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proportionally with a rise in sales volume.
A business either manufactures the products it sells or it
purchases the products it sells from other businesses. In
either case, an increase in inventory usually involves a cor-
responding increase in accounts payable. Raw materials
used in the production process are purchased on credit, and
many other manufacturing costs are not paid for immedi-
ately. Products from other businesses are bought on credit.
Instead of making immediate cash payment when inventory
is increased, a business delays payment, perhaps by a month
or so.
However, vendors and suppliers are not willing to extend
credit and wait for payment until the buyer sells the products.
They won™t wait out the entire inventory-holding period; they
want their money sooner than that. That is, the business™s
inventory-holding period is longer than the credit period of its
accounts payable. In this example, the business holds prod-
ucts in inventory for two months on average before they are
sold and delivered to customers. The average credit period of
its inventory-driven accounts payable is only one month. The
business has to make cash payment for the second month of
holding inventory.
At the end of the year the business™s inventory is two
months higher for the additional layer of sales”one month
unpaid (reflected in the increase of accounts payable) and one
month paid. The business paid for the 12 months of products
sold plus an additional month for the increase in inventory. In
short, the cash outlay for inventory for the increase in sales
volume of the standard product line is $704,167 ($650,000
additional cost of goods sold expense for the year — 13„12 =
$704,167 cash outlay for cost of goods sold and inventory
buildup).
When sales volume increases, variable expenses also
increase (see Figure 13.1). Both revenue-driven and unit-
driven variable expenses increase for all three of the product
lines. Of course, this is the very definition of variable
expenses”costs that go up and down with increases and

183
PROFIT AND CASH FLOW ANALYSIS


decreases in sales. Many variable operating expenses are not
paid until a month or more after the expenses are recorded.
The obligations for these unpaid expenses are recorded in two
liability accounts”accounts payable and accrued expenses
payable.
For most businesses, the amounts of their accounts payable
for unpaid operating expenses and accrued expenses payable
are fairly significant amounts. To expedite matters, assume
that there is a one-month delay, or lag, in paying variable
operating expenses. This is in the ballpark for many busi-
nesses. For each $12.00 of increase in variable operating
expenses, assume the business pays only $11.00 during the
year. The other dollar will be paid in the early part of the fol-
lowing year. For example, in the sales volume increase sce-
nario, unit-driven variable operating expenses for the standard
product line increase $65,000 (see Figure 13.1). Thus the cash
outlay during the year for this increase is $59,583 ($65,000
Y
additional expenses — 11„12 = $59,583 cash outlay).
FL

Summing Up the Cash Flow Effects
AM


The differences between cash flows and the accrual-basis
amounts of changes in sales revenue and expenses for the year
caused by increasing sales volume are summarized as follows:
TE




• There is a one-month lag in collecting sales revenue
because the business sells on credit, so only 11„12 of the
increase in sales revenue is collected in cash through the
end of the year.
• The sales volume increase requires a corresponding increase
in inventories that is equal to two months, or 2„12, of the
cost-of-goods-sold increase; accounts payable for invento-
ries also increase, equal to one month of the increase in
inventories. So the cash outlay for the inventories increase
is only 1„12 of the cost of goods sold increase.
• There is a one-month lag in paying variable operating
expenses, so only 11„12 of the increase in operating expenses
is paid in cash through the end of the year.

Basically there is a one-month time differential between the
accrual-basis changes in sales revenue and expenses and the
cash flows in from sales and out for expenses. There is a

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PROFIT GUSHES: CASH FLOW TRICKLES?


one-month cash flow delay from the sales revenue increase, a
one-month additional cash outlay for the cost of goods sold
increase, and a one-month delay in paying the variable
expenses increase. This one-month shift is fairly realistic for
many businesses; it certainly moves the accrual-basis num-
bers much closer to when actual cash flows occur.


CASH FLOWS ACROSS DIFFERENT PRODUCT LINES
Figure 13.2 presents the cash flow effects from increasing
sales volume 10 percent for the three product lines of the
business. I™d wager that the cash flow effects, especially for
the generic product line, surprise you. If not, you™d better take
a closer look at Figure 13.2.
The best cash flow result is for the premier product line,
but even here the cash flow increase for the year would be
only $162,500 compared with the $250,000 profit increase.
For the standard product line, the cash flow yield is only
$75,000 for a $200,000 gain in profit, and cash flow actually
decreases $5,000 for the generic product line, even though
profit increases $150,000.
For each of the product lines, the delay in collecting the
increase in sales revenue combined with the cash outlay for
increasing inventories puts a double whammy on cash flow.
The slim margin on the generic products means that the cost
of goods sold is a relatively high proportion of sales revenue.
So the increase in inventories puts a particularly large demand
on cash to be invested in inventories at the higher sales vol-
ume level. The premier product is just the reverse. The high
margin on these products means that the increase in invento-
ries does not do as much damage to cash flow.


