INTRODUCTION

Monica, after completing an internship with a national apparel company, decided that she wanted to exercise her creative design talents and her strong entrepreneurial spirit by starting her own fashion design business. She conducted fundamental market research, as she had learned in college, and determined that there was an unfulfilled market need for her designs in the moderately priced fashion handbags at the $100 retail price point. She also learned that the independent womens apparel stores she was targeting require a 50% retail margin, which retailers variously refer to as a 100% markup, or keystoning, to cover their own display and selling costs. Monica approached a number of independent local stores that liked her handbag design prototypes and her retail price point and would consider carrying her handbag line, but she was told consistently that area retailers purchased such moderately-priced fashion designer products through a particular apparel distributor. She, in turn, met with the well-established distributor, showed her designs, and discussed his operations. The regional distributor was interested in representing her line to his independent retailers, but indicated that he required a 20% wholesale margin, that is, a 20% discount off the price to the retailers. Monica realized that to be successful in her new business she would have to manage her costs and contribution margins carefully and negotiate the distribution channels and retailer relationships wisely.

Monicas Contribution Margins

Monica learned during her retail management course in college and her internship with a national retailer that she would have to generate sufficient contribution margins on her products to recover her fixed sales, general, and administrative costs of doing business, her overhead. Monica had obtained an authoritative Harvard Business School (1983) reference from her father Bill who had earned his MBA at Harvard a generation ago. In addition to this Note on Marketing Arithmetic and Related Marketing Terms, she used her college managerial accounting text (Whitecotton, Libby, and Phillips, 2013), as a more recent, second source. She determined that the contribution margin on each unit of product sold can be established by setting a reasonable price to the distributor and subtracting all variable, or direct, costs to provide each unit. Monica realized that the retail handbag market had pre-determined price points to the end consumer, e.g., $100. Her price to the distributor would be the retail price net of both the retailers and distributors margins, which motivated these partners to handle her product through their channel. Her price to the distributor had to be at least sufficient to cover the products variable costs, including direct manufacturing and shipping costs, and thus produce a positive contribution to overhead.

Determination of Monicas Price to the Distributor

So, Monica sat with her tablet at her drafting board and did the necessary financial analysis.

She assumed that her $100 retail price point to the end consumer was realistic, given the confirmations she received from several independent retailers and the regional distributor. Monica also assumed that the independent retailers would require a 50% margin, and thus would markup the distributors price to them by 100%. So, her concern was what price she should set for the distributor. She calculated the retail unit price, the retailers unit margin, the distributors price to the retailers, the distributors unit margin, and an acceptable price to the distributor. She drew out on her drafting board the transaction prices and margins in a diagram, showing the relationships between all the parties in this channel.

Variable, or Direct, Unit Costs

Monica had negotiated for the production of her designer handbags with a contract manufacturer, based in Vietnam, that she had come to know through her internship. She had also arranged monthly LTL (less than truckload) shipments of each seasons new handbags directly from the factory to the distributor who, in turn, ensured that retailers shelves were stocked with Monicas designs. At the volumes she projected each season, the manufacturing costs averaged $10 per handbag. Her shipping costs, at current volumes, averaged $5 per handbag. She extended her diagram to show these two direct costs and the relationship of the manufacturer and the shipper in the transaction flow. Monica could now determine her contribution margin per handbag.

Fixed Sales, General, and Administrative Costs

Monica had hired one salaried marketing person to assist her with all sales and promotions activities, including maintaining the website, entering order transactions, and running reports on a basic enterprise system. She had also retained an advertising agency, an attorney, an accountant, and a banker to facilitate all of her other general and administrative matters as needed. She rented a small office space near her residence for her design work, system and marketing operations, and business meetings. Monica estimated the total of all these fixed overhead expenses at $25,000 per month. She felt that these were all necessary business expenses and that she could grow her volume substantially with this support base in place.

Breakeven Volume and Market Share

Monica next determined the minimum volume of handbags that she would have to sell in order to cover her overhead expenses, which her seasoned accountant referred to as her nut. She divided her monthly overhead expense by the contribution margin per handbag, which she had calculated earlier, to determine her breakeven volume in units. She next extended this breakeven volume by her wholesale price to determine her breakeven sales volume, measured in dollars.

However, Monica also wanted some confirmation about the reasonableness of her breakeven volume expectations, and therefore sought to estimate what share of the retail market she would have to achieve in order to breakeven. Her earlier research found that the total U. S. retail market for moderately priced (that is, about $100 at retail) fashion handbags was $120,000,000 per year. Based on her findings, she calculated the total number of such bags sold at retail in the U. S. in an average month. Monica then divided her monthly breakeven volume by one-twelfth of the total annual U. S. retail market, to determine her minimum market share to breakeven.

Profit Impact

Monica, however, would not be satisfied by achieving only a financial breakeven for her enterprise. She had not taken a salary from the business so far and had invested her own capital to get the business started. She reasoned that her time was worth money and the alternative of returning to her previous employer would involve the advantages of a stable healthy income and benefits, and considerably less risk. Monica wanted her business to generate a sustainable profit, so that she could reinvest in growing her enterprise and take a steady income. She set an ambitious, initial goal of earning a profit of $50,000 per month and sought to determine what volume she would need to sell in order to reach that bottom line target. If selling the breakeven number of units per month covered the $25,000 monthly overhead expense, Monica considered how many handbags she would have to sell to generate a $50,000 monthly profit impact, beyond the breakeven.

Trade Discounts and Terms of Sales

Monica had negotiated with the distributor for a 2% discount for payment at end of month, with net amount due in 90 days. The distributor generally did not take the offered discount, but rather paid at the end of each season, as was typical in the seasonal apparel trade.

