Analyzing/Planning the P&L
Using Marginal Profit

Analyzing the P&L to Determine Marginal Profit – Is the Company Broke, Breaking-Even or Even Capable of Becoming Profitable?

Small and mid-size business ownership and management need a method to consistently and accurately determine P&L factors contributing to profit and loss.  Often the company P&L is issued in a functional general ledger format that provides little insight into the factors contributing to periodic or annual profit and loss.  Usually a P&L will present numbers contributing to operating results but is light on factors contributing to operating results.  A simple reorganization and analysis of P&L line-items can yield important management information, that may not be apparent, about the factors impacting profit and loss.

The key statistic to isolate in P&L analysis is the company’s rate of marginal profit.  The Marginal Profit Rate is the company’s rate of Gross Profit minus the rate of all of the company’s variable operating expenses expressed as a percent of Net Sales.

This business case study, based on actual experience evaluating performance this way, puts forth a simple method (a “backpack tool”, if you will) for small and mid-size business ownership and management to consistently and accurately define the company’s rate of Marginal Profit.  Defining the company’s Marginal Profit Rate can lead to better decisions about marketing expenditures and overall operating expenditures.   The company now has a clear view about the amount of profit each sale dollar contributes to fixed overheads and the P&L factors giving rise to Marginal Profit that should be evaluated and managed.

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Background

An imaginary company is evaluating year-end results.  Format A, below, shows that the company had $11.4 million in Gross Sales for the year and a rate of Gross Profit (expressed as a percentage of Net Sales) of 38.0% and the Gross Profit dollars were $4.1 million.   Annual operating expenses were $4.4 million so the company lost approximately $300,000 during the year.

Ownership and senior management can see the numbers that contributed to the loss as presented in Format A below but want a deeper understanding of the factors contributing to the loss in order to use that information to improve results next year.  Additionally, they want to know the company’s breakeven sales level and the company sales level required to earn specific rates of Pre-Tax Profit.

Format A - Uncategorized P+L

Account $'s & of Net Sales
Gross Sales 11,400.0 104.9
Returns 535.0 4.9
NET Sales 10,865.0 100.0
Cost of Sales 6,736.3 62.0
Gross Profit 4,128.7 38.0
Operating Expenses
Administrative Payroll 869.2 8.0
Bonuses 99.0 0.9
Call Center Payroll 326.0 3.0
Warehouse Payroll 217.3 2.0
Payroll Taxes 200.0 1.8
Benefits 223.8 2.1
Trucking Expense 434.6 4.0
Warehouse Supplies 400.0 3.7
Rent 625.0 5.8
Utilities 100.0 0.9
Insurance 150.0 1.4
Travel & Entertainment 50.0 0.5
Marketing Expense 500.0 4.6
Marketing Promotions 100.0 0.9
Professional Fees 100.0 0.9
Miscellaneous Operating Exp. 50.0 0.5
Total Operating Expenses 4,444.9 40.9
Profit (Loss) (316.2) (2.9)

Evaluation/Analysis – Step 1

As discussed above, Format A is the version of the company’s P&L that has been issued by the accounting department at year-end.  The first step to enhance understanding of the company’s P&L is to place each of the line-item operating expenses in the P&L into one of three categories:

  • Variable Operating Expenses
  • Step-Variable Operating Expenses
  • Fixed Operating Expenses

Variable Operating Expenses occur only when a dollar of sales occurs.  These operating expenses generally occur at a consistent rate of expense (as expressed as a percentage of Net Sales), because they occur in parity with each sales dollar as it occurs.

Step-Variable Operating Expenses generally have a fixed and variable component to them.  Call center payroll is a good example.  In this case there needs to be full-time management oversight of the call center.  So even when there are no inbound phone calls, the company is paying a manager to make sure scheduled staffing levels are appropriate for the amount of anticipated incoming calls and to manage other operational matters.  As volume increases, the rate of the fixed component of this line (the cost of the manager) will decrease because the cost of the manager will be spread (absorbed) over greater amounts of revenue.  On the other hand, the company will need to hire more operators to handle the inbound phone traffic.

In general, Step-Variable Operating Expenses have a fixed component and a variable component, and as sales volume increases the fixed component of the expense falls and the variable component of the expense increases, generally resulting in the overall rate of expense decreasing as a percentage of Net Sales.

