nishant2020
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hi, i urgently need project report on profit planning in corporate world
project report on profit planning in corporate world
ROHAN KACHALIA
Par 100 posts (V.I.P)
Hi here is the basic of profit planning in corporate world. Now you try to relate it with a company and prepare the report.If u r stuck in between please do let me know.
Profit planning is simply the development of your operating plan for the coming period. Your plan is summarized in the form of an income statement that serves as your sales and profit objective and your budget for cost.
How Is It Used?
The profit plan is used in the following ways:
* Evaluating operations. Each time you prepare an income statement, actual sales and costs are compared with those you projected in your original profit plan. This permits detection of areas of unsatisfactory performance so that corrective action can be taken.
* Determining the need for additional resources such as facilities or personnel. For example, the profit plan may show that a sharp increase in expected sales will overload the company's billing personnel. A decision can then be made to add additional invoicing personnel, to retain an EDP service, or to pursue some other alternative.
* Planning purchasing requirements. The volume of expected sales may be more than the business' usual suppliers can handle or expected sales may be sufficient to permit taking advantage of quantity discounts. In either case, advance knowledge of purchasing requirements will permit taking advantage of cost savings and ensure that purchased goods are readily available when needed.
* Anticipating any additional financing needs. With planning, the search for needed funds can begin as early as possible. In this way, financial crises are avoided and financing can be arranged on more favourable terms.
Advantages of Profit Planning
Profit planning offers many advantages to your business. The modest investment in time required to develop and implement the plan will pay liberal dividends later. Among the benefits that your business can enjoy from profit planning are the following:
* Performance evaluation. The profit plan provides a continuing standard against which sales performance and cost control can quickly be evaluated.
* Awareness of responsibilities. With the profit plan, personnel are readily aware of their responsibilities for meeting sales objectives, controlling costs, and the like.
* Cost consciousness. Since cost excesses can quickly be identified and planned, expenditures can be compared with budgets even before they are incurred, cost consciousness is increased, reducing unnecessary costs and overspending.
* Disciplined approach to problem-solving. The profit plan permits early detection of potential problems so that their nature and extent are known. With this information, alternate corrective actions can be more easily and accurately evaluated.
* Thinking about the future. Too often, small businesses neglect to plan ahead: thinking about where they are today, where they will be next year, or the year after. As a result, opportunities are overlooked and crises occur that could have been avoided. Development of the profit plan requires thinking about the future so that many problems can be avoided before they arise.
* Financial planning. The profit plan serves as a basis for financial planning. With the information developed from the profit plan, you can anticipate the need for increased investment in receivables, inventory, or facilities as well as any need for additional capital.
* Confidence of lenders and investors. A realistic profit plan, supported by a description of specific steps proposed to achieve sales and profit objectives, will inspire the confidence of potential lenders and investors. This confidence will not only influence their judgment of you as a business manager, but also the prospects of your business' success and its worthiness for a loan or an investment.
Limitations of Profit Planning
Profit plans are based upon estimates. Inevitably, many conditions you expected when the plan was prepared will change. Crystal balls are often cloudy. The further down the road one attempts to forecast, the cloudier they become. In a year, any number of factors can change, many of them beyond the con*trol of the company. Customers' economic fortunes may decline, suppliers' prices may increase, or suppliers' inability to deliver may disrupt your plan.
The profit plan requires the support of all responsible par*ties. Sales quotas must be agreed upon with those responsible for meeting them. Expense budgets must be agreed upon with the people who must live with them. Without mutual agreement on objectives and budgets, they will quickly be ignored and serve no useful purpose.
Finally, profit plans must be changed from time to time to meet changing conditions. There is no point in trying to operate a business according to a plan that is no longer realistic because conditions have changed.
Advantages vs. Disadvantages
Despite the limitations of profit planning, the advantages far outweigh the disadvantages. A realistic plan, established yearly and re-evaluated as changing conditions require will provide performance guidelines that will help you control every aspect of your business with a minimum of analysis and digging for financial facts.
Guide Objectives
In this guide, you will learn how to do the following:
* Develop a forecast for sales and gross profit, considering all of the various internal and external factors that are relevant to the forecast.
* Develop budgets for operating expenses to quickly detect excessive expenses so that corrective action can be taken and purchasing commitments held within budgetary limits.
