Management Accounting Centerpiece The Profit Model

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Suppose you're the new president of the company that has been used as the main example for studying external financial statements throughout the previous chapters. You ask me, the chief accountant and controller of the business, to prepare a profit report for your decision-making, planning, and control purposes.

Soon thereafter I present to you the profit report shown in Exhibit O on page 166. It contains highly confidential information that would not be released outside the business. Exhibit O presents an inside look at how the business made the $718,200 profit (bottom-line net income) for the year just ended, and includes a comparison with the previous year. The business did better than last period. The profit report provides the information to analyze the reasons for the profit improvement.

Let me say immediately that the design of this illustrative management profit report reflects my personal preferences. There are no standard formats or templates for these types of accounting reports. This exhibit is not necessarily the ideal format for all businesses in every respect.

The purpose of Exhibit O is to demonstrate several critical points. I do not mean to suggest that the exhibit is a universal format that does not need to be changed from company to company. On the other hand, Exhibit O serves as a road map that a business could adapt to its particular needs.

As just mentioned, the profit report is designed for the president of the business, who has broad responsibility. The corporation's board of directors can also use this report for their year-end review of the profit performance of the business. The exhibit is not designed for a manager with limited authority and responsibility, such as the sales manager or production department supervisor.

The profit model shown in Exhibit O has a twofold purpose: (1) to show what information is needed for management analysis of profit behavior that focuses on the key variables that drive profit; and, (2) to highlight ''control points,'' which are the critical factors that have high impact on profit performance.

Notice under each line in the management profit report shown in Exhibit O that there are bullets for one or more control points. For example, the number of employees and the annual sales per employee are shown under the net sales revenue line. Under the total fixed operating expenses line are two important costs—advertising and other marketing expenses, and senior management compensation. The president should keep an eye on these two expenditures.

In the limited space of this chapter I can offer only a brief overview of how business managers use a profit report. Speaking broadly, most analysis focuses on changes. Every factor and variable that determines profit is subject to change; change is constant, as any experienced business manager will verify. Business managers need a profit model that they actually can work with, one that they can make changes to like pulling handles on a machine—to quickly measure the impact of the changes on profit.

Managers must respond to changes in the profit factors in order to maintain the profit performance of the business. For example, higher transportation costs next year may increase the sales volume-driven expenses from $4.50 per unit sold (see Exhibit O) to $4.85. Or, property taxes may go up, which will increase fixed operating expenses. Or, the sales manager may make a persuasive case that the advertising budget should be increased next year. Managers have to respond to all such changes; they don't get paid to sit on their hands and idly watch the changes happen.

Top-level managers have the responsibility of developing realistic plans to improve profit performance, which means making changes in the profit equation of the business. Which specific changes? This is the key question. Suppose the president asked you to develop a plan to improve bottom-line net income 10% next year. Exactly how would you accomplish this goal? I'd suggest that you should construct your plan in terms of the specific factors and variables in the profit model that you will change to bring off the 10% profit improvement.

To illustrate the use of a profit model such as the one shown in Exhibit O, let me put a question to you. Assume that all the factors and variables in the profit model remain the same next year—except that sales price or sales volume will change next year, but not both. Which alternative is better for profit?

• Increase sales price 5% next year.

• Increase sales volume 10% next year.

Of course it would be best to make both changes (without any unfavorable changes in the other factors). But I'm putting it to you as an either-or choice. You could do only one or the other. Which alternative would increase bottom-line profit more?

I have entered the profit model shown in Exhibit O in an Excel work sheet. So, I simply changed sales price +5% for one alternative, and changed sales volume +10% for the other alternative. The outputs for the two scenarios are shown in Exhibits P and Q on the following pages. (These two profit reports are truncated at the net income line, since the focus is on the profit impact next year.)

Before looking at the results, you might ask yourself which alternative you think is better. I suspect that many persons would select the second alternative because the sales volume increase is much more than the sales price increase. But, the model shows that the sales price increase alternative is quite a bit better.

The sales manager of the company might push for the sales volume alternative because the business would increase its market share at the higher sales volume. Market share is always an important factor to consider—I wouldn't ignore this point. But, if you compare the two alternatives, bumping the sales price 5% would be much better for profit.

The main reason why the sales price alternative is so much better is that the contribution profit margin increases 20% in this scenario. Because of the sales price increase the margin increases $4.78 per unit ($28.36 at the higher sales price minus $23.58 at the old sales price = $4.78 increase per unit, or 20% higher). The sales price hike pushes up total contribution margin 20%, which is a substantial gain in profit before fixed operating expenses, interest, and income tax. Bottom-line profit would increase from $718,200 to $1,005,240 (see Exhibit P).



