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Earnings before interest and income tax $ 3,234,365
Interest expense $ 795,000
Earnings before income tax $ 2,439,365
Income tax expense $ 853,778
Net income $ 1,585,587
FIGURE 3.1 External income statement for most recent year.


Figure 3.1 is an archetype external income statement in
essential respects. I should quickly mention that external
financial statements are supplemented with footnotes (which
are not shown for the example).

Analyzing Gross Margin
The first step in making a bottom-line profit for the year is to
make enough gross margin to cover your operating expenses
for the year and to cover your interest expense and income
tax expense as well. The cost-of-goods-sold expense is
deducted from sales revenue to arrive at this extremely
important first-line measure of profit (see Figure 3.1).
As its name implies, cost-of-goods-sold expense is the cost
of the products sold to customers. Cost of goods sold is usually
the largest expense for a business that sells products, typically
50 to 60 percent or more of sales revenue (and as much as 80
to 85 percent for some high-volume retailers).
The gross margin ratio on sales varies from industry to
industry, as you probably know. The cosmetics industry has
very high gross profit margins, and Coca-Cola™s gross profit
traditionally has been over 60 percent. A full-service restau-
rant, as a rough rule of thumb, should keep its food costs at
one-third of its sales revenue, leaving a two-thirds gross mar-
gin to cover all its other expenses and to yield a satisfactory
bottom-line profit. In the past, Apple Computer made very high
gross margins until it adopted a much more aggressive sales
price strategy on its personal computers to protect its market
share. This cut deeply into its historically high profit margins.

A general rule is that the lower the gross margin ratio, the
higher the inventory turnover. The interval of time from
acquisition of the product to the sale of the product equals one
inventory turnover. High turnover generally is five or more
turns a year, or maybe six or seven turns a year depending on
whom you talk with. Food supermarkets, for example, have
extremely high inventory turnover”their products do not stay
on the shelves very long. Even taking into account the holding
period in their warehouses before the products get to the
shelves in the stores, their inventory turnover is very high,
and thus supermarkets can work on fairly thin gross margin
percents of 20 percent, give or take a little.


In contrast, a retail furniture store may hold an item in
inventory for more than six months on average before it is
sold, so they need fairly high gross margin percents. In this
business example, the company™s gross margin is 37.1 percent
of its sales revenue ($14,700,500 gross margin · $39,661,250
sales revenue = 37.1% gross margin ratio). This is in the ball-
park for many businesses.

Cost of goods sold is a variable expense; it moves
more or less in lockstep with changes in sales volume
(total number of units sold). If sales volume were to increase
10 percent, then this expense should increase 10 percent, too,
assuming unit product costs remained constant over time. But
unit product costs”whether the company is a retailer that pur-
chases the products its sells or a producer that manufactures
the products it sells”do not remain constant over time. Unit
product costs may drift steadily upward over time with infla-
tion. Or unit product costs can take sharp nosedives because
of technological improvements or competitive pressures.
Returning to the decision situation introduced previously,
the manager can use the information in the external income
statement to do the gross margin analysis presented in Figure
3.2, which compares sales revenue, cost-of-goods-sold expense,
and gross margin for the year just ended and for the contem-
plated scenario in which sales prices are 5 percent lower and
sales volume is 25 percent higher. Before looking at Figure
3.2, you might make an intuitive guess regarding what would
happen to gross margin in this scenario, then compare your
guess with what the numbers show. I™d bet that you are some-
what surprised by the outcome shown in Figure 3.2. But num-
bers don™t lie.
Sales revenue would increase 18.75 percent: Although sales
volume would increase 25.0 percent, the sales price of every
unit sold would be only 95 percent of what it sold for during
the year just ended. (Note that 1.25 — 0.95 = 1.1875, or an
18.75 percent increase in sales revenue.) Cost-of-goods-sold
expense would increase 25.0 percent because sales volume, or
the total number of units sold, would increase 25.0 percent.
Still, gross margin would increase 8.14 percent, although this
is far less than the percent increase in sales volume.
What about operating expenses? Would the total of these


For Year
Just Ended For New Percent
(Figure 3.1) Scenario Change Change
Sales revenue $39,661,250 $47,097,734 $7,436,484 18.75%
Cost-of-goods-sold expense $24,960,750 $31,200,938 $6,240,188 25.00%
Gross margin $14,700,500 $15,896,796 $1,196,296 8.14%
FIGURE 3.2 Gross margin analysis of sales price cut proposal.

expenses (excluding interest and income tax expenses)
increase more than the increase in gross margin? Without
more information about the business™s operating expenses
there™s no way to answer this question. You need information
about how the operating expenses would react to the relatively
large increase in sales volume and sales revenue. The internal
management profit report presents this key information.

