Below the gross margin line in an internal P&L statement, reporting practices vary from company to company. There is no standard pattern. One question looms large: How should the operating expenses of a profit center be presented in its P&L report?
There’s no authoritative answer to this question. Different businesses report their operating expenses differently in their internal P&L statements. One basic choice for reporting operating expenses is between the object of expenditure basis and the cost behavior basis.
By far the most common way to present operating expenses in a profit center’s P&L report is to list them according to the object of expenditure basis. This means that expenses are classified according to what is purchased (the object of the expenditure) — such as salaries and wages, commissions paid to salespersons, rent, depreciation, shipping costs, real estate taxes, advertising, insurance, utilities, office supplies, telephone costs, and so on.
To do this, the operating expenses of the business have to be recorded in such a way that these costs can be traced to each of its various profit centers. For example, employee salaries of persons working in a particular profit center are recorded as belonging to that profit center.
The object of expenditure basis for reporting operating costs to managers of profit centers is practical. And this information is useful for management control because, generally speaking, controlling costs focuses on the particular items being bought by the business.
For example, a profit center manager analyzes wages and salary expense to decide whether additional or fewer personnel are needed relative to current and forecast sales levels. A manager can examine the fire insurance expense relative to the types of assets being insured and their risks of fire losses. For cost control purposes the object of expenditure basis works well.
But, there is a downside. This method for reporting operating costs to profit center managers obscures the all-important factor in making profit: margin. Managers absolutely need to know margin.
The first and usually largest variable expense of making sales is the cost of goods sold expense (for companies that sell products). In addition to cost of goods sold, an obvious variable expense, businesses also have other expenses that depend either on the volume of sales (quantities sold) or the dollar amount of sales (sales revenue).
Virtually all businesses have fixed expenses that are not sensitive to sales activity — at least, not in the short run. Therefore, it makes sense to take operating expenses classified according to object of expenditure and further classify each expense into either variable or fixed. There would be a variable or fixed tag on each expense.
The principal advantage of separating operating expenses between variable and fixed is that margin can be reported. Margin is the residual amount after all variable expenses of making sales are deducted from sales revenue. In other words, margin equals profit after all variable costs are deducted from sales revenue but before fixed costs are deducted from sales revenue. Margin is compared with total fixed costs for the period.