Understanding Business Accounting For Dummies, 2nd Edition (66 page)

Fees that a business pays to a bank when a customer uses a credit card such as Visa, MasterCard, or American Express. (When a business deposits its copy of the credit card slip, the local bank deducts a certain percentage of the amount deposited as the bank's fee for handling the transaction, and a part of the fee is shared with the credit card issuer.)

The management profit and loss account (Figure 9-2) can be referred to as the
internal profit report
, since it is for management eyes only and does not circulate outside the business - although it may be the target of industrial intelligence gathering and perhaps even industrial espionage by competitors. Remember that in the external profit and loss account only one lump sum for the category of sales, administrative, and general (SA&G) expenses is reported - a category for which some of the expenses are fixed but some are variable. What you need to do is have your accountant carefully examine these expenses to determine which are fixed and which are variable. (Some expenses may have both fixed and variable components, but we don't go into these technical details.)

Further complicating the matter somewhat is the fact that the accountant needs to divide variable expenses between those that vary with sales
volume
(total number of units sold) and those that vary with sales
revenue
(total pounds of sales revenue). This is an important distinction.

An example of an expense driven by sales volume is the cost of shipping and packaging. This cost depends strictly on the
number
of units sold and generally is the same regardless of how much the item inside the box costs.

An example of an expense driven by sales revenue are sales commissions paid to salespersons, which directly depend on the amounts of sales made to customers. Other examples are franchise fees based on total sales revenue of retailers, business premises rental contracts that include a clause that bases monthly rent on sales revenue, and royalties that are paid for the right to use a well-known name or a trademarked logo in selling the company's products and which are based on total sales revenue.

The business represented in Figure 9-2 has just one variable operating expense - an 8 per cent sales commission, resulting in an expense total of £4,160,000 (£52 million sales revenue × 8 per cent). Of course, a real business probably would have many different variable operating expenses, some driven by unit sales volume and some driven by total sales revenue pounds. But the basic idea is the same for all of them and one variable operating expense serves the purpose here. Also, cost of goods sold expense is itself a sales volume driven expense (see Chapter 13 regarding different accounting methods for measuring this expense). The example shown in Figure 9-2 is a bit oversimplified - the business sells only one product and has only one variable operating expense - but, the main purpose is to present a general template that can be tailored to fit the particular circumstances of a business.

Fixed operating expenses
are the many different costs that a business is obliged to pay and cannot decrease over the short run without major surgery on the human resources and physical facilities of the business. You must distinguish fixed expenses from your variable operating expenses.

As an example of fixed expenses, consider a typical self-service car wash business - you know, the kind where you drive in, put some coins in a box, and use the water spray to clean your car. Almost all the operating costs of this business are fixed: Rent on the land, depreciation of the structure and the equipment, and the annual insurance premium cost don't depend on the number of cars passing through the car wash. The only variable expenses are probably the water and the soap.

If you want to decrease fixed expenses significantly, you need to downsize the business (lay off workers, sell off property, and so on). When looking at the various ways you have for improving your profit, significantly cutting down on fixed expenses is generally the last-resort option. Refer to ‘Improving profit' later in this chapter for the better options.

Better than anyone else, managers know that sales for the year could have been lower or higher. A natural question is, ‘What difference in the profit would there have been at the lower or higher level of sales?' If you'd sold 10 per cent fewer total units during the year, what would your net income (bottom-line profit) have been? You might guess that profit would have slipped 10 per cent but that would
not
have been the case. In fact, profit would have slipped by much more than 10 per cent. Are you surprised? Read on for the reasons.

Why wouldn't profit fall the same percentage as sales? The answer is because of the nature of fixed expenses
- just because your sales are lower doesn't mean that your expenses are lower.
Fixed expenses
are the costs of doing business that, for all practical purposes, are stuck at a certain amount over the short term. Fixed expenses do not react to changes in the sales level. Here are some examples of fixed expenses:

Interest on money that the business has borrowed

Employees' salaries and benefits