16.2. Set Sales Prices Right
NOTE
In real estate, the three most important profit factors are location, location, and location. In the business of selling products and services, the three most important factors are margin, margin, and margin. Of course a business manager should control expenses — that goes without saying. But the secret to making profit is making sales and earning an adequate margin on them. (Remember, margin equals sales price less all variable costs of the sale.) Chapter 9 explains that internal P&L reports to managers should clearly separate variable and fixed costs so the manager can focus on margin.
In the example in the previous section, your sales prices earn 25 percent margin on sales. In other words, $100 of sales revenue generates $25 margin (after deducting the cost of product sold and variable costs of making the sale). Therefore, $16 million in sales revenue generates $4 million margin. The $4 million margin covers your $2.5 million in fixed costs and provides $1.5 million of profit (before interest and income tax).
|
On $16 million annual sales, your margin would be $3.2 million ($16 million sales × 20 percent margin ratio = $3.2 million margin). Deducting $2.5 million fixed costs for the year leaves only $700,000 profit. Compared with your $1.5 million profit at the 25 percent margin ratio, the $700,000 profit at the lower sales prices is less than half. The moral of this story is that a 5 percent lower sales price causes 53 percent lower profit!