http://i237.photobucket.com/albums/ff263/dharma-putra/UnderstandingProfit Behavior for Better Profit DecisionOne of the main functions of accounting is to record the revenues, cost and expenses (as well as any gains and losses) of a business in order to prepare a report of its profit or loss for a period of time. Management decisions set in motion the profit-making activities of a business. The profit report is the primary source of feedback to managers on the results of their decisions. To managers, the profit report says: “You’ve made decisions, and here are the outcomes of your decisions.”

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A profit report is historical—backward looking. It presents the collective results of what has already happened. Management decisions are forward looking and are made to affect the course of future events, of course. In making profit decisions, managers should focus on the relatively few fundamental factors that drive profit—what one could call the “levers of profit.”

Business managers need a sure-handed grip on those profit levers. This post explains profit behavior to make better profit decisions: 

First, introduces and explains the format and the content of a typical profit report. Along the explaination of the profit behavior, it also presents a frofit framework report for management profit reports that focuses on the main factors that drive profit—margin, sales volume, and fixed costs. This spreadsheet-based framework is very useful for analyzing change in profit from one period to the next and variances of actual from budget. Furthermore, it’s an excellent platform for planning out the details for improving profit.

The post closes with a discussion of a compact profit model that would fit on the back of an envelope. It’s a very handy tool for doing quick calculations for the impact on profit caused by changes in unit margin and sales volume.

 

Internal and External Profit Reporting

Inside a business, a profit report is commonly called the “P&L” (profit-and-loss) report or “Income Statement. Outside a business, in the external financial reports to its shareowners, a profit report is generally called an income statement or earnings statement. The purpose of this financial statement is to present a summary of the profit-making activities of a business for a period of time. You probably know that the term bottom line refers to the amount of profit or loss for the period, which is the final line of the report.

Below table shows the basic format of a 2-years profit report, which steps down from the top line (sales revenue) to the bottom line (profit). A profit report usually includes the previous period’s figures so they can be compared with those of the period just ended.

Basic Format of Profit and Loss Report

In the above, the bottom line is labeled net earnings. Net income is also commonly used for the final profit number. Businesses that sell products disclose cost of goods (products) sold expense immediately under sales revenue in order to show gross margin (also called gross profit)–see first table above. Interest and income tax expenses are reported separately. The profit report as it is on the first table above shows a common way of reporting these two unique expenses.

You might have noticed that only one line for all operating expenses is given in above table. Actually, more lines of operating expenses are reported. A relatively large number of operating expenses are presented in internal P&L reports, which may include 20, 50, 100, or more operating expenses.

In contrast, relatively few operating expenses are disclosed in external income statements. The standards governing external financial reporting by businesses do not dictate the types or the number of operating expenses that should be disclosed in income statements. This is left to the discretion of each business, and practices vary from company to company. Taking a sample of external income statements would reveal that most businesses disclose about five operating expenses, give or take one or two.

In actual practice, businesses classify and record operating expenses according to an object of expenditure basis. Accordingly, operating costs are recorded in expense accounts, such as salaries and wages, rent, utilities, maintenance and repairs, insurance, advertising, travel, depreciation, legal, office supplies, entertainment, and transportation.

 

Even a modest-size business keeps a hundred or more operating expense accounts. This detailed level of information is necessary for effective management control. However, a large number of expense accounts can be an obstacle to getting a clear view of the “big picture” that managers need for profit analysis.

For analyzing profit behavior, a business’s variable expenses should be separated from its fixed expenses. Generally speaking, an expense account title gives a pretty good clue as to whether the expense is fixed or variable. Cost of goods sold expense is a variable expense that depends on the number of units of product sold. Sales commissions are variable expenses. Real estate property taxes are fixed annual expenses. Fire and liability insurance premiums are another example of fixed annual expenses.

Managers could request that operating expense accounts, which have been recorded on the object of expenditure basis, be reclassified as variable or fixed. Distinguishing between variable and fixed operating expenses is not quite as simple as it might appear and takes time, of course. Only the manager can decide if it’s worth the effort. Generally it’s well worth the effort to separate between variable and fixed operating expenses.

 

Understanding “Operating Earnings”

The following discussion focuses mainly on “Earnings Before Interest and Tax (EBIT). This profit measure is called operating earnings or operating profit. Interest expense depends on the amount of debt a business uses and, of course, on the interest rates it pays for using this capital. Some businesses are very conservative and use little or virtually no interest-bearing debt.

Other businesses are loaded to the gills with debt. The higher the proportion of debt that is used to finance a business, the more the business gains or loses from financial leverage.

