Business managers face constant change — in particular, the factors that drive profit change frequently. Some changes are external and beyond the control of the business, and some changes are initiated by managers themselves. Many management decisions are triggered by changes. Indeed, business managers are characterized as change agents; The costs of the products sold by the business may increase. The company may raise wages for some or all of its employees, or wage rates may actually decrease due to employee give-backs. The landlord may raise the rent. Competitors may drop their sales prices, and the business has to decide whether to follow them down. Or managers may decide that they have to raise sales prices to keep up with cost inflation. Changes set in motion a new round of decisions. After changes happen, you need to reexamine your new profit environment.
The best course of action to take for maintaining and improving your profit performance is not obvious in most situations. Often, you have to compare alternatives. And, usually, you have to make decisions in a hurry. A good profit model is very helpful!. Through this post I explain the basic profit model and its elements, the five key profit drivers of your business. By understanding profit model of your business, you will most likely be able to develop and establish an intelligent profit strategy for the business.
What and How is Profit Model Structurized?
The profit model is like a miniature Profit and Loss [P&L] . The P&L itself provides essential feedback information for management control of profit — to monitor progress and spot any problems that are brewing.
On the other hand, for a profit model, the P&L report is stripped down to its bare bones. Reading a P&L report is like looking under the hood of your auto; reading a profit model is like looking at the dashboard. Not to stretch this figure of speech too far, but a good profit model starts you off in the right direction to reach your profit destination.
Below figure presents a profit model. Five key profit factors appear in bold; the other lines are different measures of profit. The dollar amounts in the profit model example are in the range of many small businesses. Of course, your business may be larger or smaller. We round off dollar amounts in the example to keep calculations easier to follow:
Net Sales Revenue $3,000,000
Product Costs ($1,650,000)
Variable Operating Costs ( $450,000)
Fixed Operating Costs ($750,000)
Operating Profit $150,000
Interest Expense ($48,000)
Profit Before Income Tax $102,000
Let’s discuss briefly about the five key factors that drive profit. Read on…
Net Sales Revenue
The starting point in the profit model is net sales revenue, which equals the total volume (quantity) of all products sold times their net sales prices. The net sales price of a product is its list sales price less any discounts and allowances given to the customer, and less variable costs that can be directly matched against the sale.
A manufacturer’s suggested retail price (MSRP), or sticker price, is an example of a list price. The sales prices printed in its catalogs and price sheets by a business are its list prices. The shelf prices of the products sold by retailers are list prices. As you probably know, list prices aren’t always the actual amount of sales revenue received by a business. The list price on the gas pump is the actual price you pay per gallon, but for many products, list prices are just the point of departure. Actual prices are less than list prices for many reasons.
Many factors drive down the actual sales revenue received by the business. For example: retailers accept credit cards, such as VISA, MasterCard, Discover, American Express, and Diners Club. The credit card sales invoices are deposited with the participating bank. The bank discounts a certain percent from the amount of the sale and credits the balance in the business’s checking account. Discount rates vary between 2 to 4 percent (sometimes lower or higher). So, the business nets only 98¢ to 96¢ from each dollar of a credit card sale. The credit-card discount comes right off the top of each sales dollar.
The business avoids the expenses of extending and administering credit directly to its customers. Many retailers accept debit cards. The discounts and fees charged to the business by the bank that issues a debit card may be more favorable than traditional credit cards.
Sales commissions are another common example of an expense that comes right off the top of sales revenue. As you probably know, many businesses pay their sales staff on a commission basis, which usually is a certain percent of the total sales amount. If the sales commission is, say, 5 percent, the business nets only 95 cents on a dollar of sales.
In selling to other businesses, a company usually extends short-term credit, called trade credit. No matter how carefully customers are screened before they’re extended credit, a few never pay what they owe the business.
Eventually, after making repeated collection efforts, the business ends up writing off these uncollectible receivable balances. These losses are called “bad debts” and are a normal expense of doing business on credit. Based on its experience and credit policies, a business can estimate the percent of its credit sales that will end up being written off as bad debts. For example: for every $10,000 of sales revenue (net of discounts), a small business manager may expect that $250 will not be collected despite its best efforts to screen customers.
