Appendix 2

Marketing by the
Numbers
Ma_rketing . managers are facing increased accountability for the financial implications of their
actions. This appendix provides a basic introduction to measuring marketing financial performance.
Such financial analysis guides marketers in making sound marketing decisions and in assessing the
outcomes of those decisions. e-
The appendix is built around a hypothetical manufacturer of high-definition consumer electronics
products-HDinhance. In the past, HDinhance has concentrated on making high-definition televisions
for the consumer market. However, the company is now entering the accessories market. Specifically,
HDinhance is introducing a new product-a Blu-ray high-definition optical disc player (DVD) that also
plays videos streamed over the Internet. In this appendix, we will discuss and analyze the various deci-
sions HDinhance's marketing managers must make before and after the new-product launch.
The appendix is organized into three sections: The first section introduces pricing, break-even, and
margin analysis assessments that will guide the introduction of HDinhance's new product. The sec-
ond section discusses demand estimates, the marketing budget, and marketing performance meas-
ures. It begins with a discussion of estimating market potential and company sales. It then
introduces the marketing budget, as illustrated through a pro forma profit-and-loss statement fol-
lowed by the actual profit-and-loss statement. Next, we discuss marketing performance measures,
with a focus on helping marketing managers to better defend their decisions from a financial per-
spective. In the third section, we analyze the financial implications of various marketing tactics, such
as increasing advertising expenditures, adding sales representatives to increase distribution, lower-
ing price, or extending the product line.
Each of the three sections ends with a set of quantitative exercises that provide you with an
opportunity to apply the concepts you learned to situations beyond HDinhance.

Pricing, Break-Even, and

Margin Analysis (PP A11-A16) I
Pricing Considerations iI
Determining price is one of the most important marketing-mix decisions, and marketers have con-
siderable leeway when setting prices. The limiting factors are demand and costs. Demand factors, f
such as buyer-perceived value, set the price ceiling. The company's costs set the price floor. In
between these two factors, marketers must consider competitors' prices and other factors such as
reseller requirements, government regulations, and company objectives. fl
Current competing high-definition DVD/Internet streaming products in this relatively new
product category were introduc_ed in 2007 and sell at retail pr~ces_between Rs. 24,999 and Rs. 50,000.
I.
HDinhance plans to introduce its new product at a lower price m order to expand the market and
to gain market share rapidly. We first consider HD~ance's_pricing decision from a cost perspec-
tive. Then, we consider consumer value, the competitive envll'onrnent, and reseller requirements.

Determining Costs
Fil<ed costs Recall from Chapter 10 that there are different ~es of costs. Fixed costs do not vary with produc-
Costs that do not vary with . or saJes level and include costs such as rent, interest, depreciation, and clerical and management
.tion
Product· salaries. Regardless of the level of output, the company must pay these costs. Whereas total fixed
ion or sales level.

A11
LJ
A12 Appendix 2 j Marketing by the Numbers

costs remain constant as output increases, the fixed cost per unit (or average fixed cost) will decrease
Variable costs as output increases because the total fixed costs are spread across more units o~ output. Va~iable
Costs that vary directly with the costs vary directly with the level of production and include costs related t~ the direct pr~uction of
level of production. the product (such as costs of goods sold-C(X;S) and many of_ the marketing costs assoaated ~ith
selling it. Although these costs tend to be uniform for each urut produced, they are called van~ble
Total costs because their total varies with the number of units produced. Total costs are the sum of the fixed
The sum of the fixed and and variable costs for any given level of production. . . ..
variable costs for any given HDlnhance has invested Rs. 50 million in refurbishing an eXISting facility to manufacture the
level of production. new product. Once production begins, the company estimates that it will incur fixed costs of Rs. 100
million per year. The variable cost to produce each device is estimated to be Rs. 12,500 and is
expected to remain at that level for the output capacity of the facility.

Setting Price Based on Costs

HDlnhance starts with the cost-based approach to pricing discussed in Chapter 10. Recall that the
Cost-plus priclltg (or simplest method, cost-plus pricing (or markup pricing), simply adds a standard markup to the
markup pricing) cost of the product. To use this method, however, HDlnhance must specify an expected unit sales so
A standard markup to the cost that total unit costs can be determined. Unit variable costs will remain constant regardless of the out-
of the product.
put, but average unit fixed costs will decrease as output increases.
To illustrate this method, suppose HDlnhance has fixed costs of Rs. 100 million, variable costs
of Rs. 12,500 per unit, and expects unit sales of 100,000 units. Thus, the cost per unit is given by:

fixed costs Rs. 100 million

Unit cost = variable cost + . = Rs. 12,500 + = Rs. 13,500
urut sales 100,000

Note that we do not include the initial investment of Rs. 50 million in the total fixed cost figure.
Relevant costs It is not considered a fixed cost because it is not a relevant cost. Relevant costs are those that will
Costs that will occur in the occur in the future and that will vary across the alternatives being considered. HDinhance's invest-
future and that will vary across ment to refurbish the manufacturing facility was a one-time cost that will not reoccur in the future.
the alternatives being
Such past costs are sunk costs and should not be considered in future analyses.
considered.
Also notice that if HDlnhance sells its product for Rs. 13,500, the price is equal to the total cost
Break-even price per unit. This is the break-even price-the price at which unit revenue (price) equals unit cost and
The price at which total profit is zero.
revenue equals total cost and Suppose HDJnhance does not want to merely break even but rather wants to earn a 25%
profit is zero.
markup on sales. HDlnhance's markup price is:'

. unit cost Rs. 13,500

Markup pnce = - - - -- - -- -- - l _ 0.25 = Rs. 18,000
(1 - desired return on sales)

This is the price that HDlnhance would sell the product to resellers such as wholesalers or retailers
to earn a 25% profit on sales.
Return on investment Another approach HDlnhance could use is called return on investment (ROI) pricing (or
(ROI) pricing (or target-
return pricing) target-return pricing). In this case, the company would consider the initial Rs. SO million invest-
A cost-based pricing method ment, but only to determine the rupee profit goal. Suppose the company wants a 30% return on its
that determines price based on investment. The price necessary to satisfy this requirement can be determined by: 2
a specified rate of return on
investment. .
ROI pnce ·t t + ROI xinvestment 0.3 x Rs. 50,000,000
= urn cos . = Rs. 13,500 + - - - - - - - = Rs. 13,650
unit sales 100,000