And then there’s income tax expense. Income tax is a unique type of expense, to say the least. When they hear the term income tax, most people immediately think of the complexity of the federal income tax law, which can’t be denied. For profit analysis, the important aspect of income tax is that it’s a contingent expense that depends, first, on whether a business earns taxable income and, second, on how much the taxable income is (and, third, where the income is earned and, fourth, what kind of income it is, and so on).

As you undoubtedly know, under the U.S. income tax law, interest expense is deductible from revenue to determine taxable income. In very general terms, taxable income equals operating earnings minus interest expense. (Income tax professionals would cringe at this comment.)

Interest expense and income tax expense are business-wide, or entity-as-a-whole, expenses. Having said this, I should mention that it is common for a business to be organized as two or more separate legal entities, and each one can have its own debt and income tax situation. The main point is that interest and income tax have to be considered at the appropriate entity level. Management decisions, in contrast, deal with more narrow profit slices of the business. These decisions are made at the micro-level.

Managers focus on one separate source of profit at a time, such as a particular product, a product line, or a sales territory. The unit of analysis is not the whole business, but rather a particular segment of the business. The general term for a separate source of profit is profit center.

 

Profit Centers

From a one-person sole proprietorship to a mammoth business like Ford or IBM, one of the first rules of management accounting is to identify each mainline source of profit and to accumulate the sales revenue and all the expenses for these separate profit hubs, or centers. Can you imagine an auto dealership, for example, not separating revenue and costs between its new car sales and its service department? If you audit one of an auto dealer you may find it make more profit from originating car loans for its customers than it does from selling new and used cars.

Even a relatively small business may have many different sources of profit. In contrast, even a relatively large business may have just a few mainline sources of profit. There are no easy-to-apply general rules for classifying sales revenue and costs for the purpose of segregating sources of profit, that is, for defining the profit centers of a business. Every business has to figure this out on its own. But it has to be done. Clearly, business managers should know where their profit comes from.

Although a business may have a fairly large number of profit centers, one basic profit framework has broad applicability. It focuses on the main variables that drive profit. This basic formula is valid for most profit sources, whether the profit center is a product line, a sales territory, a channel of distribution, or a type of customer. Also, the profit framework can be modified and applied to service businesses.

Please look at the previous table again. Of course the business did not make just one sale during the year just ended in the amount of $28,750,000. The company made thousands of sales during the year. It sells a number of different products and services. Its managers had to set the sales prices and control the costs for all these different products and services. The collective result is that the business made EBIT $3,000,000 for the year.

A logical first question is whether the format of the profit report (see the previous table) could serve as a good framework for profit analysis. If so, a profit report could be prepared for each profit center. Suppose that the business whose summary-level, company-wide profit report is shown on the above table sells one main product through a network of distributors. This product accounts for more than one-third of its total annual sales revenue. As you would expect, the product is the largest profit center of the business.

In addition to sales revenue and cost of goods sold expense for the product, assume that the company’s accounting system records the operating expenses for each of its separate profit centers. (Please note: The accounting system of a business might not be set up to track operating expenses by sales sources.)

The profit report for this product, which is one slice of the total business, is presented on the next table:

Profit Report for Profit Center

This table, the percent of change for each line is included. As you see, sales revenue increased 4.7% and operating earnings increased 16.8% compared with the previous year. This level of profit analysis falls short of the more thorough analysis needed for decision making.

The bare-bones profit report framework shown in the second table is lacking in three basic areas: (1) It doesn’t report sales volume—the number of units of product sold. (2) It doesn’t distinguish between variable and fixed operating expenses. (3) Unit values are not included.

 

The profit report presented in below corrects these deficiencies, and then some:

Management of Profit Report

 

Much of the information in the third table, management profit report is confidential and obviously should not circulate outside the business. Your competitors would love to get their hands on this information. In fact, your competitors might attempt to get this information through industrial espionage and intelligence gathering methods.

 

Spreadsheet-Based Profit Framework Report

The latest table above is the printout of our spreadsheet. I use the Microsoft Excel spreadsheet program. In fact, all tables in this post are printouts from Excel spreadsheets. Today, spreadsheets are so widely used and understood that I hardly need to mention the advantages of this analysis tool. However, I should remind you of the “garbage-in, garbage-out” principle. The output of a spreadsheet is no better than the correct coding and accuracy of its inputs. Accordingly, let’s be clear on the definitions of the variables in the third  table profit report.

Sales volume, the first line of the bove table, is the total number of units sold during the period, net of any returns by customers. Sales volume should include only units that brought in revenue to the business. Generally speaking, businesses do a good job in keeping track of the sales volumes of their products (and services). These are closely monitored figures, such as in the automobile industry.

