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PATHWAYS TO PROFIT
The business™s operating profit, earnings before income tax,
and net income are presented in the management profit
report (Figure 8.1). Reading a profit report is passive and
reflective; computing profit is active and engaging. Managers
don™t get paid to know profit, but to make profit happen. Man-
agers need a sure-handed analytical grip on the factors that
drive profit. The following discussion explains methods of cal-
culating profit, mainly for the purpose of demonstrating how
profit is earned.

Before calculating profit it™s necessary to identify
which particular profit definition is being used: oper-
ating profit (earnings before interest and income tax), earn-
ings before income tax (earnings after interest expense), or
bottom-line net income (earnings after income tax). Income


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BREAKING EVEN AND MAKING PROFIT


tax is a contingent expense; basically it™s a certain percent of
taxable income. Taxable income, generally speaking, equals
earnings before income tax because interest expense is
deductible to determine taxable income. (Tax accountants will
cringe when they read this sentence because there are many
complexities in the federal income tax law; but to simplify I
assume that taxable income equals the business™s earnings
before income tax.) In the example, the business™s income tax
rate is 35 percent of its earnings before income tax.
In the following analysis the business™s fixed operating
expenses and its fixed interest expense are combined into one
total fixed cost for the year ($5,739,250 fixed operating
expenses + $795,000 fixed interest expense = $6,534,250 total
fixed costs). In other words, profit is defined as earnings
before income tax. The business earned $2,439,365 profit for
the year just ended (Figure 8.1).
There are three different ways to analyze how the business
earned its profit for the year, and each offers valuable lessons
for business managers.


Pathway to Profit #1: Margin Times Sales Volume
One pathway for calculating profit is as follows (data is from
Figure 8.1):
$15.51 contribution margin per unit
— 578,500 total units sold (sales volume)
= $8,973,615 total contribution margin
’ $6,534,250 fixed expenses
= $2,439,365 profit
Technical note: Contribution margin per unit shown here is a
rounded figure; the precise contribution margin per unit is
used in calculating total contribution margin.
The linchpin in this computation is the multiplication of
contribution margin per unit by sales volume to get total con-
tribution margin. Sales volume needs a good contribution
margin per unit to work with. Maybe you™ve heard the old
joke: “A business loses a little on each sale but makes it up
on volume.” This isn™t funny, you know.


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PROFIT AND CASH FLOW ANALYSIS


The Breakeven Hurdle

The business sold enough units to overcome its fixed
expenses and earn a profit. Business managers
worry a lot about their fixed costs”there™s no profit unless the
business™s sales volume is large enough to cover its fixed
expenses. The sales volume needed to cover fixed costs is
called the breakeven point, or the breakeven volume, or more
simply just breakeven. The breakeven point equals that exact
sales volume at which total contribution margin equals total
fixed expenses. The breakeven calculation tells a manager the
sales volume that has to be achieved just to cover his or her
fixed costs for the year.
Generally, businesses do not publicly divulge their
breakeven volumes. Financial reporting standards do not
require that this particular piece of information be disclosed
in external financial reports. Some years ago, a series of arti-
cles in the financial press about Chrysler Corporation referred
to the company™s breakeven point. At that time Chrysler™s
breakeven point was 1.8 million vehicles a year. One article
said that this breakeven point was reasonable because
Chrysler had sold about 2.3 million vehicles in the previous
year, but that the breakeven point was higher than Chrysler
would like it to be heading into the trough of the industry™s
sales cycle. Although now out-of-date, these articles illustrate
the importance of breakeven.
The breakeven point for the company example (i.e., the
sales volume at which the company™s profit would be zero) is
computed as follows:
$6,534,250 annual fixed expenses
= 421,242 units
$15.51 unit contribution margin
Technical note: Contribution margin per unit shown here is a
rounded figure; the precise contribution margin per unit is
used in calculating breakeven volume.
If the business had sold only 421,242 units during the year it
would have earned zero profit (earnings before income tax). The
company™s taxable income would have been zero and its income
tax would have been zero. So net income would have been zero.
Figure 8.2 illustrates the breakeven sales volume scenario.
The breakeven volume is a useful point of reference. It™s a


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BREAKING EVEN AND MAKING PROFIT




Sales Volume 421,242 Units
Per Unit Totals
Sales revenue $68.56 $28,879,837
Cost-of-goods-sold expense ($43.15) ($18,175,484)
Gross margin $25.41 $10,704,353
Variable revenue-driven operating expenses ($ 5.27) ($ 2,220,175)
Variable unit-driven operating expenses ($ 4.63) ($ 1,949,928)
Contribution margin $15.51 $ 6,534,250
Fixed operating expenses ($ 5,739,250)
Operating profit $ 795,000
Interest expense ($ 795,000)
Earnings before income tax $ 0
Income tax expense $ 0
Net income $ 0

Note: Pro forma means “as if,” or based on certain conditions or circumstances.
FIGURE 8.2 Pro forma profit report at hypothetical breakeven volume.




good way to express the total fixed-costs commitment of a
business (i.e., how many units have to be sold just to cover
fixed costs). Also, sales volume can be compared against
breakeven volume to measure a company™s margin of safety.
Furthermore, breakeven volume is very useful in analyzing
profit behavior at different levels of sales volume.