* Estimate net profit so that you can determine whether or not the projected return on your investment is satisfactory. You will also be able to determine how much cash will be generated from operations either for reinvestment in the business or to compensate owners for their investment.
Forecasting Sales And Gross Profit
Development of your profit plan should usually begin with a forecast of your expected sales and gross profit for the coming year. The sales and gross profit must be considered together since they are so closely interrelated. Gross profit percentages are determined by pricing policy, which also affects expected sales volume. A decision to increase the expected gross profit percentage will usually tend to decrease expected sales, while reducing the expected gross profit per*centage should increase sales.
A second major reason for beginning the profit plan with a sales forecast is that the volume of expected sales often determines a number of other factors such as the following:
* Expected changes in variable expenses, those expenses that tend to change in direct proportion to changes in sales. These could include expenses such as sales commissions or delivery costs.
* The impact of the added sales volume on the various fixed costs of operating your business. These costs, by definition, do not tend to vary in direct proportion to changes in sales volume. However, substantial increases in sales over an extended period can force an increase in many fixed expenses. For example, a sales increase realized through the addition of many new accounts could affect bookkeeping and credit costs.
* The ability of present resources such as storage space, display area, delivery capability, or supervisory personnel to accommodate the added volume.
* The need for funds to invest in increased inventory or accounts receivable to accommodate sales increases.
* Cash generated from operations to meet current operating needs as well as expansion requirements, debt repayments, and owners' compensation.
Realism
A realistic sales forecast must rely on careful analysis of market potential and the ability of your business to capture its share of this potential. The forecast should not be based upon "what you would like to do" or "what you hope to do." It must be "what you can do" and "what you will do."
Any forecast of a sales increase must be supported by realistic expectations for stronger market demand and specific marketing steps that will be taken to capture a share of this market.
The key to successful forecasting is realism. You only fool yourself if you reject reality in forecasting. Such fore*casts serve neither as a realistic planning basis nor as a reliable means of performance evaluation.
Your forecast can be the basis for important decisions such as decisions to add personnel, lease additional facilities, or increase promotional costs. If these decisions are based upon unrealistic sales expectations, any money expended on them will be wasted.
Forecasts are often presented to lenders or potential investors to guide them in their decisions. If they lack confidence in your forecast, they will certainly be reluctant to commit their funds to your business.
Every forecast should be supported by carefully considered, specific action plans. It is inadequate to forecast a sales increase of 20% or 30% without plans for specific actions to achieve the increase. These actions could include the intro*duction of new products, opening of new branches, market expansion, commitments from new customers, increased require*ments from existing customers, additional salesmen, or an intensified promotional effort to attract new customers.
Analysing Current Sales and Gross Profit
Your sales and gross profit forecast begins with analysis of current performance. Sales are usually divided into various categories. Each category is examined individually to deter*mine expected sales for the coming year.
Selecting Sales Categories
The selection of categories will depend upon the nature of your business. For example, a food broker selling to a large number of relatively small accounts might be interested pri*marily in analysing sales by product. The owner of a single retail store might choose to analyse sales by selling depart*ment, while the owner of a retail chain would probably be interested in analysing sales by outlet. An insurance broker with several agents might categorize sales by agent. An individual wholesaler might consider sales by sales territory.
Factors Affecting Sales
After categories have been selected and current sales divided among them, the various factors which can affect sales in each category must be considered. These factors could be either internal or external. Internal factors are those that you can influence. External factors are those that affect the market served by your business, but are generally beyond your control.
Internal Factors
The following are typical internal factors that could influence your sales forecast:
* Promotional plans
* Expansion plans
* Capacity restrictions
* New product introductions
* Product cancellations
* Sales force changes
* Pricing policy
* Profit expectations
* Market expansion to new customers or territories
External Factors
Among the external factors that must be considered are the following:
* Business trends
* Government policies
* Inflation
* Changes in population characteristics
* Economic fortunes of customers
* Changes in buying habits
* Competitive pressures
Analysing Gross Profit Percentages
It is often useful to begin a sales forecast with an examina*tion of your current gross profit percentage (mark-up percentage or gross profit percentage). The gross profit percentage is usually the best indicator of pricing policy which can have significant impact on sales volume. To some extent, the gross profit percentage will also reflect the buying economies of your business. However, the range over which costs of pur*chased goods will vary is not ordinarily as wide as the possible range of prices you may seek for your products.
