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FL
recorded (such as the CPA audit fee).

In passing, it should be noted that other assets are occasion-
AM


ally written down, though not according to any predetermined
schedule as for depreciation. For example, inventory may
have to be written down or marked down if the products can-
TE




not be sold or will have to be sold below cost. Inventory also
has to be written down to recognize shrinkage due to shoplift-
ing and employee theft. Accounts receivables may have to be
written down if they are not fully collectible. (Inventory loss
and bad debts are discussed again in later chapters.)
Managers definitely should know where such write-downs
are being reported in the profit report. For instance, are
inventory knockdowns included in cost-of-goods-sold expense?
Are receivable write-offs in fixed operating expenses? Man-
agers have to know what all is included in the basic accounts
in their internal profit report (Figure 3.3). Such write-downs
are generally fixed in amount and would not be reported as a
variable expense”although if a certain percent of inventory
shrinkage is normal then it should be included with the vari-
able cost-of-goods-sold expense. The theory of putting it here
is that to sell 100 units of product, the business may have to
buy, say, 105 units because 5 units are stolen, damaged, or
otherwise unsalable.

34
REPORTING PROFIT TO MANAGERS


CONTRIBUTION MARGIN ANALYSIS
The next step in the decision analysis, based on the informa-
tion in the management profit report (Figure 3.3), is to deter-
mine how much the business™s variable operating expenses
would increase based on the sales revenue increase and the
sales volume increase. Figure 3.4 presents this analysis, and
the results are not encouraging. The variable revenue-driven
operating expenses would increase by the same percent as
sales revenue, and the variable unit-driven expenses would
increase by the same percent as sales volume. The result is
that contribution margin would decrease $44,863 (see Figure
3.4). This is before taking into account what would happen to
fixed operating expenses at the higher sales volume level.
Fixed operating expenses are those that are not sensitive to
incremental changes in actual sales volume. However, a busi-
ness can increase sales volume only so much before some of
its fixed operating expenses have to be increased. For exam-
ple, one fixed operating expense is the cost of warehouse
space (rent, insurance, utilities, etc.). A 25 percent increase in
sales volume may require the business to rent more warehouse



For Year Just New Percent
Ended 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 $1,196,296 8.14%
Variable revenue-driven
operating expenses ($ 3,049,010) ($ 3,620,700) ($ 571,690) 18.75%
Variable unit-driven operating
expenses ($ 2,677,875) ($ 3,347,344) ($ 669,469) 25.00%
$ 8,928,752 ($ 44,863) ’0.50%
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 3.4 Contribution margin analysis of sales price cut proposal.



35
FINANCIAL REPORTING


space. In any case, you may decide to break off the analysis at
this point since contribution margin would decrease under the
sales price cut proposal.
You might be tempted to pursue the sales price reduction
plan in order to gain market share. Well, perhaps this would
be a good move in the long run, even though it would not
increase profit immediately. The point about market share
reminds me of a line in a recent article in the Wall Street
Journal: “Stop buying market share and start boosting prof-
its.” The sales price reduction proposal takes too big a bite out
of profit margins, even though sales prices would be reduced
only 5 percent. Even given a 25 percent sales volume spurt,
you would see a decline in contribution margin even before
taking into account any increases in fixed operating expenses.



s END POINT
The external income statement is useful for management
decision-making analysis, but only up to a point. It does not
provide enough information about operating expense behav-
ior. The internal profit report to managers adds this important
information for decision-making analysis. In management
profit reports, operating expenses are separated into variable
and fixed, and variable expenses are further separated into
those that vary with sales volume and those that vary with
sales revenue dollars. The central importance of the proper
classification of operating expenses cannot be overstated.
This chapter walks through the analysis of a proposal to
reduce sales prices in order to stimulate a sizable increase in
sales volume. Using information from the external income
statement, the impact of the proposal on gross margin is ana-
lyzed. To complete the analysis, managers need the informa-
tion about operating expenses that is reported in the internal
profit report. After analyzing the changes in variable operat-
ing expenses, it is discovered that contribution margin (profit
before fixed operating expenses are deducted) would actually
decrease if the sales price reduction were implemented. Fur-
thermore, the sizable increase in sales volume raises the
possibility that fixed operating expenses might have to be
increased to accommodate such a large jump in sales volume.
Future chapters look beyond just the profit impact and con-
sider other financial effects of changes in sales volume, sales

36
REPORTING PROFIT TO MANAGERS


revenue, and expenses”in particular, the impacts on cash
flow from profit. A basic profit model and basic cash flow
from profit model are developed in future chapters and
applied to a variety of decision situations facing business
managers. The discussion in this chapter is for the company
as a whole (i.e., assuming all sales prices would be reduced).
Of course, in actual business situations sales price changes
are more narrowly focused on particular products or product
lines. The profit model developed in later chapters can be
applied to any segment or profit module of the business.




