The Fast Forward MBA in Finance_3 pdf

In contrast, a retail furniture store may hold an item in inventory for more than six months on average before it is sold, so they need fairly high gross margin percents. In this business example, the company’s gross margin is 37.1 percent of its sales revenue ($14,700,500 gross margin ÷ $39,661,250 sales revenue = 37.1% gross margin ratio). This is in the ball- park for many businesses. Cost of goods sold is a variable expense; it moves more or less in lockstep with changes in sales volume (total number of units sold). If sales volume were to increase 10 percent, then this expense should increase 10 percent, too, assuming unit product costs remained constant over time. But unit product costs—whether the company is a retailer that pur- chases the products its sells or a producer that manufactures the products it sells—do not remain constant over time. Unit product costs may drift steadily upward over time with infla- tion. Or unit product costs can take sharp nosedives because of technological improvements or competitive pressures. Returning to the decision situation introduced previously, the manager can use the information in the external income statement to do the gross margin analysis presented in Figure 3.2, which compares sales revenue, cost-of-goods-sold expense, and gross margin for the year just ended and for the contem- plated scenario in which sales prices are 5 percent lower and sales volume is 25 percent higher. Before looking at Figure 3.2, you might make an intuitive guess regarding what would happen to gross margin in this scenario, then compare your guess with what the numbers show. I’d bet that you are some- what surprised by the outcome shown in Figure 3.2. But num- bers don’t lie. Sales revenue would increase 18.75 percent: Although sales volume would increase 25.0 percent, the sales price of every unit sold would be only 95 percent of what it sold for during the year just ended. (Note that 1.25 × 0.95 = 1.1875, or an 18.75 percent increase in sales revenue.) Cost-of-goods-sold expense would increase 25.0 percent because sales volume, or the total number of units sold, would increase 25.0 percent. Still, gross margin would increase 8.14 percent, although this is far less than the percent increase in sales volume. What about operating expenses? Would the total of these FINANCIAL REPORTING 30 expenses (excluding interest and income tax expenses) increase more than the increase in gross margin? Without more information about the business’s operating expenses there’s no way to answer this question. You need information about how the operating expenses would react to the relatively large increase in sales volume and sales revenue. The internal management profit report presents this key information. MANAGEMENT PROFIT REPORT Figure 3.3 presents the management profit report for the business example. (In this internal financial statement I show expenses with parentheses to emphasize that they are deductions from profit.) Instead of one amount for selling and administrative expenses as presented in the external income statement, note that operating expenses are classified accord- ing to how they behave relative to changes in sales volume and sales revenue (see the shaded area in Figure 3.3). Vari- able operating expenses are separated from fixed operating expenses, and the variable expenses are divided into revenue- driven versus unit-driven. This three-way classification of operating expenses is the key difference between the external and internal profit reports. Also note that a new profit line is included, labeled contribution margin, which equals gross margin minus variable operating expenses. It is called this because this profit contributes toward coverage of fixed operating expenses and toward interest expense, which to a large degree is also fixed in amount for the year. 31 REPORTING PROFIT TO MANAGERS For Year Just Ended For New Percent (Figure 3.1) 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% FIGURE 3.2 Gross margin analysis of sales price cut proposal. Bottom-line profit (net income) is exactly the same amount as in the external income statement (Figure 3.1). Contrary to what seems to be a popular misconception, businesses do not keep two sets of books. Profit is measured and recorded by one set of methods, which are the same for both internal and external financial reports. Managers may ask their accounting staff to calculate profit using alternative accounting methods, such as a different inventory and cost-of-goods-sold expense method or a different depreciation expense method, but only one set of numbers is recorded and booked. There is not a “real” profit figure secreted away someplace that only man- agers know, although this seems to be a misconception held by many. The additional information about operating expenses pro- vided in the management profit report (see Figure 3.3) allows the manager to complete his or her analysis and reach a deci- sion. Before walking through the analysis of the proposal to cut sales prices by 5 percent to gain a 25 percent increase in sales volume, it is important to thoroughly understand the behavior of operating expenses. Variable Operating Expenses In the management profit report (Figure 3.3), variable operat- ing expenses are divided into two types: those that vary with FINANCIAL REPORTING 32 Sales revenue $39,661,250 Cost-of-goods-sold expense ($24,960,750) Gross margin $14,700,500 Variable revenue-driven operating expenses ($ 3,049,010) Variable unit-driven operating expenses ($ 2,677,875) Contribution margin $ 8,973,615 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 3.3 Management profit report for business example. sales volume and those that vary with total sales dollars. In general, variable means that an expense varies with sales activity—either sales volume (the number of units sold) or sales revenue (the number of dollars generated by sales). Delivery expense, for example, varies with the quantity of units sold and shipped. On the other hand, commissions paid to salespersons normally are a percentage of sales revenue or the number of dollars involved. Contribution margin, which equals sales revenue minus cost-of-goods-sold and variable operating expenses, has to be large enough to cover the company’s fixed operating expenses, its interest expense, and its income tax expense and still leave a residual amount of final, bottom-line profit (net income). In short, there are a lot of further demands on the stepping- stone measure of profit called contribution margin. Even if a business earns a reasonably good total contribution margin, it still isn’t necessarily out of the woods because it has fixed operating expenses as well as interest and income tax. 