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The business will have to raise almost $1.5 million in external capital during the coming year ($1,444,752, to be more exact). The business’s chief executive working with the chief financial officer will have to decide whether to approach lenders to increase the debt load of the business and whether the business should turn to its shareowners and ask them to invest additional capital in the business. Of course, these are not easy decisions. The information in Figure 7.3 is the indis-pensable starting point.

s

END POINT

Growth is the central strategy of many businesses. Growth requires that additional capital be secured to provide money
Cash flow from profit (operating activities)

Net income planned for coming year

$2,468,358

Accounts receivable increase

($ 594,919)

Inventories increase

($ 835,225)

Prepaid expenses increase

($

87,227)

Depreciation expense

$ 943,450

Accounts payable increase

$ 325,108

Accrued expenses payable increase

$ 135,703

$2,355,248

Demands for capital

Increase in working cash balance

$ 200,000

Capital expenditures budget

$3,000,000

Cash dividends to shareowners

$ 600,000

$3,800,000

External capital needed during coming year

$1,444,752

*Figures 7.1 and 7.2 are sources of above data.

FIGURE 7.3
Cash flow from profit and external capital needed.

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for the increases in operating assets needed to support the higher sales level. Growth penalizes cash flow from profit to some extent. Generally speaking, a business cannot depend only on its internal cash flow from profit to supply all the capital needed for increasing its assets, and therefore it must go to outside sources of capital.

Based on the profit improvement plan for a business, the chapter demonstrates an efficient and practical method for forecasting the amount of capital needed to fuel the growth of the business and how much will have to come from its external capital sources in addition to its projected cash flow from profit for the coming year.

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P A R T 3

Profit and Cash

Flow Analysis

C H A P T E R 8

Breaking Even and

Making Profit

SSuccessful companies are those who year in and year out earn sufficient profit before interest and income tax from their operations. Operating earnings is the litmus test of all successful businesses. How do they do it? Not just by making sales but also by controlling their expenses so that they keep enough of their sales revenue as operating profit. The long-term sustainable success of a business rests on the ability of its managers to earn operating profit consistently. Managers must know well the pathways to operating profit and avoid detours along the way.

ADDING INFORMATION IN THE MANAGEMENT

PROFIT REPORT

The main business example used in previous chapters is continued in this chapter. Figure 8.1 presents the company’s management profit report for the year just ended—with important new information presented here for the first time.

The design of this internal accounting profit report copies the format introduced in Chapter 3. The new items of information are as follows:

• Total
sales volume
(number of units) of all products sold during the period

• The
average sales revenue per unit
(average sales price per unit)

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Sales Volume 578,500 Units

Per Unit

Totals

Sales revenue

$68.56

$39,661,250

Cost-of-goods-sold expense

($43.15)

($24,960,750)

Gross margin

$25.41

$14,700,500

Variable revenue-driven operating expenses

($ 5.27)

($ 3,049,010)

Variable unit-driven operating expenses

($ 4.63)

($ 2,677,875)

Contribution margin

$15.51

$ 8,973,615

Fixed operating expenses

($ 5,739,250)

Operating profit

$ 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 8.1
Management profit report for year just ended, including sales
volume and per-unit values.

• The
average product cost per unit
(average cost of goods sold per unit)

• The
average variable operating expenses per unit
(revenue-driven and unit-driven)

This additional information is needed for the profit analysis methods explained in this chapter.

The business has three major product lines and sells different products within each line. The business sells a fairly large number of different products, which is typical of most businesses. This chapter looks at the business as a whole, from the viewpoint of its top executives and board of directors. The chapter does not probe into profit margin differences between the business’s product lines and separate products within each product line. These topics are discussed in later chapters.

For measuring overall sales activity, businesses in many industries adopt a common denominator that cuts across all the products sold by the business. Examples are
barrels
for
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B R E A K I N G E V E N A N D M A K I N G P R O F I T

breweries,
tons
for steel mills,
passenger miles
for airlines, and
vehicles
for car and truck manufacturers.

The sales volume for the year reported in Figure 8.1 is the sum of all units sold during the year. Per-unit values in this management profit report are averages for all products. Of course, the averages depend on the
sales mix
of products during the year, which refers to the relative proportions of each product sold. Changes in a business’s sales mix can cause significant changes in the average sales price and average costs, which can cause a major shift in profit.

These important points are explored in Chapter 17. In this chapter it does no harm to pretend that the company sells just one product. This one product serves as a stand-in, or proxy, for all the products sold by the company. The business sold 578,500 units at a $68.56 sales price; product cost was $43.15; and the company incurred $5.27 revenue-driven variable costs and $4.63 unit-driven variable costs for each unit sold. Therefore, the business earned $15.51 contribution margin per unit sold (Figure 8.1). This profit margin figure equals sales price minus product cost minus the two variable operating expenses.

The business sold 578,500 units at this margin per unit, so it earned $8,973,615
contribution margin
($15.51 contribution margin per unit × 578,500 units sales volume =

$8,973,615 contribution margin). This measure of profit is before fixed operating expenses for the year and before interest and income tax expenses. Of course, contribution margin is not the bottom-line profit of a business. But it is an extremely important stepping-stone measure of profit that deserves close management attention.

