Prentice Hall's one-day MBA in finance & accounting (18 page)

$14,072,250

In this example the business’s fixed operating expenses for the year just ended include $768,450 depreciation expense. In TEAMFLY

other words, the business recorded a $768,450 write-off of its fixed assets in order to recognize the wear and tear on and the gradual loss of productivity of its long-term operating resources. In short, the year just ended was charged more than three-quarters of a million dollars for the use of fixed assets during the year. But, the amount of depreciation expense for the year should be taken with a grain of salt.

Indeed, you need a saltshaker in the case of depreciation.

Business managers should pay particular attention to the depreciation expense accounting methods used by their busi-

ness for three main reasons:

1. Depreciation expense is not a cash outlay in the year it is recorded; the fixed assets being depreciated were bought and paid for in previous years (except for the new fixed assets acquired during the most recent year).

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2. The computation of annual depreciation expense is based on an arbitrary time-based method of allocation—not on the actual level of use of fixed assets during the period.

3. For the vast majority of businesses, the amount of annual depreciation expense is determined by federal income tax—the useful lives permitted under the tax law are considerably shorter than realistic estimates for most fixed assets of most businesses; and the income tax law permits front-end loading of depreciation expense (except for buildings), which causes the expense to decline from year to year.

As a practical matter, most businesses use the useful lives for their fixed assets that are permitted by the federal income tax law, and they use one of the allocation methods allowed by the law. Most businesses abandon any attempt to base depreciation on realistic useful life estimates and actual patterns of use from year to year. One result is that a fixed asset, say a particular piece of machinery or equipment, could be fully depreciated on the books yet continue to be used for several additional years during which no depreciation expense is recorded. Business managers definitely should know whether certain of their operating fixed assets were used during the period for which no depreciation expense was recorded.

In times past there was an argument for the units-of-production depreciation method for manufacturers. The method, in brief, works as follows. The business estimates the total number of units expected to be manufactured using a particular machine or piece of equipment over its entire economic life. This number is divided into cost of the fixed asset to calculate depreciation per unit. The amount of depreciation recorded for the period depends on the number of units manufactured. Depreciation would be a
variable
cost if this method were used.

The units-of-production depreciation method is seldom if ever used—even though it has good theoretical support.

Instead businesses’ fixed assets are depreciated by either the straight-line method or an accelerated method. Both methods allocate a certain predetermined amount of a fixed asset’s cost to each year of the estimated life of the asset regardless of how much or how little the asset actually might be used during the year. Therefore, depreciation is a fixed cost.

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INTEREST EXPENSE

The business incurred $795,000 interest expense for the year just ended (Figure 8.1). Interest is not an operating expense—it’s a
financial
expense. As you know, interest is the cost of using debt for part of the total capital invested in the assets of the business. Generally speaking, the total amount of capital invested in assets swings up and down with shifts in sales revenue—though certainly not in direct proportion to changes in sales revenue or sales volume (number of units sold). Thus the amount of debt tends to move in the same direction as changes in sales. However, the linkage between shifts in sales revenue and debt is not simple and cannot easily be put into a formula.

For relatively minor swings in its sales level a business probably would not adjust the amount of its debt in most situations, so its interest expense would remain fixed in amount.

On the other hand, for major shifts in sales a business probably would adjust the amount of its debt, so its interest expense would change. In the following analysis assume that the business’s annual interest expense is fixed—keeping in mind that a major change in sales volume probably would result in a corresponding change in debt and interest expense.

PATHWAYS TO PROFIT

The business’s operating profit, earnings before income tax, and net income are presented in the management profit report (Figure 8.1). Reading a profit report is passive and reflective; computing profit is active and engaging. Managers don’t get paid to know profit, but to make profit happen. Managers need a sure-handed analytical grip on the factors that drive profit. The following discussion explains methods of calculating profit, mainly for the purpose of demonstrating how profit is earned.

Before calculating profit it’s necessary to identify which particular profit definition is being used:
operating profit
(earnings before interest and income tax),
earnings before income tax
(earnings after interest expense), or bottom-line
net income
(earnings after income tax). Income
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tax is a contingent expense; basically it’s a certain percent of taxable income. Taxable income, generally speaking, equals earnings before income tax because interest expense is deductible to determine taxable income. (Tax accountants will cringe when they read this sentence because there are many complexities in the federal income tax law; but to simplify I assume that taxable income equals the business’s earnings before income tax.) In the example, the business’s income tax rate is 35 percent of its earnings before income tax.

In the following analysis the business’s fixed operating expenses and its fixed interest expense are combined into one total fixed cost for the year ($5,739,250 fixed operating expenses + $795,000 fixed interest expense = $6,534,250 total fixed costs). In other words, profit is defined as earnings before income tax. The business earned $2,439,365 profit for the year just ended (Figure 8.1).

There are three different ways to analyze how the business earned its profit for the year, and each offers valuable lessons for business managers.

Pathway to Profit #1: Margin Times Sales Volume
One pathway for calculating profit is as follows (data is from Figure 8.1):

$15.51 contribution margin per unit

× 578,500 total units sold (sales volume)

= $8,973,615 total contribution margin

− $6,534,250 fixed expenses

= $2,439,365 profit

Technical note:
Contribution margin per unit shown here is a rounded figure; the precise contribution margin per unit is used in calculating total contribution margin.

