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Annual sales 100,000 units
Annual breakeven 120,000 units
Annual capacity 150,000 units

Per Unit Total
Sales revenue \$50.00 \$5,000,000
Product cost (\$32.50) (\$3,250,000)
Variable expenses (\$10.25) (\$1,025,000)
Contribution margin \$ 7.25 \$ 725,000
Fixed operating expenses (\$ 870,000)
Profit (loss) (\$ 145,000)

Breakeven is computed by dividing \$870,000 fixed
expenses by \$7.25 contribution margin per unit.
Annual capacity is new information given here in the
example.

FIGURE 12.4 Bad news profit report.

First Some Questions about Fixed Expenses
One thing you might do first is to take a close look at your
\$870,000 fixed operating expenses. Your fixed expenses may
include an allocated amount from a larger pool of fixed
expenses generated by the organizational unit to which your
profit module reports, or they may include a share of fixed
expenses from corporate headquarters. Any basis of allocation
is open to question; virtually every allocation method is some-
what arbitrary and can be challenged on one or more
grounds.
For instance, consider the legal expenses of the corpora-
tion. Should these be allocated to each profit responsibility
unit throughout the organization? On what basis? Relative
sales revenue, frequency of litigation of each unit, or accord-
ing to some other formula? Likewise, what about the costs of
centralized data processing and accounting expenses of the
business? Many fixed expenses are allocated on some arbi-
trary basis, which is open to question.

171
PROFIT AND CASH FLOW ANALYSIS

Itâ€™s not unusual for many costs to be allocated across differ-
ent organizational units; every manager should be aware of
the methods, bases, or formulas that are used to allocate
costs. It is a mistake to assume that there is some natural or
objective basis for cost allocation. Most cost allocation
schemes are arbitrary and therefore subject to manipulation.
Chapter 17 discusses cost allocation schemes in more detail.
Questions about the proper method of allocation should be
settled before the start of the year. Raising such questions
after the factâ€”after the profit performance results are
reported for the periodâ€”is too late. In any case, if you argue
for a smaller allocation of fixed expenses to your unit, then
you are also arguing that other units should be assessed a
greater proportion of the organizationâ€™s fixed expensesâ€”
which will initiate a counterargument from those units, of
course. Also, it may appear that youâ€™re making excuses rather
than fixing the problem.
Another question to consider is this: Is a significant amount
of depreciation expense included in the fixed expenses total?
Accountants treat depreciation as a fixed expense, based on
generally accepted methods that allocate original cost over the
estimated useful economic lives of the assets. For instance,
under current income tax laws, buildings are depreciated over
39 years and cars and light trucks over 5 years. Just because
accountants adopt such methods doesnâ€™t mean that deprecia-
tion is, in fact, a fixed expense.
Contrast depreciation with, for example, annual property
taxes on buildings and land (real estate). Property tax is an
actual cash outlay each year. Whether or not the business
made full use of the building and land during the year, the
entire amount of tax should be charged to the year as fixed
expense. There can be no argument about this. On the other
hand, depreciation raises entirely different issues.
Suppose your loss is due primarily to sales volume that is
well below your normal volume of operations. You can argue
that less depreciation expense should be charged to the year
and more shifted to future years. The reasoning is that the
assets were not used as muchâ€”the machines were not oper-
ated as many hours, the trucks were not driven as many
miles, and so on. On the other hand, depreciation may be
truly caused by the passage of time. For instance, deprecia-
tion of computers is based on their expected technological life.

172

Using the computers less probably doesnâ€™t delay the date of
replacing the computers.
Generally speaking, arguing for less depreciation is not
going to get you very far. Most businesses are not willing to
make such a radical change in their depreciation policies (i.e.,
to slow down recorded depreciation when sales volume takes
a dip). Also, this would look suspiciousâ€”the business would
appear to be choosing expense methods to manipulate
reported profit.

Whatâ€™s the Problem?
Your first thought might be that sales volume is the main prob-
lem since it is below your breakeven point (see Figure 12.4). To
review briefly, the breakeven point is determined as follows:
\$870,000 fixed expenses
= 120,000 units breakeven volume
\$7.25 unit margin
To reach breakeven (the zero profit and zero loss point) you
would have to sell an additional 20,000 units, which would
add \$145,000 additional contribution margin at a \$7.25 unit
margin. By the way, notice that breakeven is 80 percent of
capacity (120,000 units sold Ã· 150,000 units capacity = 80%).
By almost any standard, this is far too high. Anyway, just
reaching the breakeven point is not your ultimate goal, though
it would be better than being in the red.
Suppose you were able to increase sales volume beyond the
breakeven point, all the way up to sales capacity of 150,000
units, an increase of 50,000 units from the actual sales level of
100,000 units. A 50 percent increase in sales volume may not
be very realistic, to say the least. At any rate, your annual
profit report would appear as shown in Figure 12.5.
Even if your sales volume could be increased to full capac-
ity, profit would be only \$217,500, which equals only 2.9 per-
cent of sales revenue. For the large majority of businessesâ€”
the only exceptions being those with very high inventory
turnover ratiosâ€”a meager 2.9 percent return on sales is seri-
ously inadequate. Your return-on-sales profit goal probably
should be in the range of 10 to 15 percent.
In short, increasing sales volume is not the entire answer.
You have two other basic options: Reduce fixed expenses or
improve unit margin.