Three Bases of Comparison
Examination of current gross profit percentages can indicate the need for pricing policy revisions to meet competition or closer attention to purchasing costs in order to provide extra gross profit without increasing prices.
The evaluation of gross profit percentages requires comparison of current performance with three bases:
* Objectives originally set for the current year, if available
* Other businesses in the same industry
* Results of prior years
Comparison with objectives permits you to determine how well you have done compared with your original expectations. Assuming that these objectives were realistic, this is often the best single performance indicator. Deviations from objectives can quickly be identified and explored in detail to determine the cause of the deviation.
Comparison with industry averages permits identification of areas where the experience of similar businesses indicates room for improvement in your own.
Unfortunately, businesses are often too quick to dismiss the applicability of industry averages to their own operation, claiming that "Our circumstances are different." Such an attitude is self-defeating. It prevents you from taking advantage of the experience of others to improve your own sales and profit. A far more productive attitude is to say, "If everybody else can realize a gross profit of x percent, then we should be able to." Until specific circumstances are identified that make it impossible for your business to be consistent with industry averages, every attempt should be made to bring performance in line with the experience of others.
Comparison of current operations with performance in prior periods permits detection of trends so that progress, or the lack of it, can be identified. It also permits evaluation in light of those specific considerations that may be unique to your business. For example, if your gross profit as a per*centage of sales is low compared with the industry, analysis of your historic performance may reveal the cause of this apparent deficiency such as reliance upon a major customer where severe competition restricts the available gross profit percentage.
Evaluating Gross Profit Percentages
Refer to the table below, which is an analysis of gross profit percentages realized by My Appliances in the year 2002. Percentages are shown for cost of sales, gross profit, total expenses, and profit before taxes as follows:
* 2002 actual
* 2001 actual
* Industry average
* 2002 objective
Each basis of comparison provides a different viewpoint of the company's operations.
MY APPLIANCES, Pty Ltd. Profit Percentage Analysis
2002 actual 2001 actual Industry average 2002 Objective
Sales 100.0% 100.0% 100.0% 100.0%
Cost of Sales 80.0% 80.5% 81.8% 80.7%
______ ______ ______ ______
Gross Profit 20.0% 19.5% 18.2% 19.3%
Total Expenses 17.9% 18.6% 14.7% 17.2%
______ ______ ______ ______
Profit Before Taxes 2.1% 0.9% 3.5% 2.1%
In 2002, My Appliances' gross profit was 20.0% of sales. This represented an improvement over their 2001 performance of 19.5%, the industry average of 18.2%, and their 2002 objective of 19.3%. By any of these measures, this should be considered favourable. Apparently, they were able to control their pur*chasing costs and realize adequate prices in order to improve upon their own previous gross profit performance as well as the industry average.
Conflicts
Sometimes financial analysis can lead to conflicting conclusions derived from identical facts. Comparing My Appliances' 20.0% gross profit with the 18.2% industry average could raise questions. If My Appliances were more com*petitive in its pricing, could it capture a larger market share? A reasonable answer to this question would depend upon thorough knowledge of their operations and the experience of their sales personnel in dealing with specific customers. Perhaps their pricing is fully competitive in their area or local retailers are willing to pay slightly more because of the superior services they offer. If this is the case, price cutting might only trim profit margins with no realistic hope of additional sales volume to offset the effects of the price reduction.
On the other hand, if their gross profit percentage is below that of the industry, a number of other questions would be raised, such as the following:
* Are they purchasing at prices that are too high to provide an adequate gross profit?
* Is their pricing structure so low that adequate gross profit margins cannot be attained?
* Are salesmen too quick to cut prices?
* Is their marketing effort too heavily concentrated in those product lines that offer a relatively low gross profit percentage?
* Is their marketing effort directed toward those high-volume accounts that are so highly competitive that gross profit must be trimmed to an unrealistically low level?
Analysis of Sales Performance
The table shown below, analyses the 2002 sales of My Appliances by account. Actual sales, gross profit, and the gross profit percentage are shown individually for major accounts and as a group for smaller accounts. These are reported on the bottom line and represent 50 small retailers served by My Appliances.
