Author: Carlos Hugo Barbery Alpire
In this article, the author presents a methodology for accurately projecting sales budgets. Specifically, the methodology presents a series of five equations that can be used to determine the income forecast necessary for the sustainability of current profit margins, which the author calls the IFSPM Method. Examples are provided to demonstrate the methodology’s applicability in both project and service-driven businesses. Carlos Hugo Barbery Alpire is an Economist DAEN and an instructor in price management and business management. He can be reached at hugo.barbery@gmail.com.
The Journal of Professional Pricing, December 2019
What is the best method for projecting your sales budget? In business management, this is a priority discussion. The market currently offers a range of software solutions to structure a scientific argumentation which allow executives to provide a very scientific and solid approach to the board or the C-Suite.
But is it really enough to scientifically estimate sales growth? The answer is no. No, because what really matters in management is whether the company is, within the scenario of its market and environment, managing to improve or at least maintain the profit margin that ensures its sustainability as an ultimate goal. To quote Milton Friedman: “The real social responsibility of companies is to be profitable because that is the only way to guarantee jobs.”
So, the default question is: How much does it take to increase revenue to at least maintain the company’s profit margin? Even more so in the current scenario of Bolivia, where there are many costs to attend that, due to government regulations, are unavoidable (the clearest example being annual salary increases).
To address these and similar scenarios, we present in this article a precise methodology for answering the question posed and for determining how much of the projected sales budget will be needed to maintain the profit margin as well as how much (if any) will really constitute effective growth.
This methodology consists of a sequential system of equations completed in five steps, which we refer to as the method to determine the income forecast for the sustainability of the profit margin (IFSPM Method).
The first step in the IFSPM Method is to identify the different costs of the current period and their estimated incidence in the following period. This exercise will result in the need for additional income for the following period to cover the incidence of each of the identified costs, which is expressed in the following manner:
It means that the requirement for additional income for the following period (dI_{1}) as a consequence of the impact that cost x will have in the following period (dx_{1}) is given by the quotient between the monetary value of cost x in the current period and the monetary value of the total gross income for the current period (x_{0}/I_{0}) adjusted by the impact that cost x will have in the following period (dx_{1}).
The second step, as in the company there are a number of cost items (let’s call them x, y … “n”), is to determine the total requirement for additional income for the following period as a consequence of the incidence on all cost items, expressed as follows:
The third step is to adjust this total requirement for additional revenue for the following period (dTI_{1}) by considering all taxes and fees actually paid in the current period (t_{0}), expressed as follows:
This determines the additional total income requirement for the following period, adjusted by the payment of taxes and fees (dTI_{1}t_{0}), that minimally maintains the profit margin of the previous period.
However, this profit margin is only expressed in nominal terms, meaning that it is not adjusted by an approximation to the inflation forecast for the following period (i_{1}), thus expressing an equivalent profit margin in real terms (i.e. adjusted by an approximation to inflation for the same purchasing power).
For this purpose, the fourth step is established, which is expressed in the following manner:
In this way, an increase in total income for the following period equivalent to dTI_{1}t_{0}i_{1} ensures that the profit margin is maintained in real terms in relation to the previous period.
What if that requires a larger advertising and marketing budget? Then you must consider this budget increase as one more variable in the system of equations from the first step and generate the calculation again.
To summarize, this dTI_{1}t_{0}i_{1} indicator reflecting the IFSPM Method can be achieved through:
- A price increase (dp).
- An increase in sales volume (dq).
- Or a combination of both (dp*dq).
Where:
a = % which will go as a price increase (dp).
b = % which will go as an increase in sales volume (dq).
Then the fifth and last step is finally defined, which is expressed as follows:
In order to demonstrate in a practical application of the IFSPM Method, here is a hypothetical example.
Data from the example:
Current period.
- A company sells a product X at the rate of 1,000 units per year at a price of $10.00 – each.
- The incidence of the effective payment of taxes and fees in relation to your gross income is 8%.
- It has in its cost structure, three concepts: Labor Costs per $4.00 – annual, Raw Material Costs per $3.50 – annual and Other General Costs per $1.00 – annual.
Next period. – Estimates:
- Labor costs will increase by 12% due to the likely wage adjustment determined by the government in both the basic wage and the national minimum wage.
- Raw material costs will increase by only 1% due to the effect of the devaluation of neighboring countries.
