9.4. Looking More Closely at the Profit Center P&L Report

As the previous sections should make clear, profit center managers depend heavily on the information in their P&L reports. They need to thoroughly understand these profit reports. Therefore, I want to spend some time walking through each element of the P&L report. Please flip back to Figure 9-1 as I do so.

9.4.1. Sales volume

Sales volume, the first line in the P&L report, is the total number of units sold during the period, net of any returns by customers. Sales volume should include only units that actually brought in revenue to the business. In general, businesses do a good job in keeping track of the sales volumes of their products (and services). These are closely monitored figures in, for example, the automobile and personal computer industries.

Now here's a nagging problem: Some businesses sell a huge variety of products. No single product or product line brings in more than a small fraction of the total sales revenue. For instance, McGuckin Hardware, a general hardware store in Boulder, carries more than 100,000 products. The business may keep count of customer traffic or the number of individual sales made over the year, but it probably does not track the quantities sold for each and every product it sells. I explore this issue later in the chapter — see the last section, "Closing with a Boozy Example," for more details.

9.4.2. Sales revenue

Sales revenue is the net amount of money received by the business from the sales of products during the period. Notice the word net here. The business in our example, like most, offers its customers many incentives to buy its products and to pay quickly for their purchases. The amount of sales revenue in Figure 9-1 is not simply the list prices of the products sold times the number of units sold. Rather, the sales revenue amount takes into account deductions for rebates, allowances, prompt payment discounts, and any other incentives offered to customers that reduce the amount of revenue received by the business. (The manager can ask that these revenue offsets be included in the supplementary backup layer of schedules to the main page of the P&L report.)

9.4.3. Cost of goods sold

Cost of goods sold is the cost of the products sold during the period. This expense should be net of discounts, rebates, and allowances the business receives from its vendors and suppliers. The cost of goods sold means different things for different types of businesses:

• To determine product costs, manufacturers add together three costs:

  • The costs of raw materials

  • Labor costs

  • Production overhead costs

  Accounting for the cost of manufactured products is a major function of cost accounting, which I discuss in Chapter 11.

• For retailers and distributors, product cost basically is purchase cost. However, refer to Chapter 7, where I explain the differences between the FIFO and LIFO methods for releasing inventory costs to the cost of goods sold expense. The profit center manager should have no doubts about which cost of goods sold expense accounting method is being used. For that matter, the manager should be aware of any other costs that are included in total product cost (such as inbound freight and handling costs in some cases).

9.4.4. Variable operating expenses

In Figure 9-1, variable operating expenses are divided into two types: revenue-driven expenses and volume-driven expenses.

Revenue-driven expenses are those that depend primarily on the dollar amount of sales revenue. This group of variable operating expenses includes commissions paid to salespersons based on the dollar amount of their sales, credit card fees paid by retailers, franchise fees based on sales revenue, and any other cost that depends directly on the amount of sales revenue. Notice in Figure 9-1 that these operating expenses are presented as a percent of sales price in the per-unit column; in the example these costs equal 8.5 percent, or $8.50 per $100 of sales revenue in 2009 (versus only 8.0 percent in 2008).

Volume-driven expenses are driven by and depend primarily on the number of units sold, or the total quantity of products sold during the period (as opposed to the dollar value of the sales). These expenses include delivery and transportation costs paid by the business, packaging costs, and any costs that depend primarily on the size and weight of the products sold.

Most businesses have both types of variable operating expenses. However, one or the other may be so minor that it would not be useful to report the cost as a separate item to managers. Only the dominant type of variable operating expense would be presented, and it would absorb the other type — which is good enough for government work, as they say.

9.4.5. Fixed operating expenses

Managers may view fixed operating expenses as an albatross around the neck of the business. In fact, these costs provide the infrastructure and support for making sales. The main characteristic of fixed operating costs is that they do not decline when sales during the period fall short of expectations. A business commits to many fixed operating costs for the coming period. For all practical purposes these costs cannot be decreased very much over the short run. Examples of fixed costs are wages of employees on fixed salaries (from managers to maintenance workers), real estate taxes, depreciation on the buildings and equipment used in making sales, and utility bills.

Certain fixed costs can be matched with a particular profit center. For example, a business may advertise a specific product, and the fixed cost of the advertisement can be matched against revenue from sales of that product. A major product line may have its own employees on fixed salaries or its own delivery trucks on which depreciation is recorded. A business may purchase specific liability insurance covering a particular product it sells. In Figure 9-1 these costs are reported as direct fixed expenses.

In contrast, you cannot directly couple company-wide fixed operating expenses to particular products, product lines, or other types of profit units in the organizational structure of a business. General administrative expenses (such as the CEO's annual salary and corporate legal expenses) are incurred on an entity-as-a-whole basis and cannot be connected directly with any particular profit center. A business may, therefore, allocate these fixed costs among its different profit centers. The fixed costs that are handed down from headquarters are shown as allocated fixed expenses in Figure 9-1.