Understanding Business Accounting For Dummies, 2nd Edition (119 page)

You earn profit (or to be precise, profit before tax) by selling enough products that your total margin is higher than your total fixed expenses for the period. The excess of total margin over fixed expenses is profit before tax. Setting sales prices to generate an adequate total contribution margin is one of the most important functions of managers.

When thinking about changing sales price, focus on what happens to the
margin per unit
.
Suppose, for example, that you're considering dropping the sales price 10 per cent from £100.00 to £90.00. You predict that your product cost and variable expenses will remain unchanged. Here's what would happen to your margin:

Margin Factors After Before

Sales price £90.00 £100.00

Less product cost
60.00
60.00

Equals gross margin £30.00 £40.00

Less sales revenue-driven expenses 7.20 8.00

Less sales volume-driven expenses
5.00
5.00

Equals margin per unit £17.80 £27.00

Your margin would plunge £9.20 per unit - more than one-third!

Suppose you sold 100,000 units of this product during the year just ended. These sales generated £2.7 million total margin. If you drop the sales price, you give up £920,000 total margin. Where will the replacement come from for this £920,000 contribution margin? Higher sales volume? Sales volume would have to increase more than 50 per cent to offset the drastic drop in the contribution margin per unit. You'd better have a good answer. The profit model directs attention to this critical question and gives you the amount of margin sacrificed by dropping the sales price.

Understand That a Small Sales Volume Change Has a Big Effect on Profit

Is that big push before year-end for just 5 per cent more sales volume really that important? You understand that more sales mean more profit, of course. But what's the big deal? A 5 per cent increase in sales volume means just 5 per cent more profit, doesn't it? Oh no. If you think so, you need to read Chapter 9. Because fixed expenses are just that - fixed and unchanging over the short run. Seemingly small changes in sales volume cause large swings in profit. This effect is called
operating leverage
.

The following example illustrates operating leverage. Suppose your £12.5 million annual fixed expenses provide the personnel and physical resources to sell 625,000 units over the year. However, you didn't hit capacity; your company's actual sales volume was 500,000 units for the year, or 80 per cent of sales capacity - which isn't bad. Your average margin across all products is £30 per unit. Using the basic profit equation, you determine profit before income tax as follows:

[£30 margin per unit × 500,000 units] = £15,000,000 contribution margin

- 12,500,000
fixed expenses

= £2,500,000 pre-tax profit

Now, what if you had sold 25,000 more units, which is just 5 per cent more sales volume? Your fixed expenses would have been the same because sales volume would still be well below the sales capacity provided by your fixed expenses. Therefore, the profit increase would have been the £30 margin per unit times the 25,000 additional units sold, or £750,000. This is a 5 per cent gain in contribution margin. But compared to the £2,500,000 pre-tax profit, the additional £750,000 is a 30 per cent gain - from only a 5 per cent sales volume gain, which is a 6-to-1 payoff!

Operating leverage
refers to the wider swing in profit rather than the smaller swing in sales volume. In this example, a 5 per cent increase in sales volume would cause a 30 per cent increase in profit. Unfortunately, operating leverage cuts both ways. If your sales volume had been 5 per cent less, your profit would have been £750,000 less, which would have resulted in 30 per cent less profit.

Here's a quick explanation of operating leverage. In this example, total contribution margin is 6 times profit: £15 million contribution margin ÷ £2.5 million profit = 6. So a 5 per cent swing in contribution margin has a 6-times effect, or a 30 per cent impact on profit. Suppose a business had no fixed expenses (highly unlikely). In this odd situation, there is no operating leverage. The percentage gain or loss in profit would equal the percentage gain or loss in sales volume.

The fundamental lesson of operating leverage is to make the best use you can of your fixed expenses - that is, take advantage of the capacity provided by the resources purchased with your fixed expenses. If your sales volume is less than your sales capacity, the unsold quantity would have provided a lot more profit. Most businesses are satisfied if their actual sales volume is 80-90 per cent of their sales capacity. But keep in mind one thing: That last 10 or 20 per cent of sales volume would make a dramatic difference in profit!

Fathom Profit and Cash Flow from Profit

Profit equals sales revenue minus expenses - you don't need to know much about accounting to understand this definition. However, business managers should dig a little deeper. First, you should be aware of the accounting problems in measuring sales revenue and expenses. Because of these problems, profit is not a clear-cut and precise number. Second, you should know the real stuff of profit and know where to find profit in your financial statements.

Profit
is not a politically correct term. Instead, business financial reports call profit
net income
or
net earnings
. So don't look for the term
profit
in external financial statements. Remember, net income (or net earnings) = bottom-line profit after tax.

Profit accounting methods are like hemlines

Profit is not a hard-and-fast number but is rather soft and flexible on the edges. For example, profit depends on which accounting method is selected to measure the cost-of-goods-sold expense, which is usually the largest expense for businesses that sell products. The rules of the game, called
generally accepted accounting principles
(or GAAP for short), permit two or three alternative methods for measuring cost of goods sold and for other expenses as well. (Chapter 13 discusses accounting methods.)

When evaluating the profit performance of your own business or when sizing up the net income record of a business you're considering buying, look carefully at whether profit measurement is based on stingy (conservative) or generous (liberal) accounting methods. You can assume that profit is in the GAAP ballpark, but you have to determine whether profit is in the right field or the left field (or perhaps in centre field). Businesses are not required to disclose how different the profit number would have been for the period if different accounting methods had been used, but they do have to reveal their major accounting methods in the footnotes to their annual financial statements.

The real stuff of profit

Most people know that, in the general sense of the word,
profit
is a gain, or an increase in wealth, or how much better off you are. But managers and investors hit the wall when asked to identify the real stuff of profit earned by a business. To make our point, suppose that your business's latest annual profit and loss account reports £10 million sales revenue and £9.4 million expenses, which yields £600,000 bottom-line net income. Your profit ratio is 6 per cent of sales revenue, which is about typical for many businesses. But we digress.