As call volume increases it may be necessary to add another manager to the call center.  In this case, the fixed component of the expense would become larger and the overall rate of the expense will likely increase as a percentage of net sales.  Therefore, Step Variable Operating Expenses can “step up” and then “step down” because the absorption of new overheads can take time. Operating expenses added to support growth in sales volume are, for the most part, matched imperfectly with current volume levels in anticipation of future growth, and often in the beginning, increase the rate of a Step Variable Operating Expense expressed as a rate of Net Sales.

Fixed Operating Expenses are generally impervious to short-term sales fluctuations over time and so other than inflationary changes in these operating expenses they generally remain constant.

Of course, Fixed Operating Expenses over the long term can be step-variable.  For example, at one volume level a company needs x amount of warehouse space and at y volume level five years later the company needs 3x in warehouse space.  This kind of scenario is not explicitly considered in this business case.

Format B – Categorized/Unfactored P&L below shows Format A in the new format where the company’s P&L line items are placed in the categories discussed above.

While the company’s total operating expenses are still $4.4 million in Format B, ownership and management now know at this stage of the analysis that of the $4.4 million in operating expenses,  $500,000 of those expenses or 4.6% of the company’s operating expenses expressed as a percent of Net Sales are Variable; $1.1 million of those expenses or 10.4% of the company’s operating expenses expressed as a percent of Net Sales are Step-Variable, and $2.8 million or 25.9% of the company’s operating expenses expressed as a percent of Net Sales are Fixed.

Format B - Categorized/Unfactored P+L

Account $'s & of Net Sales
Gross Sales 11,400.0 104.9
Returns 535.0 4.9
NET Sales 10,865.0 100.0
Cost of Sales 6,736.3 62.0
Gross Profit 4,128.7 38.0
Operating Expenses
Variable Op. Expenses
Warehouse Supplies 400.0 3.7
Marketing Promotions 100.0 0.9
Total Variable Op. Expenses 500.0 4.6
Step-Variable Op. Expenses
Warehouse Payroll 217.3 2.0
Call Center Payroll 326.0 3.0
Payroll Taxes Call Center Payroll 43.3 0.4
Benefits Call Center Payroll 48.2 0.4
Payroll Taxes Warehouse Payroll 28.7 0.3
Benefits Warehouse Payroll 32.2 0.3
Trucking Expense 434.6 4.0
Total Step-Variable Op. Expenses 1,130.0 10.4
Fixed Operating Expenses
Administrative Payroll 869.2 8.0
Bonuses 99.0 0.9
Payroll Taxes Administrative PR 128.4 1.2
Benefits Administrative Payroll 143.3 1.3
Rent 625.0 5.8
Utilities 100.0 0.9
Insurance 150.0 1.4
Travel & Entertainment 50.0 0.5
Marketing Expense 500.0 4.6
Professional Fees 100.0 0.9
Miscellaneous Operating Expense 50.0 0.5
Total Fixed Operating Expenses 2,814.9 25.9
Total Operating Expenses 4,444.9 40.9
Profit(Loss) (316.2) (2.9)

Evaluation/Analysis – Step 2

The next step in the process is to factor the sales, returns, cost of sales and operating expense line items that have been categorized in Step 1 above into the fixed and variable components of those line items.  Format C and C1 below illustrate how this step is accomplished.

Each revenue and operating expense line item is placed in one of two columns to the right: “Fixed $’s” and “Variable $’s”.  Sales, Returns, Net Sales, Cost of Sales and Gross Profit are carried over to the Variable $’s column.  Variable Operating Expenses are carried over to the Variable $’s column.  Fixed Operating Expenses are carried over to the Fixed $’s column.

Step-Variable Operating Expenses need to be analyzed line by line to determine the fixed component of each step-variable operating expense, i.e., what percent of the line item step-variable operating expense is fixed and what percent is variable.  The dollar amount representing the fixed portion of the line item is recorded in the Fixed $’s column, and the dollar amount representing the variable portion of the line item is recorded in the Variable $’s column.

All dollar amounts are expressed as a percentage of net sales in the columns “% of Net Sales”, “Fixed % of Sls” and “Variable % of Sls”.

Format C and Format C1 below exhibit how the P & L should be factored.

