Last time, we looked at the accounts of a parachute manufacturing company. We reorganised its Profit & Loss Account to help the owners make informed decisions. The current profit is $100,000 per annum (see below), but the owner wants $200,000.
Sounds ambitious? Let’s examine his options using 3 approaches – costs, volumes and pricing.
Variable costs may be reduced by renegotiating with suppliers, streamlining processes or updating plant. Reducing “hidden” costs, such as lost time, scrap, or reworks can be very effective.
A review of fixed costs might show that some “discretionary” costs can be eliminated, office processes streamlined and interest costs reduced with improved debt collection.
(Cost reduction is often about process improvement – which should also improve customer service.)
If direct materials’ and direct labour costs can be reduced by just 0.5% sales each (total 1% sales or $20,000), and fixed costs by $10,000, that’s $30,000 more profit already.
- Volume (Changing Production Quantities or Product Mix)
Let’s say sales of product A have reduced by 10% since last year for no apparent reason. Also, the Gross Profit % (GP) on product B is higher than on product C, so he decides to promote B.
If sales of A can be increased by 5% (say $50,000 producing additional GP of $20,000) and an extra $10,000 GP can be earned by selling more B and less C, this will provide another $30,000 profit.
He asks – “If I increase all my prices by 5%, how much business can I lose before profit is reduced?”
Inevitably, he may lose some customers, depending on his competitive position. In this case, he could lose just over 11%* in volume before his net profit is affected.
What if he cuts his prices by 5% to increase market share? In this case, volume must increase by 14%* just to maintain profit. Also, he may incur additional marketing and administration costs.
After studying various options, he increases prices by 3% and expects to lose a maximum of 2% of volume. This will increase profit by about $42,000.
*These percentages vary according the planned price change and the gross profit percentages.
After implementing these apparently minor changes, nobody was fired, but profit doubled.
Cost reductions added profit of…… $30,000
Increased production and change in product mix added…… $30,000
Price increases (after lost customers) added…… $42,000
Total additional profit (before income tax)…… $102,000
The new P & L, compared with the original, is as follows:
|Original P&L||New P&L|
|Description||$||% sales||$||% sales|
|Cost of sales (variable)||1,200,000||60.0%||1,176,000||56.9%|
|Gross Profit (GP)||800,000||40.0%||892,000||43.1%|
|Finance expenses (interest)||20,000||15,000|
|Total expenses (fixed)||700,000||35.0%||690,000||33.4%|
|Net Profit before income tax||100,000||5.0%||202,000||9.8%|
- Sales increased by just $68,000 (+3.4%), but GP increased by $92,000 (+11.5%).
- Factory and marketing expenses were unchanged, and admin/ interest reduced slightly.
- Net profit before tax increased by 102%.
- Most of the additional profit, less tax, will be reflected in cash flow.
- The break-even point is reduced by $150,000. This will help if difficult times return.
It may be possible to work out how many parachutes must be sold to achieve both break-even point and required profit. This can be converted to a weekly number and measured against actual quantities sold. This provides a dashboard for performance as it happens.
The decisions made in the above example would have been difficult without a properly constructed Profit & Loss Account. This is the perfect time of year to review your management reporting and decision making systems.
See your accountant to start planning now!
Call us on 02 6652 8788 or email firstname.lastname@example.org to make an appointment.