Prevala Corporation recently suffered from its fourth straight decline in quarterly earnings—despite modest increases in sales. Unfortunately, Prevala’s industry is highly competitive, so the company is reluctant to increase its prices. However, management believes that profits would improve if the efforts of its sales force were redirected toward the more profitable products in its offerings.
Several years ago Prevala decided that its core competencies were strategy, design, and marketing and that production should be outsourced. Consequently, Prevala subcontracts all of its production. Prevala’s salespersons are paid salaries and commissions. All of the company’s salespersons sell the company’s full line of products. The commissions are 6% of the revenue generated by a salesperson and average about 70% of a salesperson’s total compensation. There has been some discussion of increasing the size of the sales force, but management prefers for the present to redirect the efforts of salespersons towards the more profitable products. While management is reluctant to tinker with the sales compensation scheme, revenue targets for the various products will be set for the regional sales managers based on the products that management wants to push most aggressively. The regional sales managers will be paid a bonus if the sales targets are met.
The company computes product margins for all of its products using the following formula:
Selling price
Less: Sales commissions
Less: Cost of sales
Less: Operating expenses
= Product margin
The cost of sales in the product margin formula is the amount Prevala pays to its production subcontractors. The operating expenses represent fixed costs. Each product is charged a fair share of those costs, calculated this year as 37.2% of the product’s selling price.
Management is convinced that the best way to improve overall profits is to redirect the efforts of the company’s salespersons. There are no plans to add or drop any products.
Required:
How would you measure the relative profitability of the company’s products in this situation? Assume that it is not feasible to change the way salespersons are compensated. Also assume that the only data you have available are the selling price, the sales commissions, the cost of sales, the operating expenses, and the product margin for each product.