Business managers are under constant pressure to improve profit performance. Before going into profit improvement analysis, I have a hypothetical question for you. Suppose that you could have one or the other but not both: As a business manager, what would you prefer; a 10 percent sales volume increase or a 10 percent sales price increase? There is a huge profit difference between the two, everything else being equal. Marketing managers would quickly argue that higher sales volume would increase market share, and in the long run, a larger market share leads to more control over sales prices. In any case, I suggest that you make a mental note of your tentative answer.
This post examines the effects of increasing sales volume and then increasing sales prices to the margin [hence profit]. One is definitely better than the other. How about if the sales volume or sales price decline?Let’s also talk about it. Enjoy!
10 Percent Sales Volume Increase
Business managers, quite naturally, are sales oriented. No sales, no business—it’s as simple as that. As they say in marketing “Nothing happens until you sell it”. Many businesses don’t make it through their startup phase because it’s very difficult to build up and establish a customer base. Customers have to be won over. Once established, sales volume can never be taken for granted. Sales are vulnerable to competition, shifts in consumer preferences and spending decisions, and general economic conditions.
Thinking more positively, sales volume growth is the most realistic way to increase profit. Sales price increases are met with some degree of customer resistance in most cases, as well as competitive response. Indeed, demand may be extremely sensitive to sales prices. Cost containment and expense control are important, to be sure, but they’re more in the nature of defensive tactics and don’t constitute a sustainable profit growth strategy.
Suppose that you could increase sales volume 10 percent and that your variable cost factors remain the same. Below figure shows the impacts of increasing sales volume 10 percent:
The 10 percent increase in sales volume increases net sales revenue, product costs, and variable operating costs 10 percent. So, margin increases 10 percent, or $90,000 in the example shown above. But now you have to answer some interesting questions:
- Would your fixed operating costs increase with 10 percent more sales volume?
- Would your interest expense increase?
I can’t offer general answers that fit all situations.
First of all:
- Do you have some sales capacity slack hidden in the $750,000 fixed operating costs?
- In other words, do you have some unused, idle sales capacity such that you could take on 10 percent more volume without having to increase your fixed costs?
Perhaps your fixed costs would increase only slightly at the higher sales level (maybe some overtime hours, for example). Many businesses have surplus sales capacity. A relatively modest increase in sales volume doesn’t increase their fixed operating costs. Assume, therefore, that fixed operating costs don’t increase (or that the increase is relatively minor).
What about your interest expense?
Let say that the ratio of annual net sales revenue to total assets is 2 to 1:
= $3,000,000 annual net sales revenue / $1,500,000 total assets
= 2 times, or 2 to 1 ratio
This ratio of sales to assets is called the “asset turnover ratio“. Some businesses are asset heavy, or capital intensive. They need a lot of assets relative to their sales, which means that they have relatively low asset turnover ratios. Other businesses don’t need a lot of assets to support their sales; they have high asset turnover ratios. In any case, the profit model builds on a 2 to 1 asset turnover ratio. Therefore, the additional $300,000 net sales revenue would drive up total assets $150,000:
= $300,000 net sales revenue increase / 2 times asset turnover ratio
= $150,000 total assets increase
In the example, operating (non-interest bearing) liabilities equal 20 percent of total assets. So, only 80 percent of the increase in assets, or $120,000, would come from an increase in capital. Debt supplies half of capital, so debt increases $60,000 at the higher sales volume level. Your interest rate is 8 percent per year, so interest expense would increase $4,800 at the higher sales volume:
= $60,000 increase in interest-bearing debt at higher sales volume level × 8.0% annual interest rate
= $4,800 interest expense increase.
It’s tempting to ignore the change in assets caused by an increase in sales volume, but it would cause you to overlook the interest expense increase caused by the increase in interest-bearing debt needed at the higher level of assets. Higher sales volume generally requires higher levels of assets (inventory, accounts receivable, and so on). Even if you don’t do a precise calculation based on your asset turnover ratio, we recommend that you make a reasonable guess for the interest expense increase.
Assume that fixed operating costs don’t increase at the higher sales volume because you have enough slack, or unused sales capacity, to handle the sales volume increase (which may not be true in some situations, of course).
