Chapter 9
Accounting in Managing Profit
In This Chapter
Facing up to the profit-making function of business managers
Scoping the field of managerial accounting
Centering on profit centers
Making internal P&L reports useful
Analyzing profit for fun and more profit
As a manager, you get paid to make profit happen. That’s what separates you from the employees at your business. Of course, you should be a motivator, innovator, consensus builder, lobbyist, and maybe sometimes a babysitter, but the hard-core purpose of your job is to make and improve profit. No matter how much your staff loves you (or do they love those doughnuts you bring in every Monday?), if you don’t meet your profit goals, you’re facing the unemployment line.
Competition in most industries is fierce, and you can never take profit performance for granted. Changes take place all the time — changes initiated by the business and changes from outside forces. Maybe a new superstore down the street is causing your profit to fall off, and you figure that you’ll have a huge sale to draw customers, complete with splashy ads on TV and Dimbo the Clown in the store. Whoa, not so fast. First make sure that you can afford to cut prices and spend money on advertising and still turn a profit. Maybe price cuts and Dimbo’s balloon creations would keep your cash register singing, but making sales does not guarantee that you make a profit. Profit is a two-sided challenge: Profit comes from making sales and controlling expenses.
This chapter focuses on the fundamental factors that drive profit — the levers of profit. Business managers need a sure-handed grip on these profit handles. One of the purposes of accounting is to provide this critical information to the managers. Externally reported income statements don’t provide all the information that business managers need for sustainable profit performance. Managers need to thoroughly understand their external income statements and also need to look deeper into the bowels of the business.
Helping Managers: The Fourth Vital Task of Accounting
As previous chapters explain, accounting serves critical functions in a business.
A business needs a dependable recordkeeping and bookkeeping system for operating in a smooth and efficient manner. Strong internal accounting controls are needed to minimize errors and fraud.
A business must comply with a myriad tax laws, and it depends on its chief accountant (controller) to make sure that all its tax returns are prepared on time and correctly.
A business prepares financial statements that should conform with established accounting and financial reporting standards, which are reported on a regular basis to its creditors and external shareowners.
Accounting should help managers in their decision-making, control, and planning. This branch of accounting is generally called managerial or management accounting.
This is the first of three chapters devoted to managerial accounting. In this chapter, I pay particular attention to reporting profit to managers and providing the essential information needed for plotting profit strategy and controlling profit performance. I also explain how managers can use accounting information in analyzing how they make profit and why profit changes from one period to the next. Chapter 10 concentrates on financial planning and budgeting, and Chapter 11 examines the methods and problems of determining product costs (generally called cost accounting).
Designing and monitoring the accounting recordkeeping system, complying with complex federal and state tax laws, and preparing external financial reports put heavy demands on the time and attention of the accounting department of a business. Even so, managers’ special needs for additional accounting information should not be given second-level priority or done by default. The chief accountant (controller) has the responsibility of ensuring that the accounting information needs of managers are served with maximum usefulness. Managers should demand this information from their accountants.
Following the organizational structure
In a small business there often is only one manager in charge of profit. As businesses get larger two or more managers have profit responsibility. The first rule of managerial accounting is to follow the organizational structure: to report relevant information for which each manager is responsible. (This principle is logically referred to as responsibility accounting.) If a manager is in charge of a product line, for instance, the controller reports the sales and expenses for that product line to the manager in charge.
Two types of organizational business units are of primary interest to managerial accountants:
Profit centers: These are separate, identifiable sources of sales revenue and expenses so that a measure of profit can be determined for each. A profit center can be a particular product or a product line, a particular location or territory in which a wide range of products are sold, or a channel of distribution. Rarely is the entire business managed as one conglomerate profit center, with no differentiation of its various sources of sales and profit.
Cost centers: Some departments and other organizational units do not generate sales, but they have costs that can be identified to their operations. Examples are the accounting department, the headquarters staff of a business, the legal department, and the security department. The managers responsible for these organizational units need accounting reports that keep them informed about the costs of running their departments. The managers should keep their costs under control, of course, and they need informative accounting reports to do this.
Note: The term center is simply a convenient word to include a variety of types of organizational sub-groups, such as centers, departments, divisions, territories, and other monikers.
