Welcome to Part Three of our series making sense of finance in the marketing process.
In our previous article, we looked closely at the second item on the income statement, the cost of sales. In this article we will analyse the costs that interest you mostly i.e. Marketing Expenses.
We note from the start that Marketing Expenses do not appear in the first part of the Income Statement, but rather can be found under the Gross Margin:
The Gross Margin shows ONLY those costs that were (directly or indirectly) involved in making the product or service available for sale. In other words, all the costs that were needed to bring the product or service to the point where we can sell it.
Marketing costs are incurred after this point and so will not affect the Gross Profit Margin. They will, however, affect the Net Profit margin!
Marketing decisions can have a direct influence on the Gross Margin if for example these decisions require changing the design of a product/service or if more expensive processes are needed for the production of the product/service.
But assuming no changes in the basic product, any performance indicators for Marketing will be related either to Sales or to the Net Profit Margin. Any marketing activity you initiate will influence the size of this margin and you need to know how anything you do in marketing, affects this Net Margin.
So for example a marketing activity may indeed increase Sales but if the cost increases by a disproportionate amount, then the Net Profit will fall! But even so, you may still be able to claim success! We will see that later on.
We can describe marketing costs in two ways:
(1) Variable or fixed costs.
For example, sales commissions are variable in the sense that they occur only if sales happen. Also, costs incurred for brokerage are usually variable as their size depends on the amount of sales. However, a one-off advertising campaign in a given year is a fixed cost as it does not change with sales volume. Similarly, the salary of a marketing manager is fixed as it is constant over time irrespective of the movement in the sales figure.
(2) Discretionary and non-discretionary costs.
Discretionary costs vary according to management decisions, such as sales commissions (also a variable cost), advertising expenditures (fixed cost), and promotional items like pens with the company’s logo or diaries, memory sticks etc. Nondiscretionary costs do not vary according to management decisions once an earlier and major decision has already been made. For example, if management builds a sales kiosk in some strategic location like an airport, then the subsequent running and maintenance (fixed) and depreciation (also fixed) on that kiosk is a nondiscretionary expense.
Hopefully most of marketing costs will be discretionary! In the main, such costs show that there is an effort to increase sales volume and sales revenue. This is the primary objective and not the other way round, i.e. increasing costs because of an increase in sales!
There are other costs similar to Marketing costs and usually we name them General and/or Administrative expenses. They too are classified as variable, fixed, discretionary and nondiscretionary.
Another term that is often used to describe costs that do not affect the cost of the product or service sold is “overhead”. This means that it is a sunk cost i.e., it is fixed and contracted to be incurred on a time basis and therefore not influencing the sales revenue. For example, accountants’ salaries are such overheads as they have to happen no matter what the level of sales. Marketing costs are often referred to as “overhead” implying that these are sunk and fixed and do not affect the level of sales. However, the truth is that marketing costs often do affect the level of sales, like for example the discretionary costs that we have just explained. Even non-discretionary costs, if well planned and thought of, could and many times do affect sales.
So the Net Profit Margin i.e.:can be affected by marketing activities and we should be able to measure the impact of marketing activities on each product in the portfolio and not only on the overall margin that captures all the products. This is slightly complex but there are ways to do it!
If you take the sales revenue of a product and deduct from it the variable cost of this product (i.e. the cost that directly affects the product, for example materials used to make it, the direct labour needed in its production process and other production costs) then you are left with what we call Contribution. The full term is “Contribution towards fixed costs” but it is always referred to as “Contribution”. In other words: how much is left from revenue to pay for the fixed costs and hopefully enough left is as a profit margin.
Case Study: why is this important?
Suppose there are two products A and B. A sells for €11 and B sells for €4.
Variable costs (raw materials, direct labour etc.) for A are €8 and for B €3.
Assume that we have just closed the period (that can be the last quarter, six months, year etc.) with sales of 1,000 units of A and 500 units of B. We have incurred fixed costs of 2,500 (Admin, Marketing, Office etc.). These fixed costs are incurred for both products and the people involved in these departments are the same people for both products. We need a method that will split these costs between the two products so we know the profitability of each.
We would normally allocate these fixed costs based on how many units we sell, so we would allocate
We now wish to show to the Board how each product is performing:
We see that product B is loss-making if we consider this allocation method of fixed costs as “fair”. It is not an easy exercise to apply fairness in allocating fixed overheads on departments and products. But let us assume it is “fair”.
At a management meeting, we hear voices asking for the termination of the production and sales of product B as it is loss-making. But let us see what happens when we stop the sales of B.
Currently the total net margin is €1,000 (1,333 – 333) i.e. the net margin of A minus the loss made by B.
If we stop B then the results will be:
We are actually worse off now as we are making a net loss! What has happened?
Let us analyse the numbers a little:
Before stopping the sales of B we had a net margin of €1,000.
What happened is that we stopped selling a product that contributed €833 towards fixed costs!
Now this €833 is loaded onto product A.
Therefore, the decision to stop B was financially wrong. To arrive at better financial decisions, we should also look at the contribution that each product brings to the firm. As long as a product contributes towards fixed costs, that product is very valuable to the firm!
In the next article, we will look at a slightly different version of Contribution which we call Break-Even. Such analysis will help us not only to determine if a product should be allowed to continue but also how many units we should expect to sell to continue being viable and contributing to the overall profitability of the organisation.