Format C - Categorized/Factored P+L

Account $'s & of Net Sales
Gross Sales 11,400.0 104.9
Returns 535.0 4.9
NET Sales 10,865.0 100.0
Cost of Sales 6,736.3 62.0
Gross Profit 4,128.7 38.0
Operating Expenses
Variable Op. Expenses
Warehouse Supplies 400.0 3.7
Marketing Promotions 100.0 0.9
Total Variable Op. Expenses 500.0 4.6
Step-Variable Op. Expenses
Warehouse Payroll 217.3 2.0
Call Center Payroll 326.0 3.0
Payroll Taxes Call Center Payroll 43.3 0.4
Benefits Call Center Payroll 48.2 0.4
Payroll Taxes Warehouse Payroll 28.7 0.3
Benefits Warehouse Payroll 32.2 0.3
Trucking Expense 434.6 4.0
Total Step-Variable Op. Expenses 1,130.0 10.4
Fixed Operating Expenses
Administrative Payroll 869.2 8.0
Bonuses 99.0 0.9
Payroll Taxes Administrative PR 128.4 1.2
Benefits Administrative Payroll 143.3 1.3
Rent 625.0 5.8
Utilities 100.0 0.9
Insurance 150.0 1.4
Travel & Entertainment 50.0 0.5
Marketing Expense 500.0 4.6
Professional Fees 100.0 0.9
Miscellaneous Operating Expense 50.0 0.5
Total Fixed Operating Expenses 2,814.9 25.9
Total Operating Expenses 4,444.9 40.9
Profit(Loss) (316.2) (2.9)

Format C1 - Factoring

Fixed $'s Fixed % of Sls Variable $'s Variable % of Sls
- - 11,400.0 104.9
- - 535.0 4.9
- - 10,865.0 100.0
- - 6,736.3 62.0
- - 4,128.7 38.0
Hidden
- - 400.0 3.7
- - 100.0 0.9
- - 500.0 4.6
Hidden
81.5 0.8 244.5 2.3
54.3 0.5 163.0 1.5
10.8 0.1 32.3 0.3
12.1 0.1 36.2 0.3
7.2 0.1 21.5 0.2
8.1 0.1 24.2 0.2
152.1 1.4 282.5 2.6
326.0 3.0 804.0 7.4
Hidden
869.2 8.0 - -
99.0 0.9 - -
128.4 1.2 - -
143.3 1.3 - -
625.0 5.8 - -
100.0 0.9 - -
150.0 1.4 - -
50.0 0.5 - -
500.0 4.6 - -
100.0 0.9 - -
50.0 0.5 - -
2,814.9 25.9 - -
3,140.9 28.9 - -
(3,140.9) (28.9) 2,824.7 26.0

After factoring sales, Gross Profit and operating expenses, the company now has new, indispensable insights about critical performance factors.

  • The company really has $3,140,900 in Fixed Operating Expenses. Pure Fixed Operating Expenses are $2,814,900 and within Step-Variable Operating Expenses there is an additional $326,000 of Fixed Operating Expenses for a total of $3,140,900.
  • The company’s rate of Marginal Profit is 26.0%. This number is calculated by subtracting from the company’s 38.0% rate of Gross Profit the pure Variable Operating Expense rate of 4.6% and the Step-Variable Operating Expense rate of 7.4%.  For every dollar of net sales, the company has 26 cents of Marginal Profit to cover fixed overheads.
  • In the current year being evaluated the company lost $316,200. That’s because the company had $3,140,900 in fixed overheads but was only able to contribute $2,824,700 of marginal profit to cover that overhead based on achieving net sales of $10,865,000.
  • The company’s break-even point based on the expenses and rates in the year being evaluated is $12,080,000 in Net Sales and $12,672,000 in Gross Sales. That means in the year being evaluated the company would have had to generate Gross Sales that were 11.1% higher than the actual results of $11,400,000 in order to achieve break-even Pre-Tax Profit.
  • The company’s break-even level of Net Sales is calculated by dividing total fixed operating expenses of $3,140,900 by 0.26 (the company’s rate of marginal profit of 26% or “26” divided by 100).

With the above information, ownership and management are now able to make sense of the company’s statement of profit and loss beyond obvious observations.   There is a system in place to define the company’s rate of Marginal Profit and the company’s break-even level of Net Sales.

Business Planning

With the Last Year results in hand, and after analyzing the P&L according to  the above method,  the company is now in a good position to model and plan for the upcoming year.

Format D – The Planning Model that appears below can help make determining the financial requirements to achieve specific financial targets easier.

