Question

Through the use of turnover rates, explain why a firm might seek to increase the volume of its sales even though such an increase can be secured only at reduced prices. Please explain

Answer 1

Solution:-

One of the key objectives of a CEO of any company is to ensure that the value generated by the company's products and services in the market are maximized. While the maximization of value depends not just on the internal company factors but external factors as well such as competitive scenarios, macro conditions, etc., it nonetheless holds true that every company must try to maximise the value it generates in the market given the prevailing conditions. One way to find out if the company is generating adequate value is to look at the efficiency with which it is utilizing its assets.

Let's look at turnover ratios to understand how they show the effiiciencies with which assets are being used and why the company may want to increase the volume of its sales even if is achieved at reduced prices. Turnover ratios helps analyzing the efficiency with which company's assets are being utilized. Let's say that a company has total assets of $100 million and fixed assets of $50 million. Further, it has a turnover of $200 million, with 2 million units sold annually at $100 per unit. In such a scenario, the total assets turnover ratio and fixed assets turnover ratios are as follows:

Total assets turnover ratio= Sales/Total assets= $200m/$100m= 2 times

Fixed assets turnover ratio= Sales/Total assets= $200m/$50m= 4 times

This shows that the company is generating a turnover of 2 times its total assets and 4 times its fixed assets.

Now, let's say the company can increase its volumes to 3 million units if its price per unit is slashed to $90 per unit. In such a case, its turnover will be $270 million (i.e. 3m*$90). In such a scenario, the total assets turnover ratio and fixed assets turnover ratios are as follows:

Total assets turnover ratio= Sales/Total assets= $270m/$100m= 2.7 times

Fixed assets turnover ratio= Sales/Total assets= $270m/$50m= 5.4 times

As can be seen, now the company is able to utilize its assets in a more productive way, generating turnover of 2.7 times its total assets and 5.4 times its fixed assets.

Therefore, in the above scenario, the company might want to increase the volume of its sales even if it is achieved through reduction in prices. Ofcourse, the company will also take a look at profitability along with the above analysis to ensure that the wealth of shareholders is maximized through their decision.