales, GROS, is normally reported as a percentage return on sales and can be equal to the percentage markup on price, GROS = G/R = Mp = (P- V)/P. If there were no fixed or period costs, then the gross return on sales would equal the net return on sales. In the example (Figure 1-2), the gross return on sales is equal to GROS = G/R = $350,000/$500,000 = 70% and, with sales of a single type of product, the markup on price, Mp, is equal to Mp = (P- V)/P The gross return on sales, like the percentage markup, is often interpreted as an output- over- input ratio to indicate the firm s efficiency at converting revenues into profits. A firm with a GROS = 70% will convert a revenue of $500,000 into a gross contribution equal to G = GROS x R = 70% x $500,000 = $350,000 The difficulty in using GROS as a measure of efficiency is that an increase in price with no change in the variable cost will increase the GROS and the perception of improved efficiency even though the gross profit is declining. For example, the price in Table 1-1 is increased from period to period with no change in the variable cost of $20 per unit. However, the increase in price each period reduces the quantity that customers are purchasing and this in turn reduces the revenue and the gross profit. 16

17 Table 1-1 Demonstration of Declining Gross Profit With Increasing Return on Sales Period 1 Period 2 Period 3 Period 4 Selling Price, P Quantity sold, Q Revenue, R Variable cost, V COGS Gross Contribution GROS = G/R or Markup on Price 71% 75% 78% 80% In Table 1-1, the quantity sold is decreasing by 41,500 units every time the price is increased by $10, (i.e., demand is Q = 600,000 4,150P). However, the GROS and the markup on price, Mp, continue to increase from 71% to 80% and the higher percentages might suggest that the operational efficiency is increasing, when, in fact, sales and gross profit contribution are declining. It can be very misleading to assume that an increase in the return on sales or the markup on price is indicating an increase in operational efficiency. Marketing Contribution The term marketing contribution, M, is being introduced in this textbook with a very specific definition. The marketing contribution is defined as the immediate profit contribution from the marketing effort in the period. The marketing contribution is calculated as the difference between the gross profit, G, and the immediate marketing expenses for the period, ME. M = G - ME Marketing contribution to net profit might be called the profit after the promotion expenses. As modern marketing is held more accountable for the expenses it incurs, there is a greater need for more accurate definitions of the profit marketing generates. The term marketing contribution defined as the dollar profit that marketing generates will be new for many marketing managers and accountants. However, it is a crucial definition when we define the return on marketing expense, ROME, and the marketing return on sales, MROS. In practice the dominant marketing expenses for many firms are the advertising and sales force expenditures in a period. That is to say, for many firms the marketing contribution would be calculated as the profit remaining after the advertising and sales force expenditures have been subtracted from the gross profit. In the example operating statement (Figure 1-2), the marketing contribution, M, is calculated as the gross profit minus the total marketing expenses for the period M = G ME = $350,000 - $200,000 = $150,000 The marketing contribution should be interpreted to mean the profit contributed by the immediate marketing effort over a specific period. The identification of which 17

18 marketing expenses, that are having an immediate impact on sales, are not the easiest things to identify. However, in theory, the marketing contribution should not take into account general marketing overheads and marketing expenditures that have long- term impacts such as market research and product development. The marketing contribution does not take into account the hundreds of other non- marketing expenses and overheads that must be reckoned with to calculated the firm s net profit. Some marketers define the term net marketing contribution to be the profit after all the immediate promotion expenses, the market research, the product development and marketing overheads are subtracted from the gross profit. In this text we argue that the marketing contribution to profit is a metric of crucial significance to marketing managers, and it should be identified by cost accountants and provided as a regular item in the firm s operating statements. Marketing Return on Sales The term marketing return on sales, MROS, has a very specific meaning in this text. MROS is defined as the ratio of the marketing contribution, M, to the sales revenue, R. That is to say, MROS = M/R The term marketing return on sales is a reflection of the marketing department s ability to create sales and convert revenues into a profit contribution from marketing effort. A marketing department with a high MROS is considered to have a high operating efficiency and is very productive in creating profits (i.e., marketing contribution) from revenues. In the example (Figure 1-2), the marketing return on sales is calculated as MROS = M/R = $150,000/$500,000 = 30%. When viewed as a measure of marketing efficiency, then a MROS = 30% implies that the marketing department is converting 30% of the sales revenue into a profit contribution. MROS can be used in cost based pricing equations when it is treated as a strategy objective or as a desired level of profit. However, the MROS, like the traditional return on sales, is difficult to use as a diagnostic metric because it increases as the selling price increases. That is to say, a higher MROS may not imply a higher level of efficiency or productivity if the selling price has been increased. However, MROS is a superior measure of marketing s efficiency and productivity compared to the traditional ROS, because there are so many non- marketing and other overhead costs in the traditional ROS that the productivity of the marketing effort is obscured. Marketing Return on Investment The marketing return on investment, MROI, is very popular and is defined in many different ways. For example, MROI may describe the rate of sales due to a marketing expense, or the ratio of leads to the number of advertising insertions or hits on a web page. There is no generally accepted definition of MROI in the field of marketing. However, accountants and finance managers will never call a period s marketing 18