- Other general costs increase by 10%.
- According to the projections of the monetary authority the inflation would be around 2%.
With that information, calculate:
- The profit margin of the current period.
- The profit margin of the next period under the ceteris paribus condition for price and sales volume variables.
- Using the IFSPM Method, calculate the minimum additional revenue requirement to ensure that the company’s profit margin is maintained in real terms.
- Quantify the incremental level of sales, considering that due to the sensitivity of the market, the price could be adjusted by a maximum of 3%.
Answer to numbers 1 and 2:
Sales in Q | 1,000 | 1,000 |
Price in $ | 10 | 10 |
Gross Revenue | 10,000 | 10,000 |
Tax | 800 | 800 |
Net Income | 9,200 | 9,200 |
Labor Costs | 4,000 | 4,480 |
Raw Material | 3,500 | 3,535 |
Other Costs | 1,000 | 1,100 |
Absolute Margin | 700 | 85 |
Relative Margin | 7.00% | 0.85% |
Based on the information provided for the current period it is concluded that the company obtains an absolute profit margin of $700.00, and considering the estimates for the following period and the condition of ceteris paribus for the sales price and the sales volume, the absolute profit margin would be $85.00.
Answer to number 3:
To this end, each of the data of both the current period and the following period will be represented in the nomenclature of the system of equations proposed in the IFSPM Method, which is as follows:
Total income from the previous period: I_{0} = 10,000
Labor costs: x_{0} = 4,000
Raw material costs: y_{0} = 3,500
Other general costs: n_{0} = 1,000
Variation in labor costs: dx_{1} = 12%
Variation in raw material costs: dy_{1} = 1%
Variation in other general costs: dn_{1} = 10%
Taxes and fees: t_{0} = 8%
Inflation: i_{1} = 2%
Then the first step of the methodology would be:
dI_{1}dx_{1} = (4,000/10,000)*12% = 4.8%.
dI_{1}dy_{1} = (3,500/10,000)*1% = 0.35%
dI_{1}dn_{1} = (1,000/10,000)*10% = 1%.
The second step of the methodology would be given by:
dTI_{1} = Σ(dI_{1}dx_{1}+ dI_{1}dy_{1}+ dI_{1}dn_{1}) = 4.8% + 0.35% + 1% = 6.15%.
The third step of the methodology, additional revenue requirement adjusted for taxes and fees, would be expressed as:
dTI_{1}t_{0} = 6.15% + {6.15% * [8%/(100%-8%)]} = 6.6847%.
The fourth step of the methodology, additional revenue requirement adjusted for taxes and fees and adjusted for approximation to inflation, would be equivalent to:
dTI_{1}t_{0}i_{1} = 6.6847% * {100% + [2%*(100%-8%)]} = 6.8301%.
This means that by obtaining additional total revenues in the order of 6.8301% in relation to the previous period, the profit margin of the previous year is maintained in real terms; that is, considering an approximation to the inflation forecast for the following period, which will maintain the purchasing power of said margin.
Answer to number 4:
According to the data in the example, due to the market sensitivity, the price can only be adjusted by 3%, so the sales volume requirement needed to obtain incremental revenues of 6.8301% must be determined, which would be calculated as follows:
The fifth step of the methodology would be, solving for b in:
6.8301% = [(100%+3%)*(1+b)]-100%
We find that:
b = 3.719%
If all the methodology is consistent, then with the calculations made and considering the assumptions of the variation in the costs of the example for the following period, it means that: increasing the price by 3% and the volume of sales by 3.719% obtains the level of income that will allow the profit margin to be maintained in real terms (that is, adjusted for an approximation to inflation, considering that the profit margin of the previous year was $700.00 and that the estimated inflation for the following period is 2%, the result would have to be a profit margin of approximately $714.00).
As shown below:
Sales | 1,000.00 | 1,037.19 | 3.719% |
Price | 10.00 | 10.30 | 3.000% |
Gross Revenue | 10,000.00 | 10,683.06 | 6.831% |
Tax | 800.00 | 854.64 | |
Net Income | 9,200.00 | 9,828.41 | |
Labor Costs | 4,000.00 | 4,480.00 | 12.000% |
Raw Material | 3,500.00 | 3,535.00 | 1.000% |
Other Costs | 1,000.00 | 1,100.00 | 10.000% |
Absolute Margin | 700.00 | 713.41 | 1.916% |
Relative Margin | 7.00% | 6.68% |
Up to this point, the example has considered only one product and the methodology has been consistent. However, the question of this methodology’s applicability will arise because, in practice, companies have a range of products or services at different sales prices and with different sales volumes depending on the life cycle of the product or service. In this case, the methodology is applicable from the first to the fourth step, and prior to the fifth step it is necessary to use analytical optimization tools and analyze the composition of the company’s product portfolio and its expected particularities for a subsequent period.
