This post tackles two basic questions about “Analyzing Profit Behavior”: How did the business make its profit? How can the business improve its profit performance?. Business managers need a sure analytical grip on the fundamental factors that drive profit. And because profit is an accounting measure, we [as an accountant] should help the business’s managers understand and analyze profit performance. The trick is not to overload managers with so much detail.
Wait!, detail is necessary for management control; managers need to keep their eyes on a thousand and one details, any one of which can spin out of control and cause serious damage to profit performance. But too much detail is the enemy of profit analysis for planning and decision-making. Management control requires gobs of detailed information.
Management decision-making, in contrast, needs condensed and global information presented in a compact package that the manager can get his or her head around without getting sidetracked by too many details.
The profit analysis methods that will be discussed in this post are not rocket science things, and would be done on a small backside of any scrap papers. All you need for the number calculation is a basic hand-held calculator (could be a unit of basic calculator or phone-cell or PDA, etc.).
More elaborate and detail-rich profit analysis methods need to be done on computers, of course. But before they delve into technical profit analysis, managers should be absolutely clear on the fundamental factors that determine profit.
How Did The Business Make Its Profit?
Income Statement – Internal Report below lays out an internal profit (Income Statement or Profit and Loss) report for the business’s managers [not for the stakeholders]. The revenue and expense information is for the most recent year of a business that I call Lie Dharma Putra, LLC.:
An internal profit report should serve as a profit map that shows managers how to get to their profit destination. The above Income Statement – Internal Report is very condensed; it’s stripped down to bare essentials. It includes the five fundamental factors that drive profit performance. These key profit drivers are the following:
- Sales volume (or the total number of units sold during the period)
- Sales revenue per unit (sales price)
- Cost of goods sold expense per unit (product cost)
- Variable operating expenses per unit
- Fixed operating expenses for the period
The other dollar amounts in the profit report (Income Statement – Internal Report) depend on these five profit drivers. For instance, the $24,000,000 sales revenue amount equals the 120,000 units sales volume times the $200 sales revenue per unit (or sales price). And, the $25 fixed operating expenses per unit amount equals the $3,000,000 total fixed operating expenses for the period divided by the 120,000 units sales volume.
Don’t confuse the internal profit report presented in “Income Statement – Internal Report” above with the income statement in the external financial reports a business distributes to its owners and creditors. The internal profit report (Income Statement – Internal Report above) includes sales volume and per unit values, which aren’t disclosed in externally reported income statements. Also, the internal profit report separates operating expenses into variable and fixed categories, which isn’t done in externally reported income statements.
The last line in the Income Statement – Internal Report above is “operating profit“, which is profit before interest and income tax. Interest and income tax are deducted to reach a business’s final, bottom-line “net income“. Income tax is a very technical topic, which makes it difficult to generalize. Some businesses are pass-through entities and don’t pay income tax directly.
Standard terminology doesn’t exist in the area of management profit reporting and analysis:
- Instead of “gross margin“, you may see “gross profit“.
- Instead of “operating profit“, you may see “operating earnings” or “earnings before interest and income tax (EBIT)“.
You may even see other terms than these. Despite the diversity of terminology, in the context of a profit report, the meanings of terms used are usually clear enough.
Before using the five profit factors for analyzing profit performance, a good thing to do is to walk down the profit structure in the internal profit report (Income Statement – Internal Report):
- The top row of the structure is “Sales Revenue“, which equals sales price time sales volume. You can think of sales revenue as profit before any expenses are deducted.
- If the business sells products, the first expense deducted against sales revenue is “Cost Of Goods Sold (COGS)“, which equals product cost (cost of goods sold expense per unit) time sales volume.
- Deducting cost of goods sold from sales revenue gives you “Gross Margin“. Managers keep a close watch on the “Gross Margin Ratio“, which for Lie Dharma Putra, LLC equals 35 percent ($70 gross margin per unit [divided by] $200 sales price = 35% gross margin ratio).
Even a relatively small shift in this ratio can have huge impacts on profit.
Virtually all businesses have “Variable Operating Expenses“, which are costs that move in tandem with changes in sales revenue. Example of a variable expense are:
- commissions paid to salespersons, which typically are a certain percent of sales revenue.
- Delivery expenses and bad debts from credit sales.
Total variable operating expenses =
Variable Operating Expenses per Unit [times] sales volume
Deducting “variable operating expenses” from “gross margin” produces “contribution margin” or “profit before fixed operating expenses” are considered.