That is, if HDlnhance sells its product for Rs. 13,650, it will realize a 30% return on its initial invest-
ment of Rs. 50 million.
In these pricing calculations, unit cost is a function of the expected sales, which were estimated
to be lOO,OOO units. But what if actual sales were lower? Then the unit cost would be higher because
the fixed costs would be spread over fewer uruts,· and the realized
· percentage markup on sa1es or
ROI would be lower. Alternatively, if sales are higher than the estimated 100,000 units, unit cost
wo~ld be lower than Rs. 13,500, so a lower price would produce the desired markup on sales or ROI.
Its important to note th t th b . .
. a ese cost- ased pncmg methods are internally focused and do not con·
sider demand competito , · . .
' rs prices, or reseller requirements. Because HDinhance will be selling this
product to consumers through h O1 1 .
'd w esa ers and retailers offering competing brands the company
must consi er markup pricing from this perspective. '

m 18
r' --~-IIIIC~:9---------
Appendix 2 I Marketing by the Numb ers Al3

Setting Price Based on External Factors

Whereas costs deternun· th . f t s when set-
. . e e pnce floor HDinhance also must consider extema1 ac or
ting pnce HDinh
d . ·
'
ance does not have the final say concerning the final price to consumers-retai ers
·1
_od. Soth1t must start with its suggested retail price and work back. In doing so, HDlhance must con-
s1 er e markups re • d b
In quire Y resellers that sell the product to consumers.
tJlarkUP . general, a rupee markup is the difference between a company's selling price for a product
·tterence between a
T)le dI • f
and its. cost . to manufacture or purchase it. For a retailer then, the markup 1s
. the d ifference b e tween
's selling price or a
cornpany the pnce 1t charges consumers and the cost the retailer must ' pay for the product. Thus, for any 1eve1
ct and its cost to of reseller:
Produ cture or purchase .1t.
,nanufa
Rupee markup = selling price - cost
Markups are usually expressed as a percentage, and there are two different ways to compute
markups-on cost or on selling price:

rupee markup
Markup percentage on cost = -----
cost
rupee markup
Markup percentage on selling price = . .
sellmgpnce
To apply reseller margin analysis, HDinhance must first set the suggested retail price and then
work back to the price at which it must sell the product to a wholesaler. Suppose retailers expect a 30%
margin and wholesalers want a 10% margin based on their respective selling prices. And suppose that
HDinhance sets a manufacturer's suggested retail price (MSRP) of Rs. 26,999 for its product.
Recall that HDinhance wants to expand the market by pricing low and generating market share
quickly. HDinhance selected the Rs. 26,999 MSRP because it is lower than most competitors' prices,
which can be as high as Rs. 50,000. And the company's research shows that it is below the threshold
at which more consumers are willing to purchase the product. By using buyers' perceptions of value
value-based pricing and not the seller 's cost to determine the MSRP, HDlnhance is using value-based pricing. For sim-
Offering just the right plicity, we will use an MSRP of Rs. 27,000 in further analyses.
combination of quality and To determine the price HDlnhance will charge wholesalers, we must first subtract the retailer's
good service at a fair price. margin from the retail price to determine the retailer's cost (Rs. 27,000 - (Rs. 27,000 x 0.30) =
Rs. 18,900). The retailer's cost is the wholesaler 's price, so HDinhance next subtracts the whole-
Markup chain saler's margin (Rs. 18,900 - (Rs. 18,900 x 0.10) = Rs. 17,010). Thus, the markup chain representing
The sequence of markups used the sequence of markups used by firms at each level in a channel for HDinhance's new product is:
by firms at each level in a
channel. Suggested retail price: Rs. 27,000
minus retail margin (30%): - Rs. 8,100
Retailer 's cost/ wholesaler's price: Rs.18,900
minus wholesaler 's margin (10%): - Rs. 1,890
Wholesaler 's cost/ HDinhance's price: Rs. 17,010

By d educting the markups for each level in the markup chain, HDinhance arrives at a price for
the product to wholesalers of Rs. 17,010 (for simplicity, we will take the price as Rs. 17,000 for future
calculations).

Break-Even and Ma rgin Ana lysis

The previous analyses derived a value-based price of Rs. 17,000 for HDlnhance's product. Although
this price is higher than the break-even price of Rs. 13,500 and covers costs, that price assumed a
demand of 100,000 units. But how many units and what level of rupee sales must HDinhance
achieve to break even at the Rs. 17,000 price? And what level of sales must be achieved to realize var-
ious profit goals? These questions can be answered through break-even and margin analysis.

Break-even analysis Determining Break-Even Unit Volume and Rupee Sales

Analys,s
· to determine the unit
volume an d dollar sales needed Based on an understanding of costs, consumer value, the competitive env ironment, and reseller
requirements, HDinhance has decided to set its price to wholesalers at Rs. 17,000. At that price, what
to be Profitable given a
Particular price and cost sales level will be needed for HDinhance to break even or make a profit? Break-even analysis
structure. determines the unit volume and Rupee sales needed to be profitable given a particular price and cost
 1
A 14 Appendix 2 Marketing by the Numbers

structure. At the break-even point, total revenue equals total costs and profit is zero. Above this
point, the company will make a profit; below it, the company will lose money. HDinhance can cal-
culate break-even volume using the following formula:3
fixed costs
Break-even volume = pnce
. - uru·t vana
. ble cost

Unit contribution The denominator (price - unit variable cost) is called unit contribution (sometimes called con-
me amount that each unit tribution margin). It represents the amount that each unit contributes to covering fixed costs. Break-
contributes to covering fixed even volume represents the level of output at which all (variable and fixed) costs are covered. In
costS-the difference between HDinhance's case, break-even unit volume is:
price and variable costs.
fixed cost Rs. 100,000,000 = 22 222 2 .
Break-even volume = . . bl = Rs. 17,000 _ Rs. 12,500 ' · uruts
pnce - vana e cost
Thus, at the given cost and pricing structure, HDinhance will break even at 22,223 units.
To determine the break-even rupee sales, simply multiply unit break-even volume by the sell-
ing price:
BE sales =BEy0 1 x price =22,223 x Rs. 17,000 =Rs. 377,791,000
Another way to calculate rupee break-even sales is to use the percentage contribution margin {here-
Contribution margin after referred to as contribution margin), which is the unit contribution divided by the selling
The unit contribution divided price:
by the selling price.
price - variable cost Rs. 17,000 - Rs. 12,500
Contribution margin = - - -- -- - = - -- - - - - - = 0.265or26.50Yo
price Rs. 17,000
Then,
fixed costs Rs. 100 000 000
Breakeven sales = .b . . = _~ ' = Rs. 377,358,491
contn ution margin 0 65

Note that the difference between the two break-even sales calculations is due to rounding.
Such break-even analysis helps HDinhance by showing the unit volume needed to cover costs.
If production capacity cannot attain this level of output, then the company should not launch this
product. However, the unit break-even volume is well within HDlnhance's capacity. Of course, the
bigger question concerns whether HDinhance can sell this volume at the Rs. 17,000 price. We'll
address that issue a little later.
Understanding contribution margin is useful in other types of analyses as well, particularly if
unit prices and unit variable costs are unknown or if a company (say, a retailer) sells many prod-
ucts at different prices and knows the percentage of total sales variable costs represent. Whereas
unit contribution is the difference between unit price and unit variable costs, total contribution is
the difference between total sales and total variable costs. The overall contribution margin can be
calculated by:

Con tn.b u ti.on margin

. = _total
_ sales
_ _- _ total
__variable costs
__:__.:..:..:-=..:.=.
total sales
Regardle~s of the ac~al level of sales, if the company knows what percentage of sales is repre-
sented b~ vanable costs, It can calculate contribution margin. For example, HDinhance's unit vari-
able cost 1s Rs. 12,500, or 74% of the selling price (Rs. 12,500 + Rs. 17,000 = 0.74). That means for every
Rs. 1 of sales revenue for HDlnhance, Rs. 0.74 represents variable costs, and the difference (Rs. 026)
rep~esents co~tribution to fixed costs. But even if the company doesn't know its unit price and unit
vanable cost, It can calculate the contribution margin from total sales and total variable costs or from
knowledge of the total cost structure. It can set total sales equal to 100% regardless of the actual
absolute amount and determine the contribution margin:

Contribution margin = lOO% - 74% = 1 - 0.74

100% 1 =1- 0.74 = 0.26 or 26%
Note that this matches the percentage calculated from th ·t · d · · ·
. . . e uni pnce an urut vanable cost informa-
tion. This alternative calculation will be very useful lat h al · • . ••
er w en an yzmg vanous marketing deasions.
 Al5
r
Appendix 2 I Marketing by the Numbers
Determining "Breakeven" for Profit Goals
Altho~gh it is useful to know the break-even point, most companies are more interested in making
a pro~t. Assume HDinhance would like to realize a Rs. 20 million profit in the first year. Ho~ mru_iy
muSt it sell at the Rs. 17,000 price to cover fixed costs and produce this profit? To determ~e ~s,
HDinhance can simply add the profit figure to fixed costs and again divide by the unit contnbution
to determine unit sales:•

Unit volume = fixe~ cost + profit goal = Rs. 100,000,000 + Rs. 20,000,000 = Rs. 26,666.7 units
pnce - variable cost Rs. 17,000 - Rs. 12,500
Thus, to earn a Rs. 20 million profit, HDinhance must sell 26,667 units. Multiply by price to deter-
mine rupee sales needed to achieve a Rs. 20 million profit:

Rupee sales= 26,667 units x Rs. 17,000 = Rs. 453,339,000

Or use the contribution margin:

Sales = fixed cost + profit goal = Rs. 100,000,000 + Rs. 20,000,000 = Rs. 452,830,189
contribution margin 0.265
Again, note that the difference between the two break-even sales calculations is due to rounding.
As we saw previously, a profit goal can also be stated as a ROI goal. For example, recall that
HDinhance wants a 30% return on its Rs. 50 million investment. Thus, its absolute profit goal is
Rs. 15 million (Rs. 50,000,000 x 0.30). This profit goal is treated the same way as in the previous
example:'
fixed cost + profit goal
Unitvolume = - -- -- - - --
Rs. 100,000,000 + Rs. 15,000,000 = Rs. 251556 units 1
price - variable cost Rs. 17,000 - Rs. 12,500
I
Rupee sales = 25,556 units x Rs. 17,000 = Rs. 434,452,000

Or
fixed cost + profit goal Rs. 100,000,000 + Rs. 15,000,000
Rupee sales = contr'b ti'
1 u on margin
. 0.265 = Rs. 433,962,264
Finally, HDinhance can express its profit goal as a percentage of sales, which we also saw in pre-
vious pricing analyses. Assume HDinhance desires a 25% return on sales. To determine the unit and
sales volume necessary to achieve this goal, the calculation is a little different from the previous two
examples. In this case, we incorporate the profit goal into the unit contribution as an additional vari-
able cost. Look at it this way: If 25% of each sale must go toward profits, that leaves only 75% of the
selling price to cover fixed costs. Thus, the equation becomes:•
fixed cost fixed cost
U ·t lume
ru vo
= price - variable cost - (0.25 X price)
or
(0 .75 X price) - variable cost

So,
Rs. 100,000,000
Unit volume = (0. 75 x Rs. 17,000) _ lZ,SOO = 400,000 units

Rupee sales necessary= 400,000 units x Rs. 17,000 = Rs. 6,800,000,000

Thus, HDinhance would need around Rs. 7 billion in sales to realize a 25% return on sales given
its current price and cost structure! Could it possibly achieve this level of sales? The major point is
this: Although break-even analysis can be useful in determining the level of sales needed to cover
costs or to achieve a stated profit goal, it does not tell the company whether it is possible to achieve
that level of sales at the specified price. To address this issue, HDinhance needs to estimate demand
for this product.
Before moving on, however, let's stop here and practice applying the concepts covered so far.
Now that you have seen pricing a nd break-even concepts in action as they related to
HDlnhance's new product, here are several exercises for you to apply what you have learned in
other contexts.
Al 6 Appendix 2 I Marketing by the Numbers

Marketing by the Numbers Exercise Set One

Now that you've studied pricing, break-even, and margin analysis as they relate to HDinhance's
new-product launch, use the following exercises to apply these concepts in other contexts.

1.1 Water World, a manufacturer of water purifiers, realizes a cost of Rs. 3500 for every unit it pro-
duces. Its total fixed costs equal Rs. 80 million. If the company manufactures 500,000 units, com-
pute the following:
a. unit cost
b. markup price if the company desires a 10% return on sales
c. ROI price if the company desires a 25% return on an investment of Rs. 40 million
1.2 An interior decorator purchases items to sell in her store. She purchases a lamp for Rs. 900 and
sells it for Rs. 1,500. Determine the following:
a. Rupee markup
b. markup percentage on cost
c. markup percentage on selling price
1.3 A consumer purchases a toaster from a retailer for Rs. 900. The retailer 's markup is 20%, and the
wholesaler's markup is 15%, both based on selling price. For what price does the manufacturer
sell the product to the wholesaler?
1.4 A men's jeans manufacturer has a unit cost of Rs. 1,100 and wishes to achieve a margin of 30%
based on selling price. If the manufacturer sells directly to a retailer who then adds a set mar-
gin of 40% based on selling price, determine the retail price charged to consumers.
1.5 Advanced Electronics manufactures DVDs and sells them directly to retailers who typically sell
them for Rs. 200. Retailers take a 40% margin based on the retail selling price. Advanced's cost
information is as follows:
DVD package and disc Rs. 25/ DVD
Royalties Rs. 20/ DVD
Advertising and promotion Rs. 10,000,000
Overhead Rs. 4,000,000
Calculate the following:
a. contribution per unit and contribution margin
b. break-even volume in DVD units and Rupees
c. volume in DVD units and Rupee sales necessary if Advanced's profit goal is 20% profit on
sales
d . net profit if 5 million DVDs are sold

Demand Estimates, the Marketing

Budget, and Marketing Performance
Measures (pp A16-A1a>
Market Potential a nd Sales Estimates
HDinhance has now calculated the sales needed to break even and to attain various profit goals on
its new product. However, the company needs more information regarding demand in order to
Total market demand
The total volume that would be assess the feasibility of attaining the needed sales levels. This information is also needed for produc-
bought by a defined consumer tion and other decisions. For example, production schedules need to be developed and marketing
group, in a defined geographic tactics need to be planned.
area, in a defined time period, The total market demand for a product or service is the total volume that would be bought
in a defined marketing by a defined consumer group in a defined geographic area in a defined time period in a defined mar-
environment. under a defined keting e~vironm~nt under a defined level and mix of industry marketing effort. Total market
level and mix of industry
demand 1s not a fixed ~umbe~ ~u_t a function of the stated conditions. For example, next year's total .
marketing effort.
market demand for high-definition DVD/Internet streaming devices will depend on how much
Market potential Sa~sung, Sony, LG, and other producers spend on marketing their brands. It also depends on many
The upper limit of market environmental factors, such as government regulations, ec~nornic conditions, and the level of con-
demand. sumer confidence in a given market. The upper limit of market demand is called market potential.
 A17
Appendix 2 j Marketing by the Numbers
One g al b . ting total market
ener ut practical method that HDinhance might use for estiJila
demand uses three · bl
vana es: (1) the number of prospective buyers, (2) the quan
tity purchased by an
average buyer per y d b s HDJnhance can
. ear, an (3) the price of an average unit. Using these mun er '
estimate total market demand as follows:

Q=nxqxp
where

Q = total market demand

n = number of buyers in the market
q = quantity purchased by an average buyer per year
P = price of an average unit

chain ratio method A variation of this approach is the chain ratio method. This method involves multiplying a
Estimating market demand by base number by a chain of adjusting percentages. For example, HDinhance's product is designed to
multiplying a base number by a play high-definition DVD movies on high-definition televisions as well as play videos streamed
chain of adjusting percentages.
from the Internet. Thus, consumers who do not own a high-definition television will not likely pur-
chase this player. Additionally, only households with broadband Internet access will be able to use
the product. Finally, not all HDTV households will be willing and able to purchase the new product.
HDinhance can estimate Indian demand using a chain of calculations like the following:
Total number of Urban Indian households owning a TV set
x The percentage of Indian households owning a high-definition television
x The percentage of Indian households with broadband Internet access
x The percentage of these households willing and able to buy this device
Managers at HDinhance estimate that there are almost 50 million urban TV households in India.
They also estimate that 1 percent of these TV households will own HDTVs by the end of 2009.
Research also indicates that 90 percent of these HDTV households would have broadband Internet
access. Finally, HDinhance's own research indicates that 78 percent of HDTV households possess the
discretionary income needed and are willing to buy a device such as this. Then, the total number of
households willing and able to purchase this product is:
50 million households x O.Ql x 0.9 x 0.78 = 351,000 households
Because HDTVs are relatively new and expensive products, most households have only one of
these televisions, and its usually the household's primary television. Thus, consumers who buy a
high-definition DVD player/ Internet streaming device will likely buy only one per household.
Assuming the average retail price across all brands is Rs. 35,000 for this product, the estimate of total
m arket demand is as follows:
351,000 households x 1 device per household x Rs. 35,000 = Rs. 12.29 billion
This simple chain of calculations gives HDinhance only a rough estimate of potential demand.
However, more detailed chains involving additional segments and other qualifying factors would
yield more accurate and refined estimates. Still, these are only estimates of market potential. They
rely heavily on assumptions regarding adjusting percentages, average quantity, and average price.
Thus, HDinhance must make certain that its assumptions are reasonable and defendable. As can be
seen, the overall market potential in rupee sales can vary widely given the average price used. For
this reason, HDinhance will use unit sales potential to determine its sales estimate for next year.
Market potential in terms of units is 351,000 (351,000 households x 1 device per household).
Assuming that HDinhance wants to attain 25% market share (comparable to its share of the HDTV
market) in the first year after launching this product, then it can forecast unit sales at 351,000 units x 0 _25 =
S7,750 units. At a selling price of Rs. 17,000 per unit, this translates into sales of Rs. 1,49l,750,000
(87,750 units x Rs. 17,000 per unit). For simplicity, further analyses will use forecasted sales of Rs. l .S billion.
This unit volume estimate is well _within HDinhance's production capacity and exceeds not
only the break-even es~mate (22,~ uruts) calculated earlier, but also the volume necessary to real-
ize a Rs. 20 million profit (26,667 uruts) or a_30 percent ROI (25,556 units). However, this forecast falls
well short of the volume necessary to realize_ a 25 percent return on sales (400,000 uru·t s.') and may
require that HDinhance revise expectations.
A18 Appendix 2 I Marketing by the Numbers
To assess expected profits, we must now look at the budgeted expenses for launching this Prod-
uct. To do this, we will construct a pro forma profit-and-loss statement.

The Profit-and-Loss Statement

and Marketing Budget <PP A1s-A19)
All marketing managers must account for the profit impact of their marketing strategies. A major
Pro forma (or projected) tool for projecting such profit impact is a pro forma (or projected) profit-and-loss statement
profit-and-loss statement (also called an income statement or operating statement). A pro forma statement shows pro-
(or income statement or jected revenues less budgeted expenses and estimates the projected net profit for an organization,
operating statement)
A statement that shows
product, or brand during a specific planning period, typically a year. It includes direct product pro-
projected revenues less duction costs, marketing expenses budgeted to attain a given sales forecast, and overhead expenses
budgeted expenses and assigned to the organization or product. A profit-and-loss statement typically consists of several
estimates the projected net major components (see • Table A2.1):
profit for an organization,
product, or brand during a • Net sales-gross sales revenue minus returns and allowances (for example, trade, cash, quantity,
specific planning period, and promotion allowances). HDinhance's net sales for 2009 are estimated to be Rs. 1.5 billion,
typically a year.
as determined in the previous analysis.
• Cost of goods sold (sometimes called cost of sales)-the actual cost of the merchandise sold by a
manufacturer or reseller. It includes the cost of inventory, purchases, and other costs associated
with making the goods. HDinhance's cost of goods sold is estimated to be 55% of net sales, or
Rs. 825 million.
• Gross margin (or gross profit)-the difference between net sales and cost of goods sold.
HDinhance's gross margin is estimated to be Rs. 675 million.

• Operating expenses-the expenses incurred while doing business. These include all other
expenses beyond the cost of goods sold that are necessary to conduct business. Operating
expenses can be presented in total or broken down in detail. Here, HDinhance's estimated oper-
ating expenses include marketing expenses and general and administrative expenses.

Marketing expenses include sales expenses, promotion expenses, and distribution expenses. The
new product will be sold through HDinhance's sales force, so the company budgets Rs. 30 million for
sales salaries. However, because sales representatives earn a 6% commission on sales, HDinhance
must also add a variable component to sales expenses of Rs. 90 million (6% of Rs. 1.5 billion net sales),
for a total budgeted sales expense of Rs. 120 million. HDinhance sets its advertising and promotion

• TABLE I A2.1 Pro Forma Profit-and-Loss Statement for the 12-Month Period Ended
December 31, 2009

% of Sales
Net Sales Rs. 1,500,000,000 100%
Cost of Goods Sold 825.000.000 55%
Gross Margin Rs. 675,000,000 45%
Marketing Expenses
Sales expenses Rs. 120,000,000
Promotion expenses 165,000,000
Freight 90,000,000 375,000,000 25%
General and Administrative Expenses
Managerial salaries and expenses Rs. 25,000,000
Indirect overhead 50.000.000 75,000.000 5%
Net Profit Before Income Tax Rs. 225,000,000 15%
 Appendix 2 I Marketing by the Numbers
to launch this product at Rs. 105 million. However, the company also budgets 4% of sales, or Rs. 60
Al9 l
milli
. o~, tor cooperative
' advertising allowances to retailers who promote HDinhanceI s new Produet . .
m err ad:e_rtising. Thus, the total budgeted advertising and promotion expenses are Rs. 165 million
th
(Rs. 105 million for advertising plus Rs. 60 million in co-op allowances). Finally, HDJnhance budgets
6%_of net sales, or Rs. 90 million, for freight and delivery charges. 1n all, total marketing expenses are
e stimated to be Rs. 120 million + Rs. 165 million + Rs. 90 million = Rs. 375,000,000.
General and administrative expenses are estimated at Rs. 75 million, broken down into Rs. 25
million for managerial salaries and expenses for the marketing function and Rs. 50 million of indi-
rec~ overhead allocated to this product by the corporate accountants (such as depreciation, interest,
maintenance, and insurance). Total expenses for the year, then, are estimated to be Rs. 450 million
(Rs. 375 million marketing expenses + Rs. 75 million in general and administrative expenses).

• Net profit before taxes-profit earned after all costs are deducted. HDinhance's estimated net
profit before taxes is Rs. 225 million.

