Business Ratios and Formulas phần 9 pps

With this in mind, the formulais to subtract from the total customer list those that have been invoiced or sold to on a cash basis within the appropriate time period and then divide the

Formula: The calculation of this formula is subject to some interpretation; the keyissue is how long to wait before a customer is assumed to have stopped buyingfrom the company In some cases, this may be anyone who has not placed an orderwithin the past month and in other cases within the past year The correct formu-lation will depend upon the nature of the business With this in mind, the formula

is to subtract from the total customer list those that have been invoiced (or sold to

on a cash basis) within the appropriate time period and then divide the remainder

by the total number of customers on the customer list:

Total number of customers – Invoiced customers

Total number of customers

Example: The customer service department of the Indonesian Linens Company isbeing inundated with requests from the president to reduce the company’s highrate of customer turnover, which is currently 30% per year The department man-ager does not have enough staff available to contact all customers regularly, and

so asks the controller for assistance in finding out which customers are most portant, so that the department can focus on them Mr Noteworthy, the controller,conducts an activity-based costing analysis of all customers and determines which

im-50 customers produce the largest amount of gross margin dollars for the company.The customer service manager gratefully shifts the department’s focus to thesekey customers A few months later, Mr Noteworthy calculates customer turnoverboth in total and for this smaller group of key customers, using the information inTable 14.2

The table shows that, although overall customer turnover has not changed, theincreased focus on high-profit customers has resulted in greatly reduced turnover

in this key area

Cautions: There may be some customers who only purchase small amounts eachyear; one may not want to include these customers in the turnover calculation, fo-cusing instead on those that provide a significant level of sales volume Anothervariation on the ratio is to determine the top customers who provide the companywith the bulk of its profits and only measure the turnover rate among that group

By subdividing customers in this manner, a company can focus its customer tention strategy on those who have the largest financial impact on the company

re-Table 14.2

Total Customer Base Key Customer Base

Customers not placing order in the last

NET PROMOTER SCORE

Description: It is extremely difficult to monitor customer satisfaction, since thiscan encompass a variety of aspects of the customer experience, such as initial ser-vice, pricing, product or service quality, warranty service, and so on One way tosummarize all these aspects of customer service into one measure is to track thepropensity of customers to recommend the company to their friends or colleagues.This approach uses a simple ten-point scale, where a score of ten represents an en-thusiastic endorsement Surveying on just this question, rather than the usual longlist of customer-satisfaction questions, also results in a higher proportion of cus-tomer responses

Formula: Conduct a customer survey, in which they are asked on a scale of 1 to

10 if they would recommend the company’s products and services to their friends

or colleagues Then divide the total of all 9 or 10 scores by the total of all 1 through

6 scores The formula is:

Number of customers giving score of 9 or 10 on 10-point scale

————————————————————————————Number of customers giving score of 1 through 6 on 10-point scaleCustomers giving scores of 7 or 8 are considered to be passively satisfied, and

so are unlikely to either recommend the company or detract from it Their scoresare therefore excluded from the ratio

Example: The Samson Hair Loss Clinic specializes in hair restoration, which is apainful and expensive process It relies primarily upon customer referrals for newbusiness, so it pays particular attention to customer satisfaction with its services

It recently completed a survey of 100 recent clients, where they gave scores on aten-point scale for whether they would recommend Samson to their friends Theresults were:

di-Cautions: This metric assumes that there is a causal relationship between revenuegrowth and a high net promoter score There is likely to be one, given the strength

of social networks for selling some types of products However, people are morelikely to go out of their way to recommend consumer products, such as a plasmatelevision, than they are for more pedestrian products, such as cement Thus, itmakes sense to first test the concept on an individual company basis to ensure thatthis tool represents a valid way to foster more revenue growth.

