© 2000 John Petroff
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© 2000 John Petroff |
C- Pricing, Cost of Goods Sold and Gross Profit Margin
1)- Interpretation of cost of goods sold numbers:
In both, cash and the accrual accounting methods, the cost of goods sold matches costs to revenues. The cost of the goods that are sold is naturally that portion of inventory sold during the year. However, only where a continuous inventory method (i.e. maintaining records for each individual items on hand) is the process of matching cost and revenue one to one. And only in industries where very expensive items are handled such as works of art, automobiles or precious stones, can companies afford the expense of maintaining continuous or perpetual inventory records. For most other segments of the economy, firms calculate cost of goods sold from the inventory on hand at the beginning of the year, plus purchases or production during the year, minus inventory at the end of the year:
Cost of goods sold = Inventory
at beginning of year
+ purchases and/or production - inventory at end of year
An analyst is unable to verify the calculation of cost of goods sold because numbers on purchases and production are practically never given in annual reports. Moreover, inventories are significantly affected by accounting methods used, as discussed in Chapter 8 Section H-1. It is necessary to rely on auditor's opinion implied assurance that the company uses appropriate GAAP accounting policies in a consistent manner.
One may argue that GAAP standard of taking inventory only once a year is rather imprecise, [especially compared to Russian firms where inventory is taken quarterly, monthly or even more often]. For the financial analyst the estimation error that results from annual inventory taking is practically negligible. Even in the retail industry where, as explained earlier, inventory is at retail prices, then converted to purchase price by applying an average mark up percentage and determining the shortage for theft, the error (including theft) does not amount to more than 2% to 4%. Errors brought on by inflation can easily be much larger than that.
Cost of goods sold is very much affected by the unit pricing method a company uses for its inventory. One recalls that full-absorption combines direct costs only, while standard cost includes an allocated portion of overhead. Because overhead is large in some industries, when firms that need to be compared, use different inventory pricing methods, the comparison may be difficult, if not meaningless. But the difficulty may be more apparent than real because it is common for all firms in a given industry to use accounting methods that are most appropriate and, therefore, very similar. This is also true for revaluation of inventory at lower of cost or market. On the contrary, the use of LIFO or FIFO is not universal and it is dictated by two considerations. The first one is obviously the rate of inflation. The second one is the need of the firm to manipulate its net earnings in a very effective and legal manner, for LIFO was specifically invented to deflate earnings. Both of these reasons are not related to any particular industry, and consequently comparison of firms using different methods is inappropriate. It would seem possible to make corrections to the cost of goods sold of firms that offer footnote details on current costs for those firms that use LIFO. But the conversion is not free from errors and it is not possible from FIFO to LIFO.
In recent years, the slowing of inflation has prompted most firms in the United States to switch back to FIFO. Only occasionally, a firm under study will be an added challenge because it still uses LIFO.
| In Russia, the use of LIFO is widespread because of hyperinflation and the tax relief that it offers. Here also the comparison is not an issue. |
See review questions Q-9C1.1 through Q-9C1.13.
The cost of goods sold differs considerably depending on the volume of production and the experience a firm has in producing an item. Personal practical experience shows that a person spends less and less time and effort to create anything as he/she becomes more skilled in producing it. For instance, a carpenter may take two days or more to create a prototype of a particular shape of window. To make two or three copies of the prototype window the carpenter may take less than a day for each window. When producing dozens of similar windows, each of the parts of the window can be cut in series (or batches) saving even more on production time, and assembling of windows may be speeded up by division of labor down to a few hours per window. If thousands of windows must be manufactured, it make sense to automate the entire process with equipment that cuts and assembles all the parts, with the carpenters supervising the process, with considerable additional saving in production time and therefore unit cost.
