What Business Managers Need to Know about Internal Profit Reporting - dummies

What Business Managers Need to Know about Internal Profit Reporting

By John A. Tracy

External financial statements, including the profit report (income statement), comply with well-established rules and conventions. In contrast, the format and content of internal accounting reports to managers is a wide-open field.

If you could sneak a peek at the internal financial reports of several businesses, you would be surprised at the diversity among the businesses. All businesses include sales revenue and expenses in their internal P&L (profit and loss) reports. Beyond this broad comment, it’s very difficult to generalize about the specific format and level of detail included in P&L reports, particularly regarding how operating expenses are reported.

Designing internal profit (P&L) reports

Profit performance reports prepared for a business’s managers typically are called P&L (profit and loss) reports. These reports should be prepared as frequently as managers need them, usually monthly or quarterly — perhaps even weekly or daily in some businesses. A P&L report is prepared for the manager in charge of each profit center; these confidential profit reports do not circulate outside the business. The P&L contains sensitive information that competitors would love to get hold of.

Accountants are not in the habit of preparing brief, summary-level profit reports. Accountants tend to err on the side of providing too much detailed data and information. Their mantra is to give managers more information, even if the information is not asked for. Managers are very busy people, and they don’t have spare time to waste, whether in reading long, rambling emails or on deciphering multi-page profit reports with too much detail.

Profit reports can be compact for a quick read. If managers want more detail, they can request it as time permits. Ideally, the accountant should prepare a profit main page that would fit on one computer screen, although this may be a smidgeon too small as a practical matter. In any case, keep it brief.

Businesses that sell products deduct the cost of goods sold expense from sales revenue and then report gross margin (alternatively called gross profit) both in their externally reported income statements and in their internal P&L reports to managers. However, internal P&L reports have a lot more detail about sources of sales and the components of cost of goods sold expense. Businesses that sell products manufactured by other businesses generally fall into one of two types: retailers that sell products to final consumers and wholesalers (distributors) that sell to retailers. The following discussion applies to both.

There’s a need for short-to-the-point or quick-and-dirty profit models that managers can use for decision-making analysis and plotting profit strategy. “Short” means on one page or even smaller than one full page — like on one computer screen that the manager can interact with in order to test the critical factors that drive profit. For example, if sales price were decreased 5 percent to gain 10 percent more sales volume, what would happen to profit? Managers of profit centers need a tool to quickly answer such questions.

Reporting operating expenses

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. One basic choice for reporting operating expenses is between the object of expenditure basis and the cost behavior basis.

Reporting operating expenses on object of expenditure 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. Yes, internal P&L reports include gross margin, which is sales revenue minus the cost of goods sold. But gross margin isn’t the final amount of operating margin that managers need to know. This leads to the important distinction between the two types of operating expenses.

Separating operating expenses further on their behavior basis

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 have other expenses that depend either on the volume of sales (quantities sold) or the dollar amount of sales (sales revenue). And 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. This head-to-head comparison of margin against fixed costs is critical.

Although it’s hard to know for sure — because internal profit reporting practices of businesses are not publicized or generally available — the large majority of companies do not attempt to classify operating expenses as variable or fixed. Yet for making profit decisions, managers need to know the variable versus fixed nature of their operating expenses.