By the Numbers; The Impact of Price and Margin Changes

 

This issue, let’s drill down one more level and look at some general numbers and see how a company might actually be affected and why. Note that these numbers aren’t real numbers from a real company. But we all know enough about what it costs to make a skateboard and what they sell for to put together some rough numbers for a mythical company we’ll call “The Company.”

 

 

About three years ago, The Company was loving life. It had an income statement that looked something like this.

 

Net Sales                                              $20,000,000                  100.00%

Cost of Goods Sold                              $11,333,340                   56.67%

Gross Margin                                        $ 8,666,660                   43.33%

 

Operating Expenses

 

Advertising, Promotion, Team                $ 2,000,000                    10.00%

Overhead                                              $ 2,000,000                    10.00%

 

Total Operating Expenses                      $4,000,000                     20.00%

 

Pretax Profit                                         $ 4,666,661                    23.33%

 

Yikes! The Company has an impossibly good business. The pretax margin is twenty three percent. Here are the rather gross assumptions I made to put this together.

 

The Company sells nothing but branded decks at $30.00 each- sort of a blended rate between direct to retail and distributor pricing. So they are selling 666,666.67 decks. I have no idea who the fool who buys the last two thirds of a deck is. Hope he got a discount.

 

The decks, back then, cost them $17.00 dollars to have made or to buy. I’m assuming this is a distributor. Obviously, if it’s a manufacturer, margins get even higher, but there are manufacturing expenses to be added to cost. In real life, they wouldn’t just be selling branded decks. There’d be other hard and soft goods and probably various brands.

 

 

Gee, what a fun couple of years it’s been. For The Company’s last complete year, sales were off thirty percent, declining to $14 million. Luckily, this was a hot brand and selling price and margins held. Assuming they kept their operating expenses constant, The Company’s pretax profit fell to $2.8 million as shown below.

 

 

Net Sales                                              $14,000,000                  100.00%

Cost of Goods Sold                              $ 7,933,333                   56.67%

Gross Margin                                        $ 6,066,667                   43.33%

 

Operating Expenses

 

Advertising, Promotion, Team                $ 1,400,000                    10.00%

Overhead                                              $ 2,000,000                    14.29%

 

Total Operating Expenses                      $3,400,000                     24.29%

 

Pretax Profit                                         $ 2,666,667                     19.05%         

Hey, that’s not so bad! You’ve still got a pretax margin of nineteen percent, down from twenty three. You can live with that. Your overhead doesn’t really go down much, but you kept your marketing expense at ten percent of sales by reducing your trade show presence, advertising a bit less, and cutting a few riders you considered marginal. And you’re just a bit stingier with that promotional product. No free t-shirts for Jeff this year. Damn.

 

But lurking in the lichens is the fact that your product is the same as everybody else’s, and keeping your gross margins depends on keeping the hype going, no matter what your sales are. Cutting those marketing expenses can be good financial sense in the short run, but be tough on the brand in the longer term. Still, you got to do what you got to do. Or you could maintain the marketing expense level at $2 million. You’d still have a pretax profit margin of a little over $2 million. Pretty nice.

 

Unless of course, The Company was a $10 million company three years ago, with an income statement that, today, with sales down thirty percent, looks like this:

 

Net Sales                                              $7,000,000                    100.00%

Cost of Goods Sold                              $3,966,667                     56.70%

Gross Margin                                        $3,033,333                     43.30%

 

Operating Expenses

 

Advertising, Promotion, Team                $   700,000                     10.00%

Overhead                                              $1,000,000                     14.29%

 

Total Operating Expenses                      $1,700,000                     24.29%

 

Pretax Profit                                         $ 1,333,333                    24.29%

 

Wow, that’s still pretty damn good! It’s amazing what a cash machine a high margin branded product can be. You can see why everybody wanted to get into this business. These kinds of pretax margins don’t come along that often.

 

Still, note how the total margin dollars available are dropping. It may be that at $7 million in revenue, The Company really needs to spend more than ten percent of sales on its marketing.

 

Retailers reading this should think about the gross margin dollars issue carefully. As much as I’m a fan of high margin percentages, you also need to think about the total margin dollars you generate. Do the numbers yourself, but you can sell fewer $50 decks with a lower gross margin percentage and still make more margin dollars than you make selling more higher margin percentage $30 decks. I think that’s probably worth a whole column next issue.

 

I confess to indulging in a little bit of gloriously naïve optimism in my discussion of The Company. A real company’s gross margin isn’t going to be lower than what you see here after you factor in discounts, freight, returns, etc. And I’ve conveniently not included any rider royalties. I also don’t think you can automatically reduce your marketing expense in this business to conform to a percentage of sales as those sales drop. So if the $7 million company shown above has only a 40% gross margin, for example, and has to hold its marketing expenses at a million dollars even with falling sales, the pretax profit is suddenly down to $500,000.

 

 

 

Sales have stabilized and even started to recover a little. The Company wipes its brow in relief realizing that volume isn’t going to drop another 30 percent. But your average selling price has dropped as a result of cheaper product being available from overseas, the actions of some of your competitors, and some retailers and customers welcoming cheaper product. The good news, kind of, is that you also have the ability to buy some of this cheaper product yourself and, continuing to assume that The Company is just a distributor, it’s been able to get its domestic manufacturers to lower their price a bit.

 

If The Company is a domestic manufacturer, it has a different set of problems. Its volume is probably down, and its OEM customers have been squeezing it for better pricing. Lower volume may mean that the all-in cost for each deck is actually up, while customers have the leverage to get you to take less for each one. That sucks.

 

In addition, the price difference between branded and blank decks has become even more compelling, and some percentage of skaters finds the price difference too compelling to resist.

 

But as we see in the numbers, selling that high margin branded product is what makes this business financially attractive, and people are going to be fighting to keep their share of that. That probably translates into higher marketing expenses, assuming you have the money to do it.

 

Let’s run some of these issues through The Company’s grossly simplified income statement, starting with The Company doing the $14 million sales have declined to.

 

Except of course that $14 million isn’t $14 million any more. The Company is doing the same number of decks, but the average selling price has dropped to, let’s say, $25. You’re now doing roughly $11.7 million in business   but you’ve squeezed your suppliers some and your cost per deck is down to $13.

 

You squeeze your overhead for all it’s worth, but you’re doing the same number of decks so there’s not much to cut there. We’ll leave the marketing budget the same. As I said before, it might be that it should actually go up. 

 

Net Sales                                              $11,700,000                  100.00%

Cost of Goods Sold                              $ 6,067,000                   51.85%

Gross Margin                                        $ 5,633,000                   48.15%

 

Operating Expenses

 

Advertising, Promotion, Team                $ 2,000,000                    17.09%

Overhead                                              $ 2,000,000                    17.09%

 

Total Operating Expenses                      $4,000,000                     34.18%

 

Pretax Profit                                         $ 1,633,000                     13.96%

 

 

What we started with as a $20 million company is now doing less than $11.7 million, but it’s still okay, but only under my admittedly naïve, optimistic scenario. Look at the percentages as well as the numbers. What would happen if The Company was an $11.7 million business when this all started three or more years ago? Not a pretty picture.

 

The big unknowns, of course, are what skaters will actually be willing to pay for decks and what companies will actually buy decks for and from where. It’s possible that a brand’s selling price could have to go down further. But it’s also that their cost can be much lower as well. The issue for skating is how we make sure there will be enough gross margins dollars left when this all works its way through the system to allow the brands to continue the marketing programs that are critical to skating.