If the people being judged by this metric are also the ones collecting the derlying data, then survey results may be skewed upward To prevent this, have athird party collect the survey information

un-BROWSE TO BUY CONVERSION RATIO

Description: In most retail establishments, it is impossible to determine howmany people browse through the store, and so there is no way to determine theratio of potential customers to those who actually make a purchase However, this

is a simple and effective calculation for any situation where the store is on-line,since the exact number of browsing customers can be compiled In this situation,

a company has a great deal of interest in the browse to buy conversion ratio, since

it can adjust its on-line store presentation to encourage a higher proportion ofbuyers and get immediate confirmation through this ratio of the effectiveness of itschanges

Formula: Divide the number of buying customers by the number of browsing tomers This measure can be subdivided into individual pages on a Web site; for ex-ample, the measure can be used individually for the camera, television, and videocamera sections of an electronics store Web site This type of “slice and dice” mea-surement may yield a greater degree of accuracy in determining which parts of anon-line store are most effective in attracting customer orders The ratio is:

cus-Number of buying customers

—————————————

Number of browsing customers

Example: An outside Web site developer has contacted the International BabySupply Center, offering to redesign its Web site to attract more paying customers.The company’s lead buyer, Mr Smythe, decides to structure the deal so that theWeb site developer is paid only if the browse to buy conversion ratio improves afterthe site changes are completed The developer is willing to modify the Web pagesdepicting products, but not the home page Accordingly, the number of browsingcustomers is measured at the product pages rather than at the home page The de-velopment contract states that the developer will be paid 10% of the sales from theincreased proportion of buyers for six months following installation of the newWeb pages Table 14.3 reveals the before-and-after statistics for the site

The developer’s efforts have resulted in an improvement in the ratio of 3% Tocalculate the amount to be paid to the developer, Mr Smythe multiplies the 3%

difference by the number of browsing customers after the changes are mented, which is:

imple-3% ×157,000 Browsing customers = 4,710 Additional buying customers

He then multiplies the increase in buying customers by the average sale percustomer of $148, to find the amount payable to the developer The calculation is:

$15 Average sale per customer ×4,710 Additional buying customers = $70,650

Cautions: The number of browsing customers used in the ratio can be subject to

a considerable degree of interpretation For example, it can be summarized fromthe number of potential customers who access the home page of the site, from thenumber who access specific product pages, or those who have placed an order butback out just prior to paying One possibility is to measure the ratio at all of thesepoints in order to determine where in the process the greatest proportion of po-tential customers drop out of the purchasing decision

RECENCY

Description: Recency refers to the time period between visits by a customer to acompany’s retail location Most stores are not equipped to track the arrival of cus-tomers at a store, except for some retail clubs that issue identification cards to theircustomers However, on-line stores can easily determine when customers have ac-cessed the site, and so have reasonable grounds for calculating this measure Anon-line store can use the measure as a target for its marketing efforts By issuingadvertisements, special deal notices, and so on, and then noting any changes in therecency measure, a company can see if its marketing efforts are changing the pur-chasing behavior of its customers

Formula: Subtract the most recent date of a customer site visit from the date ofthe last visit date This number can be summarized and averaged for all customers,

or for select subgroups of customers

The measure can be used for physical retail locations by measuring customeraccess based on the dates of their noncash purchases; however, this modification

Table 14.3

Before Changes After Changes

Number of browsing customers 130,000 157,000

to the formula will exclude those customers who have only browsed through thestore and not purchased anything.

Example: The Christmas Express Company’s marketing manager wants to culate the recency of the customers accessing its on-line store The informationfor 10 randomly selected customers is shown in Table 14.4

cal-The average recency for the information in the far right column of the table is11.8 days

Cautions: It may not be that easy to trace the recency of customers at an on-linesite, because they may be accessing the site from different on-line serviceproviders, which will give them a different identification that cannot be compared

to their identifications from previous site visits The best way to avoid this lem is to require a site log-in using a company-issued identification so that there

prob-is no question about who prob-is accessing it

DIRECT MAIL EFFECTIVENESS RATIO

Description: Direct mail campaigns have a high product design, production, andmailing cost, so it is crucial to verify the success of these endeavors A successfulcampaign usually has a low single-digit response rate and can swing between aprofit or loss if the response rate varies by a fraction of a percent Consequently,

a company that engages in this form of marketing must pay close attention to thedirect mail effectiveness ratio

Formula: This ratio can be measured in two ways Under the first approach, tential customers do not place an order at the time of the response to the direct mailcampaign, and must be contacted in order to confirm a sale To measure this type

po-Table 14.4

of activity, divide the number of leads generated by the direct mail activity by thenumber of direct mail pieces issued The formula is:

Number of leads generated

———————————————

Number of direct mail pieces issued

If customer orders arise straight from a direct mail campaign, then there will beorders instead of sales leads The ratio then becomes a comparison of direct mailsales to either the number of direct mail pieces issued, or of the total direct mailexpense Another variation is to compare the gross margin on sales derived fromthe direct mail campaign to the total direct mail expense This last version is themost effective for determining whether or not a profit has been achieved from thisactivity The three variations are:

