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Cost Accounting

Cost Control and Profit Management Fundamental

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Starting Control with Sales Revenue Change

Cost and Profit Control Fundamental

Back to the Profit and Loss example; you increased sales $634,062 in 2009 — see Profit and Loss Example. This is good news for profit, but only if costs don’t increase more than sales revenue, of course. For revenue/cost/profit analysis, it’s extremely useful to know how much of your sales revenue increase is due to change in volume (total quantity sold) versus changes in sales prices. Unfortunately, measuring sales volume can be a problem.

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An auto dealer can keep track of the number of vehicles sold during the year. A movie theater can count the number of tickets sold during the year, and a brewpub can keep track of the number of barrels of beer sold during the year. On the other hand, many small businesses sell a very large number of different products and services. And I mean a large number! A local hardware store in Boulder says it sells more than 100,000 different items, which I don’t doubt. A clothing retailer may sell several thousand different items.

Exactly how your business should keep track of sales volume depends on how many different products you sell and how practical it is to compile sales volume information in your accounting system. In many situations, a small business can’t do more than keep count of its sales transactions — number of sales rung up on cash registers, number of invoices sent to customers, customer traffic count, or something equivalent. If nothing else, you should make a rough count of the number of sales you make during the year.

In the example portrayed in Profit and Loss Example, you increase sales volume 20 percent in 2009 over the prior year, which is pretty good by any standard. You made much better use of the sales capacity provided by your workforce and facilities in 2009. You increased sales per employee and per square foot in 2009 . The 20 percent sales volume increase is very important in analyzing your costs in 2009. A key question is whether changes in your costs are consistent with the sales volume increase.

The example portrayed in Profit and Loss Example is for a situation in which product costs remain the same in both years. Therefore, cost of goods sold expense increases exactly 20 percent in 2009 because sales volume increases 20 percent over the previous year. (Of course, product costs fluctuate from year to year in most cases).

Sales revenue, in contrast, increases more than 20 percent because you were able to increases sales prices in 2009. In Profit and Loss Example, note that sales revenue increases more than the 20 percent sales volume increase. Ask your accountant to calculate the average sales price increase. In the example, your sales prices in 2009 are 7.7 percent higher than the previous year. (Trust me on this calculation; I’am accountants.)

You did not increase sales prices exactly 7.7 percent on every product you sold; this situation would be quite unusual. The 7.7 percent sales price increase is an average over all the products you sold. You should know the reasons for and causes of the average sales price increase. The higher average sales price may be due to shift in your sales mix toward higher priced products. (Sales mix refers to the relative proportions that each source of sales contributes to total sales revenue.) Or, perhaps your sales mix remained constant and you bumped up prices on most products.

In any case, what’s the bottom line (or should I say the top line because I’am talking about sales revenue)? In 2009, you had $634,062 additional sales revenue to work with compared with the prior year. More than half of the incremental revenue is offset by increases in costs. But $261,921 of the additional revenue ended up in profit. How do you like that? More than 41 percent of your additional revenue goes toward profit (see Profit and Loss Example for data):

$261,921 profit increase / $634,062 additional sales revenue = 41.3% profit from additional revenue

This scenario may seem almost too good to be true. Well, you should analyze what happened to your costs at the higher sales level to fully understand this profit boost. Could the same thing happen next year if you increase sales revenue again? Perhaps, but maybe not.


Focusing on Cost of Goods Sold and Gross Margin

For businesses that sell products, the first expense deducted from sales revenue is cost of goods sold. (You could argue that it should be called cost of products sold, but you don’t see this term in P&L statements.) This expense is deducted from sales revenue to determine gross margin. Gross margin is also called gross profit; it’s profit before any other expense is deducted from sales revenue. Cost of goods sold is a direct variable expense, which means it’s directly matched against revenue and varies with sales volume.

This expense may appear straightforward, but it’s more entangled than you may suspect. It’s anything but simple and uncomplicated. For the moment, I step around these issues and focus on the basic behavior of the expense. In the example, your business’s product costs are the same as last year. Of course, in most situations, product costs don’t remain constant very long. But it makes for a much cleaner analysis to keep product costs constant at this point in the discussion.