Another example of an expense that is a direct offset against sales revenue is one you may not think of — rent. A small business may sign a lease agreement that calls for rental amounts based on gross sales. The lease calls for a certain base amount, or fixed minimum monthly rent. In addition, the lessee pays a variable amount equal to a percent of total sales revenue. Paying a variable component on top of the fixed minimum amount of rent is common for retailers renting space in shopping centers. The franchise fee paid by a franchisee is typically based on gross sales, which is another example of a direct deduction from sales revenue.
A business may offer its credit customers prompt payment discounts from list prices if they pay within ten days of the sale. Some businesses offer quantity discounts to customers if they buy a case of products (such as a wine retailer offering 10 percent off the price per bottle). Many businesses give nonprofit customers special discounts from list prices. Businesses sometimes negotiate price reductions, called allowances, after the time of sale. Mail-in rebates have become very popular in recent years. Auto dealers give you money back when you buy a new auto or pick up truck (which they really don’t of course, but we don’t discuss this sales tactic).
In summary, the profit model starts with net sales revenue to the business, which is less than the amount of sales revenue at list prices. The sales revenue figure in the profit model is net of discounts from list prices, sales commissions, sales price allowances, and direct variable costs based on sales revenue. Suppose in the example that after deducting discounts, sales commissions, allowances, and direct costs of making sales your net sales revenue is only 85 percent of list sales prices. At list prices, sales revenue would have been more than $3,500,000. But, as you see in the profit model figure, net sales revenue is $3,000,000, which is the actual revenue you have to work with to recover your costs and to provide profit.
Product Costs and Variable Operating Costs
The product costs line in the profit model example above includes losses from inventory shrinkage and inventory write-downs caused by declines in the replacement and sales values of products. Generally these losses run parallel with your cost of goods sold expense. The $1,650,000 product costs in the profit model figure includes $82,500 loss from inventory shrinkage and write-downs, which is 5 percent of the total product costs. Of course, some businesses experience higher rates of inventory shrinkage, and some lower.
Variable operating costs (see the next line in the profit model figure) are those that depend mainly on sales volume. Packaging, shipping, and delivery costs are prime examples. For example, at stores, customers’ purchases are put in plastic bags and paper sacks, and this cost depends on the number of products sold. The size of variable operating costs relative to sales varies from business to business. In the profit model example, this cost is high enough to hold your interest.
Deducting product costs and variable operating costs from net sales revenue gives the all-important figure called margin. Margin is the measure of profit before fixed costs are deducted [Accountants also call this “contribution margin“; the idea is that margin contributes toward covering fixed costs].
In the profit model figure, you earn $900,000 margin, which is calculated by deducting $1,650,000 product costs and $450,000 variable operating costs from the $3,000,000 net sales revenue. Basically, margin is revenue minus variable costs.
Fixed Operating Costs
Every business is saddled with fixed operating costs. Your company’s fixed operating costs are $750,000 for the year, which includes depreciation expense on your fixed assets. The amount of depreciation expense recorded in the year is a fixed amount regardless of whether the long-term operating assets are used heavily or lightly during the period. Depreciation expense amount recorded annually depends on the choice of accounting method. In contrast, a business doesn’t have a choice of accounting methods for recording its other fixed operating costs — although a business does have some latitude in making estimates for some fixed costs and in the precise timing for recording certain fixed costs.
Fixed means that these operating costs, for all practical purposes, are locked in for the year. Your fixed operating costs are the same whether your sales are higher or lower than actual sales for the year.
Examples of fixed costs are: employees paid fixed salaries, building rent, many types of insurance, and your annual CPA fee. Property taxes and vehicle licenses are fixed amounts for the year. Once spent, advertising is a fixed cost.
Fixed costs are like the old joke about hell: It’s easy to get in, but very hard to get out. For all practical purposes, you can’t change fixed costs over the short run. The longer the time horizon, however, the more you can adjust fixed costs up or down. It takes a relatively long time to get out from fixed cost obligations. Once you’ve made these commitments, you can only hope that your actual sales will be high enough to justify your fixed operating costs.
