Profit Improvement Report: The Cost of Goods Not Sold

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By Dr. Albert D. Bates

One of the realities of management information systems is that they only express what actually happened. In many instances, it is important to understand the financial and operating impact of what didn’t happen. This is especially important with regard to missed sales opportunities.

Given the severity of the recession, many firms are making some major changes in their operations – lowering payroll, reducing inventory levels, and tightening credit policies. Such actions have a very pronounced and very visible impact on financial performance. At the same time, all of these actions have the potential to decrease sales. Nowhere in the MIS is there a proper entry for the economic impact of sales that are not made.

Understanding Sales Sensitivity

It should be noted from the start that incremental sales volume is almost always a mythological creature. The assumption that adding new customers doesn’t increase costs because “the truck is going right by there anyway” always proves inaccurate in the harsh realization that expenses are incurred on every sale.

However, there are a few instances when incremental sales volume is a very relevant and useful concept. This is particularly true in the context of generating additional sales volume from the existing operating structure. That is, selling more of the current product line to existing customers. In such instances, the expense impact, at least with respect to fixed expenses, is negligible.

Exhibit 1 presents financial information for a typical CEDIA member based upon the latest results from the Benchmarking Report. As can be seen in the first column of numbers, the typical firm generates $1,000,000 in sales, operates on a gross margin percentage of 36.5 percent of sales and produces $25,000 in profit or 2.5 percent of sales on a pre-tax basis.

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Exhibit 1 – Click to Enlarge

Like every firm in every industry, this typical CEDIA member has both fixed expenses and variable expenses. Fixed expenses are overhead expenses that tend to be difficult to shed as sales fall. Variable expenses, including things like commissions, are expenses that rise and fall with sales volume. For analysis purposes, variable expenses are assumed to be 5.0% of sales – a figure that would be reasonably close for most CEDIA members.

In the next two columns of numbers, sales have been increased by 5.0 percent. The second column reflects a sales increase with no change in either the expense or gross margin structure of the firm. That is, the firm really is selling more of its existing products to existing customers without lowering its prices. Therefore, fixed expenses remain the same while variable expenses rise with sales.

The impact on profits is significant. With a 5.0 percent sales increase, profits increase by 63.0 percent, from $25,000 to $40,750. This clearly demonstrates the sales sensitivity for firms in the industry. Once again, this is all predicated upon finding truly incremental sales volume, something easier said than done.

Unfortunately, the hunt for incremental volume is almost always associated with price reductions to induce the incremental sales. Once price reductions on incremental sales take place, price reductions on almost everything tend to follow. Taking this path easily negates the sales gain.

The final column of numbers examines the gross margin reduction that would exactly offset the sales increase and leave the dollar profit number unchanged. The figures in this column are not intuitive, so they need some additional explanation.

In the second column, sales cost of goods and gross margin were all increased by 5.0 percent. In the third column, the increase in cost of goods sold associated with more sales stays where it was in the second column, at $666,750. However, prices on the same physical volume are reduced by 1.6 percent, so sales do not reach the $1,050,000 level. Instead they only increase to $1,033,421. At the lower sales level and the same cost of good sold, gross margin falls to 35.5 percent of sales.

The net result is that dollar profits do not improve, but remain where they were originally. However, the firm is working 5.0 percent harder to generate the same unit sales. The important message is that incremental sales volume is a wonderful concept when it truly is incremental. However, the opportunities to destroy the profit impact of true incremental sales abound. To be successful, fixed expenses must stay fixed and the gross margin percentage must not fall.

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Ready to run some sample numbers for your business? Click here to download the Excel spreadsheet version of the chart shown in Exhibit 1.

About the Author: Dr. Albert D. Bates is founder and president of Profit Planning Group, a distribution research firm headquartered in Boulder, Colorado.

This column was reprinted with permission from CEDIA and originally appeared here.