<<

. 20
( 55 .)



>>

the products sold by the business. Examples are barrels for


110
BREAKING EVEN AND MAKING PROFIT


breweries, tons for steel mills, passenger miles for airlines,
and vehicles for car and truck manufacturers.
The sales volume for the year reported in Figure 8.1 is the
sum of all units sold during the year. Per-unit values in this
management profit report are averages for all products. Of
course, the averages depend on the sales mix of products dur-
ing the year, which refers to the relative proportions of each
product sold. Changes in a business™s sales mix can cause sig-
nificant changes in the average sales price and average costs,
which can cause a major shift in profit.
These important points are explored in Chapter 17. In this
chapter it does no harm to pretend that the company sells just
one product. This one product serves as a stand-in, or proxy,
for all the products sold by the company. The business sold
578,500 units at a $68.56 sales price; product cost was $43.15;
and the company incurred $5.27 revenue-driven variable costs
and $4.63 unit-driven variable costs for each unit sold. There-
fore, the business earned $15.51 contribution margin per unit
sold (Figure 8.1). This profit margin figure equals sales price
minus product cost minus the two variable operating expenses.
The business sold 578,500 units at this margin per unit, so
it earned $8,973,615 contribution margin ($15.51 contribu-
tion margin per unit — 578,500 units sales volume =
$8,973,615 contribution margin). This measure of profit is
before fixed operating expenses for the year and before inter-
est and income tax expenses. Of course, contribution margin
is not the bottom-line profit of a business. But it is an
extremely important stepping-stone measure of profit that
deserves close management attention.

Although not shown in Figure 8.1, contribution margin equals
22.6 percent of sales revenue ($8,973,615 contribution mar-
gin · $39,661,250 sales revenue = 22.6%). Managers should
compare this key ratio with prior years and against the com-
pany™s profit objectives for the year just ended. Any slippage
in this important ratio can have serious consequences, as
later chapters demonstrate. This chapter focuses on how the
business made the amount of profit that it did for the year.
Later chapters focus on changes in sales volume, sales prices,
cost changes, and other factors that improve or damage profit
performance.


111
PROFIT AND CASH FLOW ANALYSIS



FIXED OPERATING EXPENSES
Fixed operating expenses are deducted from contri-
bution margin to determine operating profit, which also is
called operating earnings, or earnings before interest and
income tax (EBIT). The general nature of fixed costs is
explained in Chapter 3. A business has many operating
expenses that vary either with sales volume or with sales rev-
enue. In stark contrast, a business has many operating
expenses that do not vary with sales activity. Instead these
costs remain stuck in place over a range of sales activity levels.
Examples of typical fixed operating expenses are the fol-
lowing. A business signs annual or multiyear lease contracts
for retail and warehouse space; the monthly rents are fixed in
amount and do not depend on the sales of the business.
Employees are hired and paid fixed salaries per month or are
promised 40-hour weeks at certain hourly rates. Premiums
are paid for six months to provide insurance coverage against
casualty and liability losses. Utility and telephone bills are
paid monthly and do not depend on sales levels. Property
taxes and vehicle licenses are fixed amounts for the year.
Many other examples of fixed operating costs could be listed.
In short, a business makes many commitments that incur
certain operating costs for a period of time. These fixed costs
cannot be avoided unless the business takes drastic action,
such as breaking contracts, firing employees, or not paying
property taxes. For all practical purposes, fixed operating
expenses are pretty much locked in for the year. Fixed operat-
ing expenses often are called overhead costs because these
costs hang over the head of the managers running the busi-
ness like an albatross or millstone.
Why would any rational manager commit to overhead
costs? Fixed operating expenses provide capacity. These costs
make available the capacity to carry on sales activity and
other operations of the business. Fixed expenses are incurred
to provide the needed space, equipment, and personnel to sell
products and to carry on the necessary operating activities of
the business. By committing to these costs, the business
acquires a certain amount of capacity, or ability to operate
for the period.
Business managers should estimate the sales capacity of
their business (i.e., the maximum sales volume that is feasible

112
BREAKING EVEN AND MAKING PROFIT


based on the fixed expenses of the business). Estimating sales
capacity may not be all that precise, but a reasonable, ball-
park estimate can be made. The manager could start by ask-
ing whether a 10 percent sales volume increase would require
an increase in the business™s fixed expenses. Managers should
compare the business™s sales capacity against actual sales vol-
ume. A business may have a large amount of unused sales
capacity. Perhaps sales could grow 10, 20, or 30 percent
before more space would have to be rented and more persons
would have to be hired or more equipment would have to be
installed. Having an estimate of the idle, unused sales capacity
of the business is especially important in planning ahead and
in analyzing the profit impact of changes in the key factors
that drive profit, as the following discussion reveals.

The term fixed should be used with caution. True, the fixed
costs of a business for a period are largely unchanging and
inflexible”but not down to the last penny. The main point
about fixed operating expenses is that they are insensitive to
the number of units sold during the period or the amount of
sales revenue for the period”unless a business takes drastic
action to scale down or expand its sales capacity. Many, if not
most, fixed expenses can be adjusted if sales drop off precipi-
tously or surge ahead rapidly. For example, suppose sales
take a sudden and unexpected downturn. A business could
sublet part of the space it rents, reduce insurance limits, or
sell some of the property it owns. If on the other hand sales
spurted up all of a sudden, a business could ask its employees
who are guaranteed a 40-hour workweek at a fixed hourly
rate to work overtime to handle the upsurge in sales. What
the term fixed actually means is that these costs remain
largely constant in the short run over a range of sales activity
that might be 10 to 25 percent lower or higher than the actual
sales volume of the business.