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 depre- ciation 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. 33 REPORTING PROFIT TO MANAGERS 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 pre- paid (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- 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. FINANCIAL REPORTING 34 TEAMFLY Team-Fly ® CONTRIBUTION MARGIN ANALYSIS The next step in the decision analysis, based on the informa- tion in the management profit report (Figure 3.3), is to deter- mine 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 busi- ness can increase sales volume only so much before some of its fixed operating expenses have to be increased. For exam- ple, 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 35 REPORTING PROFIT TO MANAGERS 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. 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 prof- its.” 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 behav- ior. 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 ana- lyzed. To complete the analysis, managers need the informa- tion about operating expenses that is reported in the internal profit report. After analyzing the changes in variable operat- ing expenses, it is discovered that contribution margin (profit before fixed operating expenses are deducted) would actually decrease if the sales price reduction were implemented. Fur- thermore, 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 con- sider other financial effects of changes in sales volume, sales FINANCIAL REPORTING 36 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. 37 REPORTING PROFIT TO MANAGERS 4 CHAPTER Interpreting Financial Statements F 4 Financial statements are the main and often the only source of information to the lenders and the outside investors regard- ing a business’s financial performance and condition. In addi- tion 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 speci- fications 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 any- one, 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 39 [...]... financial statements and other financial information about the business Financial statements are the main means of communication by which the management of a business renders an accounting, or a summing-up, of their stewardship of the business entrusted to them by the investors in the business The quarterly and annual financial reports of a business to its owners contain other information However, the. .. supplied the ownership capital to a business but who are not directly involved in managing the business Financial statements are prepared for the “absentee owners” of a business, in other words GAAP and financial reporting standards do not ignore the need for information by the lenders to a business 41 FINANCIAL REPORTING But the shareowners of the business are the main constituency for whom financial... practice In public discussions, the investment community wrings their hands and lambastes this practice, as you see in many articles and editorials in the financial press However, I think many investors would admit in private that they prefer that a business take a big bath in one year and thereby escape losses and expenses in future years The thinking is that taking a big bath allows a business to... value Generally speaking, the market value of stocks is higher than their book values The reason for the comment in the article is that when a stock trades below its book value, the investors trading in the stock are of the opinion that the stock is not worth even its book value But book value is backed up by the assets of the business To illustrate this point, suppose the business in the example were... Chapter 3 introduced the external income statement for a business, followed by the internal management profit report for the business Now the complete set of financial statements for the business is presented, which consists of the following: • Income statement for the year just ended (Figure 4.1) • Statement of financial condition at the close of the year just ended and at the close of the preceding year... future They plan to continue as a going concern and make a profit, at least for as far ahead as they can see Therefore the dominant factor in determining the market value of capital stock shares is the earnings potential of the business, not the book value of its ownership shares The best place to start in assessing the earning potential of a business is its most recent earnings performance Suppose... Barron’s, Investor’s Business Daily, and many other sources of financial market information They know the prices at which buyers and sellers are trading stocks The main factor driving the market price of a stock is its earnings per share EARNINGS PER SHARE The income statement presented in Figure 4.1 includes earnings per share (EPS), which is $3.75 for the year just ended Privately owned businesses... main purpose of a financial report is to submit financial statements to shareowners Generally accepted accounting principles (GAAP) and financial reporting standards have been extensively developed over the last half century These guidelines rest on one key premise— the separation of management of a business from the outside investors in the business In the formulation of GAAP it is assumed that financial... 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 FINANCIAL STATEMENTS The shareowners of a business are entitled... me, scan a sample of 50 or 100 earnings reports in the Wall Street Journal or the New York Times The 4.0 percent net income profit ratio in the Profit Ratios Income Statement Sales revenue Cost-of-goods-sold expense Gross margin Selling and administrative expenses Earnings before interest and income tax Interest expense Earnings before income tax Income tax expense Net income FIGURE 4.5 Return-on-sales . summing-up, of their stew- ardship of the business entrusted to them by the investors in the business. The quarterly and annual financial reports of a business to its owners contain other information margin $14,700,500 37 .1% Selling and administrative expenses $11,466, 135 Earnings before interest and income tax $ 3, 234 ,36 5 8.2% Interest expense $ 795,000 Earnings before income tax $ 2, 439 ,36 5. and income tax $ 3, 234 ,36 5 Interest expense $ 795,000 Earnings before income tax $ 2, 439 ,36 5 Income tax expense $ 8 53, 778 Net income $ 1,585,587 Earnings per share* $ 3. 75 *Privately owned business