My APPLIANCES, Pty Ltd. Sales Forecast, xxx3
2002 Actual 2003 Forecast
Account Sales Gross Profit % Sales Gross Profit %
Giant Discount $ 300,000 $45,000 15.0 $323,500 $45,300 14.0
Appliance Mart 150,000 27,000 18.0 174,000 31,300 18.0
TV Centre 120,000 21,600 18.0 159,000 23,900 15.0
Whitney Brothers 80,000 15,200 19.0 100,000 20,000 20.0
Packer Electronics 70,000 14,000 20.0 40,400 8,100 20.0
Consumers Outlet 40,000 7,200 18.0 50,000 9,000 18.0
Other (50stores) 440,000 110,000 25.0 553,100 142,400 25.7
__________ ________ _____ __________ ________ _____
Total $1,200,000 $240,000 20.0 $1,400,000 $280,000 20.0
Let us consider Appliance Mart, one of the major accounts shown.
In 2002, My Appliances' sales to Appliance Mart were $150,000. These sales generated gross profit of $27,000, or 18.% of sales.
In 2003, My Appliances expects a general price increase of 5% with no change in the discount structure available to them from their suppliers.
Appliance Mart's business in 2003 is expected to be affected only by general economic conditions such as the 5% price in*crease and an expected 10% industry growth in consumer demand for electrical appliances.
Appliance Mart operates a chain of discount stores in an economi*cally stable suburban area. For 2003, they have no plans to add or eliminate any stores. There are no changes expected in My Appliances' relationship with them that would materially affect sales.
Therefore, the only factors affecting the sales forecast for Appliance Mart would be the planned 5% price increase and the general 10% increase in demand. Sales to Appliance Mart in 2003 could then be forecast as follows:
2002 Sales $150,000
+ 5% Price Increase 7,500
_______
= Subtotal 157,50
+ 10% Demand Increase 15,750
_______
= Total $173,250
This amount, $173,250, has been rounded to $174,000 and entered in the 2003 sales forecast column.
Since there is no planned change in My Appliances' dis*count structure from its suppliers, nor is there any indication that competition for Appliance Mart's business will be any more or less severe, My Appliances probably should assume that gross profit as a percentage of these sales will remain at 18.0%, the 2002 level. The gross profit expected on these sales could then be calculated as follows:
$174,000 x 0.180 = $31,320
This amount has been rounded to $31,300 and entered in the gross profit forecast column.
Subdividing Sales Categories
It is often useful to subdivide sales into more detailed classifications in order to develop a more precise forecast such as potential sales to a single customer. As an example, refer to the table below, My Appliances' sales summary by product line to Giant Discount, its major customer in XXX2. Sales, gross profit, and the gross profit percentage are shown by product line so that each line may be considered separately to determine a realistic forecast for 2003.
My APPLIANCES, Pty Ltd. Customer Sales Analysis - Giant Discount
2002 Actual 2003 Forecast
Product line Sales Gross profit % Sales Gross profit %
Television $160,000 $16,000 10.0 $184,800 $18,500 10.0%
Automotive radios 20,000 6,000 30.0 -- -- --
Table radios 30,000 6,000 20.0 34,700 6,900 20.0
Stereo 40,000 7,000 18.0 46,200 8,300 18.0
Small appliances 50,000 10,000 20.0 57,800 11,600 20.0
______ ______ _____ _______ _______ ______
Total $300,000 $45,000 15.0% $323,500 $45,300 14.0
Development of the 2003 forecast will assume that Giant Dis*count's various stores are located in areas that are represen*tative of the general economy and therefore will reflect the industry's expected sales growth of 10%; the price increase of 5% will have no significant effect on Giant Discount's sales; and competition among appliance wholesalers for Giant Dis*count's business will prevent My Appliances from increas*ing its gross profit percentage in any product line.
The first product line on the table above, television sales, could then be forecast as follows:
2002 Sales $160,000
+ 5% Price Increase 8,000
_______
= Subtotal $168,000
+ 10% Demand Increase 16,800
________
= Total $184,800
Assuming that the gross profit percentage of 10.0% on television sales is maintained in 2003, the forecast for gross profit can then be calculated as follows:
$184,800 x 0.100 = $18,480, rounded to $18,500
Giant Discount plans to discontinue its sales of automotive radios in 2003. Therefore, sales, gross profit, and the gross profit percentage for all are shown as zero on the table above.