Profit and Loss Example

The 20 percent jump in sales volume increases your cost of goods sold expense 20 percent — see Profit and Loss Example again. Pay special attention to the change in your gross margin ratio on sales. Your basic sales pricing strategy is to mark up product cost to earn 45 percent gross margin on sales. For example, if a product cost is $55, you aim to sell it for $100 to yield $45 gross margin. However, your gross margin is only 42.0 percent in 2009. You gave several customers discounts from list prices. But you did improve your average gross margin ratio over last year, which brings up a very important point.

How is it that your sales volume increases 20.0 percent and your sales prices increase 7.7 percent in 2009, but your gross margin increases 40.2 percent? The increase in gross margin seems too high relative to the percent increases in sales volume and sales prices, doesn’t it? What’s going on? Below Example  presents the analysis of how much of the $351,741 gross margin gain is attributable to higher sale prices and how much to the higher sales volume.

Analyzing Your Gross Margin Increase

2008                              Change in 2009

$2,286,500 Sales revenue × 7.7%   Sales price increase       = $176,762
$874,895 Gross margin    × 20.0%  Sales volume increase  = $174,979
Total increase in gross margin               = $351,741

On the above analysis example, note that the 7.7 percent increase in sales prices causes more gross margin increase than the 20.0 percent sales volume increase. This is because of the big base effect; the smaller sales prices percent increase applies to a relatively large base (about $2.3 million) compared with the volume gain that is based on a much smaller amount (about $.9 million).

Suppose that you want to increase gross margin $100,000 next year. Assume that your 42.0 percent gross margin ratio on sales remains the same. If sales prices remain the same next year, then your sales volume would have to increase 8.15 percent:

$100,000 gross margin increase goal / $1,226,636 gross margin in 2009 = 8.15% sales volume increase
If your sales volume remains the same next year, then your sales prices on average would have to increase just 3.42 percent:

$100,000 gross margin increase goal / $2,920,562 sales revenue in 2009 = 3.42% sales price increase

In short, a 1 percent sales price increase has more profit impact than a 1 percent sales volume increase.

 

Looking Into Cost of Goods Sold Expense

Business managers have a tendency to take cost amounts reported by accountants for granted — as if the amount is the actual, true, and only cost. In contrast, business managers are pretty shrewd about dealing with other sources of information. When listening to complaints from employees, for example, business managers are generally good at reading between the lines and filling in some aspects that the employee is not revealing. And then there’s the legendary response from a customer who hasn’t paid on time: The check’s in the mail. Business managers know better than to take this comment at face value.

Likewise, you should be equally astute in working with the cost amounts reported for expenses. Everyone agrees that there should be uniform accounting standards for financial reporting by businesses. Yet, the accounting profession hasn’t reached agreement on the best method for recording certain expenses. A business can choose between a straight-line and an accelerated method for recording depreciation expense. And, a business can choose between two or three different methods for recording cost of goods sold expense.

 

Selecting a Cost of Goods Sold Expense Method

The cost of goods sold expense is the largest expense of businesses that sell products, typically more than 50 percent of the sales revenue from the goods sold. In the business example, cost of goods sold is 58 percent of sales revenue in the most recent year (refer to Profit and Loss Example). You would think that the accounting profession would have settled on one uniform method to record cost of goods sold expense. This isn’t the case, however. Furthermore, the federal income tax law permits different cost of goods sold expense methods for determining annual taxable income. A business has to stay with the same method year after year (although a change is permitted in very unusual situations).

This post is mostly directed to small business managers, not accountants. There’s no reason for a small business manager to get into the details of the alternative cost of goods sold expense methods. Your time is too valuable. Like other issues that you deal with in running a small business, the basic question is What difference does it make? Generally, the method doesn’t make a significant difference in your annual cost of goods sold expense — assuming that you don’t change horses in the middle of the stream (in other words, that you keep with the same method year after year). My advice is to instruct your Controller to give you a heads up if your accounting method causes an unusual, or abnormal impact, on cost of goods expense for the year.

