98 Understanding the Numbers New England Business Services Inc. (1996) Noble Drilling Inc. (1991) NS Group Inc. (1992) Office Depot Inc. (1999) Osmonics Inc. (1993) Pall Corporation (2000) Petroleum Helicopters Inc. (1999) Phillips Petroleum Company (1990) Pollo Tropical Inc. (1995) Praxair Inc. (1999) Raven Industries Inc. (2000) Saucony Inc. (1999) Schnitzer Steel Industries Inc. (1999) Shaw Industries Inc. (1999) The Sherwin-Williams Company (1999) Silicon Valley Group Inc. (1999) Southwest Airlines Inc. (1999) Standard Register Company (1999) SunTrust Banks Inc. (1999) Synthetech Inc. (2000) Textron Inc. (1999) Toys “R” Us Inc. (1999) Trimark Holdings Inc. (1995) Tyco International Ltd. (2000) Watts Industries Inc. (1999) Wegener Corporation (1999) NOTES 1. The American Institute of CPA’s Special Committee on Financial Reporting, Improving Business Reporting—A Customer Focus (New York: AICPA, November 1993), 4. 2. Donald Kieso and Jerry Weygandt, Intermediate Accounting, 9th ed. (New York: John Wiley, 1998), 154–161. 3. Delta Air Lines, annual reports, June 1996, 50–51, and June 2000. 4. Some might also remove these gains because they do not represent operating items. However, the ongoing disposition of flight equipment is an inherent feature of being in the airline business. It is not what they are in the business to do, but it does come with the territory. 5. Delta Air Lines does disclose some proceeds from the sale of flight equipment in its 1998–2000 statements of cash flow. The gains and losses were probably too small Analyzing Business Earnings 99 to receive separate disclosure. Delta Air Lines, annual report, June 2000, 36. Delta does disclose balances for deferred gains on sale and leaseback transactions. These balances declined by $50 million in 2000, suggesting that gains equal to this amount were included in earnings for 2000. They are treated as a reduction in lease expense and do not appear on a line item as gains on the disposition of flight equipment. 6. In fact, 1996 saw a loss of $7.4 million, followed by gains of $34.1 in 1997 and $2.6 million in 1998. Goodyear Tire and Rubber Company, annual report on Form 10-K to the Securities and Exchange Commission, December 1998, 32. 7. George A. Hormel & Company, annual report, 1993, 58. 8. H. Choi, Analysis and Valuation Implications of Persistence and Cash- Content Dimensions of Earnings Components Based on Extent of Analyst Following, unpublished PhD thesis, Georgia Institute of Technology, October 1994, 80. 9. Ibid. The authors of this chapter served as committee member and commit- tee chair for Dr. Choi’s thesis guidance committee. 10. AICPA, Accounting Trends and Techniques (New York: AICPA, 2000), 311. 11. AICPA’s Special Committee on Financial Reporting, Improving Business Re- porting—A Customer Focus (New York: AICPA, November 1993), 4 12. SFAS 131, Disclosures about Segments of an Enterprise and Related Infor- mation (Norwalk, CT: Financial Accounting Standards Board, June 1997), para. 10. 13. APB Opinion No. 30, Reporting the Results of Operations (New York: AICPA, July 1973), para. 20. 14. SFAS 4, Reporting Gains and Losses from the Extinguishment of Debt (Stam- ford, CT: FASB, March 1975). 15. SFAS 15, Accounting by Debtors and Creditors for Troubled Debt Restruc- turings (Stamford, CT: FASB, June 1977). 16. Exxon’s accident took the form of a massive oil spill in Alaska, and Union Carbide’s was a release of toxic fumes in India. 17. Armco Inc. annual report, December 1998. Information obtained from Dis- closure Inc., Compact D/SEC: Corporate Information on Public Companies Filing with the SEC (Bethesda, MD: Disclosure Inc., June 2000). 18. Securities and Exchange Commission, Staff Accounting Bulletin No. 101 (Washington, DC: SEC, 1999). 19. Southwest Airlines Inc., annual report, December 1999. 20. This statement needs some expansion. With the exception of barter transac- tions, almost all expenses involve a cash outflow at some point in time. In the case of depreciation, the cash outflow normally takes place when the depreciable assets are acquired. At that time, the cash outflow is classified as an investing cash outflow in the statement of cash flows. If the depreciation were not added back to net income in computing operating cash flow, then cash would appear to be reduced twice—once when the assets were purchased and a second time when depreciation is recorded, and with it net income is reduced. 21. To keep the books in balance, the recognition of the loss in the income statement is matched by a reduction in the carrying value of the investment in the balance sheet. 22. SEC Reg. S-X, Rule 5-02.6 (Washington, DC: SEC, 2001). 23. SEC, Staff Accounting Bulletin No. 40 (Washington, DC: SEC, February 8, 1981). 