Businesses commit to a certain level of “fixed operating expenses“ for the year. Examples of fixed expenses are: property taxes, employees on fixed salaries, insurance, depreciation, legal and accounting, and so on. In the short run, fixed costs behave like the term implies —they’re relatively fixed and constant in amount regardless of whether sales are high or low.
Fixed costs aren’t sensitive to fluctuations in sales over the short term. Lie Dharma Putra, LLC’s $3,000,000 fixed operating expenses for the period are divided by its 120,000 units sales volume to determine the $25 fixed operating expenses per unit in Income Statement – Internal Report. The final step in the walk down the profit ladder is deducting fixed operating expenses from contribution margin. The remainder is the business’s operating profit for the year. The business earned $1,800,000 operating profit for the year, which is 7.5 percent of its sales revenue for the year.
Internal operating profit (P&L) reports often include ratios (percents) for each line item based on sales revenue, so managers can track changes in these important ratios period to period.
CASE EXAMPLE: Refer to the Lie Dharma Putra, LLC example presented in Income Statement – Internal Report. Purely hypothetically, suppose the business could have sold either 5 percent more sales volume or it could have sold the same sales volume at a 5 percent higher sales price. Assume other profit factors remain the same. Which change would have been better for operating profit, the 5 percent higher sales volume, or the 5 percent higher sales price?
Let’s try a simple analysis:
5 percent additional sales volume means the business would have sold 6,000 more units than in the Income Statement – Internal Report scenario:
120,000 units sales volume in Income Statement – Internal Report × 5% = 6,000 additional units. Each additional unit sold would earn $40 contribution margin per unit (see Income Statement – Internal Report). So, total contribution margin would have been $240,000 higher. The business’s fixed operating expenses would not have increased with such a relatively small increase in sales volume.
Therefore, its operating profit would have been $240,000 higher.
But, would the sales price increase have been any better? You bet it would!, let’s continue this simple analysis….
A 5 percent jump means sales price would have been $10 per unit higher: ($200 sales price in Income Statement – Internal Report × 5% = $10 increase in sales price). This would have increased the contribution margin per unit from $40 (see Income Statement – Internal Report) to $50. Therefore, the business’s total contribution margin would have been $6,000,000: ($50 contribution per unit × 120,000 units sales volume = $6,000,000 contribution margin). This would be an increase of $1,200,000 over the contribution margin in the Income Statement – Internal Report scenario.
There’s no reason to think that fixed operating expenses would be any different at the higher sales price, so operating profit would have increased $1,200,000. In short, the 5 percent gain in sales price would have been much better for operating profit, compared with the 5 percent step up in sales volume.
Analyzing Operating Profit
When handed an internal operating profit report like the one presented in “Income Statement – Internal Report” on the first section, a business manager may say “thanks for the information” and leave it at that. An internal profit report like the one in Income Statement – Internal Report is prepared according to the standard accounting approach, which reports totals for sales revenue and expenses for the period and which starts with sales revenue and works its way down to bottom line profit (operating profit in the Income Statement – Internal Report example). Trust me, managers would be surprised not to get such profit reports on a regular basis.
However, the layout of the typical accounting internal profit report is cumbersome for “analyzing profit behavior“. As you know, business managers are busy people. They don’t have a lot of time to wade through an accounting profit report to analyze the impact of a change in sales volume, or a change in sales price, or a change in any of the key factors that drive profit. An accounting profit report is not the best format for the efficient analysis of profit behavior.
Busy business managers can analyze the profit performance of their business more efficiently using compact profit models based on the five fundamental profit drivers. There are different analysis methods, each having certain advantages. Managers are best advised to be familiar with three profit analysis methods below:
Profit Analysis Method-1: Contribution Margin Minus Fixed Costs
The basis of this method is that “fixed costs have a first claim on contribution margin“, and what’s left over is “operating profit“.
This method starts with “contribution margin per unit“, which is the catalyst of profit. To make profit, the business has to have an adequate margin per unit. The second step of this method is to multiply “contribution margin per unit” by “sales volume“. Earning a margin on each unit sold doesn’t help much if a business doesn’t sell many units, of course.
