Prentice Hall's one-day MBA in finance & accounting (27 page)

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 strategies). Product cost will be reduced 4 percent by sharper purchasing, 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 Figure 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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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 factor 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 demonstrated 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. Customers 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 specific), 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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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 managers a useful point of reference, however. Cost increases generally have to be recovered through higher sales prices. This chapter demonstrates the analysis tools for determining the higher sales prices.

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C H A P T E R 13

1

Profit Gushes:

Cash Flow Trickles?

YYou’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 managers 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!

LESSONS FROM CHAPTER 2

A

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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• Recording revenue from credit sales
before
the cash is collected 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 products are paid for
before
they are sold

• Recording depreciation expense for using long-term operating 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. Business 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 numbers. 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 million sales revenue increase for the standard product is the
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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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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 revenue 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 standard 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 customers 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 million 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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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 business could sell 10 percent more units without increasing its inventory. But generally speaking, inventory rises more or less 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 corresponding increase in accounts payable. Raw materials used in the production process are purchased on credit, and many other manufacturing costs are not paid for immediately. 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 products 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
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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