Your cost of goods sold expense accounting method affects the book value of inventory, which is the amount reported in the balance sheet. Under the first-in, first out (FIFO) accounting method, the inventory amount is based on recent costs. For example, refer to the balance sheet in Profit and Loss Example 6-3. Inventory at yearend 2009 is reported at $250,670. Under the FIFO method, this amount reflects costs of products during two or three months ending with the balance sheet date. Instead of using FIFO or LIFO, a business can split the difference as it were and use the average cost method. The average cost accounting method reaches back a little further in time compared to the FIFO method; the cost of ending inventory is based on product costs from throughout of the year under the average cost method.

If you use the last-in, first-out (LIFO) accounting method the cost value of your year-end inventory balance could reach back many years, depending on how long your have been using this method and when you accumulated your inventory layers. For this reason, businesses that use the LIFO method disclose the current replacement cost of their ending inventories in a footnote to their financial statements to warn the reader that the balance sheet amount is substantially below the current cost of the products.

Which cost of goods sold expense method should you use, then? My advice is to start by looking at your sales pricing policy.

What do you do when a product cost goes up? Do you wait to clear out your existing stock of the product before you raise the sales price? If so, I recommend the first-in, first-out (FIFO) method, because this method keeps product costs in sync with sales prices.

On the other hand, sales pricing is a complex process, and sales prices aren’t handcuffed with product cost changes. To a large extent, your choice of accounting method for cost of goods sold expense depends on whether you prefer a conservative, higher cost method (generally LIFO) — or a liberal, lower cost method (generally FIFO).

 

Overcome with Inventory Shrinkage and Inventory Write Downs

Deciding which cost of goods sold expense accounting method to use isn’t the main concern of many small businesses that carry a sizable inventory of products awaiting sale. The more important issues to them are losses from inventory shrinkage and from write downs of inventory caused by products that they can’t sell at normal prices. These problems are very serious for many small businesses.

Inventory shrinkage is caused by theft by customers and employees, damages caused by the handling, moving, and storing of products, physical deterioration of products over time, and errors in recording the inflow and outflow of products through the warehouse. A business needs to take a physical inventory to determine the amount of inventory shrinkage. A physical inventory refers to inspecting and counting all items in inventory, usually at the close of the fiscal year. This purpose is to discover shortages of inventory. The cost of the missing products is removed from the inventory asset account and charged to expense. This expense is painful to record because the business receives no sales revenue from these products. A certain amount of inventory shrinkage expense is considered to be a normal cost of doing business, which can’t be avoided.

Also, at the close of the year, a business should do a lower of cost or market test on its ending inventory of products. Product costs are compared against the current replacement costs of the products and the current market (sales) prices of the products. This is a two-fold test of product costs. If replacement costs have dropped or if the products have lost sales value, your Controller should make a year-end adjusting entry to write down your ending inventory to a lower amount, which is below the original costs you paid for the products.

Recording inventory shrinkage expense caused by missing products is cut and dried. You don’t have the products. So, the cost of the products is removed from the asset account — that’s all there is to it. In contrast, writing down the costs of damaged products (that are still salable at some price) and determining replacement and market values for the lower of cost or market test is not so clear-cut.

A business may be tempted to write down its inventory too much in order to minimize its taxable income for the year. I know a business that knocks down its ending inventory much more than can be justified by actual inventory shrinkage and lower replacement and sales values of its products. You’re on thin ice if you do this, and you better pray that the IRS won’t audit you.

In recording the expense of inventory shrinkage and inventory write down under the lower of cost of market test, your accountant has to decide which expense account to charge and how to report the loss in your P&L. Generally, the loss should be included in your cost of goods sold expense in the P&L because the loss is a normal expense that sits on top of cost of goods sold. However, when an abnormal amount of loss is recorded, your accountant should call the loss to your attention — either on a separate line in the P&L report or in a footnote to the statement.