1n all, as Table A2. l shows, HDinhance expects to earn a profit on its new product of Rs. 225 mil-
lion in 2009. Also note that the percentage of sales that each component of the profit-and-loss state-
ment represents is given in the right-hand column. These percentages are determined by dividing
the cost figure by net sales (that is, marketing expenses represent 25% of net sales determined by
Rs. 375 million + Rs. 1.5 billion). As can be seen, HDinhance projects a net profit return on sales of
15% in the first year after launching this product.

Marketing Performance Measures (PP A19-A23)

Now let's fast-forward a year. HDinhance's product has been on the market for 1 year and manage-
ment wants to assess its sales and profit performance. One way to assess this performance is to com-
Profit-and-loss statement pute p erformance ratios derived from HDlnhance's profit-and-loss statement (or income
(or income statement or statement or operating statement).
operating statement) Whereas the pro forma profit-and-loss statement show s projected financial performance, the
Astatement that shows actuaI
statement given in • Table A2.2 sh ows HDlnhance's actual financial performance based on actual
revenues less expenses and net
profit for an organization, sales, cost of good s sold, and expenses during the past year. By comparing the profit-and-loss state-
product, or brand during a ment from one period to the next, HDlnhance can gauge performance against goals, spot favorable
specific planning period, or unfavorable trends, and take appropriate corrective action.
typically a year. The profit-and-loss statement shows that HDlnhance lost Rs. 10 million rather than making the
Rs. 225 million profit projected in the pro forma statement. Why? One obvious reason is that net
sales fell Rs. 500 million short of estimated sales. Lower sales translated into lower variable costs
associated with marketing the product. However, both fixed costs and the cost of goods sold as a

• TABLE A2.2 I Profit-and-Loss Statement for the 12-Month Period Ended December 31, 2009
L % of Sales
Net Sales Rs. 1,000,000,000 100%
Cost of Goods Sold 600,000,000 60%
Gross Margin Rs. 400,000,000 40%
Marketing Expenses
Sales expenses Rs. 90,000,000
Promotion expenses 145,000,000
Freight 60,000,000 295,000,000 29.5%
General and Administrative Expenses
Managerial salaries and expenses Rs. 25,000,000
Indirect overhead 90,000,000 Rs. 115,000,000 11.5%
Net Profit Before Income Tax (Rs. 10,000,000) (-1%)
A20 Appendix 2 I Marketing by the Numbers

percentage of sales exceeded expectations. Hence, the product's contribution margin was 24% rather
than the estimated 29%. That is, variable costs represented 76% of sales (60% for cost of goods sold,
6% for sales commissions, 6% for freight, and 4% for co-op allowances). Recall that contribution mar-
gin can be calculated by subtracting that fraction from 1 (1 - 0.76 = 0.24). Total fixed costs were
Rs. 250 million, Rs. 40 million more than estimated. Thus, the sales that HDinhance needed to break
even given this cost structure can be calculated as:
fixed costs Rs. 250,000,000
Break-even sales = .b . . = 0.24 = Rs. 1,041,666,667
contr1 ution margin

If HDinhance had achieved another Rs. 42 million in sales, it would have earned a profit.
Although HDinhance's sales fell short of the forecasted sales, so did overall industry sales
for this product. Overall industry sales were only Rs. 3.33 billion. That means that HDinhance's
Market share market share was 30% (Rs. 1 billion+ Rs. 3.33 billion= 0.3 = 30%), which was higher than fore-
Company sales divided by casted. Thus, HDinhance attained a higher-than-expected market share but the overall market
market sales. sales were not as high as estimated.

Analytic Ratios
Operating ratios The profit-and-loss statement provides the figures needed to compute some crucial operating
The ratios of selected operating ratios-the ratios of selected operating statement items to net sales. These ratios let marketers com-
statement items to net sales.
pare the firm's performance in 1 year to that in previous years (or with industry standards and com-
petitors' performance in that year). The most commonly used operating ratios are the gross margin
percentage, the net profit percentage, and the operating expense percentage. The inventory turnover rate and
ROI are often used to measure managerial effectiveness and efficiency.
Gross margin percentage The gross margin percentage indicates the percentage of net sales remaining after cost of goods
The percentage of net sales sold that can contribute to operating expenses and net profit before taxes. The higher this ratio, the
remaining after cost of goods more a firm has left to cover expenses and generate profit. HDinhance's gross margin ratio was 40%:
sold-<alculated by dividing
gross margin by net sales. . gross margin Rs. 400,000,000
Gross margin percentage = net sa1es Rs. 1,000,000,000 =
0·40 = 40%

Note that this percentage is lower than estimated, and this ratio is seen easily in the percentage
of sales column in Table A2.2. Stating items in the profit-and-loss statement as a percent of sales
allows managers to quickly spot abnormal changes in costs over time. If there was previous history
for this product and this ratio was declining, management should examine it more closely to deter-
mine why it has decreased (that is, because of a decrease in sales volume or price, an increase in
costs, or a combination of these). In HDinhance's case, net sales were Rs. 500 million lower than esti-
mated, and cost of goods sold was higher than estimated (60% rather than the estimated 55%).
Net profit percentage The net profit percentage shows the percentage of each sales rupee going to profit. It is cal-
The percentage of each sales culated by dividing net profits by net sales:
dollar going to profit-
calculated by dividing net
net profit - Rs. 10,000,000
Net profit percentage = net sa1es Rs. 1,000,000,000 = -O.Ol = - 1.0%
profits by net sales.

This ratio is easily seen in the percent of sales column. HDinhance's new product generated nega-
tive profits in the first year, not a good situation given that before the product launch net profits
before taxes were estimated at more than Rs. 200 million. Later in this appendix, we will discuss
further analyses the marketing manager should conduct to defend the product.
Operating expense The operating expense percentage indicates the portion of net sales going to operating
percentage expenses. Operating expenses include marketing and other expenses not directly related to market-
The portion of net sales going
ing the product, such as indirect overhead assigned to this product. It is calculated by:
to operating expenses-
calculated by dividing total total expenses = Rs. 410,000,000 = 0.41 = 41 %
expenses by net sales. Operating expense percentage = al
nets es Rs. 1,000,000,000
This ratio can also be quickly determined from the percent of sales column in the profit-and-loss
statement by adding the percentages for marketing expenses and general and administrative
expenses (29.5% + 11.5%). Thus, about 41 paisas of every sales rupee went for operations. Although
HDinhance wants this ratio to be as low as possible, and 41 % is not an alarming amount, it is of con-
cern if it is increasing over time or if a loss is realized.
 Appendix 2 / Marketing by the NumberS A2.1
torY turnover rate Another useful ratio is the.
111\'estnockturn rate) inventory tum . inventory turnover rate (also called stocktum rate for resellers). The
(or f . over rate 15 the umbe . . specified ·
nienumber o times an Id period (often 1 year). This n r of times an inventory turns over or is sold dunng a ~e
turns over or 1s so
·nventory
1 . . tion. Higher rates . di rate tells how quickly a business is moving inventory through the orgaruza-
. a specified time period
during investments It in cate that lower investments in inventory are made, thus freeing up funds for other
one year}-<alculated
(often . . · may be computed on a cost, selling price, or unit basis. The formula based on cost is:
tiased on costs, selling price, or
In cost of goods sold
unit.I- ventory turnover rate = - - - - - - - - -
As . average inventory at cost
sunung HDlnhance's beg· · . . . . . .
respectivelv th . inning and ending inventories were Rs. 280 million and Rs. 200 million,
;, e inventory turnover rate is:

Inventory turnover rate = Rs. 600,000,000 Rs. 600,000,000

25
(Rs. 280,000,000 + Rs. 200,000,000) / 2 = Rs. 240,000,000 =
That is, HDlnhance' •
the hi h h s inventory turned over 2.5 times in 2009. Normally, the higher the turnover rate,
gt e_r td e management efficiency and company profitability. However, this rate should be com-
pare d o in ustry average
. s, competitors' rates, and past performance to determine if HDinhance is
d omg well. A competit
. or w1·th similar
. . sales but a higher inventory turnover rate will . have fewer
resources tied up in inventory, allowing it to invest in other areas of the business.
ROI RO ~omp~es frequently use ROI to measure managerial effectiveness and efficiency. For .HDinhance,
Ameasure of managerial 1 ~ the ratio of net profits to total investment required to manufacture the new product. This invest-
effectiveness and efficiency-
ment ~eludes capital investments in land, buildings, and equipment (here, the initial Rs. 50 million to
net profit before taxes divided
by total investment.
refurb15h the manufacturing facility) plus inventory costs (HDinhance's average inventory totaled
Rs. 240 million), for a total of Rs. 290 million. Thus, HDinhance's ROI for this product is:
. net profit before taxes - Rs. 10,000,000
Retu m on investment = - -investment
-- - - - - ---- 0345
Rs. 290,000,000 = - · = - 3·45°;. 0

ROI is often used to compare alternatives, and a positive ROI is desired. The alternative with the high-
est ROI is preferred to other alternatives. HDinhance needs to be concerned with the ROI realized. One
obvious way HDinhance can increase ROI is to increase net profit by reducing expenses. Another way
is to reduce its investment, perhaps by investing less in inventory and turning it over more frequently.

Marketing Profitability Metrics

Given the above financial results, you may be thinking that HDinhance should drop this new prod-
uct. But what arguments can marketers make for keeping or dropping this product? The obvious
arguments for dropping the product are that first-year sales were well below expected levels and the
product lost money, resulting in a negative ROI.
So what would happen if HDinhance did drop this product? Surprisingly, if the company drops
the product, the profits for the total organization will decrease by Rs. 80 million! How can that be?
Marketing managers need to look closely at the numbers in the profit-and-loss statement to deter-
mine the net marketing contribution for this product. In HDinhance's case, the net marketing contri-
bution for the product is Rs. 80 million, and if the company drops this product, that contribution will
disappear as well. Let's look more closely at this concept to illustrate how marketing managers can
better assess and defend their marketing strategies and programs.

Net Marketing Contribution

Net marketing contribution (NMC), along with other marketing metrics derived from it, measures
marketing profitability. It includes only components of profitability that are controlled by marketing.
Whereas the previous calculation of net profit before taxes from the profit-and-loss statement
includes operating expenses not under. mar~eting's control, NMC does not. Referring back to
HDinhance's profit-and-loss statement given in Table A2.2, we can calculate net marketing contri-
bution for the product as:
NMC = net sales - cost of goods sold - marketing expenses
=Rs.1,000 million - Rs. 600 million - Rs. 320 million =Rs. 80 million
keting expenses include sales expenses (Rs. 90 million), promotion expenses (Rs. 145 mil-
The
. fre' ht expenses (Rs. 60 rm·11·10n), and the managena
mar . I saIanes
. and expenses of the marketing
hon), ig · 1Rs 320 milli
function (Rs. 25 million), which tota . on.

I
Z IP .C
A22 Appendix 2 I Marketing by the Numbers
Thus the product actually contributed Rs. 80 million to HDinhance's profits. It was the Rs. 90
million o; indirect overhead allocated to this product that caused the negati~e profit. Further, the
amount allocated was Rs. 40 million more than estimated in the pro forma profit-and-loss statement.
Indeed, if only the estimated amount had been allocated, the product would have earned a profit of
Rs. 30 million rather than losing Rs. 10 million. If HDinhance drops the product, the Rs. 90 million
in fixed overhead expenses will not disappear-it will simply have to be allocated elsewhere.
However, the Rs. 80 million in net marketing contribution will disappear.

Marketing Return on Sales and Investment

· of th e profit unpac
To get an even deeper understanding · t of marketing strategy.
. ' we'll now exanun·
. e
two measures of marketing efficiency-marketing return on sales (marketing ROS) and marketing
return on investment (marketing ROI).' .
Marketing return on Marketing return on sales (or marketing ROS) shows the percent of net sales attributable
sales (or marketing ROS) to the net marketing contribution. For our product, ROS is:
The percent of net sales
attributable to the net
net marketing contribution _ Rs. 80,000,000 = = 0¼
Marketing ROS -- -------==-------
net sales - Rs. 1,000,000,000 0·08 8 0
marketing contribution-
calculated by dividing net
Thus, out of every Rs. 100 of sales, the product returns Rs. 8 to HDinhance's bottom line. A high mar-
marketing contribution by
net sales.
keting ROS is desirable. But to assess whether this is a good level of performance, HDinhance must
compare this figure to previous marketing ROS levels for the product, the ROSs of other products in
the company's portfolio, and the ROSs of competing products.
Marketing ROI Marketing ROI measures the marketing productivity of a marketing investment. In
A measure of the marketing HDinhance's case, the marketing investment is represented by Rs. 320 million of the total marketing
productivity of a marketing expenses. Thus, marketing ROI is:
investment--<alculated by
dividing net marketing net marketing contribution Rs. 80,000,000 = _ = %
Marketing ROI = . 0 25 25
contribution by marketing marketing expenses Rs. 320,000,000
expenses.
As with marketing ROS, a high value is desirable, but this figure should be compared with previous
levels for the given product and with the marketing ROis of competitors' products. Note from this
equation that marketing ROI could be greater than 100%. This can be achieved by attaining a higher
net marketing contribution and /or a lower total marketing expense.
In this section, we estimated market potential and sales, developed profit-and-loss statements,
and examined financial measures of performance. In the next section, we discuss methods for ana-
lyzing the impact of various marketing tactics. However, before moving on to those analyses, here's
another set of quantitative exercises to help you apply what you've learned to other situations.

Marketing by the Numbers Exercise Set Two

2.1 Determine the market potential for a product that has 50 million prospective buyers who pur-
chase an average of 3 per year and price averages Rs. 1500. How many units must a company
sell if it desires a 10% share of this market?
2.2 Develop a profit-and-loss statement for the paints division of Palam Industries. This division man-
ufactures paints and varnishes sold to consumers through hardware stores. Cost of goods sold rep-
resents 40% of net sales. Marketing expenses include selling expenses, promotion expenses, and
freight. Selling expenses include sales salaries totaling Rs. 30 million per year and sales commis-
sions (5% of sales). The company spent Rs. 30 million on advertising last year, and freight costs
were 10% of sales. Other costs include Rs. 20 million for managerial salaries and expenses for the
marketing function and another Rs. 30 million for indirect overhead allocated to the division.
a. Develop the pro~t-and-loss statement if net sales were Rs. 200 million last year.
b. Develop the profit-and-loss statement if net sales were Rs. 400 million last year.
c. Calculate the paints division's break-even sales.
2.3 Using the profit-and-loss statement you developed in question 2.2b, and assuming that the
paints di~ision's beginning inventory was Rs. 110 million, ending inventory was Rs. 70 million,
and total investment was Rs. 200 million including inventory, determine the following:
a. gross margin percentage
b. net profit percentage
c. operating expense percentage
d. inventory turnover rate
 AZJ
Appendix 2 I MarketlnQ by the Numt,er•
e. return on investment (Ron
f.netmarketingcontribution
g. marketing return
. on sales (marketing ROS)
h. marketing return .
. . on mvestment (marketing ROI)
1. Is the paints di · • d .
VIS1on omg well? Explain your answer.

