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tories are almost $6 million, so if this were a service business
its total assets would be $6 million less and its liabilities and
owners™ equity would be $6 million less.
Some service businesses (airlines, gas and electric utilities,
railroads) make heavy investments in long-term, fixed operat-
ing assets. These businesses are said to be capital-intensive.
In the past, all three of these examples were regulated indus-
tries, but more recently they have been deregulated. In con-
trast, other types of service businesses (e.g., professional legal
firms) make relatively light investments in fixed operating
assets. Many service businesses are in the middle regarding
capital invested in property, plant, and equipment. Examples
are movie theater chains, newspapers, and book publishers.
They invest in long-term operating assets, but not huge
amounts.

Y
MANAGEMENT PROFIT REPORT
FOR A SERVICE BUSINESS
FL
Figure 16.2 presents internal management reports for three
profit modules of a service business, which are used through-
AM


out the rest of the chapter. You may notice that this example
closely follows the three-profit module example for the prod-
uct business in Chapter 9. My purpose is to provide compar-
TE




isons between a middle-of-the-road source of revenue with an
average profit margin (the standard service in Figure 16.2), a
no-frills basic service with a slim profit margin, and a top-of-
the-line premier service with relatively high profit margin.
Just as product-based businesses sell different products
with different margins, many service businesses offer different
services at different prices. For example, airline companies
offer first class, standard class, and tourist class. Entertain-
ment businesses charge different prices depending on where
seats are located, as do football and baseball teams. Hotels
charge different prices for rooms with a better view. And
so on.
Compared with the management profit reports in Figure
9.1 for the product business example, the major changes in
Figure 16.2 are the absences of cost-of-goods-sold expense
and gross margin. As mentioned earlier, service businesses
don™t sell products and therefore they don™t have a cost-of-
goods-sold expense or gross margin (sales revenue less cost of

234
SERVICE BUSINESSES




Standard Service
100,000 units
Per Unit Totals
Sales revenue $100.00 $10,000,000
Revenue-driven expenses @ 8.5% $ 8.50 $ 850,000
Unit-driven expenses $ 6.50 $ 650,000
Contribution margin $ 85.00 $ 8,500,000
Fixed operating expenses $ 75.00 $ 7,500,000
Profit $ 10.00 $ 1,000,000

Basic Service
150,000 units
Per Unit Totals
Sales revenue $ 75.00 $11,250,000
Revenue-driven expenses @ 4.0% $ 3.00 $ 450,000
Unit-driven expenses $ 5.00 $ 750,000
Contribution margin $ 67.00 $10,050,000
Fixed operating expenses $ 60.33 $ 9,050,000
Profit $ 6.67 $ 1,000,000

Premier Service
50,000 units
Per Unit Totals
Sales revenue $150.00 $ 7,500,000
Revenue-driven expenses @ 7.5% $ 11.25 $ 562,500
Unit-driven expenses $ 8.75 $ 437,500
Contribution margin $130.00 $ 6,500,000
Fixed operating expenses $110.00 $ 5,500,000
Profit $ 20.00 $ 1,000,000
FIGURE 16.2 Management profit reports for service business example.




goods sold). Note that each service profit module earned $1
million for the year just ended. The purpose of this is twofold.
The three sources of sales added together provide $3 mil-
lion profit, which is approximately equal to the earnings
before interest and income tax shown in the income statement
in Figure 16.1. The main reason for showing three different

235
END TOPICS


profit modules, however, is to contrast and compare the
effects from changes in profit factors among the three.
The amount of the cost-of-goods-sold expense amounts
shown in Figure 9.1 for the product-based business are
moved to fixed operating expenses in this example for the
three service profit modules. In other words, the entire
amount of the cost-of-goods-sold expense amount is moved
down to the fixed operating expense account, which is the
largest expense for each service line. Notice the relatively high
amounts of fixed costs for each module in Figure 16.2.

By definition, a service business sells services and not prod-
ucts. Even so, incidental products are often sold along with
the services. For example, a copying business (such as
Kinko™s) sells paper to its customers. Of course, the main thing
sold is the copying service, not the paper. Airlines sell trans-
portation but also provide in-flight food and beverages. Hotels
are not really in the business of selling towels and ashtrays,
but they know that many guests take these with them on the
way out. Many personal and professional service firms (e.g.,
CPA and architect firms) sell no product at all. (Although come
to think of it, our architect charged us a small amount for
blueprint copies of our home remodeling project.)
Some expenses of a service business vary with total sales
revenue. Credit card discounts and sales commissions come to
mind. Service businesses also have some expenses that vary
with sales volume”for example, the number of passengers
flown by an airline. The number of hotel guests directly affects
certain variable expenses of this business.
Most service businesses are saddled with large annual fixed
expenses. Service takes people to render it: Most service busi-
nesses have a large number of employees on fixed salaries or
who are paid fixed hourly rates based on a 40-hour work-
week. Also, many service businesses, such as gas and electric
utilities and airlines, make large capital investments in build-
ings and equipment and record large depreciation expense
each year. Therefore, the service business example includes a
large amount of fixed expenses for each of the three profit
modules.
In contrast to product-based businesses, the contribution
margins of service-based businesses are relatively large per-


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SERVICE BUSINESSES


cents of their sales revenue. For the service business example
shown in Figure 16.1, the contribution margins are as follows:
Standard
service $85.00 unit margin · $100.00 sales price = 85%
Basic
service $67.00 unit margin · $75.00 sales price = 89%
Premier
service $130.00 unit margin · $150.00 sales price = 87%
The annual sales volumes in the three profit modules are
expressed in units of service, whatever these units might be”
billable hours for a law firm, number of tickets for a movie
theater, or passenger miles for an airline. For a long-distance
trucking company it is ton-miles hauled. Most service busi-
nesses adopt a common denominator to measure their sales
volume activity.


