Financial Analysis For Product Management_nikunj_rohan

Financial Analysis for Product Management -Rohan M. Thomas -Nikunj Barnwal

Overview • Product Managers have the complete profit and loss responsibility for their product. • To be a part of firms overall decision making, product manager must understand the financial implication of their decision. 2

Two kinds of information are important to marketing decision making: 1.

The product manager is to have the profit and loss responsibility or set short & long term objective, he or she must have a good understanding of how profits are computed.

3.

Understanding of financial performance is relevant if there is a product line or many product variant because it analyzes the performance of different product variant.

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Sales Analysis • Defined as “the gathering, classifying, comparing and studying of company sales data” • Sales analysis is a powerful tool in the hands of a product manager. 4

Major component of sales analysis 1. How sales are defined? 2. In what units can sales be analyzed? 3. In what categories or classification can the sales data be placed? 4. What are the appropriate standards against which the sales can be compared? 5

Roadblocks  Information systems are not designed by product management in mind.  Financial and accounting personnel have quite different mindsets and perspective than marketing personnel.  Lack of internal marketing on the part of product management.

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Profitability Analysis Product: New Call Income Statements, December 31, 2005 (000’s) Revenue (2M units@ $5) $10,000 Less: Direct Labor 2,500 Direct Supervision 500 Social Security 255 Materials 5 Operational Overhead 840 Expenses From Operations 4,100 Operating or gross margin 5,900 Less: Advertising $ 700 Promotions 200 Field sales 1,700 Product Management 25 Marketing Management 250 Product Development 150 Marketing Management 175 Customer Service 1,500 Testing 300 General & Administration 1,000 Total Expenses 6,000 Operation Profit (100)

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Strength &Weakness of conventional Product Profit Accounting Strength: All cost of the operation are covered by the product.

Weakness: At first glance, it appears the company would be $100,000 more profitable by eliminating the product new call? It is difficult to use full-costing approach to obtain answers for straightforward questions.

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Alternative Accounting System We can classify accounting systems into 3 groups:  Financial or custodial: Useful for external constituents who may care only about the overall financial performance of the company.

 Performance based: Looks at today's performance based on budget.

 Contribution based system: Emphasis on the cost the product manager can control. There is a clear distinction between variable and fixed cost.

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Contribution Oriented System Category Operating expenses($000) Direct Labor Direct Supervision Social Security Materials Operational overhead Subtotal: Non operating expenses Advertising Promotion Field Sales Product management Marketing Management Marketing research Customer Service Testing General & administration Subtotal Total

Total Cost $2500 500 255 5 840 $ 4,100 $ 700 200 1,700 25 250 175 1,500 300 1,000 $ 6,000 $ 10,100

Variable

Fixed

2500 500 255 5 200 3,460

640 640

200

240 $ 440 3,900

700 200 1,500 25 250 175 1,260 300 1,000 $5,560 6,200

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Contribution Margin Rate Breakeven in units =

Fixed Costs Variable Margin per Unit Breakeven in dollars = Fixed Costs Variable Margin Rate Safety factor = (Current Sales Volume – Break Even Volume)/Current Volume

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Break-Even Analysis • Break-even analyses => Short term oriented • Example of a new product… • What if some fixed cost undergo incremental change? Re 1/0.33 = Rs 3

• Target profit breakeven = (Target + Fixed Cost)/Contribution Rate 12

• Businesses which are more fixed costintensive, suffer when sales drop. – Example of Airline Industry (why price-war?)

• Products characterized by different variable margin rates have different strategic problems. – Variable costs are high and CMR is low=> price needs to be kept high to make profitability high – Fixed costs are high and Variable costs are low => price needs to be kept high to serve the Fixed costs 13

Fixed Costs • Programmed Direct Fixed CostsControlled by managers and are usually expended for a specific planning period. (Eg. Advertising) • Programmed Indirect Fixed CostsControlled by management but cover several products. (Eg. Corporate Umbrella Advertising) 14

• Standby Direct Fixed Costs- Don’t change significantly without a major change in operations, Generally not controlled by Product Manager in the short run. (Eg. A facility dedicated to a specific project) • Standby Indirect Fixed CostsCorporate Overheads (Eg. CEO’s Salary) 15

Product Manager’s Responsibility • Is his primary responsibility to make a profit by generating revenues in excess of variable costs that cover the fixed cost attributable to her product? • In other words, the product manager should be responsible for making a profit based on costs that would exist only if the product existed. 16

Income Statement: Direct vs. Indirect Fixed Costs (Pg 454) Revenues Variable Costs (Direct Labor, Supervision, Customer Service, Materials, Operations Overhead etc.)

