Chapter 3: OUTPUT ANALYSIS

The purpose of any business is to gain profit by selling goods to customers. The main measures that
assess the volume of goods sold are sales (turnover) and value added.

3.1. Sales (turnover) analysis

Financial analysis must provide management with accurate information on sales in order to improve
company profit margins. Sales analysis allows knowing which products are selling and which are
not. As well, analysis can help designing a sales strategy by identifying the influence factors.

Sales or turnover (S) represent the total revenue generated by business over a period of time.
Turnover can be determined by multiplying the volume (quantity) of production sold (q) and the
selling price per unit of product (p):

S = ∑q ⋅p

The volume of production sold reflects both the influence of internal factors (production capacity,
selling network, promotion etc.) and external factors (demand, competition etc.). Also, the selling
prices comprise the influence of several factors, some internal (price policy, product quality, cost of
production) and some external (demand, competition, market trends, taxes etc.).

Usually, price is taken into consideration as an average sale price. Average sales price (or average
selling price) is the average price for which a good or service is sold to customers. It equals the total
revenue from a product’s sales divided by the total number of units sold in a given period of time.
Financial analysis usually deals with average prices, as managers charge customers different prices
for the same product. Price levels depend on regions, stores, customers, number of units purchased,
sales channels etc. so individual prices are difficult to use in analysis. Average sales price are used
to determine how the market is responding to different price levels, forecast future sales revenues or
determine the number of units needed to reach break-even.

According to Profit & Loss Account, turnover comprises three elements:

Turnover = Sales of goods purchased for resale + Sold production +

+ Subsidies related to turnover

Dynamics of turnover

Aims to identify the trends of business. If turnover grows, the company must search new financial
resources for business. If turnover drops, new markets have to be found or the range of goods has to
be changed.

Dynamics is reflected by the following indicators:

∆S
∆S = S1 − S0 ; ∆S% = × 100 ; ∆S% = IS − 100
∆S0

S1 – the current level of sales;

S0 – the reference level of sales.

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Structural analysis of turnover

Turnover structure can be analysed by several criteria: products, markets, customers etc. Structural
analysis requires calculating the weight of each element:
S
w i = i × 100
S
Si – sales for element i.

Structural analysis can be also made with the help of Gini-Struck coefficient:
n ∑ w i2 − 1
G =
n −1
n – number of products (elements).

The coefficient can range from 0 to 1. If approaches 0, it means that turnover is relatively evenly
distributed on the products. If it approaches 1, it means that a few products have a large share in
turnover.

Herfindhal index may be used for the same purpose:

H = ∑ w i2

Herfindhal index can range from 1/n to 1. The significance is similar to Gini-Struck coefficient.

Pareto chart (ABC method) is the fourth method used to analyse turnover structure.
Sales
100%

Zone
C
Zone
B
Zone
A
Cumulative no. of
products 100 %
Figure 3.1. Pareto Chart

Three areas can be seen in the figure above:

Zone A: 10-15% of number of products have 60-65% of turnover;

Zone B: 20-25% of number of products have 20-25% of turnover;

Zone C: 60-65% of number of products have 10-15% of turnover.

Zone A includes products with a fast turnover and usually a low profit margin. They might lead to
problems related to supply and management of inventory. The operational risk is high as the
offensive of a competitor may easily threaten the market share of the enterprise. Zone B contains
items with average turnover and margin. Zone C has products with a low turnover and a high
margin. The operational risk is lower as these products have a low share in total sales.

Considering the above, companies should choose for a certain diversification of production in order
to get a reduced risk.

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Structural analysis of turnover allows identifying the type of strategy adopted by the firm. The
company can choose to concentrate on a few products or on the contrary to diversify the production.

ABC method can also be used to analyse turnover by type of customers. The following zones result:
- Zone A – a small percentage of customers has a large share in turnover;
- Zone B – comprises average customers as weights in number and sales;
- Zone C – a high percentage of customers has a small share in turnover.

This analysis allows as well drawing some conclusions regarding the risk of the firm. Zone A has
the highest share in sales but as well the highest risk. If the company loses some of these customers,
the impact on sales is considerable. More, since the customers place large orders of products, the
company has to offer them discounts. This obviously affects its profitability.

