Understanding Business Accounting For Dummies, 2nd Edition (65 page)

The profit and loss account does not report the
financial effects
of the company's profit-making activities - that is, the increases and decreases in its assets and liabilities caused by revenue and expenses. Managers need to control these financial effects for which purpose they need the complete financial picture provided by the two other primary financial statements (the balance sheet and the cash flow statement) in addition to the profit and loss account. See Chapters 6 and 7 for more about these two other primary financial statements.

Basic Model for Management Profit and Loss Account

Figure 9-2 presents a model for a
management
profit and loss account using the same business as the example whose external profit and loss account is shown in Figure 9-1. Many lines of information are exactly the same - sales revenue and cost of goods sold expense for instance - and thus gross margins are the same. The last five lines in the two statements are the same, starting with operating profit (earnings before interest and corporation tax) down to the bottom line. In other respects, however, there are critical differences between the two profit reports.

First, note that total unit sales volume and per unit amounts are included in the management profit and loss account (Figure 9-2). The business appears to sell only one product; the 520,000 units total sales volume is from sales of this product. In fact, most businesses sell a mix of many different products.

The company's various managers need detailed sales revenue and cost information for each product, or product line, or segment of the business they are responsible for. To keep the illustration easy to follow we have collapsed the business's entire sales into one ‘average' product. Instead of grappling with 100 or 1,000 different products, we condensed them all into one proxy product. The main purpose of Figure 9-2 is to show a basic template, or model, that can be used for the more detailed reports to different managers in the business organisation.

Variable versus fixed operating expenses

Another fundamental difference between the external profit report (Figure 9-1) and the internal profit report (Figure 9-2) is that the company's
operating expenses
(sales, administration and general expenses plus depreciation expense) are separated into two different categories in the management report:

Variable expenses:
The
revenue-driven expenses
that depend directly on the total sales revenue amount for the period. These expenses move in step with changes in total sales revenue. Commissions paid to salespersons based on a percentage of the amount of sales are a common example of variable operating expenses.

Fixed expenses:
The operating expenses that are relatively fixed in amount for the period, regardless of whether the company's total unit sales (sales volume) had been substantially more, or substantially less, than the 520,000 units that it actually sold during the year. An example of a fixed operating expense is the annual business rates on the company's property. Also, depreciation is a fixed expense; a certain amount of depreciation expense is recorded to the year regardless of actual sales volume.

The management profit and loss account does not, we repeat
not
, present different profit numbers for the year compared with the profit numbers reported in the company's external profit and loss account. Note that operating profit for the year (or earnings before interest and tax expenses) is the same as reported outside the business - in Figures 9-1 and 9-2 this number is the same. And in reading down the rest of the two profit and loss accounts, note that earnings before tax and bottom-line net income are the same in both the external and internal reports. The external profit and loss account of the business reports a broad, all-inclusive group of ‘sales, administration, and general expenses', and a separate expense for depreciation. In contrast, the management profit and loss account reveals information about
how the operating expenses behave relative to the sales of the business
. The actual reporting of expenses in external profit and loss accounts varies from business to business - but you never see profit and loss accounts in which operating expenses are sorted between variable and fixed.

Virtually every business has
variable operating expenses
,
which move up and down in tight proportion to changes in unit sales volume or sales revenue. Here are some examples of common variable operating expenses:

Cost of goods sold expense - the cost of the products sold to customers.

Commissions paid to salespeople based on their sales.

Transportation costs of delivering products to customers.