10,000 3,900

Contribution Margin

3,900

6,100

Fixed CostsProgrammed Direct (Advertising, Promotion, Field Sales, Product Mgmt, Mktng Research etc.)

3,025

3,075

Standby Direct (Operations Overhead, Testing, General & Administrative)

1,240

1,835

Programmed Indirect (Advertising, Mktng Mgmt, Product Development etc.)

1,235

Standby Indirect (General & Administrative)

700

1935

(100) 17

• In fact despite showing loss, the Company will be worse off dropping this money-losing product, as it is generating $1.835 m which is covering indirect fixed costs.

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• Full Costing Statement- Top Management & External Constituents. • Contribution Margin Statement- Easy to read and shows quickly the money going to cover the fixed costs, but doesn’t differentiate between Indirect and Direct fixed costs. • Statement breaking down Fixed CostsMost relevant for Product Management as it clearly states how the product is performing. 19

Variance Analysis • Variance- A discrepancy between a planned figure/objective and the actual outcome • Used for control • Major benefit => Identification of potential problem areas, not diagnosing the causes of the problems 20

An Example Item

Planned

Actual

Variance

Revenues Sales (Rs)

20,000,000 22,000,000 2,000,000

Price per lb. ($)

0.5000

Revenues ($)

10,000,000 10,500,000 500,000

Total Mkt (lbs.)

40,000,000 50,000,000 10,000,000

Share of Mkt

50%

44%

6%

30 0.2000 4,000,000

30 0.1773 3,900,000

-0.0227 (100,000)

0.4773

0.2270

Costs Variable cost per lb. ($) Contribution per lb. ($) Total ($)

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Price-Quantity Decomposition S => Share, M => Total Market Size, Q => Quantity sold in units, C => Contribution margin per unit Price/Cost Variance => (Ca - Cp)* Qa = (0.1773 – 0.2000)* 22,000,000 = -500,000 Volume Variance => (Qa - Qp)* Cp = (22,000,000 – 20,000,000)* 0.20 = 400,000 Sum of the variances => -100,000 22

Penetration-Market Size Decomposition • Variance in contribution due to market share => (Sa - Sp)* Ma* Cp (0.44 – 0.50)* 50,000,000* 0.2 = -600,000 • Offset by the gain from the increased size of the market => (Ma - Mp)* Sp* Cp (50,000,000 – 40,000,000)* 0.5* 0.2 = 1,000,000 23

Summary of the analysis Planned Profit Contribution $4,000,000 Volume Variance Share Variance ($600,000) Market Size Variance 1,000,000 400,000 Price/Cost Variance (500,000) Actual profit contribution $3,900,000

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Capital Budgeting • •

Deals with prioritizing several aspects to projects within a firm. Five discrete steps

1. 2. 3. 4.

Generating Investment proposals Estimating Cash Flows for the proposals Evaluating the Cash Flows Selecting projects based on an acceptance criterion 5. Reevaluating the projects after their acceptance

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3. Evaluating the Cash Flows Five major methods

• Average Rate of Return (Avg Annual Profit)/ Avg Investment per year

• Payback (No. of years to recover the initial investment) Initial Investment/Annual Cash Flows

• Internal Rate of Return [A =A /(1+r) + A /(1+r) +… 0

1

2

2

An/(1+r)n] (n- last period when the cash flows can be expected)

• Present Value NPV= ∑A /(1+k) • Economic Value added After-tax operating t

t

income – (Investments in assets* Weighted Average Cost of Capital)

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