Scrutinizing The Operating Expenses

Profit and Loss Report Example

Analyzing Employee Cost

As the owner/manager of a small business, your job is to judge whether the ratio of each expense to sales revenue is acceptable. Is the expense reasonable in amount? Your salaries, wages, commissions, and benefits expense equals 22.7 percent of sales revenue in 2009 (see Profit and Loss Example). In other words, your employee cost absorbs $22.70 of every $100.00 of sales revenue. This expense ratio is lower than it was last year, which is good, of course. But the fundamental question is whether it should be an even smaller percent of sales. This question strikes at the essence of cost control. It’s not an easy question to answer. But, as they say, that’s why you earn the big bucks — to answer such questions.

It’s tempting to think first of reducing every cost of doing business. It would have been better if your employee cost had been lower — or would it? Could you have gotten by with one less employee? One less employee may have reduced your sales capacity and prevented the increase in sales revenue. In the example, you have ten full-time employees on the payroll both years.

For your line of business, the benchmark is $300,000 annual sales per employee. In 2009, your sales per employee is $292,056 (see Profit and Loss Example for sales revenue):

$2,920,562 annual sales revenue / 10 employees = $292,056 sales revenue per employee

 

Summing up, your employee cost looks reasonable for 2009, assuming that your sales per employee benchmark is correct. This doesn’t mean that you couldn’t have squeezed some dollars out of this expense during the year.

Maybe you could have furloughed employees during the slow time of year. Maybe you could have fired one of your higher paid employees and replaced him or her with a person willing to work for a lower salary. Maybe you could have cut corners and not have paid overtime rates for some of the hours worked during the busy season. Maybe you could have cut health-care and vacations benefits during the year.

Business managers get paid to make tough and sometimes ruthless decisions. (See the sidebar “A speech to students on business success” for a story that illustrates this point.) This is especially true in the area of cost control. If your sales prices don’t support the level of your costs, what are your options? You can try to get more sales out of your costs. In fact, you did just this with employee costs in 2009 compared with 2008 — see Profit and Loss Example again. Your sales revenue per employee increased significantly in 2009. But you may be at the end of the line on this course of action. You may have to hire an additional employee or two if you plan to increase sales next year.

 

Analyzing Advertising and Sales Promotion Costs

The total of your advertising and sales promotion costs in 2009 is just under 7 percent of sales revenue, which is about the same it was in 2008 (see Profit and Loss Example again). As you probably have observed, many retail businesses depend heavily on advertising. Others don’t do more than put a sign on the building and rely on word of mouth. This book isn’t on marketing, advertising, and sales promotion — which ought to be rather obvious. You can advertise and promote sales a thousand different ways. Maybe you give away free calendars. You can put an insertion in the yellow pages. You can place ads in local newspapers. Maybe you make a donation to your local public radio or television station. Or perhaps you place ads on outdoor billboards or bus benches.

Like other costs of doing business, you need a benchmark or reference point for evaluating advertising and sales promotion costs. For the business example, I set the ratio at around 7 percent of annual sales. This ratio is in the typical range of the advertising and sales promotion expense of many small businesses. Of course, your business may be different. Retail furniture stores, for example, spend a lot more than 7 percent of sales revenue on advertising.

Locally owned office-supply stores, in contrast, spend far less on advertising. Although I’ am a not marketing expert, it’s fairly clear that you should keep watch on which particular advertisements and sales promotions campaigns work best and have the most impact on sales. The trick is to find out which ads or promotions that your customers respond to and which they don’t.

Keeping the name of your business on the customer’s mind is a high marketing priority of most businesses, although measuring how your name recognition actually affects customers’ purchases is difficult to track. Nevertheless, you should develop some measure or test of how your marketing expenses contribute to sales.

Of course, you can keep an eye on your competitors, but they aren’t likely to tell you which sales promotion techniques are the most effective. You increased your advertising and sales promotion costs more than $30,000 in 2009, which is more than 20 percent over last year (see Profit and Loss Example). Sales revenue went up by an even larger percent, so the ratio of the expense to sales revenue actually decreased. Nevertheless, you should determine exactly what the extra money was spent on. Perhaps you bought more newspaper ads and doubled the number of flyers distributed during the year.

