HD 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 assess the feasibility of attaining the needed sales levels. This information is also needed for production and other decisions. For example, production schedules need to be developed and marketing tactics need to be planned.

The total market demand for a product or service is the total volume that would be bought by a defined consumer group in a defined geographic area in a defined time period in a defined marketing environment under a defined level and mix of industry marketing effort. Total market demand is not a fixed number but a function of the stated conditions. For example, next year’s total market demand for this type of product will depend on how much other producers spend on marketing their brands. It also depends on many environmental factors, such as government regulations, economic conditions, and the level of consumer confidence in a given market. The upper limit of market demand is called market potential.

One general but practical method that HD might use for estimating total market demand uses three variables: (1) the number of prospective buyers, (2) the quantity purchased by an average buyer per year, and (3) the price of an average unit. Using these numbers, HD can estimate total market demand as follows:

where

A variation of this approach is the chain ratio method. This method involves multiplying a base number by a chain of adjusting percentages. For example, HD’s product is designed to stream high-definition video on high-definition televisions as well as play other video content streamed from the internet to multiple devices in a home. Thus, consumers who do not own a high-definition television will not likely purchase this player. Additionally, only households with broadband internet access will be able to use the product. Finally, not all HDTV-owning internet households will be willing and able to purchase this product. HD can estimate U.S. demand using a chain of calculations like the following:

The U.S. Census Bureau estimates that there are approximately 115 million households in the United States.ⁱⁱⁱ HD’s research indicates that 60 percent of U.S. households own at least one HDTV and have broadband internet access. Finally, the company’s research also revealed that 30 percent of households possess the discretionary income needed and are willing to buy a product such as this. Then the total number of households willing and able to purchase this product is:

Households only need to purchase one device because it can stream content to other devices throughout the household. Assuming the average retail price across all brands is $350 for this product, the estimate of total market demand is as follows:

This simple chain of calculations gives HD 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, HD must make certain that its assumptions are reasonable and defendable. As can be seen, the overall market potential in dollar sales can vary widely given the average price used. For this reason, HD will use unit sales potential to determine its sales estimate for next year. Market potential in terms of units is 20.7 million $(20.7\text{million}\text{households}\times 1\text{device}\text{per}\text{household})$.

Assuming that HD forecasts it will have a 3.6% market share in the first year after launching this product, then it can forecast unit sales at $20.7\text{million}\text{units}\times 0.036=745,200\text{units}$. At a selling price of $168 per unit, this translates into sales of $125,193,600 $(745,200\text{units}\times \text{\$}168\text{per}\text{unit})$. For simplicity, further analyses will use forecasted sales of $125 million.

This unit volume estimate is well within HD’s production capacity and exceeds not only the break-even estimate (465,117 units) calculated earlier but also the volume necessary to realize a $5 million profit (581,396 units) or a 30% return on investment (534,884 units). However, this forecast falls well short of the volume necessary to realize a 25% return on sales (20 million units!) and may require that HD revise expectations.

To assess expected profits, we must now look at the budgeted expenses for launching this product. To do this, we will construct a pro forma profit-and-loss statement.

All marketing managers must account for the profit impact of their marketing strategies. A major tool for projecting such profit impact is a pro forma (or projected) profit-and-loss statement (also called an income statement or operating statement). A pro forma statement shows projected revenues less budgeted expenses and estimates the projected net profit for an organization, product, or brand during a specific planning period, typically a year. It includes direct product production costs, marketing expenses budgeted to attain a given sales forecast, and overhead expenses assigned to the organization or product. A profit-and-loss statement typically consists of several major components (see Table A2.1):

• Net sales—gross sales revenue minus returns and allowances (for example, trade, cash, quantity, and promotion allowances). HD’s net sales for 2017 are estimated to be $125 million, 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. HD’s cost of goods sold is estimated to be 50% of net sales, or $62.5 million.

• Gross margin (or gross profit)—the difference between net sales and cost of goods sold. HD’s gross margin is estimated to be $62.5 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, HD’s estimated operating 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 HD’s sales force, so the company budgets $5 million for sales salaries. However, because sales representatives earn a 10% commission on sales, HD must also add a variable component to sales expenses of $12.5 million (10% of $125 million net sales), for a total budgeted sales expense of $17.5 million. HD sets its advertising and promotion to launch this product at $10 million. However, the company also budgets 4% of sales, or $5 million, for cooperative advertising allowances to retailers who promote HD’s new product in their advertising. Thus, the total budgeted advertising and promotion expenses are $15 million ($10 million for advertising plus $5 million in co-op allowances). Finally, HD budgets 10% of net sales, or $12.5 million, for freight and delivery charges. In all, total marketing expenses are estimated to be $\text{\$}17.5\text{million}+\text{\$}15\text{million}+\text{\$}12.5\text{million}=\text{\$}45\text{million}$.

General and administrative expenses are estimated at $5 million, broken down into $2 million for managerial salaries and expenses for the marketing function and $3 ­million of indirect 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 $50 million ($45 million marketing expenses$+$$5 ­million in general and administrative expenses).

• Net profit before taxes—profit earned after all costs are deducted. HD’s estimated net profit before taxes is $12.5 million.