DEPRECIATION: A SPECIAL KIND OF FIXED COST
Depreciation expense accounting is unique; you could even
say weird. The basic idea of allocating the cost of a long-term
operating resource over its useful, productive life is sound and
unimpeachable. (Ownership of land confers the right to
occupy a certain space in perpetuity, so the cost of land is not

113
PROFIT AND CASH FLOW ANALYSIS


depreciated.) The total cost of a company™s long-term operat-
ing resources is reported in an asset account in its balance
sheet, usually entitled property, plant, and equipment.


The original costs of fixed assets are recorded in one
account, and depreciation expense each period is
recorded in a second account called accumulated depreciation.
The balance in this contra, or offset, account is the cumulative
amount of depreciation expense recorded to date. Its balance
is deducted from the property, plant, and equipment asset
account. In this way the balance sheet discloses both the cost
of a company™s fixed assets and how much of the cost has
been depreciated so far.
For instance, at the close of its most recent year the busi-
ness™s fixed assets are reported as follows in its year-end bal-
ance sheet (from Figure 4.2):
Y
FL
Property, plant, and equipment $20,857,500
Accumulated depreciation ($ 6,785,250)
AM


Cost less accumulated depreciation $14,072,250
TE




In this example the business™s fixed operating expenses for
the year just ended include $768,450 depreciation expense. In
other words, the business recorded a $768,450 write-off of its
fixed assets in order to recognize the wear and tear on and
the gradual loss of productivity of its long-term operating
resources. In short, the year just ended was charged more
than three-quarters of a million dollars for the use of fixed
assets during the year. But, the amount of depreciation
expense for the year should be taken with a grain of salt.
Indeed, you need a saltshaker in the case of depreciation.

Business managers should pay particular attention to the
depreciation expense accounting methods used by their busi-
ness for three main reasons:
1. Depreciation expense is not a cash outlay in the year it is
recorded; the fixed assets being depreciated were bought
and paid for in previous years (except for the new fixed
assets acquired during the most recent year).

114
BREAKING EVEN AND MAKING PROFIT


2. The computation of annual depreciation expense is based
on an arbitrary time-based method of allocation”not on
the actual level of use of fixed assets during the period.
3. For the vast majority of businesses, the amount of annual
depreciation expense is determined by federal income
tax”the useful lives permitted under the tax law are con-
siderably shorter than realistic estimates for most fixed
assets of most businesses; and the income tax law permits
front-end loading of depreciation expense (except for
buildings), which causes the expense to decline from year
to year.
As a practical matter, most businesses use the useful lives for
their fixed assets that are permitted by the federal income tax
law, and they use one of the allocation methods allowed by the
law. Most businesses abandon any attempt to base deprecia-
tion on realistic useful life estimates and actual patterns of use
from year to year. One result is that a fixed asset, say a partic-
ular piece of machinery or equipment, could be fully depreci-
ated on the books yet continue to be used for several
additional years during which no depreciation expense is
recorded. Business managers definitely should know whether
certain of their operating fixed assets were used during the
period for which no depreciation expense was recorded.
In times past there was an argument for the units-of-
production depreciation method for manufacturers. The
method, in brief, works as follows. The business estimates the
total number of units expected to be manufactured using a
particular machine or piece of equipment over its entire eco-
nomic life. This number is divided into cost of the fixed asset
to calculate depreciation per unit. The amount of depreciation
recorded for the period depends on the number of units man-
ufactured. Depreciation would be a variable cost if this method
were used.
The units-of-production depreciation method is seldom if
ever used”even though it has good theoretical support.
Instead businesses™ fixed assets are depreciated by either the
straight-line method or an accelerated method. Both methods
allocate a certain predetermined amount of a fixed asset™s cost
to each year of the estimated life of the asset regardless of
how much or how little the asset actually might be used dur-
ing the year. Therefore, depreciation is a fixed cost.

115
PROFIT AND CASH FLOW ANALYSIS


INTEREST EXPENSE
The business incurred $795,000 interest expense for the year
just ended (Figure 8.1). Interest is not an operating expense”
it™s a financial expense. As you know, interest is the cost of
using debt for part of the total capital invested in the assets of
the business. Generally speaking, the total amount of capital
invested in assets swings up and down with shifts in sales
revenue”though certainly not in direct proportion to changes
in sales revenue or sales volume (number of units sold). Thus
the amount of debt tends to move in the same direction as
changes in sales. However, the linkage between shifts in sales
revenue and debt is not simple and cannot easily be put into a
formula.
For relatively minor swings in its sales level a business
probably would not adjust the amount of its debt in most situ-
ations, so its interest expense would remain fixed in amount.
On the other hand, for major shifts in sales a business proba-
bly would adjust the amount of its debt, so its interest expense
would change. In the following analysis assume that the busi-
ness™s annual interest expense is fixed”keeping in mind that
a major change in sales volume probably would result in a
corresponding change in debt and interest expense.

<<

. 20
( 55 .)



>>