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may be just plain impossible. A combination of improvements
would be needed instead of loading all the improvement on
just one factor. Also, sales volume probably would have to be
increased.
Suppose you develop the following plan: Sales prices will be
increased 5 percent and sales volume will be increased 10
percent (based on better marketing and advertising strate-
gies). Product cost will be reduced 4 percent by sharper pur-
chasing, and variable expenses will be cut 8 percent by
exercising tighter control over these expenses. Last, you think
you can eliminate about 10 percent fat from fixed expenses
(without reducing sales capacity). If you could actually achieve
all these goals, your profit report would look as shown in Fig-
ure 12.7.
You would make your profit goal and then some, but only if
all the improvements were actually achieved. Profit would be
9.1 percent of sales revenue ($522,700 profit · $5,775,000
sales revenue = 9.1 percent). This plan may or may not be
achievable. You may have to go back to the drawing board to
figure out additional improvements.


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COST/VOLUME TRADE-OFFS




Annual sales 110,000 units
Annual breakevenn 65,965 units
Annual capacity 150,000 units

Per Unit Total
Sales revenue $52.50 $5,775,000
Product cost ($31.20) ($3,432,000)
Variable expenses ($ 9.43) ($1,037,300)
Contribution margin $11.87 $1,305,700
Fixed operating expenses ($ 783,000)
Profit (loss) $ 522,700
FIGURE 12.7 Profit improvement plan.




s
END POINT
Chapters 11 and 12 examine certain basic trade-offs; both
chapters rest on the premise that seldom does one profit fac-
tor change without changing or being changed by one or more
other profit factors. Mentioned earlier but worth repeating
here is that managers must keep their attention riveted on
unit contribution margin. Profit performance is very sensitive
to changes in this key operating profit number, as demon-
strated by several different situations in Chapters 11 and 12.
Chapter 11 examines the interplay between sales price and
volume changes. Sales prices are the most external part of the
business. In contrast, product cost and variable expenses (the
subject of this chapter) are more internal to the business. Cus-
tomers may not be aware of these expense decreases unless
such cost savings show through in lower product quality or
worse service. Frequently, cost savings are not cost savings at
all, in the sense that customer demand is adversely affected.
Cost increases can be caused by inflation (general or spe-
cific), by product improvements in size or quality, or by the
quality of service surrounding the product. To prevent profit
deterioration, cost increases have to be recovered through
higher sales volume or through higher sales prices. This


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PROFIT AND CASH FLOW ANALYSIS


chapter examines the critical differences between these two
alternatives.
Depending on higher sales volume to compensate for cost
increases may not be very realistic; sales volume would have
to increase too much. This type of analysis does give man-
agers a useful point of reference, however. Cost increases gen-
erally have to be recovered through higher sales prices. This
chapter demonstrates the analysis tools for determining the
higher sales prices.




178
13
CHAPTER




Profit Gushes:
Cash Flow Trickles?



Y
You™d probably assume that if profit improved, say, $200,000
next year, then cash flow from profit would increase $200,000
during the year. Not true. In most cases the increase in cash
flow from profit would be less. The cash flow shortfall may be
rather insignificant and not worth worrying about too much.
But the lag in cash flow from increasing profit often is quite
significant.

This chapter demonstrates one basic point that business man-
agers should have clear in their minds: Certain ways of
improving profit have much better cash flow benefits than
others. The preceding four chapters analyze and demonstrate
the ways a business can improve its profit, which on the flip
side are the ways a business can see profit slip away. Hardly
anything has been mentioned about changes in cash flow
caused by changes in profit. The moral of this chapter is, don™t
count your cash flow chickens until the eggs are hatched!


A LESSONS FROM CHAPTER 2
Remember Chapter 2 explains accrual-basis accounting, necessary to
measure profit, which is more complex than simply
recording cash collections from sales and cash payments for
expenses. Accrual-basis accounting entails the following:

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PROFIT AND CASH FLOW ANALYSIS



• Recording revenue from credit sales before the cash is col-
lected from customers at a later time
• Recording certain expenses before the costs are paid at a
later time
• Recording certain expenses after the costs are paid at an
earlier time
• Waiting to record the expense for cost of products sold to
customers until the sale is recorded, even though the prod-
ucts are paid for before they are sold
• Recording depreciation expense for using long-term operat-
ing assets over the several years of their use, even though
the assets are paid for before they are used
For the most part, cash flows in from sales and out for
expenses occur at different times than when sales revenue and
expenses are recorded. To correctly measure profit, a business
cannot use cash-basis accounting and must use accrual-basis
accounting. More work, but a truer profit measure.
The amounts reported in the external income statements of
a business to its creditors and shareowners and in its internal
profit reports to managers are all accrual-basis accounting
numbers. These numbers do not equal the actual amounts of
cash flows during the period. The actual cash flows during the
period are higher or lower than the corresponding accrual-
basis numbers. The bottom-line cash flow from profit during
the period can be very different from bottom-line profit. Busi-
ness managers need bifocal lenses when focusing on profit
versus cash flow from profit.

