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The income statement reports the revenue, expenses, and profit or loss of the business for the period. Recording revenue and expenses is based on
accrual-basis
accounting methods.

The chapter begins by explaining the key differences between cash flows and accrual-basis profit accounting. Then the format
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I N T R O D U C I N G F I N A N C I A L S T A T E M E N T S

and content of each of the three primary financial statements is illustrated and explained for a typical business.

The external financial statements are oriented to the outside shareowners and lenders of the business who are not involved in managing the business. The development of the standards and conventions for presenting external financial statements has been guided by this basic orientation. For their decision-making and control functions, business managers need more useful internal profit reports, which I develop in the next chapter.

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C H A P T E R 3

Reporting Profit

to Managers

MManagers have to keep on top of the unending stream of changes in today’s business environment. Few factors remain constant very long. Managers need to quickly assess the profit and other financial impacts of these changes. Deciding on the best response to changes is never easy, but one thing is clear: Managers need all relevant information for their profit-making decision analysis.

USING THE EXTERNAL INCOME STATEMENT FOR

DECISION-MAKING ANALYSIS

The external income statement (see Figure 2.2) is useful up to a point for decision-making analysis, but it does not present all the information about operating expenses that is needed by managers. To demonstrate this important point, consider the following situation. Suppose you have done extensive market research and you’re convinced that reducing sales prices across the board next year by just 5 percent would result in a 25 percent increase in sales volume across the board. In order to concentrate on this basic decision, assume zero cost inflation next year (don’t you wish!). Would this be a good move?

Of course, your prediction of a 25 percent sales volume DANGER!

increase is critical. This big jump in sales volume may or may not materialize. Such a large response to shaving sales prices implies that sales demand is very sensitive to sales
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F I N A N C I A L R E P O R T I N G

prices. In other words, you face a very elastic demand curve, as economists say. Does the external income statement provide
all
the information needed to analyze this decision? No, not entirely. The external profit report (income statement) doesn’t include enough information about how operating expenses would react to the sales volume increase and the sales revenue increase.

External Income Statement for New Example

Figure 3.1 presents the external income statement for the most recent year for a new business example. This external profit performance report has been prepared according to
generally accepted accounting principles
(GAAP) regarding the format and disclosure standards for this key financial statement. Be warned, however, that every business is a little different when it comes to details in their income statements.

Terminology differs somewhat from business to business. For instance, some companies prefer the term
gross profit
instead of
gross margin
in their external income statements (sales revenue minus cost-of-goods-sold expense). Many businesses report two or more classes of operating expenses below the gross margin line instead of just one amount for all selling and administrative expenses as shown in Figure 3.1. For instance, a business may disclose the amount of its research and development expense for the year as separate from all its other operating expenses. Nevertheless, the example shown in Sales revenue

$39,661,250

Cost-of-goods-sold expense

$24,960,750

Gross margin

$14,700,500

Selling and administrative expenses

$11,466,135

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.

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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 restaurant, as a rough rule of thumb, should keep its food costs at one-third of its sales revenue, leaving a two-thirds gross margin 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.

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F I N A N C I A L R E P O R T I N G

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 ballpark 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 purchases 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 inflation. 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 somewhat surprised by the outcome shown in Figure 3.2. But numbers 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
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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.

MANAGEMENT PROFIT REPORT

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 according to how they behave relative to changes in sales volume and sales revenue (see the shaded area in Figure 3.3).
Variable
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.

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F I N A N C I A L R E P O R T I N G

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 managers know, although this seems to be a misconception held by many.

The additional information about operating expenses provided in the management profit report (see Figure 3.3) allows the manager to complete his or her analysis and reach a decision. 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 operating expenses are divided into two types: those that vary with
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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.