Financial Analysis of Marketing

Tactics <PP " 23_"26>
Although the first-year profit performance for HDlnhance's new product was less than desired,
management feels that this attractive market has excellent growth opportunities. Although the sales
0_f HDinhance's product were lower than initially projected, they were not unreasonable given the
s1ze of the current market. Thus, HDinhance wants to explore new marketing tactics to help grow
the market for this product and mcrease
• sales for the company.
For example, the company could increase advertising to promote more awareness of the new
product and its category. It could add salespeople to secure greater product distribution. HDinhance
could decrease prices so that more consumers could afford its product. Finally, to expand the mar- I
~et, HDinhance could introduce a lower-priced model in addition to the higher-priced original offer-
rng. Before pursuing any of these tactics, HDinhance must analyze the financial implications of each.
!I
Increase Advertising Expenditures
Although most consumers understand DVD players, they may not be aware of high-definition DVD 1
players that also stream video from the Internet. Thus, HDinhance is considering boosting its adver-
tising to make more people aware of the benefits of this device in general and of its own brand in
particular.
What if HDinhance's marketers recommend increasing national advertising by about 52% to
I
Rs. 160 million (assume no change in the variable cooperative component of promotional expendi-
tures)? This represents an increase in fixed costs of Rs. 55 million. What increase in sales will be
needed to break even on this Rs. 55 million increase in fixed costs?
A quick way to answer this question is to divide the increase in fixed cost by the contribution
margin, which we found in a previous analysis to be 24%:
increase in fixed cost Rs. 55,000,000
Increase in sales = contrt'b u t·10n margrn
. 0.24 = Rs. 229,166,667
Thus, a 52% increase in advertising expenditures must produce a sales increase of almost Rs. 230
million to just break even. That Rs. 230 million sales increase translates into an almost 7 percentage
point increase in market share (7% of the Rs. 3.33 billion overall market equals Rs. 233 million}. That
is, to break even on the increased advertising expenditure, HDinhance would have to increase its
market share from 30 percent to 36.9 percent (Rs. 1,229,166,667 + Rs. 3.33 billion = 0.3691 or 36.91
percent market share). All of this assumes that the total market will not grow, which might or might
not be a reasonable assumption.

Increase Distribution Coverage

HDinhance also wants to consider hiring more salespeople in order to call on new retailer a_ccounts
and increase distribution through more o_utlets. Even though HDinhance sells directly to whole-
salers, its sales representatives call on retail accounts to perform other functions in addition to sell-
. ch training retail salespeople. Currently, HDinhance employs 100 sales reps who earn an
mg, su as ..
000 in yearly salary plus 6% conuruss1on on sales. The product is currentlv sold
average o f Rs • 300, J

to consumers through 3' 125 retail outlets. Suppose HDinhance wants to increase that number of - ou"-
,-
lets to 4,200, an increase of 1,075 retail oubtletsk. How manthy ~dditional salespeople will HDlnhance
need and what sales will be necessary to ':a evlen on e increased cost?
One method for determining what size s~ es force HDinhance will need is the workload
~method
ilpp,oach to determining
l,l..__
method. The workload method uses th.e following formula to d etermine the salesforcc sl1.e:
~1orce .
~ size based on the NS = NC x FC x LC
tirfie loarj required and the TA
iVatlable for selling.

h f '
A24 Appendix 2 I Marketing by the Numbers
where
NS = number of salespeople
NC = number of customers
FC = average frequency of customer calls per customer
LC = average length of customer call
TA= time an average salesperson has available for selling per year
HDinhance's sales reps typically call on accounts an average of 20 times per year for about
2 hours per call. Although each sales rep works 2,000 hours p~r year ~5? .weeks per year ~~hours
per week), they spent about 15 hours per week o~ non-sell~g a~hv1ties such as adrrurustrative
duties and travel. Thus, the average annual available selling time per sales rep per year is
1,250 hours (50 weeks x 25 hours per week). We can now calculate how many sales reps HDinhance
will need to cover the anticipated 4,200 retail outlets:
4,200 X 20 X 2
NS = - -- - - = 134.4 or 135 salespeople
1,250
Therefore, HDinhance will need to hire 35 more salespeople. The cost to hire these reps will be Rs.
10.5 million (35 salespeople x Rs. 300,000 salary per sales person).
What increase in sales will be required to break even on this increase in fixed costs? The 6% commis-
sion is already accounted for in the contribution margin, so the contribution margin remains unchanged
at 24%. Thus, the increase in sales needed to cover this increase in fixed costs can be calculated by:

increase in fixed cost Rs. 10,500,000 = Rs. 43,?50,000

Increase in sales = contn.buhon
. .
margin
o.24
That is, HDinhance's sales must increase almost Rs. 44 million to break even on this tactic. So, how
many new retail outlets w ill the company need to secure to achieve this sales increase? The average
revenue generated per current outlet is Rs. 320,000 (Rs. 1 billion in sales divided by 3,125 outlets). To
achieve the nearly Rs. 44 million sales increase needed to break even, HDlnhance would need about
137 new outlets (Rs. 43,750,000 + Rs. 320,000 = 136.72 outlets), or about 3.9 outlets per new rep. Given
that current reps cover about 31 outlets apiece (3,125 outlets+ 100 reps), this seems very reasonable.

Decrease Price
HDinhance is also considering lowering its price to increase sales revenue through increased volume.
The company's research has shown that demand for most types of consumer electronics products is
elastic-that is, the percentage increase in the quantity demanded is greater than the percentage
decrease in price. It has also been found that when the price of HDTVs goes down, the quantity of
accessory products like DVD players demanded increases because they are complementary products.
What increase in sales would be necessary to break even on a 10% decrease in price? That is,
what increase in sales will be needed to maintain the total contribution that HDinhance realized at
the higher price? The current total contribution can be determined by multiplying the contribution
margin by total sales:'

Current total contribution = contribution margin x sales = 0.24 x Rs. 1 billion = Rs. 240 million

Price changes result in changes in unit contribution and contribution margin. Recall that the contribu-
tion margin of 24% was based on variable costs representing 76% of sales. Therefore, unit variable costs
can be determined by multiplying the original price by this percentage: Rs. 17,000 x 0.76 = Rs. 12,920
per unit. If price is decreased by 10%, the new price is Rs. 15,300. However, variable costs do not
change just because price decreased, so the contribution and contribution margin decrease as follows:

Old New (reduced 10%)

Price Rs. 17,000 Rs. 15,300
- Unit variable cost Rs. 12,920 Rs. 12,920
= Unit contribution Rs. 4,080 Rs. 2,380
Contribution margin Rs. 4,080/Rs. 17,000 = 0.24 or 24% Rs. 2,380/Rs. 15,300 = 0.1556 or 15.56%
 Appendix 2 I Marketing by the Numbers A25
So a 10% reduction ·
15 5
6
· 4
m pnce results in a decrease in the contribution margin from 2 percen
t t
°
; thperlcent.• To determine the sales level needed to break even on this price reduction, we calcu-
1a e e eve! of sales th t b . · h ·gm·al
t t . . a must e attained at the new contribution margin to achieve t e on
o a1 contribution of Rs. 240 million:

New contribution margin x new sales level = original total contribution

So,

New sales level = original contribution = Rs. 240,000,000 = Rs. l,542,416,452

new contribution margin 0.1556

Thus, sales must increase by about Rs. 543 million (Rs. 1.543 billion - Rs. 1 billion) just to break even
on a 10% price reduction. This means that HDinhance must increase market share to 46.3% (Rs. 1.543
billion..:..· Rs · 3 · 33 b'll• ·
1 ion) to achieve .
the current level of profits (assuming no 1.Ilcrease · the total mar-
m
ket sales). The marketing manager must assess whether or not this is a reasonable goal.