37
4
CHAPTER




Interpreting Financial
Statements



F
Financial statements are the main and often the only source
of information to the lenders and the outside investors regard-
ing a business™s financial performance and condition. In addi-
tion to reading through the financial statements, they use
certain ratios calculated from the figures in the financial
statements to evaluate the profit performance and financial
position of the business. These key ratios are very important
to managers as well, to say the least. The ratios are part of the
language of business. It would be embarrassing to a manager
to display his or her ignorance of any of these financial speci-
fications for a business.


A FEW OBSERVATIONS AND CAUTIONS
This chapter focuses on the financial statements included in
external financial reports to investors. These financial reports
circulate outside the business; once released by a business, its
financial statements can end up in the hands of almost any-
one, even its competitors. The amounts reported in external
financial statements are at a summary level; the detailed
information used by managers is not disclosed in external
financial statements. External financial statements disclose a
good deal of information to its investors and lenders that they
need to know, but no more. There are definite limits on the
information divulged in external financial statements. For
39
FINANCIAL REPORTING


instance, a business does not present a list of its major cus-
tomers or stockholders in its external financial statements.

External financial statements are general purpose in nature
and comprehensive of the entire business. The amounts
reported for some assets”in particular, inventories and fixed
assets”may be fairly old costs, going back several years. As
mentioned in Chapter 2, assets are not marked up to current
market values. The current replacement values of assets are
not reported in external financial statements.
Profit accounting depends on many good faith estimates.
Managers have to predict the useful lives of its fixed assets for
recording annual depreciation expense. They have to estimate
how much of its accounts receivable may not be collectible,
which is charged off to bad debts expense. Managers have to
estimate how much to write down its inventories and charge
to expense for products that cannot be sold or will have to be
sold at prices below cost. For products already sold, they have
to forecast the future costs of warranty and guarantee work,
which is charged to expense in the period of recording the
sales. Managers have to predict several key variables that
determine the cost of its employees™ retirement plan. The
amount of retirement benefit cost that is recorded to expense
in the current year depends heavily on these estimates.

Because so many estimates have to be made in recording
expenses, the net income amount in an income statement
should be taken with a grain of salt. This bottom-line profit
number could have been considerably higher or lower. Much
depends on the estimates made by the managers in recording
its sales and expenses”as well as which particular accounting
methods are selected (more on this later).
I don™t like to say it, but in many cases the managers of a
business manipulate its external financial statements to one
degree or another. Managers influence or actually dictate which
estimates are used in recording expenses ( just mentioned).
Managers also decide on the timing of recording sales revenue
and certain expenses. Managers massage sales revenue and
expenses numbers in order to achieve preestablished targets
for net income and to smooth the year-to-year fluctuations of
net income. Managers should be careful, however. It™s one thing
to iron out the wrinkles and fluff up the pillows in the financial

40
I N T E R P R E T I N G F I N A N C I A L S TAT E M E N T S


statements, but if managers go too far, they may cross the line
and commit financial fraud for which they are legally liable.
Financial statements of public corporations are required to
DANGER!
have annual audits by an independent CPA firm; many pri-
vate companies also opt to have annual CPA audits. How-
ever, CPA auditors don™t necessarily catch all errors and fraud.
With or without audits, there™s a risk that the financial state-
ments are in error or that the business has deliberately pre-
pared false and misleading financial statements. During the
past decade, an alarming number of public corporations have
had to go back and restate their profit reports following the
discovery of fraud and grossly misleading accounting. This is
most disturbing. Investors and lenders depend on the reliabil-
ity of the information in financial statements. They do not
have an alternative source for this information”only the
financial statements.


PREMISES AND PRINCIPLES OF
FINANCIAL STATEMENTS
The shareowners of a business are entitled to receive on a
regular basis financial statements and other financial infor-
mation about the business. Financial statements are the main
means of communication by which the management of a busi-
ness renders an accounting, or a summing-up, of their stew-
ardship of the business entrusted to them by the investors in
the business. The quarterly and annual financial reports of a
business to its owners contain other information. However,
the main purpose of a financial report is to submit financial
statements to shareowners.

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