CASH FLOW FROM BOOSTING SALES VOLUMES
The analysis of changes in profit over the preceding four
chapters deals with changes in sales revenue and expenses.
These changes are accrual-basis numbers, not cash flow num-
bers. Let™s return to the first scenario from Chapter 9, in
which sales volume (the number of units sold over the year)
increases 10 percent. Figure 13.1 summarizes the changes in
sales revenue and expenses for each of the three product lines
in the example.
The amounts of changes presented in Figure 13.1 are
accrual-basis accounting numbers. For instance, the $1 mil-
lion sales revenue increase for the standard product is the

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PROFIT GUSHES: CASH FLOW TRICKLES?




Standard Product Line
Changes
Sales revenue $1,000,000
Cost of goods sold $ 650,000
Gross margin $ 350,000
Revenue-driven expenses @ 8.5% $ 85,000
Unit-driven expenses $ 65,000
Contribution margin $ 200,000
Fixed operating expenses $ 0
Profit $ 200,000

Generic Product Line
Changes
Sales revenue $1,125,000
Cost of goods sold $ 855,000
Gross margin $ 270,000
Revenue-driven expenses @ 4.0% $ 45,000
Unit-driven expenses $ 75,000
Contribution margin $ 150,000
Fixed operating expenses $ 0
Profit $ 150,000

Premier Product Line
Changes
Sales revenue $ 750,000
Cost of goods sold $ 400,000
Gross margin $ 350,000
Revenue-driven expenses @ 7.5% $ 56,250
Unit-driven expenses $ 43,750
Contribution margin $ 250,000
Fixed operating expenses $ 0
Profit $ 250,000
FIGURE 13.1 Changes in sales revenue and expenses from higher
sales volumes (data from Figure 9.2).




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PROFIT AND CASH FLOW ANALYSIS


amount of additional sales revenue that would be recorded if
the business sells 10 percent more units. If the business made
all sales for cash on the barrelhead and did not extend credit
to its customers there would be a one-to-one correspondence
between the amount of the accrual-basis sales revenue
recorded during the period and the cash flow from sales rev-
enue during the period.


Cash Inflow from Sales Revenue Increase
The business in the example extends credit to its customers. If
next year the business sells 10 percent more units of the stan-
dard product line at the same sales prices, then sales revenue
would increase $1 million. But this doesn™t mean that the
business will collect $1 million additional cash from its cus-
tomers during the year. Cash inflow from the additional sales
revenue would be less. Customers are offered one month of
credit before they have to pay the business. Thus the actual
cash inflow from the additional sales would be less than $1
million because sales made during the last month of the year
would not be collected by the end of the year.

During the year the business would collect 11 months of the
additional sales revenue, but not the final, twelfth month.
Assuming sales are level during the year, the business would
collect 11„12 of the $1 million additional sales revenue ($1 mil-
lion additional sales revenue — 11„12 = $916,667 cash collections
during the year). The remainder wouldn™t be collected until
the early part of the following year. In short, there is a one-
month lag in collecting sales made on credit.


Cash Outflows for Expense Increases
Expenses are a little more complicated than sales revenue
from the cash flow point of view. First is cost-of-goods-sold
expense. In the 10 percent higher sales volume scenario, cost-
of-goods-sold expense increases $650,000 for the standard
product line (see Figure 13.1). You might assume that cash
outlays would also increase $650,000. Actually, cash outflow
would be more than this because the business would increase
its inventory of standard products to support the higher sales
level. In addition to paying for units sold, the business would

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PROFIT GUSHES: CASH FLOW TRICKLES?


build up its inventory, which requires additional cash outlay.
As a general rule, selling more units means that a business
must have more units on hand to sell. It™s possible that a busi-
ness could sell 10 percent more units without increasing its
inventory. But generally speaking, inventory rises more or less

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