CASH FLOW FROM BUMPING UP SALES PRICES
Chapter 10 examines the profit effects from increasing sales
prices, holding all other profit factors constant. The profit
gains are much more favorable compared with increasing
sales volume the same percent, as explained in Chapter 10.
The cash flow effects of a 10 percent sales price increase are
also much more favorable. Figure 13.3 presents the cash flow
effects from increasing sales prices 10 percent for the three
product lines. The one-month shift for cash flows explained

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PROFIT AND CASH FLOW ANALYSIS




Standard Product Line
Changes Cash Flows
Sales revenue $1,000,000 $ 916,667
Cost of goods sold $ 650,000 $ 704,167
Gross margin $ 350,000 $ 212,500
Revenue-driven expenses @ 8.5% $ 85,000 $ 77,917
Unit-driven expenses $ 65,000 $ 59,583
Contribution margin $ 200,000 $ 75,000
Fixed operating expenses $ 0 $ 0
Profit $ 200,000 $ 75,000

Generic Product Line
Changes Cash Flows
Sales revenue $1,125,000 $1,031,250
Cost of goods sold $ 855,000 $ 926,250
Gross margin $ 270,000 $ 105,000
Revenue-driven expenses @ 4.0% $ 45,000 $ 41,250
Unit-driven expenses $ 75,000 $ 68,750
Contribution margin $ 150,000 ($ 5,000)
Fixed operating expenses $ 0 $ 0
Profit $ 150,000 ($ 5,000)

Premier Product Line
Changes Cash Flows
Sales revenue $ 750,000 $ 687,500
Cost of goods sold $ 400,000 $ 433,333
Gross margin $ 350,000 $ 254,167
Revenue-driven expenses @ 7.5% $ 56,250 $ 51,563
Unit-driven expenses $ 43,750 $ 40,104
Contribution margin $ 250,000 $ 162,500
Fixed operating expenses $ 0 $ 0
Profit $ 250,000 $ 162,500
FIGURE 13.2 Changes in operating cash flow from increases in sales vol-
ume.




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PROFIT GUSHES: CASH FLOW TRICKLES?




Standard Product Line
Changes Cash Flows
Sales revenue $1,000,000 $ 916,667
Cost of goods sold $ 0 $ 0
Gross margin $1,000,000 $ 916,667
Revenue-driven expenses @ 8.5% $ 85,000 $ 77,917
Unit-driven expenses $ 0 $ 0
Contribution margin $ 915,000 $ 838,750
Fixed operating expenses $ 0 $ 0
Profit $ 915,000 $ 838,750

Generic Product Line
Changes Cash Flows
Sales revenue $1,125,000 $1,031,250
Cost of goods sold $ 0 $ 0
Gross margin $1,125,000 $1,031,250
Revenue-driven expenses @ 4.0% $ 45,000 $ 41,250
Unit-driven expenses $ 0 $ 0
Contribution margin $1,080,000 $ 990,000
Fixed operating expenses $ 0 $ 0
Profit $1,080,000 $ 990,000

Premier Product Line
Changes Cash Flows
Sales revenue $ 750,000 $ 687,500
Cost of goods sold $ 0 $ 0
Gross margin $ 750,000 $ 687,500
Revenue-driven expenses @ 7.5% $ 56,250 $ 51,563
Unit-driven expenses $ 0 $ 0
Contribution margin $ 693,750 $ 635,938
Fixed operating expenses $ 0 $ 0
Profit $ 693,750 $ 635,938
FIGURE 13.3 Changes in operating cash flow from increases in sales prices
(data from Figure 10.1).




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PROFIT AND CASH FLOW ANALYSIS


earlier for the sales volume scenario is adopted here for the
sales price increase scenario.

The cash flow effects are much more favorable for the sales
price increase scenario than the sales volume scenario. For
each of the three product lines, the increase in cash flow from
profit due to the higher sales prices is a very large percent of
the increase in profit. This is much better than in the sales
volume increase scenario. The much more favorable cash flow
effect is due to the difference in the inventories factor. In the
sales price increase scenarios, the business does not have to
increase inventories of products and thus avoids the drag on
cash flow that this causes.
A word of caution is in order. Raising sales prices 10 per-
DANGER!
cent looks good on paper compared with increasing sales
volume 10 percent. But bumping up sales prices 10 percent
in a competitive market, or in most markets for that matter,
may not be possible. Customers may flock to your competi-
tors, of course, or demand may decrease at the higher prices.
But, having said this, businesses can often sneak in minor
increases without drawing attention to the higher sales prices.
Even relatively small sales price increases can improve profit
more effectively than much larger increases in sales volume.
And profit increases from higher sales prices have much bet-
ter cash flow effects.



s END POINT
Improving profit performance is a relentless pressure on busi-
ness managers. The preceding four chapters analyze the
profit effects from changes in the key factors that drive
profit”sales volume, sales price, variable operating expenses,
and fixed expenses. This chapter shifts attention to changes in
cash flow driven by changes in profit factors. Managers must
keep in mind that profit is an accrual-basis accounting num-
ber and not a cash flow number. The actual cash flow increase

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