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SECTION Evaluating the Operations of the Business III Profit Center Reporting The last section was concerned primarily with reporting on operational issues, such as machine utilization and scrap rates. However, these are of no import if a company cannot consistently create a profit or spin off enough cash flow to keep those operations running. In this section, we review the concept of profit centers, and how one should report their results. Every company creates and issues an income statement that reveals the financial performance of the entire company. For smaller organizations that deal with just a single line of business, such as a plumbing service company, this is sufficient. However, if there are several lines of business, such as a plumbing service group, a plumbing hardware store, and an air conditioning repair staff, then the revenues and costs of each one should be recorded separately, so that management can see if some areas are less profitable than others. An example of this report is shown in Figure 9.8, where we list a separate income statement for each profit center, which summarizes into the summary-level income statement for the entire company, as shown at the far right side of the report. Also in the report is a separate column for corporate overhead. These are costs that cannot be specifically allocated to a profit center. The basic rule for making the allocation determination is whether an overhead cost will disappear if a profit center is eliminated; if not, then do not allocate the overhead cost to the profit center. Also, there is an interest expense charged to each profit center, based on the amount of fixed assets and working capital that each one uses. Finally, after the profit figures at the bottom of the report, we add back the depreciation expense for each profit center (since this is a noncash expense), which yields the actual cash inflow or outflow to or from each profit center. The report reveals that the plumbing hardware store is making very little money, partially because of the interest expense charged to it that covers the cost of funds for the store facility and inventory (as pointed out by the arrows in the figure). Both service groups, having no significant assets, have a much lower interest expense and so earn a larger profit. Based on this analysis, it is evident that the hardware store is a drag on the overall corporate earnings percentage. 282 Reporting CHAPTER 9 FIGURE 9.8 Profit Center Income Statement (000s) Description Revenue Direct Expenses: Material Direct Labor Air Summary Plumbing Plumbing Conditioning Corporate Income Service Hardware Repair Overhead Statement $1,400 $1,750 $972 $0 $4,122 625 450 1,115 250 410 350 0 0 2,150 1,050 Total Direct Cost Total Direct Margin Direct Margin Percentage 1,075 325 23% 1,365 385 22% 760 212 22% 0 0 0% 3,200 922 22% Overhead Allocation Gross Margin Gross Margin Percentage 14 311 22% 57 328 19% 14 198 20% 375 −375 — 460 462 11% General & Administrative Interest Expense 25 42 85 193 25 29 175 0 310 264 244 17% 50 3% 144 15% −550 — −112 −3% 21 81 21 37 159 Cash Inflow (Outflow) 264 131 165 −513 47 Capital Usage: Working Capital Fixed Assets Total Capital Usage 325 145 470 1,578 565 2,143 175 145 320 0 258 258 2,078 1,113 3,191 Net Profit (Loss) Net Profit Percentage + Depreciation Expense To create a profit center analysis, the accounting staff must track billings and expenses by specific profit center, rather than recording them all in a single set of account numbers, which is a slightly more complicated accounting transaction. Also, all assets should be recorded in accounts that are specifically assigned to profit centers, so that interest expenses can be charged based on these amounts. The most difficult item to track is working capital for each profit 283 SECTION Evaluating the Operations of the Business III center, because this requires the identification of all accounts receivable, inventory, and accounts payable by profit center. To record working capital accurately, it may be necessary to either maintain a separate set of accounting records for each profit center or manually compile this information whenever the accounting staff creates a profit center financial statement. Given the amount of detailed information that results from this report, the added work is well worth the effort. Customer Margin Reporting If a company creates an income statement report by profit center and the management group still feels that it does not have enough information, the next logical step is to create a customer margin matrix, because it reveals an additional level of detail by showing profits by customer for each profit center. This