Zone C has a large number of customers and therefore generates high operating costs. In these
circumstances we consider that zone B has an average degree both as safety and profitability and
the firm should pay attention to this zone.

Factorial analysis of sales

Turnover is under the influence of a large number of internal and external factors that can increase
or reduce its level. Factorial analysis aims to identify these factors, to establish the level and the
direction of their influence, and finally to set appropriate measures of intervention.

The relationship between sales and the utilization of human and material resources can be expressed
with the help of the following model:

P S
S = N ⋅ L ⋅ RS / P = N ⋅ ⋅
N P
N – average number of employees;
L – labour productivity;
RS/P – ratio of sales to production.

Labour productivity can be further divided into ratio of technical endowment of labour (EL) and
efficiency of fixed assets (E):
FA P
L = EL ⋅ E = ⋅
N FA
FA – fixed assets.

Chain substitution method can be used to calculate the influence of previous factors.

Sales analysis is important to management as it allows comparing the actual sales to company
objectives. It is a measurement process used by firms to evaluate sales effectiveness (what goods
and services have and have not sold well), compare sales force performance, evaluate sales by
product or location in order to consider improvements. The analysis is used to determine how to
stock inventory, how to set manufacturing capacity and to see how the company is performing
against its goals and competitors. Sales analysis is also important for finance department (to analyse
the company pricing strategy and its impact on sales) and manufacturing department (in order to
plan capacity). Through sales analysis, a business will keep up with emerging trends of the market.
When sales fluctuate, the company must adapt its strategy according to competitors’ strategy,
especially if they are selling performing better.

Sales analysis allows making:

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 - period comparisons: one time period to a comparable period in the past (e.g. month-over-
month sales);
- competitor comparisons: show how well a company competes against the rest.

Sales analysis means working with increases or decreases in sales but they have to be completed
with additional explanatory notes, especially if extraordinary events occur (introducing new
products, recession, price fluctuations etc.). The sales analysis needs therefore a context to be fully
understood.

Demographics are a key factor in making a sales strategy. Including demographics in sales analysis
helps a business draw a successful sales strategy. It is always useful to know which product is
selling at a particular time and where. In this respect, a business is able to identify which market
segment is growing and bringing in more revenues and which segment is declining. This
information is further used to forecast sales in every given market segment at a given time.

Sales must be analysed together with gross profits or losses. Businesses go bankrupt because
managers don’t do a good job analysing sales and company performance. When doing this, it is
important to know which the goals of the company are: increasing sales, increasing profit or
increasing rates of return. All these are references the firm must always looks at.

There are a number of ways to increase the sales volume: promotional events, giveaways, discounts
etc. Mathematically, the growth of turnover can be achieved by increasing the volume of production
or by increasing the selling price. The two factors are closely related. Most of the times, an increase
in sales prices entails a reduction in sales, while lower prices lead to increased sales. However, this
might also decrease the revenue. That’s why, when analysing sales, marginal revenue from price
and quantity must be also determined. Marginal revenue is the amount of revenue that is expected
to be received from additional sales volume. Marginal revenue is important for managers because
profit increases as long as marginal revenue exceeds marginal cost. Marginal revenue can be
calculated by multiplying the additional sales quantity by the average sales price. But, due to
diminishing marginal utility managers must reduce price in order to increase sales.

When analysing sales performance, one should consider the following:

• price changes (increases or decreases);
• competitors entering or existing on the market;
• new product or service launch;
• new product or service cannibalises existing product or service;
• customers moving between products or services;
• changes in customer demand (increasing or decreasing);
• the segments and distribution channels.

Sales analysis has the following benefits:

- allows managers to establish growth trends, by providing early warning signs;
- in the case of a range of products or services, analysis outlines which ones are causing the
growth or decline;
- analysing sales over several years enables to establish sales patterns. This will help
managers to create sales budgets;
- allows developing marketing plan each year. The marketing activities can be planned
accordingly to support the products or services that represent the greatest opportunity for
future profitable growth (especially if one product or service represents the majority of
sales);
- allows comparisons with the market and identifying strengths and weaknesses of company
relative to competition.

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3.2. Value added analysis

A business means performing an operating activity by which technology is combined with material
and labour inputs, and then processed inputs are assembled and sold on the market. A single firm
may perform only one stage in this process, or it may be vertically integrated, carrying out a large
range of operations.

