Session 7 - Value Proposition and Margins

Natureview Farms
• Grew at a CAGR (Compound Annual Growth Rate) 62%
⁃ From $100,000 to $13 million
• Their target market was higher income, higher educated, health conscious, green, young
consumers
• Customer Value Proposition:
⁃ The longer shelf life of Nature View’s yogurt products allowed the retailer, wholesaler,
and distributer to have more time in the distribution chain to have their product ‘en
route’.
⁃ Nature view’s product has a shelf life of 50 days―competitors only have a 30 day shelf
life.
⁃ This adds value on many levels; including, reducing the necessity to have multiple
manufacturing plants located throughout the country (as their competitors do)―instead,
Nature View can ship longer distances without losing the realized shelf life at retail.
⁃ Another value proposition of the elongated shelf life, at the customer level, is the
reliability of their product.
⁃ To that end, the ability to exceed customer expectations through the use of quality, all
natural ingredients leads to a constant, desirable, and predictable taste and texture.
⁃ Because of these attributes the firm can sell its product at a high price premium―with
lower price sensitivity.
⁃ The higher price premium will go to the asset utilization―i.e. not advertising and price
promotion expenses.
• Channel Strategy:
⁃ Nature View used sales brokers to sell their yogurt to both natural foods stores and
supermarket chains.
⁃ Often these brokers represented several brands of consumer products―and used their
relationships to broker discussions amongst many different retail chains, wholesalers,
and distributors.
⁃ The typical fee for these services was 4% of manufacturer’s sales.
• The combination of margins and price premiums gives Natureview Farms an advantage
• In addition to a revenue growth strategy, a firm must also address an improved cost
structure and increased asset utilization when deciding whether or not enter the supermarket
channel.
⁃ To investors quick growth may mean there are some future operations collapses
⁃ They need to see the asset base to support it, as well as their margins and markups
⁃ Investor says go from $13 million to $20 million in 2 years
• The firm would have to consider the growth rates of the current market structure
⁃ Supermarkets are 97% of the business, and continue to grow at 3%
⁃ Health Food Stores are 3%, NVF is 24%, and only expected to grow at 20%
⁃ Each objective is critical to maximize shareholder value
• Margins (% outbound sales) vs. Markups (% inbound costs)
⁃ Use margins to see what Natureview Farms is actually making
▪ (P - VC) = $CM; (P - VC)/P = %CM
▪ Retailer margin 35%.
▪ From that, since they sell it at $0.88, multiply the .88 by 1-.35, which gives you
$0.57.
✓ This $0.57 is the distributor selling price.
▪ Since their margin is 9%, you would multiply the $0.57 by (1-.09) which gives you
$0.52.
 ✓ The $0.52 is the wholesaler price.
▪ Since the wholesaler margin is 7%, you would multiply the 0.52 by (1-.07),
resulting in $0.48.
✓ The $0.48 is the manufacturer’s selling price.
▪ The case gives us the manufacturing costs of $0.31.
▪ The difference in the two is $0.17 (.48-.31).
▪ To find the margin, take the $0.17 and divide it by the price
✓ REMEMBER TO NEVER USE COST IN A MARGIN CALCULATION
✓ Which is: .17/.48=35%
▪ The current contribution margin for an 8-oz cup is 0.17/0.48 = 35% for Nature
View.
▪ Total COGS is $8.19MM and 86%, or $7.043MM, of that is for the 8-oz cup
product.
▪ From that, we divide total COGS for 8-oz cups by the VC per cup, or $0.31, to get
total units sold, which is 22.72MM cups.
▪ Therefore, total sales for this product are $10.91MM = 22.72MM/$0.48.
▪ If Nature View were to drop its price by 15%, their new sales price is $0.48*0.85 =
$0.41.
▪ To maintain the same amount of sales dollars, we need to sell $10.91MM/$0.41 =
26.6MM cups.
✓ This is an additional 3.88MM cups, or an increase of approximately 17%.
▪ Gross Margins vs. Contribution Margins
✓ Gross Margins are not being used as much due to how little manufacturing is
going on
✓ Gross Margin= 0.48 – 0.31 (VC of DCGS)- 0.01 (Fixed DCGS)= $0.16
✓ CM= 0.48 – VC of DCGS – VC of transport – VC of retailing commission
⁃ Markups
▪ price elasticity/same price elasticity + 1
▪ this is the analysis that is one to find your optimal price
▪ 0.88- 0.57= 0.31
▪ 0.31/0.57= 54% Markup
⁃ Contribution Margin Per Unit Price
⁃ Right now, Nature View has $13MM in sales, which is 24% of the market.
⁃ This means that the total market is $13MM/0.24 = $54.17MM.
⁃ One percent of this market is $0.541MM = $541,000.
⁃ With a profit margin of 37%, the extra point of market share is worth 0.37*541k
= $200k.
⁃ Supermarket sells the cup for $0.74 at a 27% margin so they buy for (1-.27)*0.74
= $0.54.
⁃ The Distributor, who sells to the retailer for $0.54 at a 15% margin, buys at (1-.
15)*0.54 = $0.46.
⁃ So Nature Valley, the manufacturer, sells for $0.46. If the 4% brokerage fee is
applied per unit, the fee is $0.46*0.04 = $0.02.
⁃ This 2 cents is added to the 31 cents of VC and we have total VC of $0.33 and a
contribution margin of 0.46-0.33 = $0.13.
⁃ The margin is CM/price or $0.13/$0.46 = 28%.
⁃ Incremental Unit Sales: it is worth its contribution margin because you don’t keep all
the revenue from a sale