 

Dealing With Depreciation Expense

Depreciation expense is the cost of owning fixed assets. The term fixed assets includes land and buildings, machinery and equipment, furniture and fixtures, vehicles and forklift trucks, tools, and computers. These long-term operating resources aren’t held for sale; they’re used in the day-to-day operations of the business. Except for land, the cost of these long-term operating resources is allocated over the estimated useful lives of the assets. (Note: Land is viewed as a property right that has perpetual life and usefulness, so its cost is not depreciated; the cost stays on the books until the land is disposed of).

As a practical matter, the useful life estimates permitted in the federal income tax law are the touchstones used by most small businesses. Instead of predicting actual useful lives, businesses simply adopt the useful lives spelled out in the income tax law to depreciate their fixed assets. The useful life guidelines are available from the IRS. Probably the most useful booklet is Publication 946 (2005), How To Depreciate Property. Your Controller should know everything in this booklet.

You should understand the following points about the depreciation expense:

  • The two basic methods for allocating the cost of a fixed asset over its useful life are the straight-line method (an equal amount every year) and an accelerated method by which more depreciation expense in recorded in the earlier years than in the later years; the straight-line method is used for buildings, and either method can be used for other classes of fixed assets.
  • Businesses generally favor an accelerated depreciation method in order to reduce taxable income in the early years of owning fixed assets; but don’t forget that taxable income will be higher in the later years when less depreciation is recorded.
  • In recording depreciation expense, a business does not set aside money in a fund for the eventual replacement of its fixed assets restricted only for this purpose. (A business could invest money in a separate fund for this purpose, of course, but I’ve never seen one that does).
  • Recording depreciation expense does not require a decrease to cash or an increase in a liability that will be paid in cash at a later time; rather the fixed asset accounts of the business are written down according to a systematic method of allocating the original cost of each fixed asset over its estimated useful life.
  • Even though the market value of real estate may appreciate over time, the cost of a building owned by the business is depreciated (generally over 39 years).
  • The eventual replacement costs of most fixed assets will be higher than the original cost of the assets due to inflation; depreciation expense is based on original cost not on the estimated future replacement cost.
  • The estimated useful lives of fixed assets for depreciation are shorter than realistic expectations of their actual productive lives to the business; therefore, fixed assets are depreciated too quickly, and the book values of the assets in the balance sheet (original cost less accumulated depreciation to day) are too low.
  • Depreciation expense is a real cost of doing business because fixed assets wear out or otherwise lose their usefulness to the business —although, a case can be made for not recording depreciation expense on a building whose market value is steadily rising.

Generally accepted accounting principles require that the cost of all fixed assets (except land) must be depreciated.

I should mention in passing that one technique used in the fields of investment analysis and business valuation focuses on EBITDA, which equals earnings before interest, tax (income tax), depreciation, and amortization.

Amortization is similar to depreciation. Amortization refers to the allocating the cost of intangible assets over their estimated useful lives to the business. By and large, small businesses do not have intangible assets, so I don’t discuss this topic.

One last point about depreciation expense: Note in Profit and Loss Example that your depreciation expense is lower in 2009 than the prior year. Yet sales revenue and all other expenses are higher than the prior year. The drop in depreciation expense is an aberrant effect of accelerated depreciation; the amount of depreciation decreases year to year. You have a year-to-year built-in gain in profit from because depreciation expense drops year to year. The aggregate effect on depreciation expense for the year depends on the mix of newer and older fixed assets. The higher depreciation on newer fixed assets is balanced by the lower depreciation on older fixed assets. One advantage of the straight-line method is that the amount of depreciation expense on a fixed asset is constant year to year, so you don’t get fluctuations in depreciation expense year to year that are caused by the depreciation method being used.

Request your Controller to explain the year-to-year change in depreciation expense in your annual P&L. In particular, ask your accountant whether a decrease in the depreciation expense is due to your fixed assets getting older, with the result that less depreciation is recorded by an accelerated depreciation method.

 

Looking at Facilities Expense

The P&L report presented in Profit and Loss Example includes a separate line for facilities expense. I argue that you should definitely limit the number of expense lines in your P&L. But in my personal view, this particular expense deserves separate reporting. Basically, this expense is your cost of physical space —the square footage and shelter you need to carry on operations plus the costs directly associated with using the space. (You may prefer the term occupancy expense instead).