Centering on profit centers
In this chapter, I concentrate on accounting for managers of profit centers. I don’t mean to shun cost centers, but, frankly, the type of accounting information needed by the managers of cost centers is relatively straightforward. They need a lot of detailed information, including comparisons with last period and with the budgeted targets for the current period. And, I don’t mean to suggest that the design of cost center reports is a trivial matter. Sorting out significant cost variances and highlighting these cost problems for management attention is very important. But the spotlight of this chapter is on profit analysis techniques using accounting information for managers with profit responsibility.
Note: I should mention that large businesses commonly create relatively autonomous units within the organization that, in addition to having responsibility for their profit and cost centers, also have broad authority and control over investing in assets and raising capital for their assets. These organization units are called, quite logically, investment centers. Basically, an investment center is a mini business within the larger conglomerate. Discussing investment centers is beyond the scope of this chapter.
From a one-person sole proprietorship to a mammoth business organization like General Electric or IBM, one of the most important tasks of managerial accounting is to identify each source of profit within the business and to accumulate the sales revenue and the expenses for each of these sources of profit. Can you imagine an auto dealership, for example, not separating revenue and expenses between its new car sales and its service department? For that matter an auto dealer may earn more profit from its financing operations (originating loans) than from selling new and used cars.
Even small businesses may have a relatively large number of different sources of profit. In contrast, even a relatively large business may have just a few mainstream sources of profit. There are no sweeping rules for classifying sales revenue and costs for the purpose of segregating sources of profit — in other words, for defining the profit centers of a business. Every business has to sort this out on its own. The controller (chief accountant) can advise top management regarding how to organize the business into profit centers. But the main job of the controller is to identify the profit centers that have been (or should be) established by management and to make sure that the managers of these profit centers get the accounting information they need. Of course managers should know how to use the information.
Internal Profit Reporting
External financial statements, including the profit report (income statement) comply with well-established rules and conventions, which I discuss in Chapter 2. 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 financial 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 (profit and loss) 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 reported.
Designing internal profit (P&L) reports
Profit performance reports prepared for a business’s managers typically are called a P&L (profit and loss). These reports should be prepared as frequently as managers need them, usually monthly or quarterly — perhaps even weekly or daily in some businesses. A P&L report is prepared for the manager in charge of each profit center; these confidential profit reports do not circulate outside the business. The P&L contains sensitive information that competitors would love to get hold of.
Accountants are not in the habit of preparing brief, summary-level profit reports. Accountants tend to err on the side of providing too much detailed data and information. Their mantra is to give managers more information, even if the information is not asked for. My attitude is just the reverse. I’m sure it’s not news to you that managers are very busy people, and they don’t have spare time to waste, whether in reading long rambling e-mails or on multi-page profit reports with too much detail. My preference is that profit reports should be compact for a quick-read. If a manager wants more back-up detail they can request it as time permits. Ideally, the accountant should prepare a profit main page that would fit one computer screen, although this may be a smidgeon too small as a practical matter. In any case, keep it brief.
Businesses that sell products deduct the cost of goods sold expense from sales revenue, and then report gross margin (alternatively 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. 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. Also, this chapter lays the foundation for companies that manufacture products, which I discuss in Chapter 11.
One thing I have learned over the years is that there’s a need for short-to-the-point, or quick-and-dirty profit models that managers can use for decision-making analysis and plotting profit strategy. By short, I mean on one page or even smaller than one full page. Like on one computer monitor screen, for instance, with which the manager can interact and test the critical factors that drive profit. For example: If sales price were decreased 5 percent to gain 10 percent more sales volume, what would happen to profit? Managers of profit centers need a tool to quickly answer such questions. Later in the chapter I introduce just such a profit analysis template for managers (see “Presenting a Profit Analysis Template”).
Reporting operating expenses
Below the gross margin line in an internal P&L statement, reporting practices vary from company to company. There is no standard pattern. 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.
Reporting operating expenses on object of expenditure basis
By far the most common 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.
The object of expenditure basis for reporting operating costs to managers of profit centers is practical. 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.
Separating operating expenses further on their behavior basis
The first and usually largest variable expense of making sales is the cost of goods sold expense (for companies that sell products). In addition to cost of goods sold, an obvious variable expense, businesses also have other expenses that depend either on the volume of sales (quantities sold) or the dollar amount of sales (sales revenue). And virtually all businesses have fixed expenses that are not sensitive to sales activity — at least, not in the short run. Therefore, it makes sense to take operating expenses classified according to object of expenditure and further classify each expense into either variable or fixed. There would be a variable or fixed tag on each expense.