19 expense an investment. Although the money being spent on promotion in a period, is spent with the goal of getting an incremental increase in profit contribution that is larger than the promotion expense and there is a risk that an increase in profit may not occur. The idea that the promotional budget is money put at risk for a profit sounds a little like making an investment. However, the nature of risk in a promotional expense is nothing like the nature of the risk in an investment in a bank account or a savings bond. Unfortunately the terms return on marketing investment and marketing return on investment have become very popular as generic descriptions of marketing performance and as such have very little residual value for specific measurements. In this text the terms marketing return on investment or return on marketing investment will be avoided because they tend to generate more confusion than enlightenment. In this text, the term return on marketing expense will replace the term return on marketing investment. Return on Marketing Expense The term return on marketing expense, ROME, is defined as the ratio of the marketing contribution, M, divided by the period s marketing expenses, ME. In the sample operating statement (Figure 1-2), the return on marketing expenses, ROME, is calculated as ROME = M/ME = $150,000/$200,000 = 0.75= 75% Because the majority of the marketing expenses in a period deal with promotion and communication efforts, many managers might define the ratio ROME to be the return on promotion or the return on communication. Unfortunately, the term Return on Marketing Investment is in such common usage, the acronym ROMI may always dominate the more accurate definition of ROME. ROME, like MROS, is very popular among marketing managers as a measure of performance and marketing productivity. However, ROME is a metric that is easily abused and confused. ROME is not a metric to be maximized because it has the interesting property of always declining as more and more effort is spent on promotional expense. The characteristic of a declining productivity is discussed in more detail in the chapters where the elasticity of ROME is discussed. Part 6: Detailing the Marketing Expenses in the Operating Statement The marketing expenses that are designed to have a direct and immediate impact on sales revenue are critical pieces of information for a timely diagnosis of the firm s marketing performance. The various elements that make up the immediate marketing expenses over the period are often reported in more detail as illustrated in the expanded operating statement illustrated in Figure

20 Figure 1-3 Operating Statement for a Sample Firm Twelve Months Ending December 31, 2011 % of Sales Selling price per Unit, P $100 Quantity of Units Sold, Q 5,000 Sales Revenue, R = P x Q $500,000 Variable Cost per Unit, V $30 Cost of Goods Sold, COGS = V x Q $150,000 Gross Contribution, G = R - COGS $350,000 70% Advertising Expense, AD $100,000 20% Consumer Promotion, CP $20,000 4% Sales Force Expense, SF $50,000 10% Dealer Promotion, DP $30,000 6% Total Marketing Expenses, E $200,000 40% Marketing Contribution, M = G- E $150,000 30% Product Development $80,000 Market Research $45,000 Total Marketing Overhead $125,000 General Overhead Expenditures e.g., rent, 0 salaries, heating, personnel, insurance, etc. Net Profit, Z $25,000 5% It is common for practitioners to use the term marketing as a synonym for advertising and to use the phrase marketing expenses to mean advertising expenses. For many sales people, advertising is traditionally considered a staff function and held apart from the line function of the sales department. Therefore it is common for many sales people to assume that marketing expenses are advertising expenses and do not include sales force expenses. However, in this age of integrated marketing communications, the total marketing expenses in a period include sales force and advertising expenses. We define the marketing expenses as those that are primarily designed to produce immediate revenues in the period and include sales force expenses, consumer promotions, direct marketing expenditures, relationship management efforts as well as advertising expenses. Modern marketers are very concerned with the integration of all marketing communications that will directly affect the revenue and profit (i.e., marketing performance) in the immediate period. Advertising Expenses In this example, we define the advertising expenses, AD, represent all the marketing expenditures on any form of non- personal presentations and promotions that are sponsored by the firm and designed to increase sales by informing and persuading potential customers to buy the firm s products. In later chapters we define 20