Model For Final Accounts






General Polnls



Ûcjnlrtl Points

Nel Salts Revanua





■ Safes pi" Employee (Htoadwunt. 77 and



mm pi Spms Sou)





■ Inventory ShcWagu md Writs-Downs

ISI 26,700)


Graso Margin, before Qperal ¡r.g Empínaos

» a&c

$ 3,6*0.000

1 41.60


■ Rfitjin an Salas



Vartabla Opere! rg £a pen wa

■ Siles Vsiume-CuiveJi Enpensis Salas Ravenue-Díivart Expanses


«».»Si (WÎ.0&3!

(6 74,

H 50,000) (Í73.600)


CariLribullon Phalli Margin

S 23.SS

Ï 2.3M.DOD

S 20 36

í 2.B36.4D0

■ neijm or> Ssies


Total Fixed Dpi rating £ k pe nsn s



• A<*wlislog hu Olhtf Mafatog Btpams - Sflnlpf Management Ctmpensahon

(SÎW.lMi (S62S.OCO)

(Siïe.ow) (SSÏfi.OOOl

Úpirating Prorit

i 1 .300,000

Î 1,77S..40IJ

- Fieljm on Satoi



intttCit fi»Ptíl»



■ Averaga Annual 1 mares! Hala on rjubl



Earnings beloru Income


Î 1.&7Í.JOO

Incumt Toi Eüpin-ir



■ Eheclive Tax Rele



Met Income

S 718,500

S 1 .K5.2<¡f>

4 Return cn Sales




Salís Volume [Tola! Units. SoM


110,000 uni tí

Per Unit


Control Points

Ft* Unit


Control Polnlî

Hit Silica Revenue





■ Sales pt* Gnipioyso (Neatfcounl ; Tí and 6?)



Cosí &f Goads SflLd




• Inventory S I- rinkage end Wrfe Devins



Gross Margin, bofort Operating Exponas

S 3640

£ 3,5JO,000

S 3S.4ÍI

S 4,(W4.«D

* Return on Sejes


Veriable Operating Expenses

■ Sate Vshrme-Driven Eipenws - Salas Revenue-Driven EnpiflSii

(<-50] [3.3?]



(435.000) 01MOO)


Contribution Profit Margin

I 33.58

t 3.353.QW

$ 33.53

S 2.593.BOO

- Return en Saies



total Fired Operating Expanse!



■ Advertising and Oilier Marketing Expenses

■ SarKor Management Compensation

(S226.00C) ($623.000)


Operating Prallt

$ 1,300,000

î 1.53S,60û

■ Return <?n Sales



Interest Expense



■ Average Annual Interes* Pole oíl Orjbt


Earnings before Income Tex

Î ¡.IS/.OiO

$ 1,432.300

Income ta* Eiícn»



■ Ëlfeôive Tax Rate



Ket Income


S 3S9.68Ö

Return en Sales


In contrast, the sales volume increase scenario improves total contribution margin just 10%, which is equal to the sales volume increase (see Exhibit Q). Of course, it may more realistic to sell 10% more sales volume compared with pushing through a 5% sales price increase. Many customers may balk at the higher sales price and take their business elsewhere.

Setting sales prices certainly is one of the most perplexing decisions facing business managers. The price sensitivity of customers is never clear-cut. In any case, business managers should understand that a relatively small change in sales price can have a major impact on profit margin. For instance, a 10% shift in sales price can cause a twofold, threefold, or even higher impact on profit margin.

A Few Parting Comments

Some years ago a local women's investment club invited me to their monthly meeting to talk about the meaning and uses of financial statements. It was a lot of fun, and it also forced me to re-think a few basic points. These women are a sophisticated group of investors who pool their monthly contributions and invest mainly in common stocks traded on the New York Stock Exchange. Several of their questions were incisive, although one point caught me quite by surprise.

As I recall at that time they were thinking of buying 100 common stock shares in General Electric. Two members presented their research on the company with the recommendation to buy the stock at the going market price. The discussion caused me to suspect that several of the members thought their money would go GE. I pointed out that no, the money would go to the seller of the stock shares, not to GE.

They were not clear on the fundamental difference between the primary capital market (the original issue of securities by corporations for money that flows directly into their coffers), which is entirely separate from the secondary capital market (in which people sell securities they already own to other investors, with no money going to the corporations that originally issued the securities). I compared this with the purchase of a new car in which money goes to GM, Ford, or Chrysler (through the dealer) versus the purchase of a used car in which the money goes to the previous owner.

We cleared up that point, although I think they were disappointed that GE would not get their money. Once I pointed out the distinction between the two capital markets they realized that while they were of the opinion that the going market value was a good price to buy at, the person on the other side of the trade must think it was a good price to sell at.

On other matters they asked very thoughtful questions. I'd like to share these with you in this chapter, as well as a few other points that are important for anyone investing in stock and debt securities issued by corporations. These questions are also important when buying a business as a whole—for corporate raiders attempting hostile takeovers; corporate managers engineering a leveraged buyout of the business; one corporation taking over another; or, an individual purchasing a closely held business. Buyouts and takeovers bring up the business valuation question, which is discussed briefly.

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