Cash Flow Breakeven
As explained previously, depreciation is a fixed cost, but it is
different in one very important respect from other fixed costs.
Depreciation is not a cash outlay in the year the expense is
recorded. The other fixed costs of a business are cash-based.
Some of these fixed costs are prepaid (such as insurance pre-
miums paid in advance for future coverage), and many are
paid after the expense is recorded in either the accounts
payable or the accrued expenses payable liability account. But
the cash flows for these fixed costs take place mostly in the
period in which the expenses are recorded. In contrast, there
is no cash payment for depreciation expense.


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PROFIT AND CASH FLOW ANALYSIS


Therefore, depreciation can be stripped out of the fixed
costs for the period and the cash flow breakeven volume can
be calculated as follows:
$6,534,250 annual total fixed expenses
’ $768,450 depreciation expense for year
$5,765,800 cash-based fixed expenses for year
=
$15.51 unit contribution margin
= 371,703 units
For cash flow analysis, this concept of breakeven is rele-
vant. But managers are much more concerned about profit
numbers that will be presented in the business™s external
income statement and its internal profit reports. So, the most
used concept of breakeven includes all fixed costs.

Margin of Safety
One purpose of calculating breakeven is to compare it against
actual sales volume. The excess of actual sales volume over
breakeven sales volume provides the measure of a company™s
margin of safety. This excess over breakeven sales volume
reveals how much the company™s sales would have to drop
before the business slips out of the black and into the red”
from profit to loss. The company sold 578,500 units during
the year just ended compared with its 421,242 units breakeven
volume. So it sold 157,258 units over its breakeven, which is
its margin of safety. The company™s margin of safety equals 27
percent of its actual sales volume for the year (157,258 units
excess over breakeven · 578,500 units sold during the year =
27%). Of course this 27 percent margin of safety does not nec-
essarily guarantee a profit next year. Sales could drop dramat-
ically, or expenses could rise dramatically. Later chapters
explore what would happen based on changes in the key fac-
tors that drive profit.


Pathway to Profit #2: Jumping
the Breakeven Hurdle
A second way to calculate profit is to use the number of units
sold in excess over breakeven as the source of profit, as follows:


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BREAKING EVEN AND MAKING PROFIT


578,500 total units sold (sales volume)
’ 421,242 breakeven volume
= 157,258 units sold in excess of breakeven
— $15.51 contribution margin per unit
= $2,439,365 profit
Technical note: Contribution margin per unit shown here is a
rounded figure; the precise contribution margin per unit is
used in calculating profit.
This method assigns the first 421,242 units sold during the
year to covering fixed expenses. In other words, the contribu-
tion margin from the first 421,242 units sold during the year
is viewed as consumed by fixed expenses. The 157,258 units
sold in excess of the breakeven volume are viewed as the
source of profit. In other words, annual sales volume is
divided into two piles: (1) the breakeven group and (2) the
profit group.
Profit is the same amount as calculated by the first method,
although the method of getting there is different. The differ-
ence is a little more complex than meets the eye. It™s not just
an exercise with numbers; it concerns how managers think
about making profit in the first place. The first method of
computing profit stresses the multiplication of unit contribu-
tion margin by sales volume to get total contribution margin
for the period. Fixed expenses are not ignored, but are
deducted from total contribution margin to work down to
profit. In contrast, the excess over breakeven method puts
fixed expenses first and profit second”the business first has
to exceed its fixed expenses before it gets into the black.


Pathway to Profit #3: Average Profit Per Unit
The excess over breakeven profit method divides sales volume
into two piles: (1) the breakeven quantity necessary to cover
total fixed expenses and (2) the surplus over breakeven vol-
ume that provides profit. A third pathway to profit divides
every unit sold into two parts: fixed expenses and profit.
The basic concept of the third method is that profit derives
from spreading fixed expenses over a sufficiently large sales


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PROFIT AND CASH FLOW ANALYSIS


volume to ensure that the average fixed cost per unit is less
than the contribution margin per unit. The fundamental think-
ing is that every unit sold has to do two things: (1) contribute
its share to cover fixed expenses and (2) provide a profit resid-
ual. The computation of profit by this method is as follows:
$6,534,250 total fixed costs
· 578,500 units sales volume for year
= $11.29 average fixed cost per unit sold
versus $15.51 contribution margin per unit
= $ 4.22 average profit per unit
— 578,500 total units sold (sales volume)
= $2,439,365 profit
Technical note: The contribution margin per unit, average
fixed cost per unit, and average profit per unit are rounded
figures; the precise figures for each are used in calculating
profit.
This method spreads fixed expenses for the year over the
total number of units sold, which gives $11.29 as the average
fixed cost per unit. Profit according to this method is viewed

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