Sales, gross profit, and gross profit percentages have all been determined for the remaining product lines and shown on the 2003 forecast on the table above. You will note that the gross profit as a percentage of total sales in the 2003 forecast, 14.0%, is well below the 2002 experience of 15.0% even though the gross profit on each product line remains the same. This is due to the elimination of the highly profitable automotive radio line which produced a 30% gross profit but is being discontinued from Giant Discount's stores. In fact, the net effect of this discontinuation is that My Appliances will realize addi*tional gross profit of less than $1,000 on sales to Giant Discount despite a sales increase of almost $24,000. This important fact probably would not have been revealed if sales to Giant Discount had not been subdivided into individual product lines for analysis.
This negligible increase in gross profit will probably be more than offset by normal cost increases in various expense accounts required to handle Giant Discount's business in 2003, At this point, the owners of My Appliances would be well advised to take a hard look at their pricing strategy to see if more favourable prices can be realized in any product line without any significant sales loss so that the gross profit earned from this, its largest account, can be improved.
Developing Expense Budgets
After a realistic forecast has been developed for sales and gross profit, expenses for the coming year must be estimated in order to establish expense budgets and to determine ex*pected operating profit.
Comparisons
As with the forecast of sales and gross profit, expense estimating begins with a review of the current year's per*formance based upon comparison with the following indicators:
* Performance in prior periods
* Industry averages
* Objectives established for the current year
For purposes of comparison, it is often useful to express each expense as a percentage of total sales.
Comparing Variable Expenses
The use of percentages as a basis of comparison and forecast*ing is particularly applicable when analysing variable expenses. Variable expenses are those that tend to change as a result of changes in sales volume. For example, if salesmen's commissions are based upon a percentage of sales, the total dollar amount of commissions earned would increase as sales increase. If sales in a month were 20% higher than expected, commissions paid would also increase 20% as a direct result of the higher sales volume.
Comparing Fixed Expenses
On the other hand, fixed expenses are not directly affected by short-term variations in sales volume. Therefore, a 20% increase in the dollar amount of any fixed expense such as salaries or rent would normally be considered unacceptable even if sales for the period increased by 20%. When com*paring fixed expense levels with objectives or from one period to another, it is more realistic to make comparisons in absolute dollars rather than in percentages.
A business has sales and rent expense in January, February, and March as follows:
Rent expense
Month Sales $ % Sales
January $100,000 1,000 1.00
February 80,000 1,000 1.25
March 125,000 1,000 0.80
As a percentage of sales, rent expense was high in February and low in March. However, this does not indicate that con*trol of this expense was more or less effective in either month. It simply reflects the changes in sales volume. In all three cases, the actual rent expense was 1,000.
Long-Range Considerations
Despite the shortcomings of using percentages to evaluate fixed expense control within the business from month to month, they can be useful when making long-term comparisons or com*parisons with industry averages. These averages normally express expenses as percentages of sales, regardless of whether they are fixed or variable.
For example, assume that a business found that its rent expense as a percentage of sales was 2% compared with an industry average of 1%. This differential would have to be offset by better than average performance in gross profit or other expense classifications if the business expects to realize net profit equal to its industry average. Perhaps the reason for the high percentage is due to an exorbitant rental expense, or it may be caused by inadequate sales. In either case, certain questions must be answered. These could include the following:
* Are we renting more space than we need?
* Is our space too expensive for our requirements?
* Could a less elaborate facility be located that would be adequate for our needs?
* Would a less costly location be sufficient?
* Is our space utilization inefficient?
* Will expected sales increases be handled without renting additional space? Will this bring our rent expense per*centage in line with the industry?
* Can the terms of our lease be re-negotiated?
Similarly, when comparing long-term performance with prior periods, the use of fixed expense percentages can be helpful. For example, if you found that warehouse salaries jumped from 2% of sales to 4%, a number of important questions would be raised. These could include the following:
* Are we now using too many warehouse personnel?
* Are warehouse personnel less efficient?
* Has ineffectiveness crept into the warehouse layout or operating procedure?
* Are warehouse workers overpaid?