Most of the specific costs making up facilities expense are fixed commitments for the year. Examples are lease payments, utilities, fire insurance on contents and the building (if owned), general liability insurance premiums, security guards, and so on. You could argue that depreciation on the building (if owned by the business) should be included in facilities expense. However, it’s best to put depreciation in its own expense account. In this example, your business uses 12,000 square feet of space, and you’ve determined that a good benchmark for your business is $300 annual sales per square foot. Accordingly, your space could support $3,600,000 annual sales.

In 2009, your annual sales revenue is short of this reference point. Therefore, you presumably have space enough for sales growth next year. These benchmarks are no more than rough guideposts. Nevertheless, benchmarks are very useful. If your actual performance is way off base from a benchmark, you should determine the reason for the variance. Based on your own experience and in looking at your competitors, you should be able to come up with reasonably accurate benchmarks for sales per employee and sales per square foot of space.

In the business example portrayed in Profit and Loss Example, you use the same amount of space both years. In other words, you did not have to expand your square footage for the sales growth in 2009. The relatively modest increase in facilities expense (only 5.2 percent, as shown in Profit and Loss Example) is due to inflationary cost pressures. Sooner or later, however, continued sales growth will require expansion of your square footage. Indeed, you may have to relocate to get more space.

 

Looking Over or Looking Into Other Expenses

In your P&L report (see Profit and Loss Example again), the last expense line is the collection of residual costs that aren’t included in another expense. A small business has a surprising number of miscellaneous costs — annual permits, parking meters, office supplies, postage and shipping, service club memberships, travel, bad debts, professional fees, toilet paper, signs, to name just a handful. A business keeps at least one account for miscellaneous expenses.

You should draw the line on how large an amount can be recorded in this catchall expense account. For example, you may instruct your Controller that no outlay over $250 or $500 can be charged to this account; any expenditure over the amount has to have its own expense account.

The cost control question is whether it’s worth your time to investigate these costs item by item. In 2009, these assorted costs represented only 1.5 percent of your annual sales revenue. Most of the costs, probably, are reasonable in amount – so, why spend your valuable time inspecting these costs in detail?

On the other hand, these costs increase $15,594 in 2009 (see Profit and Loss Example), and this amount is a relatively large percent of your profit for the year:

$15,594 increase in other expenses / $95,651 net income for year = 16.3% of profit for year

If this were my business, I’d ask the accountant to list the two or three largest increases. You may see some surprises. Perhaps an increase is onetime event that will not repeat next year. You have to follow your instincts and your experience in deciding how deep to dive into analyzing these costs.

If your employees know you never look into these costs, they may be tempted to use one of these expense accounts to conceal fraud. So, it’s generally best to do a quick survey of these costs, even if you don’t spend a lot of time on them. It’s better to give the impression that you’re watching the costs like a hawk, even if you’re not.

 

Understanding Interest Expense [How It is Work and How To Control it]

Interest expense is a financial cost — the cost of using debt for part of the total capital you use in operating the business. It’s listed below the operating profit line in the P&L report (see Profit and Loss Example). Putting interest expense below the operating profit line is standard practice, for good reason. Operating profit (also called operating earnings, or earnings before interest and income tax) is the amount of profit you squeeze out of sales revenue before you consider how your business is financed (where you get your capital) and income tax.

Because you negotiated the terms of the loans to the business, you should know whether this interest rate is correct. By the way, the interest expense in your P&L may include other costs of borrowing such as loan origination fees and other special charges in addition to interest. If you have any question about what’s included in interest expense, ask your Controller for clarification.


Focusing on Profit Centers and Cost Reduction

A business consists of different revenue streams, and some are more profitable than others. It would be very unusual if every different source of sales were equally profitable. A common practice is to divide the business into separate profit centers, so that the profitability of each part of the business can be determined. For example, a car dealership is separated into new car sales, used car sales, service work, and parts sales. Each profit center’s sales revenue may be further subdivided. New vehicle sales can be separated into sedans, pick up trucks, SUVs, and other models. In the business example I use in this post, you sell products both at retail prices to individual consumers and at wholesale prices to other businesses. Quite clearly, you should separate your two main sources of sales and create a profit center for each.