100 Understanding the Numbers 24. Handy and Harman Inc., annual report, December 1997. Information ob- tained from Disclosure Inc., Compact D/SEC: Corporate Information on Public Companies Filing with the SEC (Bethesda, MD: Disclosure Inc., June 1998. 25. Even with great improvements in supply chain management, it is still diffi- cult to get along without any inventories. 26. Reviews and compilations represent a level of outside accountant service well below that of an audit. Compilations typically provide only an income statement and balance sheet. Neither notes nor a statement of cash flows are part of the standard compilation disclosures. 27. Absent disclosures, the effect of a LIFO liquidation can be estimated. This requires the assumption that the observed increase in the gross margin is due largely to the LIFO liquidation. The pretax effect of the LIFO liquidation can then be ap- proximated by multiplying sales for the period of the liquidation times the increase in the gross margin percentage. 28. Archer Daniels Midland Company, annual report, June 2000, 20. 29. Guidance in this area is found in SFAS No. 109, Accounting for Income Taxes (Norwalk, CT: FASB, February 1992). 30. The offsetting of gains and losses in the 1998 other income and expense note is swamped by a $329 million nonrecurring gain on the disposition of C.R. Bard’s car- diology business. 31. Reg. S-K, Subpart 229.300, Item 303(a)(3)(i) (Washington, DC: SEC, 2001). 32. Mason Dixon Bancshares might take issue with this characterization. Finan- cial firms tend to characterize these disclosures as designed to measure core earnings. However, our experience is that the end product is very similar to sustainable earn- ings, where the focus is on purging nonrecurring items from reported net income. 33. Phillips Petroleum, annual report, December 1999, 33. 34. Ibid., 33. 35. Other companies that have provided similar presentations in recent years in- clude Amoco Corp., Carpenter Technology, Chevron Corp., Deere & Company Inc., Halliburton Co. Inc., Maxus Energy Corp., and Raychem Corp. 36. C. R. Bard Inc., annual report, December 1999, 17. 37. A hedge of foreign-currency exposure is achieved by creating an offsetting position to the financial statement exposure. The most common offsetting position is established by the use of a foreign-currency derivative. These issues are discussed more fully in Chapter 12. 38. These alternative translation methods are discussed and illustrated in Chap- ter 12. 39. Dibrell Brothers Inc., annual report, December 1993, 35. 40. Ibid., 14. 41. Arthur Levitt, The Numbers Game, speech given at the NYU Center for Law and Business, September 28, 1998 (available at: www.sec.gov/news/speeches /spch220.txt). 42. The earnings of a subsequent period are increased by reducing the previously accrued restructuring charge on the basis that the accrual was too large. The amount by which the liability is reduced is also included in the income statement as either an item of income or an expense reduction. Analyzing Business Earnings 101 43. Office Depot Inc., annual report, December 1999, 57, 56. 44. SFAS No. 130, Reporting Comprehensive Income (Norwalk, CT: FASB, June 1997). 45. Translation (remeasurement) gains and losses that result from the application of the temporal (remeasurement) method continue to be included in the income statement as part of conventional net income. Only translation adjustments that re- sult from application of the all-current translation method are included in other com- prehensive income. Recent changes in the accounting for financial derivatives also result in the inclusion of certain hedge gains and losses in other comprehensive in- come: SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities (Norwalk, CT: FASB, November 1998). 46. An annual survey conducted by the AICPA reveals the following pattern of adoption of the alternative reporting methods of SFAS No. 130 for 497 firms: (1) a combined statement of income and comprehensive income, 26 firms; (2) a separate statement of comprehensive income, 65 firms; and (3) reporting comprehensive in- come directly in shareholders’ equity, 406 firms. AICPA, Accounting Trends and Techniques (New York: AICPA, 2000), 429. 47. An earlier version of the Baker Hughes case study also appeared in E. Comiskey and C. Mulford, Guide to Financial Reporting and Analysis (New York: John Wiley, 2000), chapter 3. 48. Phillips Petroleum, annual report, December 1999, 33. 49. Research and development costs must be written off immediately—even if the in-process R&D is purchased from another firm. Whether this expense is de- ductible for tax purposes turns on the manner in which the acquisition is structured. Generally, the expense is deductible in transactions structured as asset acquisitions but not in the case of stock acquisitions. 