Deducting the $4,800 interest expense increase from the $90,000 margin increase gives the $85,200 boost to the bottom line (profit before income tax), resulting in an 83.5 percent increase in profit:
= $85,200 increase in profit before income tax / $102,000 profit at present sales volume
= 83.5% increase in profit at 10% higher sales volume level
This percentage gain in profit is impressive, to say the least. But don’t forget that it’s based on the critical assumption that fixed operating costs don’t increase at the higher sales volume level. If you had to increase your fixed costs to support the higher sales volume level, the increase in profit would be much smaller, of course. Indeed, it could be that you’d have to increase fixed operating costs more than the $90,000 margin increase to support a 10 percent jump in sales volume — which should give you second thoughts about increasing sales volume, of course. But if your fixed operating costs can support a higher sales volume, then the profit payoff is quite handsome.
By the way, the 83.5 percent gain in profit versus the much smaller 10 percent increase in sales volume (in this example) is referred to as the operating leverage effect. In other words, you’re getting better leverage out of your fixed costs by selling more units. You’re spreading your fixed operating costs over a greater number of units.
An experienced business manager would raise some very pertinent questions about an increase in sales volume. How are you going to increase sales volume? Would your customers buy 10 percent more units without any increase in advertising, or without sales price incentives, or without product improvements, or without other inducements?
Increasing sales volume usually requires some stimulant, such as more advertising, that would increase your fixed operating costs. Improving product quality would increase product cost. If you increase sales by opening another location, your fixed costs would definitely increase. These are good points to keep in mind.
When Sales Volume Decline
Suppose that things don’t look good for next year; you forecast that you’ll sell 10 percent fewer units next year, and perhaps even worse. You’d be very much concerned, of course, and probe into the reasons for the decrease:
- More competition?
- Are people switching to substitute products?
- Are hard times forcing customers to spend less?
- Is the location deteriorating?
- Has customer service slipped?
A sales volume decline is one of the most serious problems confronting any business. Unless the decline is quickly reversed, you’ll have to make extremely wrenching decisions regarding how to downsize the business.
These decisions usually involve laying off employees, selling off fixed assets, shutting down locations, and so on. The profit impact of a sales volume decrease depends heavily on whether you can reduce your fixed operating costs in order to adjust to the lower sales volume.
Suppose that your sales volume drops 10 percent, and you’re not able to decrease fixed operating costs. Your margin would drop $90,000. (See the first figure for dollar amounts), keeping in mind that we’re talking about a negative change in sales volume.) Because you don’t reduce fixed operating costs, your operating profit would drop $90,000. Your assets would fall at the lower level of sales. Supposedly, you could decrease your debt load at the lower level of assets, in which case your interest should fall somewhat. But any way you slice it, suffering a 10 percent drop in sales volume wipes out most of your profit.
The moral is that if you suffer decline in sales volume and can’t reverse the decline, then you must reduce your fixed operating costs. But, to be frank, this step is no more than bailing water out of the lifeboat. If sales continue to decline, you have to seriously consider throwing in the towel and getting out of business. Worse!
Raising Sales Prices
Setting sales prices is one of the most perplexing decisions facing business managers. Competition normally dictates the basic range of sales prices. But usually you have some room for deviation from your competitor’s prices because of product differentiation, brand loyalty, location advantages, and quality of service — to cite just some of the reasons that permit higher sales prices than your competitors.
In any case, the purpose here is to look at the effects of higher sales prices while holding sales volume constant. Suppose that your net sales prices had been 10 percent higher than previously.
Of course, a 10 percent increase in net sales prices is very significant. Customers would probably react to a sales price increase of this magnitude —well, except for increases in gas prices at the pump, it seems.
The next figure shows the profit factor changes if sales prices had been 10 percent higher. Basically, net sales revenue increases 10 percent, or $300,000, and only your interest expense would go up with the higher sales prices. Because you sell the same volume of products, your product costs and variable operating costs would not change, and your fixed operating costs should not change at the higher sales prices. You would generate more sales revenue, so your total assets and debt would increase. Your interest would increase $4,800 at the higher debt level.
The above figure shows that profit would increase almost four times, from about $100,000 to about $400,000. Quite clearly, a 10 percent sales price increase is far superior to 10 percent sales volume increase. Two main reasons result in the relatively large gain in profit from the sales price increase:
[-] The incremental $300,000 net sales revenue is pure margin; product costs and variable operating costs don’t increase at the higher sales prices, so the entire increase in net sales revenue benefits margin.
