Take a Closer Look at the Lines in the Profit Template - dummies

Take a Closer Look at the Lines in the Profit Template

By John A. Tracy

Profit center managers depend heavily on the information in their P&L reports. They need to thoroughly understand these profit reports. They should examine each element of the profit template.

Sales volume in the profit template

Sales volume, the first line in the profit template, is the total number of units sold during the period, net of any returns by customers. Sales volume should include only units that actually brought in revenue to the business. In general, businesses do a good job in keeping track of the sales volumes of their products (and services).

Now here’s a nagging problem: Some businesses sell a huge variety of products. No single product or product line brings in more than a fraction of the total sales revenue. The business may keep count of customer traffic or the number of individual sales made over the year, but it probably does not track the quantities sold for each and every product it sells.

Sales revenue in the profit template

Sales revenue is the net amount of money received by the business from the sales of products during the period. Notice the word net here. Many businesses offer their customers many incentives to buy products and to pay quickly for their purchases.

The sales revenue amount takes into account deductions for rebates, allowances, prompt payment discounts, and any other incentives offered to customers that reduce the amount of revenue received by the business. (The manager can ask that these revenue offsets be included in the supplementary layer of schedules to the main page of the P&L report.)

Cost of goods sold in the profit template

Cost of goods sold is the cost of the products sold during the period. This expense should be net of discounts, rebates, and allowances the business receives from its vendors and suppliers. The cost of goods sold means different things for different types of businesses:

  • To determine product costs, manufacturers add together three costs: the costs of raw materials, labor costs and production overhead costs.

  • For retailers and distributors, product cost basically is purchase cost. The profit center manager should have no doubts about which cost of goods sold expense accounting method is being used. For that matter, the manager should be aware of any other costs that are included in total product cost (such as inbound freight and handling costs in some cases).

Variable operating expenses in the profit template

In the profit analysis template, variable operating expenses are divided into two types: revenue-driven expenses and volume-driven expenses.

Revenue-driven expenses are those that depend primarily on the dollar amount of sales revenue. This group of variable operating expenses includes commissions paid to salespersons based on the dollar amount of their sales, credit card fees paid by retailers, franchise fees based on sales revenue, and any other cost that depends directly on the amount of sales revenue.

Volume-driven expenses are driven by and depend primarily on the number of units sold, or the total quantity of products sold during the period (as opposed to the dollar value of the sales). These expenses include delivery and transportation costs paid by the business, packaging costs, and any costs that depend primarily on the size and weight of the products sold.

Most businesses have both types of variable operating expenses. However, one or the other may be so minor that it would not be useful to report the cost as a separate item. Only the dominant type of variable operating expense would be presented in the profit analysis template; the one expense would absorb the other type — which is good enough for government work, as they say.

Fixed operating expenses in the profit template

Managers may view fixed operating expenses as an albatross around the neck of the business. In fact, these costs provide the infrastructure and support for making sales. The main characteristic of fixed operating costs is that they do not decline when sales during the period fall short of expectations.

A business commits to many fixed operating costs for the coming period. For all practical purposes these costs cannot be decreased much over the short run. Examples of fixed costs are wages of employees on fixed salaries (from managers to maintenance workers), real estate taxes, depreciation and rent on the buildings and equipment used in making sales, and utility bills.

Certain fixed costs can be matched with a particular profit center. For example, a business may advertise a specific product, and the fixed cost of the advertisement can be matched against revenue from sales of that product. A major product line may have its own employees on fixed salaries or its own delivery trucks on which depreciation is recorded.

In contrast, you cannot directly couple company-wide fixed operating expenses to particular products, product lines, or other types of profit units in the organizational structure of a business.

General administrative expenses (such as the CEO’s annual salary and corporate legal expenses) are incurred on an entity-as-a-whole basis and cannot be connected directly with any particular profit center. A business may, therefore, allocate these fixed costs among its different profit centers. The fixed costs that are handed down from headquarters, if any, are included in fixed operating expenses.