Some businesses sell a huge variety of products. No single product or no single product line brings in more than a small fraction of their total sales revenue. For instance, a well-known general hardware store in Boulder, Colorado, carries over 100,000 products. A business may keep count of customer traffic or the number of individual sales made over the year, but it may not track the quantities sold for every product.

Sales revenue is the net amount of money received by the business from the sales of the products during the period. Notice the word net here. This business, like most, offers its customers many incentives to buy its products and to pay quickly for their purchases. The sales revenue amount on the 3rd table above is not simply the list prices of the products sold times the number of units sold. Rather, the sales revenue amount is the total after deductions for rebates, allowances, prompt-payment discounts, and any other thing that reduces the amount of revenue received by the business.

Cost of goods sold is the product cost of the units sold during the period. This expense should be net of discounts, rebates, and allowances received by the business from its vendors and suppliers.

Manufacturers add together their costs of raw materials, labor, and production overhead to determine product cost. (Accounting for the cost of manufactured products is called cost accounting.)

For other businesses, product cost basically is purchase cost. A business must choose the sequence in which product cost is charged out to cost of goods sold expense. One choice is the first-in, first-out (FIFO) method. The opposite method is the last-in, first-out (LIFO) sequence.

 

One common problem is where to put the cost of inventory shrinkage. It may be included in cost of goods sold expense, or it may be included in the volume-driven operating expenses. A manager definitely should know what has been placed in the cost of goods sold expense, in addition to the product cost of units sold during the period.

The third table separates operating expenses into four classes—two types of variable expenses and two types of fixed expenses. Revenue-driven expenses are those that depend primarily on the dollar amount of sales revenue. This group of variable operating expenses includes salespeople’s commissions that are based on the amount of sales, as well as 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 on the 3rd table that these operating expenses are presented as a percent of sales price in the per unit column.

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). It includes delivery and transportation costs paid by the business, packaging costs, and any costs that depend 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 lines for each type to managers for their analysis of profit. Only the dominant type of variable operating expense would be presented, and it would absorb the other type.

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 disadvantage, of course, is that these operating costs do not decline if 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 over the short run. Examples of fixed costs are wages of employees on fixed salaries for the period (from managers to maintenance workers), real estate taxes, depreciation on the buildings and equipment used in making sales, and utility bills.

Certain fixed costs can be matched with a particular profit center. For example, a business may advertise a specific product, and the fixed cost of the advertisement can be matched against 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. The third table above, reports these costs as direct fixed expenses.

In some cases, it’s not possible to directly attach companywide fixed operating expenses to particular products, product lines, or other organization units. General administrative expenses (such as the chief executive officer’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.

Therefore, a business may allocate these fixed costs among its different profit centers. These fixed costs handed down from headquarters are shown as allocated fixed expenses in the third table above.

 

Understanding Profit Margin

The last table above introduces one new line of information—margin. Margin is operating profit before operating fixed expenses are deducted. It’s not to be confused 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. With the information in the table, the manager can pinpoint the reasons for the unit margin increase—from $22.66 in 2009 to $25.00 in fiscal year 2010. There were two favorable changes: (1) The unit sales price increased, and (2) the unit product cost decreased. The gain in the gross margin per unit was offset by unfavorable changes in both variable operating expenses.

In this example, unit margin increased from $22.66 in 2009 to $25.00 in fiscal year 2010—and the business sold 2,500 more units in 2010. Therefore, total margin jumped $290,650, to $2,500,000 for 2010. The total amount of fixed operating expenses increased $75,000 over 2009, which offsets part of the margin gain. Operating earnings increased a very healthy $215,650 during 2010, which is a 16.8% gain. Most managers would be quite satisfied with this performance.

By the way, the same analysis can be used to explain the variances between actual and budgeted amounts for the period just ended. Actual results would be in the 2010 columns. Budgeted amounts for 2010 would be put in the comparison columns on the 2009 side, instead of 2009 results.

The manager’s attention should be riveted on unit margin, and the manager should definitely understand the reasons for changes in unit margin. Even a relatively small change in unit margin can have a big impact on operating earnings. For instance: what if unit margin had remained the same at $22.66 during fiscal year 2010? The business sold 2,500 more units than the previous year, which would have increased its total margin ($56,650 / $22.66) × 2,500 additional units = $56,650 total margin increase.

As you see in third table above, the company’s total fixed operating expenses (direct plus allocated) increased $75,000 over the previous period. Therefore, if unit margin had remained the same as in 2009, the company’s operating earnings would have decreased. Fortunately, unit margin increased $2.34 (i.e., $25.00 – $22.66 = +$2.34), and this increase more than overcame the increase in fixed expenses and provided a nice boost in operating earnings.