To demonstrate this, the data from the previous example will be used through the fourth step where it was determined that with 6.8301% of incremental income for the following period, the profit margin is maintained in real terms. But now, the analysis will be broadened by formulating a portfolio of four products that reach a weighted price of $10.00 and a total sales volume for the current period of 1,000 units, as explained below:
Current Period | |||
Product | P | Q | Income |
A | 19.99 | 60 | 1,199 |
B | 9.88 | 360 | 3,557 |
C | 24.99 | 45 | 1,125 |
D | 7.70 | 535 | 4,120 |
10.00 | 1,000 | 10,000 |
Now for the next period, consider the following assumptions:
- Because products C and D are under a regulatory regime, it is not possible for them to have an increase in their prices. At the same time, because they are products that have a high presence of substitute products, it is expected that product C will have a fall in sales volume of -2% and product D will have a fall in sales volume of -1%.
- Products A and B, after market research, were determined to have opportunity to increase their prices by 2% and 3% respectively.
Under these conditions, the optimal sales volume of products A and B must be determined in order to achieve an increase in revenues of 6.3801% which will allow the profit margin to be maintained in real terms.
To do this, we use the help of Microsoft Excel 2013 Solver to achieve the objective, which presents the simulation as follows:
- Target: 6.8301% of incremental revenue
- Variables to be sensitized: sales volume of products A and B
Subject to the following restrictions:
- Quantity of Product A for the following period must be ≥ 60 units and have a share in income from the portfolio ≥ 11.99%, i.e. at least the current period.
- Quantity of Product B for the following period must be ≥ 360 units and have a share in income of the portfolio ≥ 35.57%, at least the current period.
When running the simulation with these conditions, it is determined that, to obtain our objective, an increase of the sales volume of product A by 5.06% and an increase of the sales volume of product B by 15.13% is required. Therefore, it is the level of additional sales for products A and B that the investor must demand as minimum objective to his work team.
This simulation is shown in the following images:
As a final result, the variation of the weighted average price (a) was 1.623% and the variation of the total sales volume (b) was 5.124%.
Once these values are obtained, we can move on to the fifth step of the methodology to check its application. When these values are placed in the formula, the resulting expression is:
6.8301% = [(1+a)*(1+b)]-1
6.8301% = [(100%+1.623%)*(100%+5.124%)]-100%
6.8301% = 6.8301%
As this equation demonstrates, the methodology proposed in this academic proposal is applicable and can be validated with information from any type of company, whether product or service-driven.
It is important to clarify some concepts:
- Reference to sales prices refers to effective sales prices; that is, free of all discounts and excluding list sales prices.
- On the other hand, “sales volumes” refers to effective sales volumes (i.e., free of all types of returns, promotions, free samples, etc.) and not to sales volumes from inventory records.
- We emphasize that when the profit margin is analyzed in real terms, it only protects the purchasing power of the investor’s profit, but it does not contribute resources to future investment needs, which if needed (and under the scenario analyzed) would only be possible through additional contributions of the investor’s capital or through greater indebtedness.
The main contribution of this methodology is being able to calculate and determine minimum goals in terms of sales volumes, price adjustments or a combination of both, for a portfolio of products or services that allow the investor to have clarity regarding the effort required to (at least) maintain profit margin levels of in real terms (considering an approximation to the foreseen inflation).
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(*) This publication in its original Spanish version can be found in Bulletin # 25 of April 2016 of the National Academy of Sciences of Bolivia, in Santa Cruz. Copyright before the National Intellectual Property Service of Bolivia, Administrative Resolution # 1-506 / 2017. IFSPM corresponds to its acronym in Spanish.
(**) MSc. DAEN. Member of the Council of Researchers in the area of Economic Development of the National Academy of Sciences of Bolivia, in Santa Cruz. He is currently Planning and Prices Manager at ROHO Homecenter.