Break-Even Analysis
• Break Even: Q=Fixed Costs/CM
 • Break-Even Sales Change Analysis: tells you what unit sales increase must arise from a price cut
to leave operating profits (aka total contributions) unchanged.
• Break-even sales levels can be calculated in terms of both accounting profit and present value.
• Accounting profit break-even uses annual expenses as calculated using accounting rules.
• Present value break-even uses the equivalent annual cost of the initial investment.
• The equivalent annual cost is the amount we would have to pay for the initial investment if we
divided it up evenly over its lifetime taking into account the time value of money.

Example:
• BIKE Corporation is considering the introduction of a motor scooter.
• The staff has put together the following cash-flow forecasts (figures in millions of dollars).
• The initial cost of this project is $150 million. Assume a discount rate of 10%. Find the NPV.
• Assumptions used to obtain Cash Flows:
⁃ Size of the Scooter market: 1 million units
⁃ BIKE’s Market share: 10%
⁃ Unit Sales Price: $3,750
⁃ Unit Variable Cost: $3,000
⁃ Annual Fixed Costs: $30,000,000
• Calculation of Revenue:
⁃ Revenue = (Size of Scooter market)(BIKE’s Market share)(Unit Sales Price)
⁃ = (1,000,000)(0.10)($3,750)
⁃ = $375,000,000
Year 0 Years 1-10
Initial Investment $150
1. Revenue $375
2. Variable cost 300
3. Fixed cost 30
4. Depreciation (10-year straight 15
line)
5. Pretax profit (1 – 2 – 3 - 4) 30
6. Tax (50% tax rate) 15
7. Net Profit (5 - 6) 15
8. Operating cash flow (4 + 7) 30
Net cash flow -$150 +$30

Accounting Profit Break-Even

• After-tax profit per unit: (Unit Price – Variable Cost) (1 – Tc) = ($3750 - $3000) (1 - .5) =
$375
• This value is known as the contribution margin since it represents the additional amount that
each motor scooter contributes to after-tax profit.
• After-tax annual accounting costs: (Fixed costs + Depreciation) (1 – Tc) = (30 + 15) (1 - .5) =
$22.5 Million
• Accounting Break-even is the number of scooters that makes after-tax profits equal to after-tax
annual accounting costs.

Value Creation in the Strategy Map:

• A framework for linking intangible assets to shareholder value creation
⁃ Financial Value:
▪ Cost Structure: Lower Unit Costs + Increase Asset Utilization
 ▪ Revenue Model: Enhance Price Premiums + Boost Unit Sales
⁃ Customer Value Proposition:
▪ Attributes: Quality + Availability + Selection + Reliability + Functionality
▪ Relationships: Post-Sale Service + Partnership
▪ Image: Brand + Communications
⁃ Internal Process Value:
▪ Operations Management
▪ Customer Service
▪ Culture of Innovation
▪ Regulatory Initiatives

Formulas
• Total Revenue: TR = P x Q (P=price, Q= Quantity)
• Profit = TR-TC
• B.E is when TR-TC=0
• Total (operating) cost: TC= F + (VC x Q) (F= Fixed costs, VC = variable costs)
• Breakeven (units): TFC/ P – VC (also CM)
• Price Fixity = FC/TC
• Break even sales change analysis = (P0-MC)/Q0 < (P0 – MC)Q1
• Contribution Margin Percentage= CM/Whole price