Direct mail sales

———————————————

Number of direct mail pieces issued

Direct mail sales

———————————

Total direct mail expenseGross margin on direct mail sales

———————————————

Total direct mail expense

Example: The marketing manager of the Curious Gifts Catalog Company wants

to measure the performance of her latest direct mail campaign The relevant formation is shown in Table 14.5

in-With this information, the manager finds that sales per direct mail piece is $0.35(calculated as $842,000 sales, divided by 2,400,000 pieces issued) The ratio of di-rect mail sales to related expenses is roughly 3:1 (calculated as $842,000 sales, di-vided by $284,000 direct mail expense) The most telling comparison is the ratio ofgross margin to the direct mail expense of 1.33:1 (calculated as $379,000 grossmargin, divided by $284,000 direct mail expense); this last measure shows thatthere was a reasonable profit resulting from the direct mail campaign

Cautions: If there are multiple direct mail campaigns going on at the same time, it

is easy for sales leads or orders derived from them to be mixed up so that it is possible to tell which campaign was the most effective To correct this problem,

there should be a mailing-specific identification number on each direct mail piecedelivered, which should be used to identify each sales lead or order as it is received.

INBOUND TELEMARKETING RETENTION RATIO

Description: This specialized measure is only useful for companies that maintain

an inbound telemarketing function, and which have subscription or other recurringforms of revenue In these cases, customers will likely contact the call center inorder to notify the company that they are canceling their ongoing purchases from

it If so, the company should track the ability of the employees taking those calls

to persuade customers not to cancel The inbound telemarketing retention rate can

be used to determine the effectiveness of this activity

Formula: Divide the total number of initial customer order cancellation requestsinto the number of cancellations that have been successfully reversed Dependingupon the situation, this measurement can vary significantly, depending uponwhich employee is talking to customers; thus, the measure can be effectively used

to determine differences in the retention rate between employees in the inboundtelemarketing operation The formula is:

Number of customer order cancellations reversed

————————————————————————

Number of initial customer order cancellations requested

Example: The Potent Credit Company issues platinum credit cards to a set ofwealthy clients It has recently instituted a no-loss program of offering free credit

to any canceling customers for three months, in an effort to drop its cancellations

as close to zero as possible It has accumulated the information about the new gram shown in Table 14.6

pro-The table reveals that the company has certainly engineered a drastic ment in its retention rate, but at a cost of $413 per customer retained An additionalanalysis at this point would be to determine the amount of profit to be expectedfrom each customer to see if there is a cost/benefit advantage to retaining cus-tomers at this much higher cost

improve-Table 14.6

Before New Program After New Program

Retention cost per reversed cancellation $163 $413

Cautions: The cost of retaining customers who want to cancel can be significant.For example, a credit card company may offer zero-interest financing on any ex-isting credit card debt for the next few months if a customer agrees to continueusing the card; the cost of the interest income lost through this concession is thecost of retaining the customer Consequently, it is useful to also track the cost ofthe deals used to retain customers, and then compare this information to the re-tention rate to see if the customer retention effort is worthwhile.

PROPORTION OF COMPLETED SALES TO HOME PAGE VIEWS

Description: A variety of advertising techniques can be used to lure on-line tomers to a company’s home page, but converting those customers to completedsales transactions can be extremely difficult This can involve low price points, auser-friendly interface, easily readable Web pages and navigation, and so on Con-sequently, it is extremely useful to measure a Web site’s sales capability by com-paring the base of customers who initially arrive at a company’s home page to thenumber of sales generated

cus-Formula: Subtract the number of page views of the company home page bysearch bots from the total number of page views on the home page, and then di-vide the result into the number of sales transactions on the site during the mea-surement period The formula is:

Number of sales transactions through company Web site

—————————————————————————————–(Total page views of company home page) – (Total hits by search bots)

Example: The Jigsaw Mania Company sells hundreds of custom-designed jigsawpuzzles on the Internet It is experimenting with a variety of advertising techniques

to draw more visitors to its site, and has used just one advertising technique permonth, so there is no mixing of the results from each approach Jigsaw has con-structed Table 14.7 to track the effectiveness of each technique

The results show that a higher volume of customers are drawn to the site throughsearch engines, but that the quality of customer is lower—these page views result