SALES PRICE AND VOLUME CHANGES
The profit impacts of increasing sales prices 10 percent versus
increasing sales volumes 10 percent are compared in Figure
16.3. Please keep in mind that the baseline profit for each of
the three profit modules is $1 million. The amount of the profit
increase is divided by $1 million to determine the percentage
increases shown in Figure 16.3. For all three service lines,
note the relatively small difference in profit increase between
the sales volume and the sales price increase scenarios.

Looking back at the profit effects for a product-based business
(refer to Figure 10.2), there is a huge advantage to increasing
sales price versus increasing sales volume by the same per-
cent. But as Figure 16.3 shows, this is not true for a service
business because price increases on top of the relatively high
unit margins of a service business don™t pack the same wallop
as price increases for a product business.
For instance, consider the standard product line (Figure 9.1)
versus the standard service line (Figure 16.2). In both, the sales
price is $100.00 per unit. The unit margin for the standard
product line is $20.00 versus $85.00 for the standard service
line. A 10 percent sales price increase yields a $9.15 unit mar-
gin increase (net of revenue-driven variable expenses). This


237
END TOPICS




Standard Service
Sales Volume Increase Sales Price Increase
110,000 units 100,000 units
Per Unit Totals Per Unit Totals
Sales revenue $100.00 $11,000,000 $110.00 $11,000,000
Revenue-driven expenses
@ 8.5% $ 8.50 $ 935,000 $ 9.35 $ 935,000
Unit-driven expenses $ 6.50 $ 715,000 $ 6.50 $ 650,000
Contribution margin $ 85.00 $ 9,350,000 $ 94.15 $ 9,415,000
Fixed operating expenses $ 68.18 $ 7,500,000 $ 75.00 $ 7,500,000
Profit $ 16.82 $ 1,850,000 $ 19.15 $1,915,000
Profit increase (compared
with Figure 16.2) 85% 92%
Basic Service
165,000 units 150,000 units
Per Unit Totals Per Unit Totals
Sales revenue $ 75.00 $12,375,000 $ 82.50 $12,375,000
Revenue-driven expenses
@ 4.0% $ 3.00 $ 495,000 $ 3.30 $ 495,000
Unit-driven expenses $ 5.00 $ 825,000 $ 5.00 $ 750,000
Contribution margin $ 67.00 $11,055,000 $ 74.20 $11,130,000
Fixed operating expenses $ 54.85 $ 9,050,000 $ 60.33 $ 9,050,000
Profit $ 12.15 $ 2,005,000 $ 13.87 $ 2,080,000
Profit increase (compared
with Figure 16.2) 101% 108%
Premier Service
55,000 units 50,000 units
Per Unit Totals Per Unit Totals
Sales revenue $150.00 $ 8,250,000 $165.00 $ 8,250,000
Revenue-driven expenses
@ 7.5% $ 11.25 $ 618,750 $ 12.37 $ 618,750
Unit-driven expenses $ 8.75 $ 481,250 $ 8.75 $ 437,500
Contribution margin $130.00 $ 7,150,000 $143.88 $ 7,193,750
Fixed operating expenses $100.00 $ 5,500,000 $110.00 $ 5,500,000
Profit $ 30.00 $ 1,650,000 $ 33.88 $ 1,693,750
Profit increase (compared
with Figure 16.2) 65% 69%
FIGURE 16.3 Comparison of 10 percent increases in sales volume versus
sales price.

238
SERVICE BUSINESSES


equals a 46 percent leap in unit margin for the product busi-
ness ($9.15 · $20.00 = 46%), but only an 11 percent gain for
the service business ($9.15 · $85.00 = 11%). For a service busi-
ness, a price increase is better than a volume increase, but the
advantage is much less than for a product business.


WHAT ABOUT FIXED COSTS?
One key issue concerns the large amount of fixed
operating expenses for a typical service business. The profit
increases shown in Figure 16.3 are based on the premise that
fixed costs remain constant at the higher sales volumes. How-
ever, if the business were already operating at or close to its
capacity limits, its fixed costs probably would have to be
increased to enable higher sales volumes. Keep in mind that
basically fixed costs provide capacity, or the ability to handle
a certain level of sales activity during the period.
Capacity for a service business is measured by the total
number of hours its employee workforce could turn out during
the year, the number of passenger miles that an airline could
fly, the number of energy units a utility could deliver over the
period, and so on. Always a key question is whether capacity
is being fully used or not. Some slack, or unused capacity, is
normal, which allows for a modest growth in sales volume.
When sales volume is too far below capacity and top manage-
ment sees no way to rebuild sales volume, the option is to
downsize the capacity of the business.
Looking at Figure 16.3 again, the business could afford

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