The principal advantage of separating operating expenses between variable and fixed is that margin can be reported. Margin is the residual amount after all variable expenses of making sales are deducted from sales revenue. In other words, margin equals profit after all variable costs are deducted from sales revenue but before fixed costs are deducted from sales revenue. Margin is compared with total fixed costs for the period. This head-to-head comparison of margin against fixed costs is critical. I come back to this important point in the next section.
Although it’s hard to know for sure — because internal profit reporting practices of businesses are not publicized or generally available — my experience is that the large majority of companies do not attempt to classify operating expenses as variable or fixed. If you gave me a dollar for every company you found that classifies its operating expenses on the object of expenditure basis and I gave you a dollar for every business that further separates between variable and fixed behavior, I guarantee you that I would end up with many more dollars than you. Yet, for making profit decisions managers absolutely need to know the variable versus fixed nature of their operating expenses.
Presenting a Profit Analysis Template
Figure 9-1 presents a profit analysis template for a profit center example. After arguing for the separation of fixed and variable expenses, you shouldn’t be surprised to see in Figure 9-1 that I divide operating expenses according to how they behave relative to sales activity. There are just four lines for expenses — cost of goods sold (a variable expense), two variable operating expenses, and fixed operating expenses. No further details for sales revenue and expenses are included in this profit model, in order to keep the template as brief (and therefore, as useful) as possible.
Figure 9-1: Profit analysis template for a profit center.
Conceivably, such a template such as shown in Figure 9-1 could be the first, top-level page for the formal P&L reports to managers. The following pages would have more detailed information for each line in the profit template. The additional information for each variable and fixed expense would be presented according to the object of expenditure basis. For example, depreciation on the profit center’s fixed assets would be one of many items listed in the fixed expenses category. The amount of commissions paid to salespersons would be listed in the revenue-driven expenses category.
The example shown in Figure 9-1 is for one year. 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. 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 profile.
The profit template 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 possible, 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.
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.
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 (but not always) 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).
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.
Stopping at operating earnings
In Figure 9-1, the profit template 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.
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 and should not be 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.
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 2012 to $25.00 in fiscal year 2013. 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.
As a manager, your attention should be riveted on margin per unit, and you should understand the reasons for changes in this key profit driver from period to period. A small change in unit margin can have a big impact on operating earnings. (See “Don’t underestimate the impact of small changes in sales price” later in the chapter.)
Answering Critical Profit Questions
Suppose you are the manager of a profit center, and you have just received your P&L report for the latest year. The first, or top, page of the report is the same as Figure 9-1. There are many more pages to your annual P&L with a lot more details about sales and expenses, but we concentrate on the first page here. So, refer to Figure 9-1 as we go along. You should immediately ask yourself two questions:
How did I make $1.5 million profit (operating earnings before interest and income tax) in 2013?
Why did my profit increase $215,650 over last year ($1,500,000 in 2013 – $1,284,350 in 2012 = $215,650 profit increase)?
How did you make profit?
Actually, you can answer this profit question three ways (see Figure 9-1 for data):
Answer # 1: You earned total margin that is more than fixed expenses.
You earned $25 profit margin per unit and sold 100,000 units; therefore:
$25 unit margin × 100,000 units sales volume = $2,500,000 margin
Your profit center is charged with $1 million fixed expenses for the year; therefore:
$2,500,000 margin – $1,000,000 fixed operating expenses = $1,500,000 operating profit
Answer # 2: Your sales volume exceeded your break-even point.
Your break-even point is the sales volume at which total margin exactly equals total fixed expenses. Your break-even point for 2013 was:
$1,000,000 total fixed expenses for year ÷ $25 margin per unit = 40,000 units sales volume break-even point
Your actual sales volume for the year was 100,000 units, or 60,000 units in excess of your break-even point. Each unit sold in excess of break-even generated $25 “pure” profit because the first 40,000 units sold covered your fixed expenses. Therefore:
60,000 units sold in excess of break-even × $25 margin per unit = $1,500,000 operating profit
Answer # 3: Your high sales volume diluted fixed expenses per unit to below your margin per unit.