method results in a matrix, as shown in Figure 9.9, that segregates all company customers into one of four quadrants on a profitability and volume chart. The quadrant in the lower left corner contains those customers that are marginally profitable and also have minimal sales volume. The quadrant in the lower right corner is the worst one, for it contains those customers with low profit margins and high volume (e.g., the company is expending much effort for little result). The company’s objective for the customers located in these first two quadrants is to either eliminate them or raise their prices to improve profits. The quadrant in the upper left corner contains customers with high margins but low sales volume. The objective here is to improve their purchasing volume. The final quadrant, which is in the upper right corner, is for high-volume, high-profit customers, and contains all the prized customers that a company absolutely does not want to lose. This report format is extremely revealing in terms of which customers should be dropped and which given special treatment, and, with some deft customer management, can result in a much more profitable mix of customers. The cutoff figures for margin and volume, as noted in the example, will change depending on the business. The dividing line for high and low margins may not be 25 percent, as shown in the example, nor may the volume demarcation be $100,000. A company can set 284 Reporting CHAPTER 9 FIGURE 9.9 Customer Margin Matrix Margin All Day Fitness Better Body Fitness Body Builder Warehouse Custom Bodies Co. Fitness Designs Jump Higher Aerobics Weights by Design Weights Warehouse 25% No. of Customers = 5 Total Sales = $800K Average Margin = 38% No. of Customers = 8 Total Sales = $450K Average Margin = 41% Margin 52% 38% 41% 43% 45% 39% 62% 29% Margin 41% 47% 33% 35% 34% No. of Customers = 4 Total Sales = $1,417K Average Margin = 11% No. of Customers = 7 Total Sales = $325K Average Margin = 1% All Round Fitness Dumbells Only Fit by Night Inc. Ladies Workout Co. Midwest Fitness Powerhouse Bodies Pumped Workouts Co. Central City Gym Fitter Bodies Co. Nationwide Gyms Powerbuilder Plus Runner’s Palace Margin –3% 0% 3% 7% 5% 0% –14% Barbells Plus Fitness Distribution Co. Kids Gyms and Day Care Southern Fitness $100K Margin 13% 7% 11% 10% Revenue Volume its own boundaries with different figures. Also, the margins on which this information is based can be calculated in several ways. One is to use direct costing (i.e., price minus direct labor and material costs), because of its simplicity. Alternatively, the margin calculation can include fully burdened costs, although this approach may result in overhead costs being assigned that have little real basis in fact. Accordingly, if margins are to include overhead costs, use activity-based costing to ensure that there is a justifiable reason for assigning costs to a customer. With the operations reports, profit center analysis, and customer margin matrix, a management team will have a plethora of information on which to base its decisions to improve company profitability. 285 SECTION Evaluating the Operations of the Business III Summary Businesses have varying reporting responsibilities to federal, state, and local jurisdictions. They have other external reporting requirements to creditors and investors. Finally, they have internal reporting functions used for planning and control. The federal reporting requirements include employment reports on wage-earning employees, tax reports, and Social Security taxes. Employers pay unemployment taxes for their employees. The federal government has arranged for banks and federal depositories to receive taxes collected from employees and those paid by the employer. The employer withholds federal income tax and Social Security taxes and pays those into the federal depository pursuant to IRS guidelines. Annually, the IRS requires employers to report to their employees the wages and taxes paid and withheld. Depending on the form of the business organization, there are various reporting requirements for federal tax liabilities. Sole proprietorships, S corporations, and partnerships pay income taxes for the business entity. However, S corporations and partnerships file information returns. Corporations are taxed as a separate legal entity. Other reporting requirements arise out of the nature of the business. For example, dealers in firearms are strictly licensed and regulated by the United States Treasury Department. Other businesses are regulated as to rates, charges, and services offered. Utilities, transportation companies, banks, and other such industries are closely regulated. Some, because of the dangers associated with working