Determining how to partition a business into profit centers is a management decision. The first question is whether the segregation of sales revenue into distinct profit centers helps you better manage the business. Generally, the answer is yes. The information helps you focus attention and effort on the sources of highest profit to the business. Comparing different profit centers puts the spotlight on sources of sales that don’t generate enough profit, or even may be losing money.

Generally, a business creates a profit center for each major product line and for each location (or territory). There are no hard and fast rules, however. At one extreme, each product can be defined as a profit center. As a matter of fact, businesses keep records for every product they sell. Many managers want a very detailed report on sales and cost of goods sold for every product they sell. This report can run many, many pages. A hardware store in Boulder sells more than 100,000 products. Would you really want a print out a report that lists the sales and cost of goods of more than 100,000 lines? The more practical approach is to divide the business into a reasonable number of profit centers and focus your time on the reports for each profit center.

A profit center is a fairly autonomous source of sales of a business, like a tub standing on its own feet. For example, the Boulder hardware store sells outdoor clothing, which is quite distinct from the other products it sells. Does the hardware store make a good profit on its outdoor clothing line of products?

The first step is to determine the gross margin for the outdoor clothing department. The cost of goods sold is deducted from sales revenue for the outdoor clothing line of products.

Is outdoor clothing a high gross margin source of sales? Frankly, I don’t know, but the manager of the hardware store certainly should know!

The report for a profit center doesn’t stop at the gross profit line. One key purpose of setting up profit centers is, as far as possible, to match direct operating costs against the sales revenue of the profit center. Direct operating costs are those that can be clearly assigned to the sales activity of the profit center.

Examples of direct operating costs of a profit center are the following:

  • Commissions paid to salespersons on sales of the profit center
  • Shipping and delivery costs of products sold in the profit center
  • Inventory shrinkage and write downs of inventory in the profit center
  • Bad debts from credit sales of the profit center
  • The cost of employees who work full-time in a profit center
  • The cost of advertisements for products sold in the profit center

Assigning direct operating costs to profit centers doesn’t take care of all the costs of a business. A business has many indirect operating costs that benefit all, or at least two or more profit centers. The employee cost of the general manager of the business, the cost of its accounting department, general business licenses, real estate taxes, interest on the debt of the business, and liability insurance are examples of general, business-wide operating costs.

Accountants have come up with ingenious methods for allocating indirect operating costs to profit centers. In the last analysis, however, the allocation methods have flaws and are fairly arbitrary. The game may not be worth the candle in allocating indirect operating costs to profit centers. Generally, there is no gain in useful information. You have all the information you need by ending the profit center report after direct operating costs.

The bottom line of a profit center report is a measure of profit before general business operating costs and interest expense (and income tax expense, if applicable) are taken into account. The bottom line of a profit center is more properly called contribution toward the aggregate profit of the business as a whole. The term profit is a commonly used label for the bottom line of a profit center report, but keep in mind that it doesn’t have the same meaning as the bottom line of the P&L statement for the business as a whole.

 

Cost Reduction Exercise [CRE]

This section covers a few cost reduction tactics that I have observed over the years. It’s not an exhaustive list, to be sure. But you may find one or two of these quite useful.

  • Have your accountant alert you to any expense that increases more than a certain threshold amount, or by a certain percent.
  • Hire a cost control specialist. Many of these firms work on a contingent fee basis that depends on how much your expense actually decreases. These outfits tend to specialize in certain areas such as utility bills and property taxes, to name just two.
  • Consider outsourcing some of your business functions, such as payroll, security, taking inventory, and maintenance.
  • Put out requests for competitive bids on supplies you regularly purchase.
  • Make prompt payments of purchases on credit to take advantage of early payment discounts. Indeed, offer to pay in advance if you can gain an additional discount.
  • Keep all your personal and family costs out of the business.
  • Keep your assets as low as possible so that capital you need to run the business is lower, and your cost of capital will be lower.
  • Set priorities on cost control, putting the fastest rising costs at the top.
  • Ask your outside CPA for cost control ideas she or he has observed in other businesses.

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