173
PROFIT AND CASH FLOW ANALYSIS

Annual sales 150,000 units
Annual breakeven 120,000 units
Annual capacity 150,000 units

Per Unit Total
Sales revenue \$50.00 \$7,500,000
Product cost (\$32.50) (\$4,875,000)
Variable expenses (\$10.25) (\$1,537,500)
Contribution margin \$ 7.25 \$1,087,500
Fixed operating expenses (\$ 870,000)
Profit (loss) \$ 217,500

Notice that even at full capacity, profit is only 2.9 percent of
sales revenue, which in almost all industries is far too low.

FIGURE 12.5 Sales at full capacity profit report.
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FL

There may be flab in your fixed expenses. It goes without
AM

saying that you should cut the fat. The more serious question
is whether to downsize (reduce fixed operating expenses
and capacity). For instance, assume you could slash fixed
TE

expenses by one-third (\$290,000) but that this would reduce
capacity by one-third, down to 100,000 units. If no other fac-
tors change, your profit performance would be as shown in
Figure 12.6.
Your profit would be \$145,000, which is better than a
loss. But profit would still be only 2.9 percent of sales rev-
enue, which is much too low as already explained. Keep in
mind that making profit requires a substantial amount of
capital invested in the assets needed to carry on profit-
making operations. The capital invested in assets is supplied
by debt and equity sources and carries a cost (as discussed
in Chapter 6).
Suppose, to illustrate this cost-of-capital point, that the \$5
million sales revenue level requires investing \$2 million in
assetsâ€”one-half from debt at 8.0 percent annual interest and
one-half from equity on which the annual ROE target is 15.0
percent. The interest expense is \$80,000 (\$1 million debt Ã—
8.0%), leaving only \$65,000 earnings before tax. Net income

174

Annual sales 100,000 units
Annual breakeven 80,000 units
Annual capacity 100,000 units

Per Unit Total
Sales revenue \$50.00 \$5,000,000
Product cost (\$32.50) (\$3,250,000)
Variable expenses (\$10.25) (\$1,025,000)
Contribution margin \$ 7.25 \$ 725,000
Fixed operating expenses (\$ 580,000)
Profit (loss) \$ 145,000

Notice that even if fixed expenses are reduced by one-
third, profit is only 2.9 percent of sales revenue, which in
almost all industries is far too low.

FIGURE 12.6 Profit at one-third less fixed costs and capacity.

after income tax is not enough to meet the companyâ€™s ROE
goal, which would be the \$1 million ownersâ€™ equity capital
times 15.0 percent, or \$150,000 net income.
By cutting fixed operating expenses you have removed any
room for growth, because sales volume would be at capacity.
In summary, itâ€™s fairly clear that your main problem is a unit
contribution margin that is too low.

Improving Unit Margin
Now for the tough question: How would you improve unit
margin? Is sales price too low? Are product cost and variable
expenses too high? Do all three need improving? Answering
these questions strikes at the essence of the managerâ€™s func-
tion. Managers are paid for knowing what to do, what has to
be changed, and how to make the changes. Analysis tech-
niques donâ€™t provide the final answers to these questions. But
the analysis methods certainly help the manager size up and
quantify the impact of changes in factors that determine unit
contribution margin.
One useful approach is to set a reasonably achievable profit

175
PROFIT AND CASH FLOW ANALYSIS

goalâ€”say \$500,000â€”and load all the needed improvement on
each factor to see how much change would be needed in each.
To move from \$145,000 loss to \$500,000 profit is a \$645,000
swing. If sales volume stays the same at 100,000 units, then
achieving this improvement would require that the unit mar-
gin be increased \$6.45 per unit, which is a tall order. You
could compare the \$6.45 unit margin increase to each profit
factor; doing this shows that the following improvement per-
cents would be needed:

Unit Margin Improvement as Percent of Each Profit Factor
\$6.45 Ã· \$50.00 sales price = 13 percent increase
\$6.45 Ã· \$32.50 product cost = 20 percent decrease
\$6.45 Ã· \$10.25 variable expenses = 63 percent decrease
Making changes of these magnitudes would be very tough, to
say the least.
Raising sales prices 13 percent would surely depress
DANGER!
demand. Lowering product cost 20 percent is not realistic in
most situations. And lowering variable expenses 63 percent
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