Using this method Lie Dharma Putra, LLC’s profit for the year is analyzed as follows:
Profit Analysis Method-2: Excess Over Breakeven
The thinking behind this method is that a business has to first recover its fixed costs by selling enough units before it starts making profit. This profit analysis technique pivots on the breakeven volume of the business, which you calculate as follows for Lie Dharma Putra, LLC (see Income Statement – Internal Report for data):
$3,000,000 annual fixed operating expenses [divided] $40 contribution margin per unit = 75,000 units breakeven point (volume)
Every additional unit sold over the breakeven volume brings in marginal profit (also referred to as “incremental profit“). The underlying theme of this method is that after you sell enough units to recoup your fixed operating expenses for the year, you’re free as it were (of course, you can’t forget about interest expense and income tax). Using this method Lie Dharma Putra, LLC’s profit for the year is analyzed as follows:
Profit Analysis Method #3: Minimizing Fixed Costs Per Unit
The thinking behind this method of analyzing profit is that a business has to spread its “fixed costs“ over enough “sales volume“ to drive the “average fixed cost per unit“ below its “contribution per unit“. In this way, the business makes operating profit.
In this method of profit analysis, you compare the “contribution margin per unit” with “fixed operating expenses per unit“, which you calculate by dividing “annual fixed operating expenses“ by the “number of units sold“. For Lie Dharma Putra, LLC, its average fixed operating expenses per unit are $3,000,000 annual fixed operating expenses [divided] 120,000 units sold = $25 fixed operating expenses per unit sold.
The spread between the “contribution margin per unit“ and the “average fixed costs per unit“ gives the profit per unit, which is scaled up by “sales volume” as follows:
How Can The Business Improve Its Profit Performance?
Business managers should always looking for ways to improve profit performance. One obvious way to improve profit is to sell more units without reducing sales prices. A business may have to increase its market share to sell more volume, which is no easy task as you know. In any case, the logical place to begin profit improvement analysis is an increase in sales volume.
Every business would like to have sold more units than they did during the most recent period, wouldn’t they? All businesses are on the lookout for how to increase sales volume.
A fundamental growth strategy is to increase sales volume.
CASE EXAMPLE: According to Income Statement – Internal Report [on the very forst section], Lie Dharma Putra, LLC sold 120,000 units during the year. If the business had sold 5 percent more units, would its profit have been 5 percent higher?
Before attempting to answer this question, I would need to address an important point:
When you start simulating increases in sales volume, you have to make assumptions every step of the way. In this case, the question asks us to simulate a 5 percent (6,000 additional units) increase in sales volume to see what happens in the profit example (as shown in Income Statement – Internal Report). In order to answer the question, we have to assume:
- That the “sale price (average sales revenue per unit)” stays the same at $200 per unit
- That the “product cost per unit” remains the same at $130 per unit
- That “variable operating expenses” hold the same at 15 percent of sales revenue
- That Lie Dharma Putra, LLC’s “fixed operating expenses” stay the same at $3,000,000 for the year
The last assumption is an important one to understand because it means that the business has enough unused, or untapped, capacity to sell an additional 6,000 units of product. In other words, we’re assuming that there was some slack in the organization such that it could have sold 6,000 more units without stepping up its fixed costs to support the higher sales volume. For relatively small changes in sales volume, that circumstance is probably true in most situations. But on the other hand, what if the question had asked you to simulate an increase in sales volume of 30, 40, or 50 percent? With a change of this extent, a business probably would have to hire more people, buy more delivery trucks, buy or rent more warehouse space, and so on — with the result that its fixed operating expenses would be higher at the higher sales volume level.
Capacity is a broad concept that refers to the capability of a business to handle sales activity. It encompasses all the resources needed to make sales, including employees, machines, manufacturing and warehouse space, retail space, and so on. Many of the costs of capacity are fixed in nature.
Keeping in mind the assumptions listed, operating profit would have increased much more than 5 percent if Lie Dharma Putra, LLC had sold 5 percent more units during the year. The key point is this: Contribution margin would stay the same at $40 per unit because sales price, product cost, and variable operating expenses per unit all remain the same (see Income Statement – Internal Report). So the additional 6,000 units would have generated $240,000 additional contribution margin:
$40 contribution margin per unit × 6,000 units sales volume increase = $240,000 contribution margin increase
Assuming that fixed operating expenses remain the same at the higher sales volume, operating profit increases $240,000 from a 5 percent increase in sales volume. This is an increase of over 13 percent:
$240,000 operating profit increase × $1,800,000 operating profit = 13.3 percent increase in contribution margin
In the end, a sales volume increase of only 5 percent would increase operating profit over 13 percent!
In the example scenario, the bigger 13.3 percent swing in profit compared with the 5 percent change in sales volume is referred to as operating leverage. At the higher sales volume, the business gets more leverage, or better utilization, from its fixed operating expenses. At a lower sales volume, the percent drop in profit would be more severe than the percent drop in sales volume. In other words, the magnifying effect of operating leverage works both ways.