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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 depreciation 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.

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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 prepaid (such as insurance) and many are paid after being recorded (such as the CPA audit fee).

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

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-

not be sold or will have to be sold below cost. Inventory also has to be written down to recognize shrinkage due to shoplift-

TEAMFLY

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.

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Team-Fly®

R E P O R T I N G P R O F I T T O M A N A G E R S

CONTRIBUTION MARGIN ANALYSIS

The next step in the decision analysis, based on the information in the management profit report (Figure 3.3), is to determine 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 business can increase sales volume only so much before some of its fixed operating expenses have to be increased. For example, 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%

Contribution margin

$ 8,973,615

$ 8,928,752

($

44,863) −0.50%

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.

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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 profits.” 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 behavior. 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 analyzed. To complete the analysis, managers need the information about operating expenses that is reported in the internal profit report. After analyzing the changes in variable operating expenses, it is discovered that contribution margin (profit before fixed operating expenses are deducted) would actually decrease if the sales price reduction were implemented. Furthermore, 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 consider other financial effects of changes in sales volume, sales
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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.

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C H A P T E R 4

Interpreting Financial

Statements

FFinancial statements are the main and often the only source of information to the lenders and the outside investors regarding a business’s financial performance and condition. In addition 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 specifications 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 anyone, 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
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instance, a business does not present a list of its major customers 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
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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 private companies also opt to have annual CPA audits. However, CPA auditors don’t necessarily catch all errors and fraud.

With or without audits, there’s a risk that the financial statements are in error or that the business has deliberately prepared 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 reliability of the information in financial statements. They do not have an alternative source for this information—only the financial statements.

PREMISES AND PRINCIPLES OF