[-] Fixed operating costs aren’t affected by the higher sales prices; the fact that you’re moving more sales dollars through the business at the higher prices should not cause any of your fixed costs to change.
Now, you may be thinking that the 10 percent higher sales prices scenario shown in the above figure is too good to be true. You know the first principle in economics is that there is no such thing as a free lunch. So, what’s the catch?
Well, the main caveat is that in most cases it’s extremely difficult to raise sales prices 10 percent. As you know, customers generally are very sensitive to sales prices, and pushing through a sales price increase of this magnitude would be very difficult in most situations. On the other hand, your sales prices may be too low, and your customers may not bolt to a competitor if you raised prices 10 percent. In any case our purpose is to demonstrate the profit power of increasing sales prices versus increasing sales volume.
I can demonstrate the relative advantage of sales price increases over sales volume increases in another manner. In the 10 percent sales volume increase scenario, profit increases $85,200, from $102,000 to $187,200 (assuming that fixed operating costs don’t increase at the higher sales volume level).
By what percent would you have to increase net sales prices to increase profit the same amount?
Remember that interest expense increases as net sales revenue increases. In the above figure, interest expense equals 1.6 percent of net sales revenue. This ratio is based on the business’s asset turnover ratio of 2 to 1, the proportion of its debt to total capital, and the interest rate. The following calculations show that interest equals 1.6 percent of net sales revenue (see the above figure for data):
$48,000 interest expense / $3,000,000 net sales revenue = 1.6% in profit model example
$52,800 interest expense / $3,300,000 net sales revenue = 1.6% in higher sales price scenario
In other words, interest expense absorbs 1.6 percent of the increase in net sales revenue. Therefore, to increase profit $85,200, you have to increase net sales revenue a little more, or $86,585, to be precise:
= $85,200 / 98.4% profit after interest expense increase
= $86,585 net sales revenue increase to cover interest expense increases
The $86,585 increase in net sales revenue would require a 2.9 percent increase in sales prices:
= $86,585 increase in net sales revenue / $3,000,000 net sales revenue
= 2.9 percent increase in sales prices
Less than a 3 percent sales price increase would produce the same profit gain as a 10 percent sales volume increase. Given your druthers, you should look first to the possibility of increasing sales prices. But, in many situations, you can’t boost sales prices, so your only option is to increase sales volume. Or, perhaps you could do some of both. In passing, we should mention that in most cases, certain products and product lines have higher margins than others, and increasing sales volume in these areas would be better than in the lower margin areas.
Overcome Sales Price Decrease
It’s no secret that a small business may be forced to cut sales prices in some situations. You don’t like taking this step, of course, but you should at least have a clear idea of how bad a profit hit you’d take from cutting sales prices. If I was the owners/managers of a business, I’d definitely make a quick calculation of the profit damage from cutting sales prices — rather than waiting for the sad results to show up in our next P&L report. Indeed, the analysis is very helpful in deciding just how far you can go in slashing sales prices without courting disaster.
Even a seemingly minor sales price decrease can wipe out profit. Suppose that your business comes under competitive pressure and you’re thinking of lowering your sales prices by, say, 5 percent. You plan to offer special rebates and bigger quantity discounts. List prices will not be reduced, but the effect will be to reduce the net sales prices of the products you sell by 5 percent. A 5 percent sales price cut may not seem too bad on the surface. But you better do some quick calculations to be sure about this. The profit model is the best tool for this analysis.
In the example, you’re seriously considering cutting net sales prices 5 percent. Hopefully, this tactic is temporary. You hope that you’ll be able to raise sales prices back to their normal levels before too long. Keep in mind, however, that once you lower sales prices, you may see a ratchet effect. Your customers may get used to the lower prices and resist any attempt to raise prices back up to their previous levels. So, be very cautious about cutting sales prices.
Suppose that the lower sales prices continue for one year, and that other factors in the profit model don’t change. In other words, product costs, as well as variable and fixed operating costs, don’t change during the year (which may not be the case of course).
What’s the moral of the story? Profit is very sensitive to changes in sales prices. As the example demonstrates, a 5 percent decline in sales prices can wipe out operating profit. Profit performance swings wildly with changes in sales prices, much more so than an equal percent change in sales volume. This lesson is extremely important for keeping your business in the profit column.