* Is warehouse supervision inadequate?
Identifying Excessive Expenses
At My Appliances, no objectives were available for 2002 performance. Therefore, excessive expenses can be identified only by comparison with 2001 results, and, in some cases, with industry averages.
Industry Average Comparisons
Comparisons with industry averages are not available in all of My Appliances' expense accounts. However, this can be determined by examining those accounts on the company's income statement that can be combined for comparison with industry averages. For example, the industry averages show that office salaries for the industry were 4.9% of sales. Examining the operating expense accounts at My Appliances, the accounts that would appear to fall into this classification are the following:
* Salary - Office Manager 1.4%
* Salaries - Clerical 1.0%
* Salaries - Warehouse 1.8%
The total of these expenses, 4.2% of sales, compares favourably with the industry average of 4.9%.
Comparison with Previous Periods
The information permits comparison of all expenses in 2002 with 2001 results.
The only variable expense at My Appliances in 2002 is salesmen's commissions. These represented 2.0% of sales in both 2001 and 2002. Therefore, they would not appear to be excessive.
In the fixed expense accounts, sharp increases could be noted in the following accounts and would warrant review and pos*sible corrective action.
Account 2002 2001
Salary - Owner $24,000 $20,000
Salaries - Warehouse 22,000 18,000
Salaries - Clerical 12,000 10,000
Employee Benefits 8,000 6,000
Utilities 4,000 3,000
Telephone 4,000 2,000
Supplies 2,000 1,000
Travel and Entertainment 13,000 10,000
Comparing My Appliances' 2002 fixed expenses with its experience in 2001, significant increases are noted in almost every account. Some of these increases should be regarded with more concern than others and therefore given prompt attention. Reasons for the increases and possible corrective action must be determined.
Some increases were probably unavoidable, having been dictated by contract, legal requirements, or price increases beyond the company's control. Others could probably be reduced with closer control. For example, travel and entertainment expense jumped from $10,000 to $13,000, an increase of $3,000. This sharp increase should indicate that a closer look at all travel and entertainment expenditures is in order to determine whether or not all were necessary. Could some have been avoided by restricting salesmen's expense accounts? Could more economical means of travel have been used? Could the company eliminate unnecessary trips that resulted in costs far beyond any real value to the business?
Supplies expense doubled from $1,000 to $2,000 although the volume of business increased by only about 10%. This sales increase would not seem to indicate a need for such a sharp increase in supplies usage. Such an expense could be con*trolled by closer attention to purchasing procedures and supplies issued to employees, use of less expensive supplies where possible, and so on.
Determining Expense Budgets
Budgets for each expense must be established, considering both external and internal factors, as in sales forecasting.
From the standpoint of expense budgeting, the following would be considered internal factors:
* Corrective actions planned to bring excessive expenses in line.
* Policy changes such as new commission plans.
* Commitments such as equipment purchases, leases on new facilities, or professional service contracts.
* Planned salary increases.
* Planned changes in benefit programs.
* Additional personnel.
* Promotional plans.
* External factors could include the following:
* Inflation and its effect on price increases from suppliers.
* Tax rate increases including payroll taxes, local property taxes, inventory taxes, and so on.
* Utility rate increases.
Additionally, the interrelated effects of expense increases must be considered. For example, payroll increases will increase payroll taxes and, possibly, employee benefits. Rent on larger facilities can also involve additional utilities expense.
Initial Forecast
The table below shows My Appliances' initial forecast for 2003 operating expenses.
The owner's salary will be increased from $24,000 to $26,000.
The office manager's salary will be increased from $17,000 to $18,000.
Salesmen's salaries will remain unchanged.
The expected sales increase will cause salesmen's commissions, 2% of sales, to increase from $24,000 to $28,000.
Warehouse salaries will be increased about 5% from $22,000 to $23,000.
Clerical salaries will be increased about 17% from $12,000 to $14,000.
Payroll taxes, approximately 8% of total compensation, will increase to $10,000 as a result of the compensation increases
Employee benefits expense is expected to increase from the present $8,000 to $9,000. This increase is dictated by increased premium costs for employees' health insurance.
Rent expense will increase from $9,000 to $10,000 due to a tax escalator clause in the lease agreement and a proposed municipal tax increase.
Utilities expense is expected to remain unchanged at $4,000.
