9.2. Presenting a P&L Template
NOTE
Profit performance reports prepared for a business's managers typically are called P&L (profit and loss) reports. These reports are prepared as frequently as managers need them, usually monthly or quarterly — perhaps even weekly in some businesses. An internal P&L report goes to the manager in charge of each profit center; these confidential profit reports do not circulate outside the business.
External financial statements comply with well-established rules and conventions. In contrast, the format and content of internal accounting reports to managers is a wide-open field. If you could sneak a peek at the internal P&L reports of several businesses, I think you would be surprised at the diversity among the businesses. All businesses include sales revenue and expenses in their internal P&L reports. Beyond this broad comment, it's very difficult to generalize about the specific format and level of detail included in P&L reports, particularly regarding how operating expenses are disclosed.
Businesses that sell products deduct the cost of goods sold expense from sales revenue, and then report gross margin (also called gross profit) — both in their externally reported income statements and in their internal P&L reports to managers. However, internal P&L reports have a lot more detail about sources of sales and the components of cost of goods sold expense. In this chapter, I use the example of a business that sells products, so the P&L report that I introduce in the next section follows this pattern. Businesses that sell products manufactured by other businesses generally fall into one of two types: retailers that sell products to final consumers, and wholesalers (distributors) that sell to retailers. The following discussion applies to both retailers and wholesalers, and also lays the foundation for manufacturing businesses, which I discuss in Chapter 11.
From the gross margin on down in an internal P&L statement, reporting practices vary from company to company. One question looms large: How should the operating expenses of a profit center be presented in its P&L report? There's no authoritative answer to this question. Different businesses report their operating expenses differently in their internal P&L statements. One basic choice for reporting operating expenses is between the object of expenditure basis and the cost behavior basis.
9.2.1. Reporting operating expenses on the object of expenditure basis
One way to present operating expenses in a profit center's P&L report is to list them according to the object of expenditure basis. This means that expenses are classified according to what is purchased (the object of the expenditure) — such as salaries and wages, commissions paid to salespersons, rent, depreciation, shipping costs, real estate taxes, advertising, insurance, utilities, office supplies, telephone costs, and so on. To do this, the operating expenses of the business have to be recorded in such a way that these costs can be traced to each of its various profit centers. For example, employee salaries of persons working in a particular profit center are recorded as belonging to that profit center.
NOTE
The object of expenditure basis for reporting operating costs to managers of profit centers is practical and convenient. And this information is useful for management control because, generally speaking, controlling costs focuses on the particular items being bought by the business. For example, a profit center manager analyzes wages and salary expense to decide whether additional or fewer personnel are needed relative to current and forecast sales levels. A manager can examine the fire insurance expense relative to the types of assets being insured and their risks of fire losses. For cost control purposes the object of expenditure basis works well. But, there is a downside. This method for reporting operating costs to profit center managers obscures the all-important factor in making profit: margin. Managers absolutely need to know margin, as I explain in the following sections.
9.2.2. Reporting operating expenses on their cost behavior basis
NOTE
Margin is the residual amount after all variable expenses of making sales are deducted from sales revenue. The first and usually largest variable expense of making sales is the cost of goods sold expense (for companies that sell products). But most businesses also have other variable expenses that depend either on the volume of sales (quantities sold) or the dollar amount of sales (sales revenue). In addition to variable operating expenses of making sales, almost all businesses have fixed expenses that are not sensitive to sales activity — at least not in the short run. Margin equals profit after all variable costs are deducted from sales revenue but before fixed costs are deducted from sales revenue.
Figure 9-1 presents a P&L report for a profit center example that classifies operating expenses according to how they behave relative to sales activity. The detailed expenses under each major heading are not presented in the P&L report itself; instead, this information is presented in supporting schedules that supplement the main page of the P&L report.
This two-level approach provides a hierarchy of information. The most important and critical information is included in the main P&L report, in summary form. As time permits, the manager can drill down to the more detailed information in the supporting schedules for each variable and fixed expense in the main P&L report. The supplementary information for each variable and fixed expense is presented according to the object of expenditure basis. For example, depreciation on the profit center's fixed assets is one of several items listed in the direct fixed expenses category. The amount of commissions paid to salespersons is listed in the revenue-driven expenses category.
The example shown in Figure 9-1 is an annual P&L report. As I mention earlier, profit reports are prepared as frequently as needed by managers, monthly in most cases. Interim P&L reports may be abbreviated versions of the annual report. But at least once a year, and preferably more often, the manager should see the complete picture of all expenses of the profit center. Keep in mind that this example is for just one slice of the total business, which has other profit centers each with its own profit (P&L) report.
Figure 9.1. A P&L report template for a profit center.
NOTE
The P&L report shown in Figure 9-1 includes sales volume, which is the total number of units of product sold during the period. Of course, the accounting system of a business has to be designed to accumulate sales volume information for the P&L report of each profit center. Generally speaking, keeping track of sales volume for products is not a problem, unless the business sells a huge variety of different products. When a business cannot come up with a meaningful measure of sales volume, it still can classify its operating costs between variable and fixed, although it loses the ability to use per-unit values in analyzing profit and has to rely on other techniques.