Although not shown in Figure 8.1, contribution margin equals 22.6 percent of sales revenue ($8,973,615 contribution margin ÷ $39,661,250 sales revenue = 22.6%). Managers should compare this key ratio with prior years and against the company’s profit objectives for the year just ended. Any slippage in this important ratio can have serious consequences, as later chapters demonstrate. This chapter focuses on how the business made the amount of profit that it did for the year.

Later chapters focus on changes in sales volume, sales prices, cost changes, and other factors that improve or damage profit performance.

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FIXED OPERATING EXPENSES

Fixed operating expenses are deducted from contri-

bution margin to determine
operating profit,
which also is called
operating earnings,
or
earnings before interest and
income tax
(EBIT). The general nature of fixed costs is explained in Chapter 3. A business has many operating expenses that vary either with sales volume or with sales revenue. In stark contrast, a business has many operating expenses that do not vary with sales activity. Instead these costs remain stuck in place over a range of sales activity levels.

Examples of typical fixed operating expenses are the following. A business signs annual or multiyear lease contracts for retail and warehouse space; the monthly rents are fixed in amount and do not depend on the sales of the business.

Employees are hired and paid fixed salaries per month or are promised 40-hour weeks at certain hourly rates. Premiums are paid for six months to provide insurance coverage against casualty and liability losses. Utility and telephone bills are paid monthly and do not depend on sales levels. Property taxes and vehicle licenses are fixed amounts for the year.

Many other examples of fixed operating costs could be listed.

In short, a business makes many commitments that incur certain operating costs for a period of time. These fixed costs cannot be avoided unless the business takes drastic action, such as breaking contracts, firing employees, or not paying property taxes. For all practical purposes, fixed operating expenses are pretty much locked in for the year. Fixed operating expenses often are called
overhead costs
because these costs hang over the head of the managers running the business like an albatross or millstone.

Why would any rational manager commit to overhead

costs? Fixed operating expenses provide
capacity.
These costs make available the capacity to carry on sales activity and other operations of the business. Fixed expenses are incurred to provide the needed space, equipment, and personnel to sell products and to carry on the necessary operating activities of the business. By committing to these costs, the business acquires a certain amount of capacity, or ability to operate for the period.

Business managers should estimate the sales capacity of their business (i.e., the maximum sales volume that is feasible
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based on the fixed expenses of the business). Estimating sales capacity may not be all that precise, but a reasonable, ballpark estimate can be made. The manager could start by asking whether a 10 percent sales volume increase would require an increase in the business’s fixed expenses. Managers should compare the business’s sales capacity against actual sales volume. A business may have a large amount of unused sales capacity. Perhaps sales could grow 10, 20, or 30 percent before more space would have to be rented and more persons would have to be hired or more equipment would have to be installed. Having an estimate of the idle, unused sales capacity of the business is especially important in planning ahead and in analyzing the profit impact of changes in the key factors that drive profit, as the following discussion reveals.

The term
fixed
should be used with caution. True, the fixed costs of a business for a period are largely unchanging and inflexible—but not down to the last penny. The main point about fixed operating expenses is that they are insensitive to the number of units sold during the period or the amount of sales revenue for the period—unless a business takes drastic action to scale down or expand its sales capacity. Many, if not most, fixed expenses can be adjusted if sales drop off precipi-tously or surge ahead rapidly. For example, suppose sales take a sudden and unexpected downturn. A business could sublet part of the space it rents, reduce insurance limits, or sell some of the property it owns. If on the other hand sales spurted up all of a sudden, a business could ask its employees who are guaranteed a 40-hour workweek at a fixed hourly rate to work overtime to handle the upsurge in sales. What the term
fixed
actually means is that these costs remain largely constant in the short run over a range of sales activity that might be 10 to 25 percent lower or higher than the actual sales volume of the business.

DEPRECIATION: A SPECIAL KIND OF FIXED COST

Depreciation expense accounting is unique; you could even say weird. The basic idea of allocating the cost of a long-term operating resource over its useful, productive life is sound and unimpeachable. (Ownership of land confers the right to occupy a certain space in perpetuity, so the cost of land is not
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depreciated.) The total cost of a company’s long-term operat-

ing resources is reported in an asset account in its balance sheet, usually entitled
property, plant, and equipment.

The original costs of
fixed assets
are recorded in one account, and depreciation expense each period is

recorded in a second account called
accumulated depreciation.

The balance in this contra, or offset, account is the cumulative amount of depreciation expense recorded to date. Its balance is deducted from the property, plant, and equipment asset account. In this way the balance sheet discloses both the cost of a company’s fixed assets and how much of the cost has been depreciated so far.

For instance, at the close of its most recent year the busi-

ness’s fixed assets are reported as follows in its year-end bal-

ance sheet (from Figure 4.2):

Property, plant, and equipment

$20,857,500

Accumulated depreciation

($ 6,785,250)

Cost less accumulated depreciation