Extend the Product Line

As a final option, HDlnhance is considering extending its product line by offering a lower-priced
Cannibalization
The situation in which one model. Of course, the new, lower-priced product would steal some sales from the higher-priced
product sold by a company model. This is called cannibalization-the situation in which one product sold by a company takes
takes a portion of its sales from a portion of its sales from other company products. Uthe new product has a lower contribution than
other company products. the original product, the company's total contribution will decrease on the cannibalized sales.
However, if the new product can generate enough new volume, it is worth considering.
To assess cannibalization, HDinhance must look at the incremental contribution gained by hav-
ing both p roducts available. Recall in the previous analysis we determined that unit variable costs
were Rs. 12,920 and unit contribution was a little over Rs. 4,000. Assuming costs remain the same
n ext year, HDinhance can expect to realize a contribution per unit of approximately Rs. 4,000 for
every unit of the original product sold.
Assume that the first model offered by HD!nhance is called HDl and the new, lower-priced
model is called HD2. HD2 will retail for Rs. 18,000, and resellers will take the same markup percent-
ages on price as they do with the higher-priced model. Therefore, HD2's price to wholesalers will be
Rs. 11,340 as follows:

Retail price: Rs. 18,000

minus retail margin (30%): -Rs. 5,400
Retailer 's cost/ wholesaler's price: Rs. 12,600
minus wholesaler 's margin (10%): - Rs. 1,260
Wholesaler 's cost/ HDinhance's price Rs. 11,340

If HD2's variable costs are estimated to be Rs. 8,340, then its contribution per unit will equal Rs. 3,000
(Rs. 11,340 _ Rs. 8,340 = Rs. 3,000). That means for every unit that HD2 cannibalizes from HDl,
HDinhance will Jose Rs. 1,000 in contribution toward fixed costs and profit (that is, contributionHD2 -
contributionttm = Rs. 3,000 - Rs. 4,000 =-Rs. 1,000). You might conclude that HDinhance should not
pursue this tactic because it appears as though the comp~?' will be worse off if it introduces the
lower-priced model. However, if HD2 captures enough add1t1011al sales, HDinhance will be better off
even though some HDl sales are cannibalized. The company must examine what will happen to total
contribution, which requires estimates of unit volume for both products.
Originally, HDlnhance estimated th~t next year's sales of HDl would be 60,000 units. However,
with the introduction of HD2, it now estimates that 20,000 of those sales will be cannibalized by the
new model. If HDinhance sells only 20,000 units of the new HD2 model (all cannibalized from HDl),
the company would lose Rs. 20 million in total contribution (20,000 units x -Rs. 1,000 per cannibalized
unit = -Rs. 20 million)-not a good outcome. However, HDinhance estimates that HD2 will generate
the 20 000 of cannibalized sales plus an additional 50,000 unit sales. Thus, the contribution on these
additi~nal HD2 units will be Rs. 150 million (i.e., 50,000 units x Rs. 3,000 per unit = Rs. 150 million).
The net effect is that HDlnhance will gain Rs. 130 million in total contribution by introducing HD2. I'
A26 Appendix 2 j Marketing by the Numbers

The following table compares HDinhance's total contribution with and without the introduc-
tion ofHD2:

HD1 only

60,000 units x Rs. 4,000

HD1 and HD2

40,000 units x Rs. 4,000

l
HD1 contribution
= Rs. 240,000,000 =Rs. 160,000,000
HD2 contribution 0 70,000 units x Rs. 3,000
=Rs. 210,000,000
Total contribution Rs. 240,000,000 Rs. 370,000,000

The difference in the total contribution is a net gain of Rs. 130 million (Rs. 370 million - Rs. 240
million). Based on this analysis, HDinhance should introduce the HD2 model because it results in a
positive incremental contribution. However, if fixed costs will increase by more than Rs. 130 million
as a result of adding this model, then the net effect will be negative and HDinhance should not pur-
sue this tactic.
Now that you have seen these marketing tactic analysis concepts in action as they related to
HDinhance's new product, here are several exercises for you to apply what you have learned in this
section in other contexts.

Marketing by the Numbers Exercise Set Three

3.1 Khanna, Inc. sells tricycles for kids to consumers through retail outlets. Total industry sales for
Khanna's relevant market last year were Rs. 500 million, with Khanna's sales representing 10%
of that total. Contribution margin is 25%. Khanna's sales force calls on retail outlets and each
sales rep earns Rs. 240,000 per year plus 2% commission on all sales. Retailers receive a 30%
margin on selling price and generate average revenue of Rs. 100,000 per outlet for Khanna.
a. The marketing manager has suggested increasing consumer advertising by Rs. 1,500,000. By
how much would rupee sales need to increase to break even on this expenditure? What
increase in overall market share does this represent?
b. Another suggestion is to hire five more sales representatives to gain new consumer retail
accounts. How many new retail outlets would be necessary to break even on the increased
cost of adding five sales reps?
c. A final suggestion is to make a 20% across-the-board price reduction. By how much would
rupee sales need to increase to maintain Khanna's current contribution? (See endnote 13 to
calculate the new contribution margin.)
d. Which suggestion do you think Khanna should implement? Explain your recommendation.
3.2 A soft drink producer sells its soft drinks in approximately 500,000 retail establishments, such as
supermarkets, general stores, and paan shops. Sales representatives call on each retail account
weekly, which means each account is called on by a sales rep 52 times per year. The average length
of a sales call is 30 minutes (or 0.5 hours). An average salesperson works 2,000 hours per year
(50 weeks per year x 40 hours per week), but each spends 10 hours a week on nonselling activi-
ties, such as administrative tasks and travel. How many salespeople does the company need?
3.3 Hair Zone manufactures a brand of hair-styling gel. It is considering adding a modified version
of the product-a foam that provides stronger hold. Hair Zone's variable costs and prices to
wholesalers are:

Current Hair Gel New Foam Produd

Unit selling price 35 45

Unit variable costs 15 30

Hair Zone expects to sell 10 million units of the new styling foam in the first year after introduc-
tion, but it expects that 60% of those sales will come from buyers who normally purchase Hair
~one's styling gel. Hair Zone estimates that it would sell 15 million units of the gel if it did not
introduce the foam. If the fixed cost of launching the new foam will be Rs. 15 million during the
first year, should Hair Zone add the new product to its line? Why or why not?