Fixed operating costs can’t be scaled down over the short run — unless the business takes drastic action, such as breaking contracts, firing employees, or delaying payment of property taxes. For all practical purposes, fixed operating costs are locked in place for the year. Fixed operating costs are called overhead costs because these costs hang over the head of the managers running the business like an albatross. Fixed costs are also called the nut of the business, and a tough nut to crack.
Why would any rational manager commit to fixed overhead costs? The short answer is that fixed operating costs provide sales capacity. These costs make available the people and facilities to carry on sales activity and the operations of the business. Fixed costs are incurred to provide the needed space, equipment, and personnel to sell products and to carry on the operating activities of the business. By committing to these costs, the business acquires a certain amount of capability of making sales.
A business manager [or owner] should estimate the sales capacity of the business —the maximum sales volume provided by the fixed operating costs of the business. Estimating sales capacity is not all that precise. But you can make a reasonable, ballpark estimate. The manager can start by asking whether a 10 percent sales volume increase would require an increase in the business’s fixed costs. Your business may have a sizable amount of unused sales capacity. Perhaps your sales could grow 10, 20, or 30 percent before you’d need to rent more space, hire more employees, or purchase more equipment. Sizing up the unused sales capacity of your business is especially important in planning ahead and in analyzing the profit impact of changes in the key factors that drive profit.
One bit of advice: The term fixed should be used with some caution. True, the fixed operating costs of a business for the year are largely unchanging and inflexible — but not down to the last penny. The main point about fixed costs is that they’re insensitive to the number of units sold during the period. You can adjust many fixed costs if sales drop off precipitously or surge ahead rapidly. For example, suppose that your sales take a sudden and unexpected downturn. You could sublet part of the space you rent, reduce your insurance policy limits, or sell some real estate you own. On the other hand, if sales spurted up suddenly, you could ask employees to work overtime hours.
The term fixed really means that these costs remain largely constant over a range of sales activity that may be 10 or 20 percent lower or higher than your actual sales volume. Managers should be equally vigilant and hard-nosed about their fixed operating costs as they are about their product costs and variable operating costs (see preceding section).
Managers should take a close look at their fixed costs even when sales are good. All too often, it takes a steep nosedive in sales to get managers to scrutinize their fixed costs. Reducing fixed costs require tough decisions. You may have to lay off employees, sell off surplus assets, and rent smaller quarters. But if you’re not utilizing the full potential of your fixed operating costs and if you don’t predict much future sales growth, you should bite the bullet and get to work downsizing your fixed operating costs.
In the profit model example, the $750,000 fixed operating costs are deducted from the $900,000 margin to determine your $150,000 operating profit, which also is called operating earnings, or earnings before interest and income tax (EBIT). Don’t forget that to make profit, you need assets, and to finance your assets, you probably use some debt capital.
On one side of your balance sheet are your assets. On the other side are the sources of your assets, which consist of three basic types — operating liabilities, interest-bearing debt, and owners’ equity. Accounts payable and accrued expenses payable are the two main kinds of operating liabilities. Debt is classified as either short term (maturity dates of one year or shorter) or long term (maturity dates more than one year out).
The business shown in the profit model figure has $1,500,000 total assets. This amount of total assets is not atypical for a business that has $3,000,000 annual sales. The total of its operating liabilities (mainly accounts payable and accrued expenses payable) is $300,000. These non-interest bearing liabilities arise in the normal course of operations, in particular from making purchases on credit and not paying certain expenses immediately. Subtracting operating liabilities from total assets gives $1,200,000, which is the amount of capital that your business has raised. One-half, or $600,000 of your capital, is from interest-bearing debt. Your interest expense for the year is $48,000 (see the profit model example). Thus, your annual interest rate is 8 percent:
$48,000 annual interest expense / $600,000 debt = 8% annual interest rate
The mix of debt to equity, or debt to equity ratio, varies from business to business, and interest rates vary, of course. Using debt for half of your capital is fairly aggressive. Many businesses are more conservative and prefer to keep their debt level less than half of total capital. The main point is that you should have a clear idea of the amount of assets you need to support your level of sales and how much of the capital for your total assets is supplied from interest-bearing debt. As the owner/manager of the business, you make this critical decision regarding how to finance the business.