102 3 COST-VOLUME- PROFIT ANALYSIS William C. Lawler Abigail Peabody was a very well-known nature photographer. Over the years she had had a number of best-sellers, and her books adorned the coffee tables of many households worldwide. On this particular day she was contemplating her golden years, which were fast approaching. In particular she was reviewing her year-end investment report and wondering why she was not better pre- pared. After all, she had been featured in the Sunday New York Times book section, had discussed her works with Martha Stewart, and had been the keynote speaker at the Audubon Society’s annual fund-raiser. She knew it was not her investment advisers’ fault. Their performance over the past years had been better than many of the market indixes. She wondered if she was just a poor businessperson. The last thought struck a pleasant chord. She had a grandson who was a junior at a well-known business school just outside Boston. It was time, anyway, to catch up to his latest business idea. She dialed the number from memory. He was as lively as usual. “Hi, Abbey, I was just going to call you. How’s the new bird book coming?” [Of her many grandchildren, he had the most irresistible charm.] How she loved his ability to make her feel young—and his ability to remember never to call her anything that began with Grand “Actually, Stephen, that’s why I’m calling. I was just reviewing my retire- ment portfolio, and I think it’s time for me to renegotiate my royalty structure with my publisher. I could use some help from a bright business mind.” “Love to help you. What’s wrong with the current contract? Haven’t you been with them since the beginning?” “Yes I have, but things have changed. In the old days, they provided me with many services. They brainstormed projects with me, suggested different Cost-Volume-Profit Analysis 103 ideas such as the Baskets of Nantucket best-seller, and edited my work word- by-word and frame-by-frame. They worked hard for me and earned every penny they made on me. I was not the easiest artist to put up with.” Stephen was interested. “Go on.” “Well, now I barely talk with them. I am at the point where loyal readers suggest many of my projects. I design them myself, edit them myself, and even help my publisher prepare the promotion materials. They don’t work so hard anymore. I think I have paid my dues. I want a bigger piece of the pie.” “That could be a problem, Abbey. I just finished a case study on that in- dustry, and it is very competitive. There are many parts to the industry value system that ultimately ends with someone buying a book (see Exhibit 3.1). It starts with people like you who have the intellectual capital. The next piece of the system is the publisher, who manages the creativity process, supplies the editing, prints the book, and markets it. Wholesalers like Ingram add value to this system by buying books in large quantity from publishers, warehousing them, and selling in smaller quantities to bookstores. Of course, the last piece is the bookstore, where in-store promotion and the final sales process takes place. On, say, a $50 book, the bookstore buys it from the wholesaler for about $35, netting about $15 to cover its costs such as rent and salespeople. The wholesaler buys the book from the publisher in large lot sizes for about $30 a book, giving the wholesaler about $5 to cover its logistics costs. Of the $30 the publisher sells it for, 15% of the retail price, or $7.50 ($50 × 15%) is your roy- alty, and the rest covers printing, client development, returned books, adminis- trative expenses, and a profit. The publisher really can’t give you too much more since its margin is already very slim. Sorry to disappoint you but that’s how it is.” Abbey was disappointed. “Stephen, for all that money your parents are paying, doesn’t that business school teach creativity? You have to look at the world and think of what it could be, not what it is today.” Unembarrassed by Abbey’s chastisement, Stephen, reacted positively. “How much risk do you want to take on this new project, Abbey?” EXHIBIT 3.1 Publishing industry value system. Author Customer Competency: Intellectual Printing Logistics Promotion Capital Editing Warehousing Sales Development Revenue: $7.50 $30.00 $35.00 $50.00 Purchase cost: 30.00 35.00 Gross margin: $15.00$ 5.00 Publisher Wholesaler Bookstore 104 Understanding the Numbers “That’s more like it. For now, let’s ‘roll the bones’—I mean, assume risk is not an issue. What do you have in mind?” “Well, this semester I have a Web-marketing course and I need a project. Are you familiar with the World Wide Web?” “I spend a good part of the day corresponding with friends on it.” “Good. What you just said to me is that you don’t see too many pieces of the publishing system adding value commensurate with the value they extract. How about setting up your own Web