The linchpin in this computation is the multiplication of contribution margin per unit by sales volume to get total contribution margin. Sales volume needs a good contribution margin per unit to work with. Maybe you’ve heard the old joke: “A business loses a little on each sale but makes it up on volume.” This isn’t funny, you know.

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The Breakeven Hurdle

The business sold enough units to overcome its fixed expenses and earn a profit. Business managers

worry a lot about their fixed costs—there’s no profit unless the business’s sales volume is large enough to cover its fixed expenses. The sales volume needed to cover fixed costs is called the
breakeven point,
or the
breakeven volume,
or more simply just
breakeven.
The breakeven point equals that exact sales volume at which total contribution margin equals total fixed expenses. The breakeven calculation tells a manager the sales volume that has to be achieved just to cover his or her fixed costs for the year.

Generally, businesses do not publicly divulge their breakeven volumes. Financial reporting standards do not require that this particular piece of information be disclosed in external financial reports. Some years ago, a series of articles in the financial press about Chrysler Corporation referred to the company’s breakeven point. At that time Chrysler’s breakeven point was 1.8 million vehicles a year. One article said that this breakeven point was reasonable because Chrysler had sold about 2.3 million vehicles in the previous year, but that the breakeven point was higher than Chrysler would like it to be heading into the trough of the industry’s sales cycle. Although now out-of-date, these articles illustrate the importance of breakeven.

The breakeven point for the company example (i.e., the sales volume at which the company’s profit would be zero) is computed as follows:

$6,534,250 annual fixed expenses

ᎏᎏᎏᎏ = 421,242 units

$15.51 unit contribution margin

Technical note:
Contribution margin per unit shown here is a rounded figure; the precise contribution margin per unit is used in calculating breakeven volume.

If the business had sold only 421,242 units during the year it would have earned zero profit (earnings before income tax). The company’s taxable income would have been zero and its income tax would have been zero. So net income would have been zero.

Figure 8.2 illustrates the breakeven sales volume scenario.

The breakeven volume is a useful point of reference. It’s a
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Sales Volume 421,242 Units

Per Unit

Totals

Sales revenue

$68.56

$28,879,837

Cost-of-goods-sold expense

($43.15)

($18,175,484)

Gross margin

$25.41

$10,704,353

Variable revenue-driven operating expenses

($ 5.27)

($ 2,220,175)

Variable unit-driven operating expenses

($ 4.63)

($ 1,949,928)

Contribution margin

$15.51

$ 6,534,250

Fixed operating expenses

($ 5,739,250)

Operating profit

$

795,000

Interest expense

($

795,000)

Earnings before income tax

$

0

Income tax expense

$

0

Net income

$

0

Note: Pro forma
means “as if,” or based on certain conditions or circumstances.

FIGURE 8.2
Pro forma profit report at hypothetical breakeven volume.

good way to express the total fixed-costs commitment of a business (i.e., how many units have to be sold just to cover fixed costs). Also, sales volume can be compared against breakeven volume to measure a company’s
margin of safety.

Furthermore, breakeven volume is very useful in analyzing profit behavior at different levels of sales volume.

Cash Flow Breakeven

As explained previously, depreciation is a fixed cost, but it is different in one very important respect from other fixed costs.

Depreciation is not a cash outlay in the year the expense is recorded. The other fixed costs of a business are cash-based.

Some of these fixed costs are prepaid (such as insurance premiums paid in advance for future coverage), and many are paid after the expense is recorded in either the accounts payable or the accrued expenses payable liability account. But the cash flows for these fixed costs take place mostly in the period in which the expenses are recorded. In contrast, there is no cash payment for depreciation expense.

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Therefore, depreciation can be stripped out of the fixed costs for the period and the
cash flow breakeven volume
can be calculated as follows:

$6,534,250 annual total fixed expenses

− $768,450 depreciation expense for year

= $5,765,800 cash-based fixed expenses for year

ᎏᎏᎏᎏᎏ

ᎏ

$15.51 unit contribution margin

= 371,703 units

For cash flow analysis, this concept of breakeven is relevant. But managers are much more concerned about profit numbers that will be presented in the business’s external income statement and its internal profit reports. So, the most used concept of breakeven includes all fixed costs.

Margin of Safety

One purpose of calculating breakeven is to compare it against actual sales volume. The excess of actual sales volume over breakeven sales volume provides the measure of a company’s
margin of safety.
This excess over breakeven sales volume reveals how much the company’s sales would have to drop before the business slips out of the black and into the red—from profit to loss. The company sold 578,500 units during the year just ended compared with its 421,242 units breakeven volume. So it sold 157,258 units over its breakeven, which is its margin of safety. The company’s margin of safety equals 27

percent of its actual sales volume for the year (157,258 units excess over breakeven ÷ 578,500 units sold during the year =

27%). Of course this 27 percent margin of safety does not necessarily guarantee a profit next year. Sales could drop dramatically, or expenses could rise dramatically. Later chapters explore what would happen based on changes in the key factors that drive profit.

Pathway to Profit #2: Jumping

the Breakeven Hurdle

A second way to calculate profit is to use the number of units sold in excess over breakeven as the source of profit, as follows:
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578,500 total units sold (sales volume)