Accounting Chapter 10.pdf

CHAPTER 10 O ver the summer, we learned a lot of accounting skills; no question. Now, let’s use the experience of running our own business and think about things on a slightly higher level. It’s one thing to be able to do something. It’s another thing to be able to understand the big lessons invo...

CHAPTER 10 O ver the summer, we learned a lot of accounting skills; no question. Now, let’s use the experience of running our own business and think about things on a slightly higher level. It’s one thing to be able to do something. It’s another thing to be able to understand the big lessons involved in doing something. So far in this book, we’ve learned about the three financial statements—the Balance Sheet, the Income Statement, and the Cash Statement. We’ve learned how each is structured, its purpose and relationships to the other two. We’ve also learned how to separate Cost of Goods or Cost of Services from Expenses. We learned the Accrual versus Cash Method of accounting, service company accounting, capitalizing versus expensing, depreciation, and Cash versus Earnings. What bottom line have we focused on all book long? Net Profit. Now that you know all you’ve learned so far, you may be wondering, how did my lemonade stand really do and how do I find out how I did? Let’s begin by asking you to review how the summer went and how you feel about your stand and its performance overall. Take a moment to reflect on this and write down your thoughts. 148 T H E AC C O U N T I N G GA M E Is there anything you would have done differently? Did you work hard? Did the business grow? Did you make money? What are the things you did and decisions you made at the lemonade stand that affected profit positively or negatively? Many things happened that influenced profits. Compare this list to what you wrote. We hired our best friend to make advertising signs rather than do them ourselves. We decided to make our own lemonade. Later we hired our sister to make some of the lemonade—did we negotiate the right price for labor? We went on a vacation and had to sell some inventory at cost—would you have wanted to give up the vacation? We sold to some customers with questionable credit and got stiffed. We borrowed money and had to pay interest. We chose the LIFO method which gave the illusion of lower profits. We bought property that required maintenance and depreciation. We bought pre-made lemonade and paid more for it than it would have cost to make the lemonade ourselves. We decided to open a new business opportunity at the ball game. We had to pay more to buy lemonade at the grocer near the ballpark. We successfully negotiated credit to get the lemonade when our cash was low. We forgot to use some the lemons we bought and they spoiled. All of these decisions had a direct impact on our company’s profit. Could you have done better? Now that you look at all the above, do you feel any disappointment in your summer’s performance? C H APTER 1 0 Here’s the real question. Whether you own your company or work as an employee for a company, do you make decisions that affect your company’s profits? Truly, does any person in an organization not have an affect on company profitability? Does whether or not your company make a profit affect you personally? How? How often do you think about how your actions and decisions affect profits? Daily? Weekly? Monthly? Yearly? Never? What does it mean for a company to be making a profit? What are the benefits of profit? What are decisions that have been made in your department or company that have affected profits? 149 150 T H E AC C O U N T I N G GA M E We’ve talked about profits throughout this book and you probably recognize by now that of the three financial statements, the Income Statement provides the clearest picture of profit. But in the last chapter, we said on a daily basis, cash runs the business, not profits. So which is more important—cash or profits? Cash runs the business and profit is the bottom line. Cash is not even mentioned on the Income Statement. Does all of this seem a little confusing? If it is, then great. Please let yourself live in this apparent paradox and feel its discomfort for awhile. Living in this paradox and resolving its seeming conflicts is a great part of the art and science of business leadership and success. Part of the problem is that many of us do not understand what profit really is. We know from the last chapter what cash is. It is so tangible and measurable. Profit is also measurable, however it is not real—it’s just a theory. I bet that shakes up your brains a little. So how do I mean it’s not real? Let’s take some examples from our lemonade stand. In Week Two we sold some lemonade and made a profit. It certainly was measurable and we recorded it in our financial statements. But then a customer who owed us $4 moved away from town (or went bankrupt) and $4 of our profits disappeared just like that. So even though you have profits today, tomorrow they can vanish. At the end of the summer we had $10 worth of old lemons that we let spoil. We had to throw them out and another $10 of our profits disappeared. Imagine that the wagon didn’t work out, and we discontinued the idea of selling at the little league games. Businesses make mistakes all the time or stop a venture they’ve started. We would have had to write off the $20 for the wagon as another loss to profits unless we could have found a buyer for the wagon. Profits are easily and clearly measurable so they can readily be used by businesses as an objective measure of efficiency, productivity, and innovation. Their vulnerability to being lost is certainly one reason business leaders want so much to enroll their employees in maximizing and preserving company profitability. But many employees do not truly understand profits and certainly do not know measures they can use to guide decisions and behavior. To discover these, let’s go back to the Income Statement whose bottom line is Net Profit. What are the three other major items on the Income Statement that affect profits? C H APTER 1 0 Profits are not real because they only exist on paper. Go to any business and ask them to show you some profits. They can’t do it. They can show you assets – cash, inventory, fixed assets, etc. These assets increase or decrease when companies make profits or losses. Sales, Cost of Goods/Services, and Expenses. Profit by definition is the amount by which your sales exceed your costs of providing the goods or services and to run the business. Your company’s sales measure how much your customers are willing to vote (with their cash) for your product or service. The two cost categories measure how motivated and effective the company’s employees are in making decisions and managing the operation. If you look at the three measures, how do you increase profits? The obvious answer is to increase sales and decrease Cost of Goods/Services and Expenses. We all know that none of these is an absolute. We would not want to increase sales on a product that gives a very low profit margin or if we were unable to meet the increased production schedule. We might want to increase Costs of Goods and Expenses if we’re starting up a new line of production. So what do you measure and use to guide decisions if you work on a production line or in an administrative department? It certainly begins with Sales, COGS, and Expenses, but the raw numbers for these presents a problem. Look at the numbers for our summer at the lemonade stand and see if you can discover the problem in just using the raw numbers. Since we artificially eliminated Expenses in week three, the chart below is going to compare weeks 1, 2, 4, and 5. 