Telephone expense is expected to be reduced from $4,000 to $3,000 because of tighter controls introduced by management in response to the sharp increase in 2002.
New controls on supplies should hold this expense at $2,000 despite price increases.
To increase sales, the advertising and promotion budget will be increased from $13,000 to $15,000, a 20% increase.
Through tighter control, the owner expects to restrict travel and entertainment expense to the 2002 level of $13,000 despite the general increase in travel-related costs.
Freight expense will increase from $16,000 to $18,000 reflecting the increased sales volume and higher freight tariffs.
Professional fees are expected to remain at $5,000.
Depreciation expense will increase from $6,000 to $8,000 due to the addition of new receiving equipment being purchased at a cost of $10,000 and depreciated over 5 years.
Total operating expenses will increase from $200,000 to $218,000. Profit before interest and taxes will be $62,000, an increase from $40,000 in 2002
MY APPLIANCES, Pty Ltd. Sales And Expense Forecast July 1 To June 31, 2003
Revised
2002 2002 2001 2001 Industry 2003
Actual (% sales) Actual (% sales) (% Sales) Forecast
Sales $1,200,000 100.0% $1,080,000 100.0% 100.00% 1,400,000
Cost of Sales 960,000 80.0% 880,000 81.5 81.8 1,120,000
________ _______ _______ _______ _______ _________
Gross Profit $240,000 20.0% $200,000 18.5% 18.2% 280,000
Operating Expenses:
Salary-Owner $ 24,000 2.0% $ 20,000 1.9% 1.7 26,000
Salary-Office Manager 17,000 1.4 16,000 1.5 18,000
Salaries-Salesmen 12,000 1.0 11,000 1.0 12,000
Commissions-Salesmen 24,000 2.0 22,000 2.0 28,000
Salaries-Warehouse 22,000 1.8 18,000 1.7 23,000
Salaries-Clerical 12,000 1.0 10,000 0.9 14,000
Payroll Taxes 9,000 0.8 8,000 0.7 10,000
Employee Benefits 8,000 0.7 6,000 0.6 9,000
Rent 9,000 0.8 9,000 0.8 0.7 10,000
Utilities 4,000 0.3 3,000 0.3 4,000
Telephone 4,000 0.3 2,000 0.2 3,000
Supplies 2,000 0.2 1,000 0.1 2,000
Advertising and Promotion 13,000 1.1 12,000 1.1 15,000
Travel and Entertainment 13,000 1.1 10,000 0.9 13,000
Freight 16,000 1.3 16,000 1.5 18,000
Professional Fees 5,000 0.4 4,000 0.4 5,000
Depreciation 6,000 0.5 5,000 0.5 0.5 8,000
________ _____ _______ ______ _______ _______
Total Operating Expenses 200,000 16.7% $173,000 16.0% $218,000
Profit Before
Interest and Taxes $40,000 3.3% $27,000 2.6% $62,000
Interest 15,000 1.3 12,000 1.1 17,000
________ _______ _______ ______ _______ _______
Profit Before Income Taxes 25,000 2.1% $15,000 1.4% 2.5% 45,000
Income Taxes 6,000 0.5 4,000 0.4 15,000
________ _______ _______ _______ _______ _______
Net Profit $19,000 1.6% $11,000 1.1% $30,000
Re-evaluating the Plan
Once an initial plan has been established, it is often useful to review it in order to identify areas of further improvement.
In the example of My Appliances, the expected profit before income taxes, 3.2% of sales ($46,000 : $1,400,000), is well above the industry average of 2.5% and no extensive re-evaluation appears needed.
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Summary
Too often, the owners of small businesses rely upon their eyes and ears to tell them whether or not the performance of their business is up to par. Unfortunately, our eyes and ears often betray us. The sales representative with the glib tongue and quick wit may appear to be your star performer while the facts, actual sales and profit, may show that someone else is doing a far better job. The secretary who constantly appears busy may be far less efficient than another who works in a more organized fashion with fewer errors and less need for duplicate effort.
There are also many aspects of a business that our eyes and ears cannot always sense. Changes in the market, shifts in customers' economic fortunes, and gradual but seemingly irreversible increases in costs can develop into crises unless they are detected at an early stage and effective action is taken promptly.