This reduction in time and cost as volume increases is called the learning curve. It is observable in all industries and plays an important role in the strategy of firms moving from phase to phase in the product life cycles of its products. Indeed, a product that enters its maturing phase, requires a different strategy compared to the introduction or expansion phases (discussed in Chapter 14 Section B). As products mature, lower prices and larger volumes are desirable. The lower price is dictated by the broader customer base which has a lower disposable income. Another justification of lower prices upon entering the standardization phase is to fend off competitors from gaining market share price cutting. Look at the personal computer market where prices have come down at the rate of 20 or 25% a year for the past 15 years (i.e. price relative to speed, size and features). At the same time sales have increased considerably.
A firm must exploit its market by producing and marketing products, that generate the greatest increase in wealth of owners (and other directly interested social groups as well). Taking advantage of the learning curve is imperative. In most cases, it translates into seeking larger production and sales volumes. Sales volume growth becomes a target in itself. That means that management must achieve sales increase to capitalize on the learning curve, and advertising and other aggressive sales strategies become its tools.
It goes without saying that all firms in an industry can possibly increase volume, but not market shares at the same time. Some firms may seek larger profits by maintaining a high price and finding valid arguments for customers to justify the higher price they pay by various desirable quality features, such as service, design, content, or location. As previously pointed out, finding a niche and leaving the mass production to leading firms can be a very appropriate strategy. Yet, even small firms do seek to take advantage of the learning curve in their own way. For the leading firm, it would be unforgivable to fail to exploit its market with larger quantities, even in a shrinking market or for a product that has entered the obsolescence phase.
| Take the case of beer. While it is doubtful that beer could ever become an obsolete product (notwithstanding what some housewives may wish that), beer has recently experienced a downward trend in sales with a more health conscious population in the United States. The leading American brewery is Budweiser, thanks to one of the largest advertising and promotional budgets of any American firm. The unit cost of production at Budweiser is 10 to 20% less than that of its competitors, which is very significant in an industry where profit margins are small. One American brewery that has promoted an image of quality (comparing itself to the best beers of Germany) to justify its high price has been Samuel Adams. The advertising budget of Samuel Adams is also quite large. That illustrates that large and small firms seek to take advantage of the learning curve. |
Decreasing unit costs will be taken up once again in the analysis of strategies associated with automation and fixed costs as part of operating leverage analysis Chapter 10 Section D.
| In Russia, the learning curve appears to be a socialist dogma which has been believed at the highest level of government and which still persists years after the fall of communism. There is a clear penchant for bigness: everything is planned on a large scale (this is especially true when approaches to markets in Russia are compared to those of European countries). For instance, the grocery stores in 1995 still have a list of just 19 obligatory items. When one of these 19 items is delivered to stores, it occupies much shelf space until the arrival of another one of the 19 items. |
The learning curve often implies that increases in sales volume and market share are goals in themselves. The analyst must become convinced that the goals are achievable and that the saving from a larger volume will bring about reductions in unit costs. Naturally, volume and unit cost strategies must, in the end, have a positive impact on profitability (even if, for a year or so, promotion efforts eat into earnings).
See review questions Q-9C2.1 through Q-9C2.9.
3)- Profit margin and pricing
The gross profit is the difference between the sales revenue and cost of goods sold. Gross profit margin GPM is stated as a percentage: dividing gross profit by revenue from sales.
GPM = (Sales revenue - cost of goods sold)/ Sales revenue
Profit margin is the end result of unit cost and volume strategies, discussed above, as well as pricing strategy.