The average fixed expenses per unit sold for the year is:
$1,000,000 total fixed expenses ÷ 100,000 units sold = $10 fixed expenses per unit sold
Your margin per unit was $25; so operating earnings per unit were $15 ($25 margin per unit – $10 fixed expenses per unit = $15 operating earnings per unit). Therefore:
$15 operating earnings per unit × 100,000 units sales volume = $1,500,000 operating earnings
Each answer is valid. In certain situations, one method of analysis is more useful than another. If you were thinking of making a large increase in fixed operating expenses, for example, you should pay attention to the effect on your break-even point; answer #2 is useful in this situation. If you were thinking of changing sales prices, answer #1, which focuses on margin per unit, is very relevant. (See the later section “Using the Profit Template for Decision-Making Analysis.”) Likewise, if you’re dealing with changes in product cost or variable operating expenses that affect unit margin, answer #1 is very helpful.
Answer #3 is useful to focus on the full cost of a product. In the example, the sales price is $100 per unit (refer to Figure 9-1). The total of variable costs per unit is $75 (which includes product cost and the two variable operating costs per unit). The average fixed cost per unit sold is $10, which added to the $75 variable cost per unit gives $85 full cost per unit. Subtracting the full cost per unit from the $100 sales price gives the $15 profit per unit (before interest and income tax expenses are considered).
How did you increase profit?
In your profit center report (refer to Figure 9-1), note that your total fixed expenses increased from $925,000 last year to $1 million in 2013, a $75,000 increase. Of course, you should investigate the reasons for your fixed expense increases. These fixed costs are your responsibility as manager of the profit center. You definitely should know which of these costs were higher than last year, and the reasons for the increases.
In any case, you were able to increase margin more than enough to cover the fixed costs increases and to boost profit. In fact, your margin increased $290,650 over last year ($2,500,000 margin in 2013 – $2,209,350 margin in 2012 = $290,650 margin increase). How did you do this?
This question can be answered more than one way. In my view, the most practical method is to calculate the effect of changes in sales volume and the margin per unit. Being the superb manager that you are, to say nothing of your marketing genius, your profit center increased sales volume over last year. Furthermore, you were able to increase margin per unit, which is even more impressive. The profit impact of each change is determined as follows (refer to Figure 9-1 for data):
Sales volume change impact on profit:
$25 margin per unit × 2,500 units sales volume increase = $62,500 increase in margin
Margin per unit change impact on profit:
$2.34 increase in margin per unit × 97,500 units sales volume last year = $228,150 increase in margin
Even if your sales volume had stayed the same, the $2.34 increase in your margin per unit (from $22.66 to $25) would have increased margin $228,150. And by selling 2,500 more units than last year, you increased margin $62,500. Quite clearly, the major factor was the significant increase in your margin per unit. You were able to increase this key profit driver by more than 10 percent (10.3 percent to be precise). However, you may not be able to repeat this performance in the coming year; you may have to increase sales volume to boost profit next year.
Taking a Closer Look at the Lines in the Profit Template
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 profit template. Flip back to Figure 9-1 as I do so.
Sales volume
Sales volume, the first line in the profit template, 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 fraction of the total sales revenue. For instance, McGuckin Hardware, a general hardware store in Boulder, carries more than 100,000 products according to its advertising. 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.
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 layer of schedules to the main page of the P&L report.)
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).
Variable operating expenses
In the profit analysis template (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 2013 (versus only 8.0 percent in 2012).
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. Only the dominant type of variable operating expense would be presented in the profit analysis template; the one expense would absorb the other type — which is good enough for government work, as they say.
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 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 and rent 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 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, if any, are included in fixed operating expenses in Figure 9-1.
Using the Profit Template for Decision-Making Analysis
The profit template (refer to Figure 9-1) is very useful for decision-making analysis. To demonstrate, suppose that you’re under intense competitive pressure to lower the sales price of one product you sell. This product is one “slice” of the total activity reported in Figure 9-1. Suppose that during the year (2013) you sold 1,000 units of the product at a $100 sales price, and the unit costs of this product are the same as in Figure 9-1.