site and selling your latest project your- self? We would have to contract with others to provide the necessary parts of the chain, but selling the book through our Web site is possible. It could fail, and you would have one very unhappy publisher.” Abbey thought she was now getting somewhere. “As long as you are get- ting credit for it, why don’t you develop this idea further. See if it’s possible and what my risks would be. I might even give you a piece of the action.” COST STRUCTURE ANALYSIS A month later Abbey met Stephen for lunch in Boston. He was excited. “Abbey, this is what I have found so far. Setting up a Web site is very easy, but maintaining it and keeping it fresh and exciting so that people want to re- visit it is the challenge. Neither you nor I want to do that, trust me. I have talked with a number of companies who offer this type of service. Many of them were excited when I showed them copies of your past books. To set up and maintain the site, the offers ran anywhere from a low of $25,000 a year to four times that. The high-end ones also charge a 5% fee on all revenues gener- ated. I think we want a high-end site that is creative, custom designed, and ex- citing so I lean toward the more expensive ones. They are good.” Abbey liked how he used the word we. And being an artist, she too thought that her Web site should be exciting, creative, and different. “Go on.” “I also found a number of printers who specialize in small run sizes, typi- cally less than 50 books in any one printing. Their technology is called print- on-demand, and they also work with photographs. I brought some samples of printed photos.” Abbey was impressed with the quality. It looked no different than her previous books. “What would they charge?” “They said they could print your books on demand and guarantee the quality for about $35 each. Now, this is much more than what traditional print- ers charge, but they always run large volumes, a minimum of 5,000 copies in one printing, and want to be paid for every one of them even before we could sell them. Bottom line, we would be at risk if this doesn’t work.” Abbey was disappointed that she was again making someone else rich, but moved on. “How would we do all the promotion and sales?” “Two ways. Once your readers learn of your site, they will visit it. If the Web-design company delivers what they promise, we should be able to sell Cost-Volume-Profit Analysis 105 di rectly to them. Until that traffic happens, the Web designers will develop links with all the major sites that might be interested.” “How does that work?” “Well, your newest project is a Florida bird book for all the retired baby boomers down there, right? So we develop what is called a link with the Audubon’s Web site and maybe AARP and the Florida Tourism Bureau. When people see your book on those sites, they click on a link and get transferred to our site. If they buy the book, we pay the site a 10% royalty.” “Does that mean I spend all my days, assuming we are successful, mailing books all over the world? That doesn’t interest me.” “No. I also talked with logistics companies like UPS and FedEx. They will do all of that. When we sell a book, we just notify them electronically. They work with the printer to obtain the book and with the credit card company to get paid, and they ship it. They even collect the money, pay everyone involved with the sale, and electronically deposit the remainder in your account. They would charge about $10 per book for all of this, assuming we can guarantee a certain minimal volume.” “Now that sounds like your parents are getting their money’s worth. Have you summarized all of this?” “Sure have. You’re still thinking about a price of $80 for this book?” “My others have sold for that, and I think the demand for this might even be greater. So $80 is a good assumption.” “Okay. First, all business models have only two types of costs, variable and fixed. Each is defined by the behavior of the total cost function. Variable costs are those that increase proportionately with volume—basically, the more books we sell the higher these total costs will be. They can be expressed either on a per-unit basis or as a percentage of the selling price. Notice we have both types. Our printing and logistics costs total $45 for each book sold—$35 print- ing plus $10 logistics. Our Web-site sales referral cost of 10% and Web-design cost of 5% for every dollar of revenue are examples of the latter kind of vari- able cost. For the targeted price of $80, these costs come to $12 for each book sold ($80 × 15%). Note this type of variable cost is a little more complicated than the simple $45 per book—here if we change selling price, the variable cost will change. Given the $80 selling price, the total variable cost per book is then $57 per unit ($45 + $12). Unlike