Profit Margin

Monica was soon able to achieve her goal of an average profit impact of $50,000 per month on sales to the distributor of $1,440,000 per year. She also was interested to know what the average profit margin, expressed as a percentage, of her expanded business might be, for comparison purposes.

A Grand New Opportunity

Monica next set an ambitious goal to grow her business into a $2 million company in annual sales to distributors. Soon, her sales assistant approached her while she was seated at her drafting board with some good news! A buyer for Grand*Mart, a very large regional discount retail chain, who had seen Monicas handbag designs on her website, e-mailed an invitation to propose a contract. The Grand*Mart buyer, however, was specific about several conditions for Monicas proposal. Monica was excited about this prospective new customer, which in addition to her independent retailer business would help achieve her new total sales goal.

Sales and Profit Impact of the New Deal

Grand*Mart would initially receive 2,000 handbags per month for three months of seasonal designs similar to Monicas most popular handbags and stock them in 20 test stores outside Monicas traditional territory, handling all of the transportation from the overseas factory and all of the distribution to their stores in the U. S. Grand*Mart indicated that they would pay within 90 days, as the handbags sold through their stores. They also would substantially increase their order to a minimum of 10,000 handbags per month during the second quarter, based on the success of the initial trial, and would consider carrying an exclusive line of Monica handbags in Grand*Marts entire chain, including all 100 stores. They proposed that a wholesale price of $20 per handbag would be acceptable to them under the terms and conditions, beginning with the first quarter. Grand*Mart extended an invitation to Monica to call on their Mobile, Alabama headquarters during the next week and to propose her best and final offer to their buyers.

Monica realized that this one initial deal would achieve larger scale and her set goal of becoming a $2 million revenue business! However, she was concerned that Grand*Marts suggested wholesale price was low relative to the wholesale price she received in the independent retailer channel. Monica calculated that the proposed price would cover her present direct manufacturing cost and eliminate her direct shipping costs. However, she estimated that she would have to double her existing $25,000 per month overhead expenses just to meet the initial required level of customer service that Grand*Mart specified for first quarter store advertising, customer support, and returns handling. She drew out Grand*Marts suggested transactions and relationships between parties in another diagram. Again, she sought to determine the unit contribution margin and the profit impact that the initial 2,000 bag per month deal, as proposed, would bring to pay the incremental overhead and drop to her bottom line each month.

Monica, who was an optimist at heart, also was tempted by the prospective Grand*Mart order increase for the second quarter, if the initial trial quarter was successful. She envisioned the advantages of selling 10,000 handbags per month exclusively to Grand*Mart. She estimated that her overhead expenses, attributable to Grand*Mart, would grow substantially to $75,000, or three times the amount required for the initial 2,000 handbag deal. But she also wondered if she could then achieve the same profit impact just from exclusively supplying Grand*Mart, while dropping the independent retailer channel.

A Time for Serious Reflection

Monica looked at the existing and new diagrams and realized that she had some key decisions to make. She needed to decide if a) She should propose the initial 2,000 bag per month Grand*Mart deal, on the terms that they suggested, including their wholesale price; b) She should take a pass on the Grand*Mart deal, and stay exclusively with the independent retailers channel in which she has had success; c) She should go to Mobile and renegotiate the initial 2,000 bag per month deal, offering a best and final price that could be acceptable to both parties; or d) She should propose the exclusive deal to Grand*Mart, based on a successful trial and a minimum order volume of 10,000 handbags per month, beginning in the second quarter. And, importantly, she wondered what other financial and non-financial considerations (such as, cannibalization, or even loss, of her independent retailer channel by the exclusive Grand*Mart deal) she should contemplate before getting on a flight to Alabama.

Monicas Further Research on Grand*Mart

Monica promptly went to three local Grand*Mart stores, thoroughly inspected the handbag sections, and recorded the prices of similar merchandise on the shelves. She also sent e-mail inquiries to several of her industry colleagues who knew the discount chain and the discount fashion trade well. From her field research, she garnered that Grand*Mart probably would price her handbags at $45 each, and that they would require at least a 33-1/3% contribution margin on their retail price (which also could be expressed as a 50% markup on their wholesale costs). With this intelligence, Monica was able to estimate the maximum wholesale price, after incurred costs, that Grand*Mart might be willing to pay for each handbag. With both her minimum breakeven price and their maximum wholesale price in mind, Monica was in a better position to make a decision about her best and final price offer alternatives. She could also estimate the incremental profit impact of her possible deals with Grand*Mart.

QUESTIONS FOR STUDENTS TO ANSWER

1. What are Monicas other key financial and non-financial considerations (such as, cannibalization of the independent retailer channel) for the suggested Grand*Mart deal?
2. Should Monica propose the Grand*Mart deal as suggested? Or should she take a pass and stay exclusively with the independent retailer channel? Or should she renegotiate the initial 2,000 bag deal for the first quarter? Should she offer Grand*Mart an exclusive 10,000 deal for the second quarter?
3. What is the maximum wholesale price that Grand*Mart could be willing to pay Monica, given their probable retail price and typical margin requirements? If Monica decides to renegotiate the initial Grand*Mart deal as of the first quarter with volumes of 2,000 bags per month and incremental overhead of $25,000 per month, what best and final price should she propose that would be acceptable to both parties? What is the revised incremental profit impact?
4. If Monica decides to offer Grand*Mart an exclusive deal as of the second quarter at minimum volumes of 10,000 bags per month with overhead expenses of $75,000 per month, what best and final price should she propose that would be acceptable to both parties? What is the profit impact of this exclusive deal?