How rapidly can expanding sales reduce a firm's earnings?

By Investopedia Staff AAA
A:

In order to operate and make money, a company must spend money. Revenue - the dollar amount of sales - can be seen on a company's income statement. From there, various expenses are deducted such as cost of goods sold and marketing. But it is the earnings figure, or net income, that reveals what the company retains from all its sales. The incongruity arises from the steps a company takes to go from sales to earnings. If sales are rapidly rising but earnings are falling, it means costs are growing faster than earnings.

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As can be seen above, sales have risen 100%, but in order to generate these sales, the company raised its marketing efforts by 200% for a 243% increase in COGS. These higher costs outweigh the increased sales, which lead to a 9% decrease in earnings. Here are some possible reasons why an increase in revenue can hurt earnings:

  • Operating Expenses - This is a company's overhead, or the cost of doing business. As a company attempts to boost sales, it may have to pay more employees, lease more office space or buy new equipment to increase production. Unless a company raises its productivity, it may, by increasing sales, simply become bloated. This will lower its margins, which leads to lower earnings.
  • Marketing Costs - Advertising, free trials, discounts and other promotional material can all be used to increase sales. While these tactics are often effective, they cost money, ultimately affecting the bottom line.
  • Lower Prices - When a company lowers the price of its product, it can stimulate greater sales. While the price is lower, the amount sold may greatly increase, which lifts revenue. However, if costs are not going down, the company's margins will be smaller, leading to lower earnings.

It is important to recognize the distinction between sales revenue and earnings: while earnings may rise, so could expenses. Ideally, revenues and earnings should be moving in the same direction. Decreasing revenues and increasing earnings mean greater profit margins. Higher revenues and lower earnings means that income is being eroded by expenses.

It should be noted, however, that increased revenue amid lowered earnings is not uncommon. In maturing industries, companies must fight for their market share. This can mean price wars, huge marketing campaigns and other promotions that hurt margins. Many companies allow lowered earnings because taking a loss is necessary to expand customer base, which eventually helps to recoup losses.

(To learn more, see Understanding The Income Statement.)

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