these costs, the Web-site design cost is a mixed cost 1 and has to be broken into a variable and a fixed component. We have already treated the 5% variable cost component. There is also a fixed charge per year of about $100,000 if we go high-end. Note the difference in behavior of this cost. Here the total cost is not dependent on a volume factor such as “books sold.” Fixed costs are often called period costs since they are time dependent. So in summary, we have a time-dependent fixed charge of $100,000 per year, which remains the same regardless of the number of books sold, and a variable cost, which is better understood on a per-unit or, in this case, per-book rate of $57. I made a graph of this—what businesspeople call cost structure (see Exhibit 3.2).” 2 106 Understanding the Numbers Abbey thought she understood. “So this structure will always be the same?” “With one proviso,” Stephen affirmed. “Although my chart looks the same from zero volume to an infinite amount sold, we really should only be talking about a smaller relevant range. Both the printer and the logistics com- pany are assuming an annual volume of between 10,000 and 25,000 books—es- sentially what your past books sold. Outside this range, especially on the high side, the costs probably will change. I don’t think the printer can do much more than 25,000 a year for us. Likewise, at greater than this volume, we would probably have to redesign the Web site. So the cost structure could change if we were to move outside the range.” “Okay. So now I think I do understand what the cost structure would be given our plans for the Web site. All that you said makes sense, and I’m sure my new book will sell in that range. So tell me why I shouldn’t do this.” COST-VOLUME-PROFIT ANALYSIS “If we add a revenue line to my first exhibit,” said Stephen, “we will start to get a better picture of the answer to this question (see Exhibit 3.3). First, you must understand the concept of contribution margin. For us, it is simple. For every $80 book we sell, there is a variable cost to print, sell, and deliver that book of $57. This means that the net contribution of each book sold is $23. Does this make sense?” “Sure does,” Abbey answered, delighted. “This is wonderful. I was only making $12 with my publisher, and now I can make almost double that.” “Not quite. You forgot one thing. Contribution margin must first go to- ward covering the fixed costs before we can realize any profit. Each year we have to cover the Web-site designer’s charge of $100,000. At a contribution margin of $23 per book, it will take about 4,350 books sold to do this (see EXHIBIT 3.2 Web site cost structure. 0 200 400 600 800 1,000 1,200 1,400 1,600 1,800 0 5,000 10,000 15,000 20,000 25,000 Dollars (thousands) Units Relevant range Cost-Volume-Profit Analysis 107 Ex hibit 3.4). On my graph, this is the point where the revenue line intersects the total cost line and is called the break-even point. After that, you are cor- rect. For any additional book we sell, the $23 contribution per book is all profit. So, as I see it, there is little risk since you are sure that we will sell at a mini- mum 10,000 copies per year.” Abbey became a bit uncomfortable. “Actually, I think this book will sell about 20,000 copies per year at a minimum. But isn’t my alternative to stay with my publisher? And if so, shouldn’t we be talking about whether I would be better off with the Web site?” Stephen was suddenly not so cocky. Abbey thought that maybe some re- medial work on those tuition dollars was needed. “I have some work to do. Why don’t you get back to me on that, Stephen?” Two nights later, after faxing her two charts, Stephen phoned Abbey. “I sent you a different type of chart, called a profit chart, which shows the two EXHIBIT 3.3 Web site CVP analysis. Dollars (thousands) Units Total revenue line Total cost line Fixed cost Profit area Break-even point 0 500 1,000 1,500 2,000 2,500 10,000 15,000 20,000 25,0005,0000 EXHIBIT 3.4 Break-even calculations. Solving for x, General Rule: Break-even point Fixed Costs Contribution Margin = $$$, $$, $, , 80 57 100 000 23 100 000 100 000 23 4 348 xx x x −= = == books Sales Revenue Fixed Costs Variable Costs=+ =+$$,$80 100 000 57xx . derivative. These issues are discussed more fully in Chapter 12. 38. These alternative translation methods are discussed and illustrated in Chap- ter 12. 39. Dibrell Brothers Inc., annual report, December. coffee tables of many households worldwide. On this particular day she was contemplating her golden years, which were fast approaching. In particular she was reviewing her year-end investment. million nonrecurring gain on the disposition of C.R. Bard’s car- diology business. 31. Reg. S-K, Subpart 229.300, Item 303(a)(3)(i) (Washington, DC: SEC, 2001). 32. Mason Dixon Bancshares might take