In all, as Table A2.1 shows, HD expects to earn a profit on its new product of $12.5 million in 2017. Also note that the percentage of sales that each component of the profit-and-loss statement 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 36% of net sales determined by $\text{\$}45\text{million}÷\text{\$}125\text{million}$). As can be seen, HD projects a net profit return on sales of 10% in the first year after launching this product.

Now let’s fast-forward a year. HD’s product has been on the market for one year and management wants to assess its sales and profit performance. One way to assess this performance is to compute performance ratios derived from HD’s profit-and-loss statement (or income statement or operating statement).

Whereas the pro forma profit-and-loss statement shows projected financial performance, the statement given in Table A2.2 shows HD’s actual financial performance based on actual sales, cost of goods sold, and expenses during the past year. By comparing the profit-and-loss statement from one period to the next, HD can gauge performance against goals, spot favorable or unfavorable trends, and take appropriate corrective action.

The profit-and-loss statement shows that HD lost $1 million rather than making the $12.5 million profit projected in the pro forma statement. Why? One obvious reason is that net sales fell $25 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 percentage of sales exceeded expectations. Hence, the product’s contribution margin was 21% rather than the estimated 26%. That is, variable costs represented 79% of sales (55% for cost of goods sold, 10% for sales commissions, 10% for freight, and 4% for co-op allowances). Recall that contribution margin can be calculated by subtracting that fraction from one $\left(1–0.79=0.21\right)$. Total fixed costs were $22 million, $2 million more than estimated. Thus, the sales that HD needed to break even given this cost structure can be calculated as:

If HD had achieved another $5 million in sales, it would have earned a profit.

Although HD’s sales fell short of the forecasted sales, so did overall industry sales for this product. Overall industry sales were only $2.5 billion. That means that HD’s market share was $4\%\left(\text{\$}100\text{million}÷\text{\$}2.5\text{billion}=0.04=4\%\right)$, which was higher than forecasted. Thus, HD attained a higher-than-expected market share but the overall market sales were not as high as estimated.

The profit-and-loss statement provides the figures needed to compute some crucial ­operating ratios—the ratios of selected operating statement items to net sales. These ratios let marketers compare the firm’s performance in one year to that in previous years (or with industry standards and competitors’ 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 return on investment (ROI) are often used to measure managerial effectiveness and efficiency.

The gross margin percentage indicates the percentage of net sales remaining after cost of goods sold that can contribute to operating expenses and net profit before taxes. The higher this ratio, the more a firm has left to cover expenses and generate profit. HD’s gross margin ratio was 45%:

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 determine 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 HD’s case, net sales were $25 million lower than estimated, and cost of goods sold was higher than estimated (55% rather than the estimated 50%).

The net profit percentage shows the percentage of each sales dollar going to profit. It is calculated by dividing net profits by net sales:

This ratio is easily seen in the percent of sales column. HD’s new product generated negative profits in the first year, not a good situation given that before the product launch net profits before taxes were estimated at more than $12 million. Later in this appendix, we will discuss further analyses the marketing manager should conduct to defend the product.

The operating expense percentage indicates the portion of net sales going to operating expenses. Operating expenses include marketing and other expenses not directly related to marketing the product, such as indirect overhead assigned to this product. It is calculated by:

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 $\left(39\%+7\%\right)$. Thus, 46 cents of every sales dollar went for operations. Although HD wants this ratio to be as low as possible, and 46% is not an alarming amount, it is of concern if it is increasing over time or if a loss is realized.

Another useful ratio is the inventory turnover rate (also called stockturn rate for resellers). The inventory turnover rate is the number of times an inventory turns over or is sold during a specified time period (often one year). This rate tells how quickly a business is moving inventory through the organization. Higher rates indicate that lower investments in inventory are made, thus freeing up funds for other investments. It may be computed on a cost, selling price, or unit basis. The formula based on cost is:

Assuming HD’s beginning and ending inventories were $30 million and $20 million, respectively, the inventory turnover rate is:

That is, HD’s inventory turned over 2.2 times in 2017. Normally, the higher the turnover rate, the higher the management efficiency and company profitability. However, this rate should be compared to industry averages, competitors’ rates, and past performance to determine if HD is doing well. A competitor with 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.

Companies frequently use return on investment (ROI) to measure managerial effectiveness and efficiency. For HD, ROI is the ratio of net profits to total investment required to manufacture the new product. This investment includes capital investments in land, buildings, and equipment (here, the initial $10 million to refurbish the manufacturing ­facility) plus inventory costs (HD’s average inventory totaled $25 million), for a total of $35 million. Thus, HD’s ROI for this product is:

ROI is often used to compare alternatives, and a positive ROI is desired. The alternative with the highest ROI is preferred to other alternatives. HD needs to be concerned with the ROI realized. One obvious way HD 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.

Given the above financial results, you may be thinking that HD should drop this new product. 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 return on investment.

So what would happen if HD did drop this product? Surprisingly, if the company drops the product, the profits for the total organization will decrease by $4 million! How can that be? Marketing managers need to look closely at the numbers in the profit-and-loss statement to determine the net marketing contribution for this product. In HD’s case, the net marketing contribution for the product is $4 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.