9.2.3. Separating variable and fixed expenses
For a manager to analyze a business's profit behavior thoroughly, she needs to know which expenses are variable and which are fixed — in other words, which expenses change according to the level of sales activity in a given period, and which don't. The title of each expense account often gives a pretty good clue. For example, the cost of goods sold expense is variable because it depends on the number of units of product sold, and sales commissions are variable expenses. On the other hand, real estate property taxes and fire and liability insurance premiums are fixed for a period of time.
Managers should always have a good feel for how their operating expenses behave relative to sales activity. But to be honest, separating variable and fixed operating expenses is not quite as simple as it may appear at first glance. One problem that rears its ugly head is that some expenses, which are recorded on an object of expenditure basis, have both a fixed cost component and a variable cost component. A classic example was the "telephone and telegraph" expense (as it was called in the old days). Businesses had to pay a fixed charge per month for local calls, but long-distance charges depended on how many calls were made and to where. Of course, modern communication networks using cell phones and the Internet are quite different. In any case, the accountant should separate between the fixed and variable cost components of expenses for reporting to managers.
9.2.3.1. Variable expenses
Virtually every business has variable expenses, which move up and down in tight proportion with changes in sales volume or sales revenue, like soldiers obeying orders barked out by their drill sergeant. Here are examples of common variable expenses:
The cost of goods sold expense, which is the cost of products sold to customers
Commissions paid to salespeople based on their sales
Franchise fees based on total sales for the period, which are paid to the franchisor
Transportation costs of delivering products to customers via FedEx, UPS, and freight haulers (railroads and trucking companies)
Fees that a retailer pays when a customer uses a credit or debit card
Cost of goods sold is usually the largest variable expense of a business that sells products, as you would suspect. Other variable expenses are referred to as operating expenses, which are the costs of making sales and running the business. The sizes of variable operating expenses, relative to sales revenue, vary from industry to industry. Delivery costs of Wal-Mart and Costco, for instance, are minimal because their customers take the products they buy with them. (Wal-Mart and Costco employees generally don't even help carry purchases to their customers' vehicles.) Other businesses deliver products to their customers' doorsteps, so that expense is obviously much higher (and dependent on which delivery service the company uses — FedEx or UPS versus the U.S. Postal Service, for example).
9.2.3.2. Fixed expenses
Fixed operating expenses include many different costs that a business is obligated to pay and cannot decrease over the short run without major surgery on the human resources and physical facilities of the business.
As an example of fixed expenses, consider the typical self-service car wash business — you know, the kind where you drive in, put some coins in a box, and use the water spray to clean your car. Almost all the operating costs of this business are fixed; rent on the land, depreciation of the structure and the equipment, and the annual insurance premium don't depend on the number of cars passing through the car wash. The main variable expenses are the water and the soap, and perhaps the cost of electricity.
Fixed expenses are the costs of doing business that, for all practical purposes, are stuck at a certain amount over the short term. Fixed expenses do not react to changes in the sales level. Here are some more examples of fixed operating expenses:
Gas and electricity costs to heat, cool, and light the premises
Employees' salaries and benefits
Real estate property taxes
Annual audit fee (if the business has its financial statements audited)
General liability and officers' and directors' insurance premiums
If you want to decrease fixed expenses significantly, you need to downsize the business (lay off workers, sell off property, and so on). When looking at the various ways for improving profit, significantly cutting down on fixed expenses is generally the last-resort option. Refer to the section "Know your options for improving profit" later in the chapter. A business should be careful not to overreact to a temporary downturn in sales by making drastic reductions in its fixed costs, which it may regret later if sales pick up again.
9.2.4. Stopping at operating earnings
In Figure 9-1, the P&L report terminates at the operating earnings line; it does not include interest expense or income tax expense. Interest expense and income tax expense are business-wide types of expenses, which are the responsibility of the financial executive(s) of the business. Generally, interest and income tax expenses are not assigned to profit centers, unless a profit center is a rather large and autonomous organizational division of the business that has responsibility for its own assets, finances, and income tax.
NOTE
The measure of profit before interest and income tax is commonly called operating earnings or operating profit. It also goes by the name earnings before interest and tax, or EBIT. It is not called net income, because this term is reserved for the final bottom-line profit number of a business, after all expenses (including interest and income tax) are deducted from sales revenue.
9.2.5. Focusing on margin — the catalyst of profit
Figure 9-1 includes a very important line of information: margin — both margin per unit and total margin. Margin is your operating profit before fixed expenses are deducted. Don't confuse this number with gross margin, which is profit after the cost of goods sold expense is subtracted from sales revenue but before any other expenses are deducted. (Please refer to the sidebar "Different uses of the term margin.")
With the information in Figure 9-1 in hand, you can dig into the reasons that margin per unit increased from $22.66 in fiscal year 2008 to $25.00 in fiscal year 2009. Two favorable changes occurred: The sales price per unit increased, and the product cost decreased — no small achievement, to be sure! However, the gain in the gross profit per unit was offset by unfavorable changes in both variable operating expenses. The profit center manager must keep on top of these changes.
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