conditions, are closely scrutinized. Coal mining, toxic chemical companies, and airlines are just a few such activities. State governments also regulate and tax many businesses and activities. States generally tax the real property of businesses and the structures attached to the property through their ad valorem taxing authority. A business’s equipment, fixtures, appliances, and inventories might be taxed using tangible personal property taxes. Intangible items of ownership, such as stocks, bonds, and notes, are taxed through intangible personal property taxes. In some cases, sales and purchases made in other states are taxed. Some products, 286 Reporting CHAPTER 9 such as groceries, medicines, and telephone services, are exempt in some states. Local governments may impose taxes, licensing requirements, and zoning restrictions on the operations of some businesses. Some county or city governments may have franchise requirements for the provision of services; these may be exclusive rights to provide services, such as cable television. Creditors have or seek certain information to ensure the likelihood of payment. Balance sheets, income statements, and statements of cash flow may be prepared and distributed. Investors, likewise, are concerned with these reports. Finally, businesses have internal reporting requirements for planning and control. These needs vary with the size and type of business and with the style of management used. 287 Index A B Accounts payable Controls, 90 Number of days sales in, 164–165 Reduction of, 145 Accounts receivable Controls, 85–86 Liquidity, 184–186 Number of days sales in, 164 Reduction of, 144–145 Acid test ratio, 184 Ad valorem tax, 266 Advances, non-payment of, 80 Agency securities, 106–107 Annuity definition, 40 Arithmetic mean, 210 Asset Theft, 80 Turnover ratio, 192 Automation, budgeting, 7 Bad debt method, 233 Balanced scorecard, 204–207 Balloon loans, 169 Bank Financing, 167 Reconciliations, 83–84 Banker’s acceptance, 107 Boiler and machinery insurance, 245–246 Bond financing, 170, 171 Breakeven analysis, 69, 222–229 Brokerage house financing, 167 Budget Capital, 33–34 Cash flow, 112–132 Definition, 3–4 Direct labor, 29–30 Facilities, 33 General and administrative, 32 289 Index Budget (Continued) Improvements, 6–8 Ineffectiveness, signs of, 4–6 Interlocking system of, 25–35 Inventory, 29 Overhead, 30–31 Marketing, 32 Production, 28 Purchasing, 29 R&D, 28 Reports, 23, 24 Revenue, 26 Tracking and maintenance, 21–25 Updates, 7, 35–36 Business interruption insurance, 246 C Capacity utilization, 215–222 Capital Asset pricing model, 51 Budgeting, 7, 33–34, 39–75 Cost of, 49–54 Captive insurance company, 249 Cash Controls, 81–84 Disbursement, 127–130 Flow, analysis of, 108–112 Flow, budgeting, 112–132 Flow, discounted, 58–59 Flow, example of, 133–142 Flow worksheet, 54–57 290 Forecast, 34–35, 160–161 Fraud, 79 Investment factors, 104–105 Management, 113–126 Certificate of deposit, 107–108 Charter tax, 267 Claim administration, 242–243 Coefficient of variation, 212 Collateral, 173 Commercial paper, 107, 170 Commercial property insurance, 246 Common stock, see Stock Compensation planning, 236 Comprehensive auto insurance, 246 Concentration banking, 109 Control systems Accounts payable, 90 Accounts receivable, 85–86 Cash, 81–84 Cost of goods sold, 93–94 Current liability, 90–91 Elimination of, 97–99 Fixed assets, 88–89 General, 96–97 Inventory, 86–88 Investment, 84–85 Need for, 77–79 Notes payable, 91–92 Payroll, 95–96 Prepaid expenses, 88 Revenue, 92–93 Travel and entertainment expense, 94–95 Controlled disbursement, 110 Index Corporation tax return, 259–260 Cost Accumulation of, 11–25 Center, 10–11 Fixed, 12–14 Historical, 17–19 Of capital, 49–54 Of goods sold controls, 93–94 Variable, 14–16 Mixed, 16–17 Coverage ratios, 188–189 Creditors, 268–269 Current liability controls, 90–91 Current ratio, 163 Customer margin matrix, 285 D Debt Convertible, 152–153 Cost of, 50 Description of, 149–150 Ratios, 187–188 Deferred installment sales, 232–233 Definitions Annuity, 40 Budgeting, 3–4 Capital budgeting, 39 Internal rate of return, 41 Net present value, 40 Payback period, 40 Present value, 40 Present value index, 41 Delayed shipment report, 276 Depreciation Estimates, 65 Rapid, 235 Direct labor budget, 29–30 Directors and officers insurance, 246 Discounted cash flow, 58–59 Disbursement, controlled, 110 Distribution of outcomes, 62 Dividend restrictions, 172 Documentary stamp tax, 266 E Earning power percentage, 192 Economic development authority loans, 170 Employee stock ownership, 236–237 Environmental Protection Agency, 262 Excise tax, 267 Expense account fraud, 80 F Facilities, 33 Federal Energy Regulatory Commission, 262 Feedback loops, 5 291