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sus too seldom. With computers and other electronic means of communication today, it is tempting to bombard managers with too much control information too often. Sorting out the
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truly relevant from the less relevant and truly irrelevant information is at the core of the manager’s job.

Profit Control Reports

The type of management profit report illustrated in previous chapters is a logical starting point for designing reports to managers for profit control. First and foremost, profit margins and total contribution margin should be the main focus of attention and should be clear and easy to follow. These two key measures of performance should be reported for each major product or product line (backed up with detailed schedules for virtually every individual product) in management profit performance reports. These are very confidential data, which are not divulged in external income statements—or, for that matter, very widely within the business organization.

Variable expenses should be divided between those

that depend on sales volume and those that depend

on sales revenue and broken down into a large number of specific accounts. Sales volumes for each product and product line should be reported. Fixed expenses should be broken down into major components—salaries, advertising, occupancy costs, and so on. Sales and/or manufacturing capacity should be reported. Any significant change in capacity due to changes in fixed expenses should be reported.

Management control reports should analyze changes in profit. In particular, the impact of sales volume changes should be separated from changes in sales price, product cost, and variable expenses as explained in earlier chapters (see Chapters 9 and 10). If trade-off decisions were made—for example, cutting sales price to increase sales volume—there should be follow-up analysis in the management control profit reports that track how the decision actually worked out. Did sales volume increase as much as expected?

As this chapter explains later in more detail, a fringe of negative factors constantly threaten profit margins and bloat fixed expenses. Each of these negative factors should be singled out for special attention in management profit control reports. Inventory shrinkage, for example, should be reported on a separate line, as should sales returns, unusually high bad
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debts, and any extraordinary losses or gains recorded in the period (with adequate explanations).

If there is a general fault with internal profit reports for management control purposes, it is in my opinion the failure of the accounting staff to explain and analyze why profit increased or decreased relative to the previous period or relative to the budget for the period. Such profit-change analysis would be very useful to include in the profit reports. But managers generally are left on their own to do this. The analysis tools discussed in previous chapters are very helpful for this.

Sales Price Negatives

When eating in a restaurant, you don’t argue about the menu prices. And you don’t bargain over the posted prices at the gas pump or in the supermarket. In contrast, sales price negotiation is a way of life in many industries. Many businesses advertise or publish list prices. Examples are sticker prices on new cars, manufacturer’s suggested retail prices on consumer products, and standard price sheets for industrial products.

List prices are not the final prices; they are only the point of reference for negotiating the final terms of the sale. In some cases, such as new car sales, neither the seller nor the buyer takes the list price as the real price—the list price simply sets the stage for bargaining. In other cases, the buyer agrees to pay list price, but demands other types of price concessions and reductions or other special accommodations.

Prompt-payment discounts are offered when one business sells to another business on credit. For example a 2 percent discount may be given for payment received within 10 days after the sales invoice date. These are called
sales discounts.

Buyers should view these as penalties for delayed payment.

Also, businesses commonly give their customers quantity discounts for large orders, and most businesses offer special discounts in making sales to government agencies and educational institutions.

Many consumer product companies offer their customers rebates and coupons, which lower the final net sales price received by the seller, of course. Businesses also make allowances or adjustments to sales prices after the point of sale when customers complain about the quality of the
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product or discover minor product flaws after taking delivery.

Instead of having the customer return the product, the company reduces the original sales price.

Managers must decide how these sales price negatives should be handled in their internal management control reports. One alternative is to report sales revenue net of all such sales price reductions. I don’t recommend this method. The better approach is to report sales revenue at established list prices.

All sales price negatives should be recorded in sales revenue contra accounts that are deducted from gross (list price) sales revenue.

Figure 17.1 illustrates the reporting sales price negatives to managers. Seven different reductions from sales revenue are shown in this figure. A business may not have all the sales contra accounts shown, but three or four are not unusual. The amounts of each contra account may not be as large as shown (hopefully not).

In the external income statement of the business, only net sales revenue ($8,303,000 in Figure 17.1) is reported, as a general rule. For internal management control reporting, however, gross (list price) sales revenue before all sales price reductions should be reported to give managers the complete range of information they need for controlling sales prices.

Sales price negatives should be accumulated in contra (deduction) accounts so that managers can monitor each one relative Gross sales revenue, at list prices

$10,000,000

Sales price negatives:

Sales price discounts—normal

($150,000)

Sales price discounts—special

($200,000)

Sales returns

($175,000)

Quantity discounts

($275,000)

Rebates

($650,000)

Coupons

($165,000)

Sales price allowances

($ 82,000)

($ 1,697,000)

Net sales revenue

$ 8,303,000

FIGURE 17.1
Sales revenue negatives in a management control
report.

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to established sales pricing policies and so they can make comparisons with previous periods and with the goals (or budget) for the current period.

Inventory Shrinkage

Inventory shrinkage is a serious problem for many busi-DANGER!

nesses, especially retailers. These inventory losses are due to shoplifting by customers, employee theft, and short counting from suppliers. Many businesses also suffer inventory obsolescence, which means they end up with some products that cannot be sold or have to be sold below cost. When this becomes apparent, inventory should be decreased by write-down entries. The inventories asset account is decreased and an expense account is increased.