Your competitors are undercutting your sales price, so you’re thinking of cutting the sales price 10 percent next year, or $10 per unit. You predict that the price reduction will boost sales volume 25 percent and increase your market share. Seems like a good idea — or does it? You should run some numbers before making a final decision, just to be sure. Answer #1 in the earlier section How did you make profit? is the best method for this analysis. For the year just ended, this product generated $25,000 margin:
$25 margin per unit × 1,000 units sold = $25,000.00 margin
Assuming your prediction about sales volume at the lower price is correct and sales volume increases to 1,250 units, and assuming that the variable costs for the product remain the same, next year you would earn $19,812.50 margin:
$15.85 margin per unit × 1,250 units sold = $19,812.50 margin
Cutting the sales price $10 reduces the margin per unit $9.15. (The revenue-driven operating expense would drop $.85 per unit with the $10.00 sales price decrease.) Therefore, the new margin per unit would be $15.85 per unit. That’s a 37 percent drop in margin per unit. A 25 percent gain in sales volume cannot make up for the 37 percent plunge in margin per unit. You’d need a much larger sales volume increase just to keep margin the same as in 2013, and even more sales to increase margin next year. You’d better think twice about dropping the sales price.
You may gain a larger market share, but your margin would drop from $25,000.00 to $19,812.50 on this product if you go ahead with the sales price cut. Is the larger market share worth this much sacrifice of margin? That’s why you get paid the big bucks: to make decisions like this. As your controller I can only help you do the analysis and calculate the impact on profit before you make a final decision.
Another factor to consider is this: Fixed expenses (people, warehouse space, distribution channels, and so on) provide the capacity to make sales and carry on operations. A small increase in sales volume, such as selling 250 more units of the product in question, should not push up the total fixed expenses of your profit center (unless you are already bursting at the seams). On the other hand, a major sales volume increase across the board would require additional capacity, and your fixed expenses would have to be increased.
This sales price reduction decision is just one example of the many decisions business managers have to deal with day in and day out. The profit analysis template is a useful — indeed an invaluable — analysis framework for many decisions facing business managers.
Tucking Away Some Valuable Lessons
The profit analysis template shown in Figure 9-1 offers managers several important lessons. Like most tools, the more you use it the more you learn. In the following sections I summarize some important lessons from the template.
Recognize the leverage effect caused by fixed operating expenses
Suppose sales volume had been 10 percent higher or lower in 2013, holding other profit factors the same. Would profit have been correspondingly 10 percent higher or lower? The intuitive, knee-jerk reaction answer is yes, profit would have been 10 percent higher or lower. Wouldn’t it? Not necessarily. Margin would have been 10 percent higher or lower — $250,000 higher or lower ($25 margin per unit × 10,000 units = $250,000).
The $250,000 change in margin would carry down to operating earnings unless fixed expenses would have been higher or lower at the different sales volume. The very nature of fixed expenses is that these costs do not change with relatively small changes in sales volume. In all likelihood, fixed expenses would have been virtually the same at a 10 percent higher or lower sales level.
Therefore, operating earnings would have been $250,000 higher or lower. On the base profit of $1.5 million, the $250,000 swing equals a 17 percent shift in profit. Thus, a 10 percent swing in sales volume causes a 17 percent swing in profit. This wider swing in profit is called the operating leverage effect. The idea is that a business makes better use of its fixed expenses when sales go up; its fixed expenses don’t increase with the sales volume increase. Of course, the downside is that fixed expenses don’t decrease when sales volume drops.
Don’t underestimate the impact of small changes in sales price
Recall that in the example the sales price is $100, and revenue-driven variable expenses are 8.5 percent of sales revenue (refer to Figure 9-1). Suppose the business had sold the product for $4 more or less than it did, which is only a 4 percent change — pretty small it would seem. This different sales price would have changed its margin per unit $3.66 net of the corresponding change in the revenue-driven variable expenses per unit. ($4 sales price change × 8.5 percent = $.34 per unit, which netted against the $4 sales price change = $3.66 change in margin per unit.)
Therefore, the business would have earned total margin $366,000 higher or lower than it did at the $100 sales price. ($3.66 change in margin per unit × 100,000 units sales volume = $366,000 shift in margin.) Fixed expenses are not sensitive to sales price changes and would have been the same, so the $366,000 shift in margin would carry down to profit.
The $366,000 swing in profit, compared with the $1.5 million baseline profit in the example, equals a 24 percent swing in profit. A 4 percent change in sales price causes a 24 percent change in profit. Recall that a 10 percent change in sales volume causes just a 17 percent change in profit. When it comes to profit impact, sales price changes dominate sales volume changes.
The moral of the story is to protect margin per unit above all else. Every dollar of margin per unit that’s lost — due to decreased sales prices, increased product cost, or increases in other variable costs — has a tremendously negative impact on profit. Conversely, if you can increase the margin per unit without hurting sales volume, you reap very large profit benefits.
