Understand That a Small Sales Volume Change Has a Big Effect on Profit
Is that big push before year-end for just 5 per cent more sales volume really that important? You understand that more sales mean more profit, of course. But what’s the big deal? A 5 per cent increase in sales volume means just 5 per cent more profit, doesn’t it? Because fixed expenses are just that – fixed and unchanging over the short run. Seemingly small changes in sales volume cause large swings in profit. This effect is called operating leverage.
Fathom Profit and Cash Flow from Profit
Profit equals sales revenue minus expenses – you don’t need to know much about accounting to understand this definition. However, business managers should dig a little deeper. First, you should be aware of the accounting problems in measuring sales revenue and expenses. Because of these problems, profit is not revenue and expenses. Because of these problems, profit is not a clear-cut and precise number. Second, you should know the real stuff of profit and know where to find profit in your financial statements.
Profit accounting methods are like hemlines
Profit is not a hard-and-fast number but is rather soft and flexible on the edges. For example, profit depends on which accounting method is selected to measure the cost-of-goods-sold expense, which is usually the largest expense for businesses that sell products. The rules of the game, called generally accepted accounting principles (or GAAP for short), permit two or three alternative methods for measuring cost of goods sold and for other expenses as well.
The real stuff of profit
Most people know that, in the general sense of the word, profit is a gain, or an increase in wealth, or how much better off you are. But managers and investors hit the wall when asked to identify the real stuff of profit earned by a business. To make our point, suppose that your business’s latest annual profit and loss account reports £10 million sales revenue and £9.4 million expenses, which yields £600,000 bottom-line net income. Your profit ratio is 6 per cent of sales revenue, which is about typical for many businesses. But we digress.
Govern Cash Flow Better
A business wants to make profit, of course, but equally important, a business must convert its profit into usable cash flow. Profit that is never turned into cash or is not turned into cash for a long time is not very helpful. A business needs cash flow from profit to provide money for three critical uses:
- To distribute some of its profit to its equity (owner) sources of capital – to provide a cash income to them as compensation for their capital investment in the business.
- To grow the business – to invest in new fixed (long-term) operating assets and to increase its stock and other shortterm operating assets.
- To meet its debt payment obligations and to maintain the general liquidity and solvency of the business.
Call the Shots on Your Management Accounting Methods
Business managers too often defer to their accountants in choosing accounting methods for measuring sales revenue and expenses. You should get involved in making these decisions. The best accounting method is the one that best fits the operating methods and strategies of your business. As a business manager, you know these operating methods and strategies better than your accountant.
To sum up, your profit budget is dovetailed with the assets and liabilities budget and the cash flow budget. Your accountant takes your profit budget (your strategic plan for improving profit) and builds the budgeted balance sheet and the budgeted cash flow statement. This information is essential for good planning – focusing in particular on how much cash flow from profit will be realized and how much capital expenditures will be required, which in turn lead to how much additional capital you have to raise and how much cash distribution from profit you will be able to make.