Figure 3.3 presents the management profit report
for the business example. (In this internal financial statement
I show expenses with parentheses to emphasize that they are
deductions from profit.) Instead of one amount for selling and
administrative expenses as presented in the external income
statement, note that operating expenses are classified accord-
ing to how they behave relative to changes in sales volume
and sales revenue (see the shaded area in Figure 3.3). Vari-
able operating expenses are separated from fixed operating
expenses, and the variable expenses are divided into revenue-
driven versus unit-driven. This three-way classification of
operating expenses is the key difference between the external
and internal profit reports.

Also note that a new profit line is included, labeled
contribution margin, which equals gross margin
minus variable operating expenses. It is called this because
this profit contributes toward coverage of fixed operating
expenses and toward interest expense, which to a large
degree is also fixed in amount for the year.


Sales revenue $39,661,250
Cost-of-goods-sold expense ($24,960,750)
Gross margin $14,700,500
Variable revenue-driven operating expenses ($ 3,049,010)
Variable unit-driven operating expenses ($ 2,677,875)
Contribution margin $ 8,973,615
Fixed operating expenses ($ 5,739,250)
Earnings before interest and income tax (EBIT) $ 3,234,365
Interest expense ($ 795,000)
Earnings before income tax $ 2,439,365
Income tax expense ($ 853,778)
Net income $ 1,585,587
FIGURE 3.3 Management profit report for business example.

Bottom-line profit (net income) is exactly the same amount as
in the external income statement (Figure 3.1). Contrary to
what seems to be a popular misconception, businesses do not
keep two sets of books. Profit is measured and recorded by
one set of methods, which are the same for both internal and
external financial reports. Managers may ask their accounting
staff to calculate profit using alternative accounting methods,
such as a different inventory and cost-of-goods-sold expense
method or a different depreciation expense method, but only
one set of numbers is recorded and booked. There is not a
“real” profit figure secreted away someplace that only man-
agers know, although this seems to be a misconception held
by many.
The additional information about operating expenses pro-
vided in the management profit report (see Figure 3.3) allows
the manager to complete his or her analysis and reach a deci-
sion. Before walking through the analysis of the proposal to
cut sales prices by 5 percent to gain a 25 percent increase in
sales volume, it is important to thoroughly understand the
behavior of operating expenses.

Variable Operating Expenses
In the management profit report (Figure 3.3), variable operat-
ing expenses are divided into two types: those that vary with


sales volume and those that vary with total sales dollars. In
general, variable means that an expense varies with sales
activity”either sales volume (the number of units sold) or
sales revenue (the number of dollars generated by sales).
Delivery expense, for example, varies with the quantity of
units sold and shipped. On the other hand, commissions paid
to salespersons normally are a percentage of sales revenue or
the number of dollars involved.
Contribution margin, which equals sales revenue minus
cost-of-goods-sold and variable operating expenses, has to be
large enough to cover the company™s fixed operating expenses,
its interest expense, and its income tax expense and still leave
a residual amount of final, bottom-line profit (net income). In
short, there are a lot of further demands on the stepping-
stone measure of profit called contribution margin. Even if a
business earns a reasonably good total contribution margin, it
still isn™t necessarily out of the woods because it has fixed
operating expenses as well as interest and income tax.

In this business example, contribution margin equals 22.6
percent of sales revenue ($8,973,615 contribution margin ·
$39,661,250 sales revenue = 22.6%). For most management
profit-making purposes, the contribution margin ratio is the
most critical factor to watch closely and keep under control.
Gross margin is important, to be sure, but the contribution
margin ratio is even more important. The contribution margin
is an important line of demarcation between the variable
profit factors above the line and fixed expenses below the line.

Fixed Expenses
Virtually every business has fixed operating expenses as well
as fixed depreciation expense. The company™s fixed operating
expenses were $5,739,250 for the year, which includes depre-
ciation expense because it is a fixed amount recorded to the
year regardless of whether the long-term operating assets of
the business were used heavily or lightly during the period.
Depreciation depends on the choice of accounting methods
adopted to measure this expense”whether it be the level,
straight-line method or a quicker accelerated method. Other
fixed operating expenses are not so heavily dependent on the
choice of accounting methods compared with depreciation.


Fixed means that these operating costs, for all practical
purposes, remain the same for the year over a fairly broad
range of sales activity”even if sales rise or fall by 20 or 30
percent. Examples of such fixed costs are employees on fixed
salaries, office rent, annual property taxes, many types of
insurance, and the CPA audit fee. Once-spent advertising is a
fixed cost. Generally speaking, these cost commitments are
decided in advance and cannot be changed over the short run.
The longer the time horizon, on the other hand, the more
these costs can be adjusted up or down.
For instance, persons on fixed salaries can be laid off, but
they may be entitled to several months or perhaps one or
more years of severance pay. Leases may not be renewed, but
you have to wait to the end of the existing lease. Most fixed
operating expenses are cash-based, which means that cash is
paid out at or near the time the expense is recorded”though
it must be mentioned that some of these costs have to be pre-
paid (such as insurance) and many are paid after being


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