Losses caused by damage to and deterioration of products being held in inventory and inventory write-downs to recognize product obsolescence should be separated from losses due to theft and dishonesty—but sometimes the term
inventory shrinkage
is used to include any type of inventory disappearance and loss. Inventory shrinkage of 1.5 to 2.0 percent of retail sales is not unusual.

Inventory loss due to theft is a particularly frustrating expense. The business buys (or manufactures) products and then holds them in inventory, which entails carrying costs, only to have them stolen by customers or employees. On the other hand, inventory shrinkage due to damage from handling and storing products, product deterioration over time, and product obsolescence is a normal and inescapable economic risk of doing business.

Internal management control reports definitely should separate inventory shrinkage expense and not include it in the cost-of-goods-sold expense. Inventory shrinkage is virtually never reported as a separate expense in external income statements; it is combined with cost-of-goods-sold or some other expense. However, managers need to keep a close watch on inventory shrinkage, and they cannot do so if it is buried in the larger cost-of-goods-sold expense.

Another reason for separating inventory shrinkage in management control reports is that this expense does not behave the same way as cost-of-goods-sold expense. Cost-of-goods-

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sold expense varies with sales volume. Inventory shrinkage may include both a fixed amount that is more or less the same regardless of sales volume and an amount that may vary with sales volume.

Strong internal controls help minimize inventory shrinkage.

But even elaborate and expensive inventory controls do not eliminate inventory shrinkage. Almost every business tolerates some amount of inventory shrinkage. For instance, most businesses look the other way when it comes to minor employee theft; they don’t encourage it, of course, but they don’t do anything about it, either. Preventing all inventory theft would be too costly or might offend innocent customers and hurt sales volume. Would you shop in retail stores that carried out body searches on all customers leaving the store? I doubt it. Many retailers even hesitate to require customers to check bags before entering their stores. On the other hand, closed-circuit TV monitors are common in many stores. Retailers are constantly trying to find controls that do not offend their customers. As you know, product packages are often designed to make it difficult to shoplift (e.g., oversized packages that are difficult to conceal).

In internal management control reports, the negative factors just discussed should be set out in separate expense accounts if they are relatively material or listed separately in a supplementary schedule. Managers may have to specifically instruct their accountants to isolate these expenses. In external income statements, these costs are grouped in a larger expense account (e.g., cost of goods sold, general and administrative expenses).

Sales Volume Negatives

Sales returns can be a problem, although this varies from industry to industry quite a bit. Many retailers accept sales returns without hesitation as part of their overall marketing strategy. Customers may be refunded their money, or they may exchange for a different product. On the other hand, products such as new cars are seldom returned (even when recalled).

Sales returns definitely should be accumulated in a separate sales contra account that is deducted from gross sales revenue
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(see Figure 17.1 again). The total of sales returns is very important control information. On the other hand, in external income statements only the amount of net sales revenue (gross sales revenue less sales returns and all other sales revenue negatives) is reported.

Lost sales due to temporary
stock-outs
(zero inventory situations) are important for managers to know about. Such non-sales are not recorded in the accounting system. No sales transaction takes place, so there is nothing to record in the sales revenue account. However, missed sales opportunities should be captured and kept track of in some manner, and the amount of these lost sales should be reported to managers even though no sales actually took place. Managers need a measure of how much additional contribution margin could have been earned on these lost sales.

Customers may be willing to back-order products, or sales may be made for future delivery when customers do not need immediate delivery; these are called
sales backlogs.
Information about sales backlogs should be reported to managers, but not as sales revenue, of course. If a customer refuses to back-order or will not wait for future delivery, the sale may be lost.

As a practical matter, it is difficult to keep track of lost sales.

The manager may have to rely on other sources of information, such as complaints from customers and the company’s sales force.

Key Sales Ratios

Many retailers keep an eye on measures such as sales revenue per employee and sales revenue per square foot of retail space. Most retailers have general rules ($300 to $400 sales per square foot of retail space, $250,000 sales per employee, etc.). These amounts vary widely from industry to industry.

Trade associations collect data from their members and publish industry averages. Retailers can compare their performances against local and regional competition and against national averages. Hotels and motels carefully watch their occupancy rates, which is an example of a useful ratio to measure actual sales against capacity.

When sales ratios are lagging, the business probably has too much capacity—too many employees, too much space, too
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many machines, and so on. The obvious solution is to reduce the fixed operating costs of the business. However, reducing these fixed expenses is not easy, as you probably know.

Employees may have to be fired (or temporarily laid off ), major assets may have to be sold, contracts may have to be broken, and so on. Downsizing decisions are extremely difficult to make. For one thing, they are an admission of the inability of the business to generate enough sales volume to justify its fixed expenses. Nonetheless, part of the manager’s job is to make these painful decisions.

The tendency is to put off the decision, to delay the tough choices that have to be made. In an article in the
Wall Street
Journal,
the former CEO of Westinghouse observed that one of the biggest failings of U.S. chief executives is one of procrasti-nating—executives are reluctant to face up to making these decisions at the earliest possible time.