151 152 T H E AC C O U N T I N G GA M E TREND ANALYSIS Week I II IV V Sales 25 32 50 50 C O GS 10 15 20 30 Expenses 5 7 6 8 Net Profit 10 10 24 12 The problem is that from period to period the numbers are not stable—they fluctuate. Fluctuations in these numbers occur for many reasons—seasonally (we sell more lemonade in summer than winter), normal business cycle, marketing campaigns, etc. What can we do to give us better numbers to work with that take out the fluctuations? We hope that your answer was to use comparisons or ratios. Regardless of whether the numbers are increasing or decreasing, we can get consistency by comparing Cost of Goods to Sales, Expenses to Sales, and Net Profit to Sales. Let’s look at these numbers for week 5. Sales were $50, Cost of Goods $30, Expenses $8, and Net Profit $12 (pre-tax). The three ratios are: Cost of Goods Sales = 30 50 = .60 or 60% Expenses Sales = 8 50 = .16 or 16% 153 C H APTER 1 0 Net Profit Sales = 12 50 = .24 or 24% What do these mean? Out of every dollar in Sales, it costs us 60 cents for the goods for the sale, 16 cents to run the business, and we make 24 cents in Net Profit. But are these numbers good or bad? We need still more comparison. And what would we compare to? First, our competitors, and since different industries and different types of businesses have different ratios, it’s important that we compare ourselves to our true competitors. How do we find out our competitors’ numbers, so we can do a competitive analysis? Should we simply call them up and ask for their ratios? Not likely! Well, this may take a little library or Internet research—because several companies keep a record of Industry Ratios and Norms. Dunn & Bradstreet and Robert Morris & Associates are two that keep key rations and industry norms. Getting this information compares us to competitors, but who else did we say we want to compare to? Ourselves. How are we to compare ourselves to ourselves? Let’s use a sports team, the Chicago Bulls, as an analogy. If they won last night, what does that tell us? Certainly, we may be happy they won (if we’re fans), but does that make them a good team all of the time? What if they lost last night? Does that make them a bad team? The point is, looking at a single game doesn’t tell us much. What will tell us more? A season would tell us quite a bit more. But the best indicator of the whole organization would be several seasons—i.e., a trend. In business we would call this analysis a “trend analysis.” In this book, we’ve taken the liberty of using weeks as our accounting period. In a real life, a trend analysis would use years. So, we’re going to use four weeks and pretend they are years, just to show you how it works. Since we had no expenses in week three, we will leave that week out and look at weeks 1, 2, 4, and 5. 154 T H E AC C O U N T I N G GA M E The trend analysis table will show us our Sales, Cost of Goods, Expenses, and Net Profit. It will also show our three ratios: COGS/Sales, Expenses/Sales, and Net Profit/Sales. TREND ANALYSIS Week I II IV V Sales 25 32 50 50 C O GS 10 15 20 30 Expenses 5 7 6 8 Net Profit 10 10 24 12 RATIOS C O GS/Sales 10 = .4 5 10 25 10 32 = .40 6 = .31 24 30 = .60 50 = .12 8 = .16 50 50 32 = .4 20 50 7 = .22 = .2 25 NP/Sales = .47 32 25 Exp./Sales 15 = .48 32 12 = .24 50 Now, using our key ratios, review the trend analysis table and answer the following questions: 1. Did we make a profit? ________ 2. How is the Net Profit/Sales trending, up or down? _________ 3. If the Net Profit/Sales ratio is going down, is the problem reflected in the COGS/Sales ratio, the Expenses/Sales ratio, or both? ___________________ 4. What has been happening in the business that is causing the problem? C H APTER 1 0 5. As a business leader, how would you resolve the problem? Now, let’s review the questions. We did make a profit each week this summer. However, with a Net Profit/Sales ratio that went from 0.4 to 0.24, this ratio was going down, which is a problem. Looking at the two cost ratios, we see that although there was some fluctuation in the Expenses/Sales ratio, it was pretty steady over the four periods. The problem is in COGS/Sales which went from 0.4 to 0.6, a very dramatic increase. What has happened in the business to cause the problem? The easy answer is that the cost of lemonade was a lot higher at the grocer near the game than at your regular grocer’s. From the larger perspective, you made a rash and poorly planned decision to start a new venture. There was no plan to continue the stand which was making money, while starting the new venture at the game. Purchasing the equipment almost put you out of business and certainly had an indirect effect on profit. There was very poor planning about the purchase of new inventory and the cash shortage limited your options and negotiating power at the new grocery store. Finally, you failed to recognize that people pay a lot more for drinks at a game and did not raise your prices accordingly, which could have lessened the pain of your increased costs. It should now be fairly clear what you would do differently. How do you like being a consultant? You’re pretty darn smart, aren’t you? You should feel pretty happy to have the tools to analyze your and other company’s profit performance and the key questions that can lead to discovering how to improve it. You can now go back to the list of things that affected profit and prioritize the things you would change or do differently. Hey! We still need to complete The Accounting Game. To do so, please take the Post-Test. You’ll recognize it as the same as the Pre-Test you took at the start of this book. But we guarantee that your score will be a lot higher now! Take a few minutes and complete the test. When you’re done, you’ll find the answers at the end of this book. Score both the Pre- and Post-Test. Then congratulate yourself on how much you’ve learned! 155