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An an example of gross margin calculation, let us take J.C. Penney. Sales revenue of $ 30.678 billions and cost of goods sold of $ 21.859 billions for 1998 are taken from J.C. Penney Income Statement. Gross margin is therefore GPM = (30,678 - 21,859) / 30,678 = 8,819 / 30,678 = 0.0287 or 29% as shown in J.C. Penney Normalized Income Statement. |
How prices are determined varies from industry to industry and among firms. One very common form of pricing is the cost-plus method in which the cost is incremented by some percentage (sometimes known as mark-up) or dollar amount. In this method, the price is the by-product of a profit margin strategy which is, in turn, guided by the need to cover overhead, taxes and return to owners. There are many variations of the cost-plus method of pricing. In many practical circumstances, managers entering a particular market for the first time find it most reasonable to use the profit margin of competitors as an appropriate return for the firm. For instance, in retailing, the mark up in different stores is similar. This is often dictated by competition: stores that would overprice by even a few pennies items available everywhere, will see their sales tumble. This also means that the technology leader sets the highest price. As indicated earlier, other firms use pricing strategies that align their own prices proportionately under that of the technology leader.
When cost-plus method of pricing is used, there are dangers which the analyst must assess. First, cost-plus pricing does not encourage efficiency of production since the costs are simply passed on to consumers. Second, pricing of products can be sub-optimal from a market point of view. When a firm prices its products according to market demand, price should correlate with quality because, as long as the consumer is wise enough to judge a product by intrinsic benefits, the better quality product will be in much greater demand than the lower quality product at the same price. The firm should learn from this message that customers will pay a higher price when product shortages occur. But when the cost-plus method is used, differences in production costs determine prices, not quality as perceived by the market.
Theoretically, pricing should be based on consumer preferences. Market research exists for the purpose of helping managers to choose optimum marketing and pricing strategies. Historical data on market reaction to price changes is most useful. But, it can only provide answers on existing sales. When a product is introduced, it may be necessary to adjust price as experience tells when the product is over or under priced. Unfortunately, price changes are themselves destabilizing for consumers and should be avoided. Marketing experts teach us to use comparable test markets to gather empirical information.
Economic theory tells us that total revenue is maximized at the point where the demand price elasticity is one. This results from the fact that if a price is either increased or reduced, the consequent change in quantity reduces total revenue. But firms do not necessarily set total revenue as their goal (with the exception of the benefit from the learning curve previously outlined). Instead, one will recall that it is profit that they seek to maximize at the point where marginal revenue is equal to margin cost (i.e. one item more or less would result in actual or opportunity marginal loss). The consequence is that prices, as well as costs, are dependent on volume.
Naturally, a monopoly will try to price its product at a much higher price than a firm in perfect competition. In addition, the monopoly will also try to segment its markets and price discriminate among different groups of customers, so that the profit is maximized from each individual sale rather than from total profit. A firm in a monopoly position is clearly more profitable than a firm with competitors. However, firms that take excessive advantage of their customers, such as in the case of some utilities (e.g. AT&T prior to its break up, or Microsoft more recently), may find that customer unhappiness leads to governmental anti-trust action.
The analyst must find evidence in the business plan and in the annual report that the firm has given all necessary attention to customer preferences in order not to over or under price the product. After all, the firm exists to serve its customers. It is customers' attitudes and preferences that should determine price. Yet, the firm must also be answerable to its employees that deserve adequate remuneration, and most importantly, its owners that expect a return commensurate with the risk they have assumed. Ant that dictates maximizing profits.
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In Russia, pricing seems to be based on two very different approaches. In the government stores and all stores that sell basic products (such as bread, salt, milk), price is determined by costs, taxes and social policy. As indicated earlier, there are 19 such items. In general, those are low cost items. Price changes in these items have little to do with demand, but only with increasing costs of production. The second group of products are luxury items and include the majority of items, even bathroom tissue paper. Here, the wide discrepancies that exist between stores clearly suggest that some firms try to use their monopoly position resulting from shortages of all items. Some prices are extremely high when compared to Western prices and considering the level of income in Russia. Take, for instance, the rental price of apartments. Apartments rented to Westerners are priced over $1,000 for a two room apartment, while rental of the same apartment to a Russian can be as low as $10 (in part because the rental prices for Russians are based on income level). |
See review questions Q-9C3.1 through Q-9C3.14.
See research assignments R-9C.1 through R-9C.6.
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