 

 
How the Business Made Profit

The management analysis profit report shown on the third table previously that provides the information I need to answer the question posed at the start of the post: How do you make profit? So, how did the business earn $1,500,000 operating profit from this profit center for fiscal year 2010?

Actually, there are three answers to the question. Please refer to the 3rd table above in reading each answer.

  • Answer #1: The business earned a profit margin of $25 per unit, and it sold 100,000 units of the product: $25 unit margin × 100,000 units sales volume = $2,500,000 total margin. The product had $1,000,000 total fixed expenses for the year. Thus, total operating earnings was $1,500,000 for the year.
  • Answer #2: The company had to sell 40,000 units of the product to reach its breakeven point: $1,000,000 total fixed expenses [divideed] by $25 unit margin = 40,000 units breakeven point. The business sold 60,000 units in excess of the breakeven point. Each unit sold in excess of the breakeven point brought in $25 “pure” profit because the first 40,000 units sold covered fixed expenses. The 60,000 units in excess of breakeven at $25 unit margin provided $1,500,000 operating earnings.
  • Answer #3: The business spread its $1,000,000 total fixed expenses over 100,000 units sold during the year, which was an average of $10 per unit. This fixed cost per unit is not presented on the third table. Fixed costs are monolithic in nature; they are bulk-size costs that are not sensitive to changes in sales volume over the short run.

 

However, this third answer for how the business made its profit needs the average fixed costs per unit. The business made $25 unit margin per unit sold, which is $15 more than the $10 fixed costs per unit: $15 × 100,000 units sold = $1,500,000 operating earnings.

Each answer is valid. In a certain situation, one of the three ways for explaining how to make profit is more useful. If you were thinking of making a large increase in fixed operating expenses, for example, you should pay attention to the effect on your breakeven point, so answer #2 is most useful in this situation.

If you were thinking of changing sales prices, answer #1, which focuses on unit margin, is most relevant. Likewise, if you’re dealing with changes in product cost or variable operating expenses that affect unit margin, answer #1 is the most helpful because it focuses on the “spread,” or margin, between sales price and variable expenses.

 

A More Compact Profit Model

The profit report framework shown on the third table above is a terrific tool for understanding and analyzing profit performance. It’s an excellent platform for planning how to improve profit next year. The framework can be applied to any business that sells products. With a few modifications, it can also be used by service businesses that don’t sell products. But, frankly, it’s not the most popular kid on the block; many managers don’t use this tool. Despite its utility, business managers may have problems in using this profit report framework.

A major obstacle is that the managers of a business may not be able to get information about variable and fixed operating costs out of their accounting system. Supplying this information is one more demand on the system. A business’s accounting system must accumulate a large amount of information needed for preparing its financial statements and its income tax and many other tax returns. Variable and fixed information is not needed for these purposes. Also, a company’s accounting system has to provide a wide range of information for its day-to-day operations, including the vital functions of payroll, purchasing, billing and collections, cash disbursements, and property records.

Variable and fixed expense information is not needed for these functions either. The managers of a business could insist that the accounting department compile variable and fixed operating expense information. The computer accounting programs used by most businesses today make much more feasible sorting between variable and fixed expenses. But, clearly this is not done in many businesses.

All is not lost, however. Based on his or her experience and close contacts with the profit factors of the business, a manager can make educated estimates for the variable and fixed operating expenses for a particular product or product line or other profit center. You don’t really have to use actual accounting data; you can substitute experience-based estimates for the variables.

Managers may have another reason for not using a profit report framework such as the one shown in the above table#3. They may think that the framework is too cumbersome and would be too time-consuming, especially if they have a large number of different profit sources to manage. Well, this may be true. The one thing a manager never has enough of is time. To make it more time efficient, the framework shown on the third table can be telescoped into a more compact profit model.

Instead of using the full-blown profit report framework, a manager could use a “mini” profit model. The next table presents a profit model for the product (for fiscal year 2010). This profit model is a repeat of answer #1 given earlier for explaining how the business made $1,500,000 profit from this product.

Profit Model for a Product

Basically the profit model is a shorthand method for thinking about and analyzing profit. For instance, suppose you are thinking of cutting sales price by $5 next year in order to boost sales volume 10%. Would this be a smart move? Dropping sales price $5 would reduce unit margin $5, assuming product cost and other variable expenses hold constant. So next year you would earn only $2,200,000 total margin on the product: $20 unit margin × 110,000 units sold = $2,200,000 total margin. Bad idea!

 

Managers make decisions toward achieving the profit goals of the business. Managers need feedback on the results of their decisions, of course. The periodic profit reports prepared by the business’s accounting department provide the primary feedback to managers.