Since various companies may produce and sell similar products, it’s important to know the
company’s contribution to total price. This contribution is reflected by value added.

Value added measures the value created by the operating activity of enterprises in a certain period
of time. For industrial companies, it corresponds to the difference between the value of the products
(sales) and the expenses for third parties (intermediate consumption or intermediate expenditure).
Intermediate consumption consists of the total value of goods and services consumed or used up as
inputs in production by enterprises (raw materials, services and various other operating expenses).

Value added is an important indicator as it reflects the contribution of the enterprise in the value of
goods sold. When a company sells a product or provides a service, it is not the creator of the whole
value of product or service. Companies must purchase raw materials and services produced by other
firms (comprised in intermediate consumption). They further perform a production or a resale by
adding own resources (manpower and productive capital). They create value because the value of
the goods is higher than the sum of the value of inputs: the difference between the selling price of
goods and the total value of raw materials and services purchased and included in these goods is
added value.

Expenditure on the purchase of goods and services represents intermediate consumption: these
goods and services are consumed during the production of a good and consequently are
intermediaries.

For goods that are not processed (merchandises), the value added is the difference in selling price
against purchasing price (also named trade margin).

Value added can be calculated using two formulas. The first formula is as follows:

Value Added = (Value of goods and services - Intermediate consumption) +

+ Trade margin

Trade margin = Sales of merchandises - Cost of merchandises.

Value added is the difference between the price of the finished product/service and the cost of the
inputs involved in making it. Added value is equivalent to the increase in value that a business
creates by undertaking the production process. A finished good has a value (price) that is more than
the cost of the sum of the parts. How much value has been added is determined by the price that a
customer pays.

Value added represents the part from the value of goods corresponding to each stage of production.
Value added has a higher portion in revenue for integrated companies (e.g. manufacturing
companies) and a lower portion for less integrated companies (such as retail companies).

In fact, value added is approximated by total labour expense (including wages, salaries and benefits)
plus "cash" operating profit (defined as operating profit plus depreciation expense or operating
profit before depreciation). The first component (total labour expense) is a return to labour and the

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second component (operating profit before depreciation) is a return to capital (fixed assets). The
value added is shared between factors of production and this sharing gives rise to issues of
distribution.

By taking into consideration the destination of value added, it comprises:

Value Added = Personnel expenses + Interest expenses + Taxes +

+ Depreciation cost + Net income.

According to the second formula, value added is the remuneration of the business stakeholders:
• Staff – personnel expenses (salaries, wages etc.)
• Creditors – interests
• State – taxes
• Equipments – depreciation cost
• Shareholders – net income.

Note that the two formulas won’t lead the same level of value added. The first formula is the correct
one, while the second is only used to analyse the distribution of value added among stakeholders.

In business, a unit value added can also be calculated, as a difference between the sale price and the
intermediate cost of a product.

Unit value added = Sale price – Unit intermediate cost

Total value added results by summing value added per unit over all units sold.

Dynamics of value added

Dynamics is reflected by the indicators:

∆VA
∆VA = VA1 − VA 0 ; ∆VA% = × 100 ; ∆VA% = I VA − 100
∆VA 0

VA0, VA1 – the reference and the current level of value added.

Structural analysis of added value

The weight of a product in total value added is:

VA i
wi = × 100
VA
VAi – value added for product i.

Structural analysis can also be done by considering the components according to the destination of
value added: personnel expenses, depreciation cost, taxes, interest expenses, net income.

Businesses can add value by:

 Building a brand – a reputation for quality that customers are prepared to pay for.
 Delivering excellent service – high quality, attentive personal service can make the
difference between achieving a high price or a medium one.
 Product features and benefits –additional functionality in different versions of products can
enable a manufacturer to charge higher prices.
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  Offering convenience – customers will often pay a little more for a product that they can
have straightaway, or which saves them time.

Finding ways to add value is an important activity for a business. It can make the difference
between survival and failure, between profit and loss.

The advantages to a business of adding value include:

Charging a higher price;

Differentiation from the competition;

Protecting from competitors charging lower prices;

Focusing a business more closely on its target market segment.

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