The company has determined that they would like to earn Pre-Tax Profit at the rate of 3% of Net Sales in the year being planned for.  They also know the following things as they are planning:

  • The company will not be able to raise product selling prices in the Plan Year because of competitive market pressures.
  • Price increases in Cost of Sales will increase the Cost of Sales rate one percentage point in the Plan Year when expressed as a percent of Net Sales (see updated Last Year column below).
  • As a result of the Cost of Sales increase, the rate of Gross Profit will be reduced by one percentage point in the Plan Year when expressed as a percent of net sales (see updated Last Year column below).
  • Variable Operating Expenses will increase by 5% in the Plan Year and increase the rate of that expense category by 0.6 percentage points from Last Year to 12.6% when expressed as a percent of net sales (See Updated Last Year column below).
  • Due to the reduced rate of Gross Profit, and the increased rate of Variable Operating Expenses, the Marginal Profit Rate in the Plan Year will fall to 24.4% when expressed as a percent of Net Sales (see update Last Year column below).
  • Fixed Operating Expenses will increase 5% from Last Year.

With the above elements determined, the company can now easily calculate the sales required in the Plan Year to achieve Pre-Tax Profit dollars at the rate of 3% of Net Sales in the Plan Year.  This is accomplished by dividing the Plan Year Fixed Expenses of $3,297,900 by the company’s Marginal Profit Rate of 24.4% MINUS 3.0 percentage points or 21.4% (i.e. $3,297,900 divided by 0.214).  The result is $15,410,748 in Plan Year Net Sales to achieve a 3.0% rate of Pre-Tax Profit (see Plan Year column below).

Format D - The Planning Model

Accounts Last Year $'s % of Net Sales Updated Last Year $'s % of Net Sales Plan Year % of Net Sales
Gross Sales 11,400.0 104.9 11,400.0 104.9 16,165.8 104.9
Returns 535.0 4.9 535.0 4.9 755.1 4.9
Net Sales 10,865.0 100.0 10,865.0 100.0 15,410.7 100.0
Cost of Sales 6,736.3 62.0 6,845.0 63.0 9,708.7 37.0
Gross Profit 4,128.7 38.0 4,020.0 37.0 5,702.0 37.0
Variable Operating Expenses 1,304.0 12.0 1,369.2 12.6 1,941.7 12.6
Marginal Profit 2,824.7 26.0 2,650.8 24.4 3,760.3 24.4
Fixed Operating Expenses 3,140.9 28.9 3,297.9 30.4 3,297.9 21.4
Profit(Loss) (316.2) (2.9) (647.1) (6.0) 462.4 3.0

In this case the company needs to achieve a 41.8% increase in Net Sales over the prior year to achieve its financial target for the Plan Year.  In most cases this kind of organic sales increase from one year to the next is not realistic.  Therefore, ownership and management need to “go back to the drawing board” in formulating the plan.  Changes might include plans to improve Gross Profit or reduce fixed overheads.  In any event, a combination of management interventions and innovations are required to make such a large, and improbable sales increase necessary from year to year.   Using the method described in this business case, the company can focus on remediating the factors that are critical to preparing a realistic plan.

Implementation/Conclusion

The method discussed in this business case study is a reliable way to evaluate business results captured in the company’s statement of profit and loss and focus on the critical financial factors contributing to actual results.  The method transports management thinking beyond simple discussions of profit and loss.  Additionally, this method is extremely valuable in business planning and the development of the Plan Year P & L.  An example of this kind of insight can be found in the Plan Year column in Format D.

From this information it is clear that Fixed Operating Expenses are not the major factor requiring such a large sales increase in the Plan Year.  In the Plan Year, Fixed Operating Expenses are 21.4% of Net Sales; a decrease of 7.5 percentage points from the prior year.  Of course, at a lower sales level in the Plan Year, the Fixed Operating Expenses will become a higher percentage of Net Sales.  This percentage is still likely, however, to be significantly lower than the prior year percentage.  Said another way, a 7.5 percentage point rate decrease in Fixed Operating Expenses year to year is almost too extreme (a hyper absorption rate in one year) and signals an out-of-balance condition elsewhere.  In this business case study, the issue is clearly the inability to raise prices and overcome the relatively modest increase in the rate of Variable Operating Expenses.  Therefore, the focus for the company should be on reducing the rate of Cost of Goods (easier said than done) and improving the rate of Gross Profit and therefore the company’s rate of Marginal Profit.

One final point is that the company’s financial organization should be tasked with studying Step-Variable Operating expenses to accurately determine current fixed and variable components and be able to forecast how these components might change because of increasing or decreasing levels of sales. The influence of Step-Variable Operating expenses on accurate profit forecasting is considerable and requires serious preparatory financial analysis before relying on the information.

This business case is an example for illustrative purposes only. FEOD is not responsible for company results or other actual results that could occur as a result of using the methods and observations discussed in this business case example.

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