Know your options for improving profit
Improving profit boils down to three critical factors, listed in order from the most effective to the least effective:
Increasing margin per unit
Increasing sales volume
Reducing fixed expenses
Say you want to improve your profit from the $1.5 million you earned in 2013 to $1.8 million next year, which is a $300,000 or 20 percent increase. Okay, so how are you going to increase profit $300,000? Here are your basic options:
Increase your margin per unit $3, which would raise total margin $300,000 based on the 100,000 units sales volume.
Sell 12,000 additional units at the present margin per unit of $25, which would raise your total margin by $300,000. (12,000 additional units × $25 = $300,000 additional margin.)
Use a combination of these two strategies: Increase both the margin per unit and sales volume such that the combined effect is to improve total margin $300,000.
Reduce fixed expenses $300,000.
The last alternative may not be very realistic. Reducing your direct fixed expenses $300,000, on a base of $1,000,000, would be drastic and probably would reduce your capacity to make sales and carry out the operations in your part of the business. Perhaps you could do a little belt-tightening in your fixed expenses area, but in all likelihood you would have to turn to the other alternatives for increasing your profit.
The second approach is obvious — you just need to set a sales goal of increasing the number of products sold by 12,000 units. (How you motivate your already overworked sales staff to accomplish that sales volume goal is up to you.) But how do you go about the first approach, increasing the margin per unit by $3?
The simplest way to increase margin per unit by $3 would be to decrease your product cost per unit $3. Or you could attempt to reduce sales commissions from $8.50 per $100 of sales to $5.50 per $100 — which may hurt the motivation of your sales force, of course. Or you could raise the sales price about $3.38 (remember that 8.5 percent comes off the top for sales commission, so only $3 would remain to improve the unit margin). Or you could combine two or more such changes so that your unit margin next year would increase $3.
Closing with a Boozy Example
Some years ago, several people I knew pooled their capital and opened a liquor store in a rapidly growing area. In their estimation, the business had a lot of promise. If they had asked me for advice, I would have told them one thing to do during their planning stage — in addition to location analysis and competition analysis, of course. I would have recommended that they run some critical numbers through a basic profit model like Figure 9-1 in order to estimate the annual sales revenue they would need to break even. Of course, they want to do better than break even, but the break-even sales level is a key point of reference.
Starting up any business involves making commitments to a lot of fixed expenses. Leases are signed, equipment is purchased, people are hired, and so on. All this puts a heavy fixed cost burden on a new business. The business needs to make sales and generate margin from the sales that is enough to cover its fixed expenses before it can break into the profit column. So, the first step I would have suggested is that they estimate their fixed expenses for the first year. Next, they should have estimated their profit margin on sales. Here there is a slight problem, but one that is not difficult to deal with.
During their open house for the new store, I noticed the large number of different beers, wines, and spirits available for sale — to say nothing of the different sizes and types of containers many products come in. Quite literally, the business sells thousands of distinct products. The store also sells many products like soft drinks, ice, corkscrews, and so on. Therefore, the business does not have an easy-to-define sales volume factor (the number of units sold) for analyzing profit. The business example I discuss in this chapter uses a sales volume factor, which is the number of units sold during the period. In the liquor store example, this won’t work. So, a modification is made. Total sales revenue is used for the measure of sales volume, not the number of units (bottles) sold.
The next step, then, is to determine the average margin as a percent of sales revenue. I’d estimate that a liquor store’s average gross margin (sales revenue less cost of goods sold) is about 25 percent. The other variable operating expenses of the liquor store probably run about 5 percent of sales. (I could be off on this estimate, of course.) So, the average margin would be 20 percent of sales (25 percent gross margin less 5 percent variable operating expenses). Suppose the total fixed operating expenses of the liquor store were $100,000 per month (for rent, salaries, electricity, and so on), which is $1.2 million per year. So, the store needs $6 million in annual sales to break even:
$1,200,000 annual fixed expenses ÷ 20% average margin = $6,000,000 annual sales revenue to break even
Selling $6 million of product a year means moving a lot of booze. The business needs to sell another $1 million to provide $200,000 of operating earnings (at the 20 percent average margin) — to pay interest expense and income tax and leave enough net income for the owners who invested capital in the business and who expect a decent return on their investment.
I’m not privy to the financial statements of the liquor store. It appears that they have been quite successful. Business seems to be booming, even without my advice. Perhaps they did exactly the sort of profit model analysis that I would have recommended.