Table 14.7

Advertising Sales Initial Home Proportion of Sales to

Cross promotion from toy site 1,886 82,000 2.3%

Paid link from puzzle convention 1,333 43,000 3.1%

site

in fewer sales Conversely, the more targeted advertising through the puzzle vention Web site results in a much higher proportion of sales to home page views.Thus, depending on the cost of advertising, the more targeted ads appear to be themost efficient advertising approach.

con-Cautions: Once customers bookmark a company’s site as a favorite location,they will have a much higher propensity to purchase from the site, so this ratio willimprove over time as customers “lock in” on the site However, customer book-marks may bypass the company’s home page and go straight to specific pages onthe Web site, so it may be more useful to use total page views for all entrancepages An entrance page is the initial page on which a viewer first accesses a Website, and is commonly tracked by many Web site statistics packages

QUOTE TO CLOSE RATIO

Description: The quote to close ratio is one of the most heavily used performancemeasures by the sales manager This reveals which sales personnel have the bestability to close a deal once it has been quoted Though this measures the effec-tiveness of only one step in the sales funnel, it is nonetheless an important one andcan reveal considerable differences between the closing abilities of the varioussales staff

Formula: Divide the dollar value of orders received by the total amount of quotedorders An alternative is to compare the number of orders received to the numberquoted, but is not recommended—the ratio can be too easily skewed by a largenumber of small quotes Also, given the inordinate length of time that customerssometimes wait before approving an order, this measure needs to be spread overseveral months in order to effect a reasonable comparison of quoted to receivedorders The formula is:

Dollar value of orders received

—————————————

Dollar value of quoted orders

Example: The Geomorphics Software Company has had great difficulty in mining the sales effectiveness of its new sales staff Its software is difficult for thesales staff to learn, and so requires a long time period before sales personnel canbecome effective sellers The sales manager has hit upon the use of the quote toclose ratio on a trend line to see if this is a better way to measure their effective-ness Accordingly, the sales manager has compiled dollars quoted and orders re-ceived information for two new sales personnel, Mr Brandy and Ms Browne.Their sales results over a four month period are shown in Table 14.8

deter-Based on the quote to close ratios for both sales trainees, it appears that Mr.Brandy is gradually improving his ability to close on sales, whereas Ms Browne

is not

Cautions: This measure can be difficult to use for individual sales personnel,since quotes are frequently made by teams, whose composition changes for eachquote In these cases, it can only be used to measure the closing ability of an en-tire sales team It is also less effective in cases where quoted sales comprise only

a small fraction of total sales dollars

PULL-THROUGH RATE

Description: Some salespeople can convince nearly every customer to make apurchase, while others are far less efficient at converting initial customer contactsinto sales This capability, known as the pull-through rate, is critical for managerswho want to increase the sales efficiency of their salespeople, either through theelimination of poor performers or through ongoing sales training

Formula: Divide the number of customer orders placed by the number of initialcustomer contacts It is most effective to measure by individual salesperson or ge-ographic sales location The formula is:

Number of customers placing an order

in Table 14.9

The pull-through measurement indicates that the sales training program had anoticeably positive impact on sales, but the subsequent performance decline inJuly indicates that further training or some other form of follow-up with the callcenter staff might be appropriate

Cautions: This measure is best used in call center environments, because it is iest to track customers calling in to initiate the buying process, as well as actualorders achieved as a result of those calls It is less effective in unstructured envi-ronments (e.g., a retail store), where there is no easy way to record the initial cus-tomer contact in a database.

eas-SALES PER eas-SALESPERSON

Description: Sales per salesperson is the classic measure for determining thesales effectiveness of the sales staff This measure is commonly used to awardbonuses to sales personnel, and to judge which sales staff are retained However,

as noted under the Cautions section, there are several key issues to be aware of thatcan make this a misleading measure

Formula: Summarize all nonrecurring sales and divide them by the total number

of full-time equivalents in the sales department The resulting measure will onlyyield average sales per salesperson within the department, which will hide thepoor performance of any individual sales staff within the group, so one can alsocalculate the ratio on an individual basis The measure should not include any re-curring sales (as occurs for subscriptions or ongoing insurance sales) since theserequire little sales effort Also, the measure should include all sales support staff

in the full-time equivalents number in the denominator, even though they are notactively selling—they are key to supporting the sales staff, and their absence willimpact sales effectiveness, so they should be included The formula is:

Nonrecurring sales

—————————————

Number of FTE sales personnel

Example: The Ski & Snowboard Magazine Emporium’s sales manager is cerned about the performance of its salespeople, Ms Dunriddy and Ms Enoch.They both have identical total sales, but one is relying on recurring magazine sub-scriptions for a larger proportion of her sales, which results in a much slower rate

con-of sales growth for the company The sales manager compiles the informationshown in Table 14.10

The information in the table suggests that Ms Enoch is the newer of the twosalespeople and is striving to increase sales much more rapidly, so she can derive

a benefit in later years from the commission rate on recurring subscriptions ternatively, Ms Dunriddy has already built up her recurring subscription base, and

Al-is coasting along with minimal effort to attract new sales To provide a greaterincentive for both salespeople, the sales manager reduces the commission on re-curring subscriptions and increases it on new subscriptions

Cautions: The primary concern is that the sales staff may alter their sales ior so thoroughly in order to maximize their performance under this measurementthat actual profits decline For example, a salesperson may focus on selling aproduct with a high price, rather a lower-priced product that carries a much highergross margin Another example is when a salesperson gives away so many otheritems in order to secure a sale, such as long payment terms or free maintenance,that gross margins are driven down even when sales remain high A third exam-ple is when the sales staff indulges in the excessive use of travel and entertainmentexpenses in order to secure sales, once again driving down profitability Finally,

behav-it is common for sales personnel to secure orders from customers wbehav-ith a minimalability to pay for the goods and then browbeat the in-house credit department inorder to secure the extension of credit to these customers For all of these reasons,the sales per salesperson measurement can easily result in salesperson behaviorthat does not maximize profits If it is possible to measure profitability by sales-person (a sometimes complex endeavor, since the chart of accounts is rarely set up

to provide this information), then this is a much better way to control the sellingbehavior of the sales employees

SALES PRODUCTIVITY

Description: Part of the problem with the preceding sales by salesperson surement is that a salesperson can focus on sales of high-cost, low-margin prod-ucts in order to make the measure look good, even though the company earns only

mea-a smmea-all mmea-argin on the smea-ales The smea-ales productivity memea-asure cmea-an show better theability of the sales force to sell those products having the highest margins with theleast amount of sales expense This is an excellent method for determiningbonuses or employee retention within the sales department

Formula: Subtract the variable cost of goods sold from new sales, and divide theresult by the sales expense This measure should be used for each of the sales staff,since sales productivity can vary considerably within the department Also, thesales figure within the formula should only be for nonrecurring revenue (i.e., newsales), so that the sales staff does not receive credit for renewal billings for whichthey expended no sales effort The sales expense used in the calculation should in-clude the base pay, commission, travel and entertainment, and all other directlytraceable costs of the sales staff It should not include any overhead allocation,since this is not a direct cost of making a sale The formula is:

Gross nonrecurring revenue –Variable cost of sales

The table reveals that, although Salesperson A sells the most volume, the ucts have a lower gross margin than those being sold by the other two sales staff

prod-In addition, Salesperson A is spending far more money to secure sales than are theother two sales employees This results in the worst sales productivity ratio (of2.7:1) for Salesperson A, while Salesperson C, who has the lowest sales volume,has achieved the highest sales productivity score Based on this information,Salesperson A should be laid off

Cautions: Using this calculation, it is possible that an introductory-level, paid salesperson who achieves a modest amount of sales could theoreticallyachieve a higher sales productivity score than a more experienced salespersonwith a higher base pay, because the sales expense portion of the calculation is somuch lower Also, this measure does not address the issue of sales being made thatimpact a company’s bottleneck production operation; this is covered in the nextmeasurement

SALES EFFECTIVENESS

Description: An alternative way to measure the ability of the sales staff is to sellproducts that avoid use of the company’s chief production constraint If too manyproducts are sold that require a large proportion of constraint time, then a companywill soon find itself unable to increase sales without a large investment to increasethe size of the constraint However, if the sales staff is made aware of the amount

of constraint time used by each product, then this measure can be used to mine how well they avoid the constraint

deter-Formula: Subtract the variable cost of goods sold from gross revenue, and thendivide the result by the amount of constraint time used to produce the items sold

A key factor is determining which costs within the cost of goods sold are trulyvariable In many instances, only material costs are variable, with even directlabor costs being fixed in the short term The formula is:

Gross revenue – Variable cost of goods sold

Constraint time used

Example: The Hard Rock Candy Company has maximized the output from itsbottleneck operation, which is a candy cooker, and cannot produce a higher level

of output without purchasing an additional cooker The president instructs thesalespeople to shift their efforts into product sales that require less cooker time.The president compiles Table 14.12 before-and-after information about the sales-people’s performance to see if they are following his instructions

The table reveals that the salesperson has achieved a slightly lower level ofsales but has altered the gross margin mix, so the same gross margin (of $250,000)has been achieved both before and after the change in sales instructions The pri-mary change is that the number of hours of cooker time required by the sales hasdropped from 168 hours to 153, which means that the gross margin earned perhour of constraint time has increased from $1,488 per hour to $1,634 per hour Inshort, the salesperson is appropriately following the president’s instructions

Cautions: It can be difficult to accumulate the information needed to operate thismeasurement in an effective manner A company must accurately determine itsvariable cost of goods sold and be able to efficiently trace it back to individual

Table 14.12

Variable cost of goods sold $750,000 $700,000

product sales as well as inform the sales staff of the constraint usage times for eachproduct This can also require a significant revamping of the sales compensationplan in order to shift salesperson efforts away from usage of the constraint.

SALES TREND PERCENTAGE BY PRODUCT LINE

Description: The marketing and engineering departments need to know how thesales of each of a company’s product lines are progressing, so that they can altertheir marketing positioning, sales concepts, and product features in coordinationwith the perceived position of each product in its life cycle For example, if salesare steady or dropping, then the engineering department should use this informa-tion to design a replacement or enhanced version of the existing product that willspur sales when introduced

Formula: Subtract total sales dollars in the previous period from those in the rent period, and divide the result by total sales in the previous period This yieldsthe percentage change in sales during the period The measure can also be based

cur-on the number of units sold, but ignores the price point at which sales are made,and so yields less information This measure is best used for an entire product linerather than for individual products, since there may be so many products and ac-cessories within a product line, including many that are cannibalizing sales fromeach other, that the multitude of resulting ratios will not yield any useful informa-tion The formula is:

(Total sales in current period) – (Total sales in previous period)

———————————————————————————

Total sales in previous period

Example: The Nomicon Office Seating Company has designed a deluxe officechair, the Flexomatic, that has seen skyrocketing sales for the last few years How-ever, competitors have brought out two comparable models, which will soon cutinto the unit volume on sales of the Flexomatic Consequently, the sales managerwants to keep close track of its sales trend to spot the point at which sales are trail-ing off The relevant information for the past four months is shown in Table 14.13.The sales trend percentage for the Flexomatic reveals a potential problem in themost recent month of April, where the rate of sales growth has dropped from theusual 50% rate to 33% If this reduced sales trend were to continue much longer,

Table 14.13

January February March April

Change in sales from previous period — $500,000 $750,000 $750,000

the sales manager might consider dropping the Flexomatic price to become morecompetitive with the other models on the market.

Cautions: Changes in sales levels from period to period may be closely tied topromotional, seasonal, or pricing changes, and so must be reviewed with these is-sues in mind To avoid this problem, a sales trend could be compared to the sametrend calculation for the period in the previous year, along with a commentary onchanges in marketing and engineering efforts in the interim that might have had animpact on sales

PRODUCT DEMAND ELASTICITY

Description: This is useful for determining the ability of a company to maximizeits profit on product sales by altering prices However, as noted under the Cautionssection, there are so many other variables impacting sales effectiveness besidesprice that this measurement’s effectiveness is restricted

Formula: Divide the percentage change in quantity of product sold by the centage change in price The product demand is considered to be inelastic if the re-sult of the measurement is greater than 100%, and elastic if it is less than 100%.The formula is:

per-Percentage change in quantityPercentage change in price

Example: The Meridian Vacuum Company has been selling an industrial-gradevacuum cleaner for a number of years at a price of $250 per unit After comparingthis product to the competition, Meridian’s marketing team believes that it canspend only $25 to reposition the vacuum as a premium product with an aluminumcasing At a gross margin of 50%, this means that the product’s price must in-crease by $50, to $300 In addition, due to its repositioning as a premium product,the marketing staff would like to increase its price further, to $325 A marketingtest at this price point reveals that the number of units sold declines from 5,000 to4,000 as a result of the increased price Is this product price elastic or inelastic?Use the preceding formula to find out:

Percentage change in quantity

————————————— =Percentage change in price(5,000 Units – 4,000 Units) / 5,000 Units

————————————————— =

($325 – $250) / $250

20%

—— =30%

67%

The measurement reveals that the suggested price increase will result in asmaller proportional drop in unit sales Consequently, the new price point should

be implemented

Cautions: There are many factors that go into a consumer’s decision to purchase

a product besides price, all of which render the product demand elasticity measuredifficult to determine For example, a customer may pay a higher price simply be-cause it is offered more lenient credit terms by the seller Also, a seller that has es-tablished a high-quality brand name through extensive marketing efforts cancommand a premium on its product sales Further, differences in product qualitymay shift the buying habits of consumers when faced with otherwise similar prod-ucts Also, if there are substitute products available, then prices will be drivendown to match those of the substitute For these reasons, it tends to be difficult touse this measurement except when large pricing changes are implemented thatwill overwhelm all the other factors noted here

DAYS OF BACKLOG

Description: The days of backlog measure is extremely important for the duction department, because this group can use it to determine the amount of pro-duction capacity that should be made available in the short term It is also usefulfrom a financial planning standpoint, since it shows likely short-term changes insales that will impact reported financial results It can also be used to project pro-duction outsourcing needs, when the amount of backlog exceeds a company’sshort-term productive capacity

pro-Formula: Determine the amount of annual sales, divide it by 365, and divide theresult into the dollar total of all unfilled sales orders The annual sales figure mayinclude budgeted sales through the end of the year, which may vary considerablyfrom actual results; to avoid an unrealistic annual sales figure, one can use the lat-est 12 months of sales results on a rolling basis Also, be careful not to include anyprojected sales in the backlog figure for which firm orders have not yet been re-ceived from customers, since the intent of this measurement is to obtain a realis-tic understanding of actual orders that have not yet been filled The formula is:

Dollar volume of sales backlogAverage annual sales / 365

Example: The MicroMelt Plastics Company management team is consideringadding capacity to its line of 50-ton injection molding machines It will only dothis if there is a clear trend of an increasing backlog in sales that can be runthrough this type of machine To see if this is the case, the controller compiles in-formation for the last four quarters (see Table 14.14)

The days of backlog in the preceding table reveals that, though the dollar ume of the sales backlog is increasing, existing production capacity has actuallybeen able to reduce the number of days of backlog This may eliminate the short-term need for additional equipment; however, the company should review thepercentage of capacity utilization on each existing machine to see if they arereaching their maximum sustainable levels of production If so, then it still may benecessary to buy more production equipment if sales levels are expected to in-crease in the future.

vol-Cautions: The backlog figure should be separated into in-house production workand product resales, because resales require no in-house production capacity.Also, this can be a misleading measurement, for it ignores the amount of sales thatmust pass through a company’s bottleneck operation If the mix of sales within thebacklog requires a large amount of processing time at the bottleneck operation, acompany may find itself unable to handle the existing backlog even if the totalbacklog appears to be low

Table 14.14

Quarter 1 Quarter 2 Quarter 3 Quarter 4

Rolling 12-month sales $1,500,000 $1,785,000 $2,645,000 $3,000,000

The formulas presented in this chapter are by no means difficult The sion is confined to the simplest and most understandable spreadsheet commands,and avoids the use of complicated macros The discussion focuses on usingspreadsheets for five types of analysis: financial statements, project analysis, in-vestment analysis, risk analysis, and trend analysis In each case, it is noted howExcel can be used to solve a problem, and then a sample situation is provided.

discus-A key issue that is noted throughout this chapter is the difference between aspreadsheet and a worksheet In Excel, a spreadsheet can have a number of inter-linked layers known as worksheets When an entry is made in one worksheet, itcan be referenced by other worksheets in the same spreadsheet This is a prefer-able approach to using Excel for financial analysis, since one can separate the databeing analyzed in one worksheet, ratios in another, and graphics in yet anotherworksheet – but with formulas linking all of them together In the examples used

in the first few sections of this chapter, nearly all of the analysis is done on onespreadsheet that contains a half-dozen worksheets

*This chapter is reprinted with permission from Chapter 14 of Financial Analysis, by

Steven M Bragg (John Wiley & Sons, 2000).