Performance Evaluation
The establishment of a profit plan permits you to evaluate performance in your business based upon facts, not upon random observations. Certainly, there is no substitute for the "gut feel" of the small business owner in making these important decisions that affect the prosperity of the business. However, the effectiveness of the owner's gut feel, when combined with facts, can dramatically increase the accuracy of management decisions.
Profit Plan
With a well-considered profit plan, out-of-line conditions can be detected at the earliest possible date. Corrective action can be taken promptly, eliminating the erosive effect of continuing losses as well as the need to react in a time of crisis. The profit plan also permits the owner to agree upon specific responsibilities with all employees who are in a position to influence sales or costs. Their performance can be evaluated and any deficiencies brought to their at*tention so that they can participate in the development of corrective action plans. As a further plus, the disciplined thinking about the future will permit you to foresee many problems before they occur and assist you in anticipating opportunities in your market that will permit you to build your business for greater sales and profit.
Profit planning is simply the development of your operating plan for the coming period. Your plan is summarized in the form of an income statement that serves as your sales and profit objective and your budget for cost.
How Is It Used?
The profit plan is used in the following ways:
* Evaluating operations. Each time you prepare an income statement, actual sales and costs are compared with those you projected in your original profit plan. This permits detection of areas of unsatisfactory performance so that corrective action can be taken.
* Determining the need for additional resources such as facilities or personnel. For example, the profit plan may show that a sharp increase in expected sales will overload the company's billing personnel. A decision can then be made to add additional invoicing personnel, to retain an EDP service, or to pursue some other alternative.
* Planning purchasing requirements. The volume of expected sales may be more than the business' usual suppliers can handle or expected sales may be sufficient to permit taking advantage of quantity discounts. In either case, advance knowledge of purchasing requirements will permit taking advantage of cost savings and ensure that purchased goods are readily available when needed.
* Anticipating any additional financing needs. With planning, the search for needed funds can begin as early as possible. In this way, financial crises are avoided and financing can be arranged on more favourable terms.
Advantages of Profit Planning
Profit planning offers many advantages to your business. The modest investment in time required to develop and implement the plan will pay liberal dividends later. Among the benefits that your business can enjoy from profit planning are the following:
* Performance evaluation. The profit plan provides a continuing standard against which sales performance and cost control can quickly be evaluated.
* Awareness of responsibilities. With the profit plan, personnel are readily aware of their responsibilities for meeting sales objectives, controlling costs, and the like.
* Cost consciousness. Since cost excesses can quickly be identified and planned, expenditures can be compared with budgets even before they are incurred, cost consciousness is increased, reducing unnecessary costs and overspending.
* Disciplined approach to problem-solving. The profit plan permits early detection of potential problems so that their nature and extent are known. With this information, alternate corrective actions can be more easily and accurately evaluated.
* Thinking about the future. Too often, small businesses neglect to plan ahead: thinking about where they are today, where they will be next year, or the year after. As a result, opportunities are overlooked and crises occur that could have been avoided. Development of the profit plan requires thinking about the future so that many problems can be avoided before they arise.
* Financial planning. The profit plan serves as a basis for financial planning. With the information developed from the profit plan, you can anticipate the need for increased investment in receivables, inventory, or facilities as well as any need for additional capital.
* Confidence of lenders and investors. A realistic profit plan, supported by a description of specific steps proposed to achieve sales and profit objectives, will inspire the confidence of potential lenders and investors. This confidence will not only influence their judgment of you as a business manager, but also the prospects of your business' success and its worthiness for a loan or an investment.
Limitations of Profit Planning
Profit plans are based upon estimates. Inevitably, many conditions you expected when the plan was prepared will change. Crystal balls are often cloudy. The further down the road one attempts to forecast, the cloudier they become. In a year, any number of factors can change, many of them beyond the con*trol of the company. Customers' economic fortunes may decline, suppliers' prices may increase, or suppliers' inability to deliver may disrupt your plan.
The profit plan requires the support of all responsible par*ties. Sales quotas must be agreed upon with those responsible for meeting them. Expense budgets must be agreed upon with the people who must live with them. Without mutual agreement on objectives and budgets, they will quickly be ignored and serve no useful purpose.
Finally, profit plans must be changed from time to time to meet changing conditions. There is no point in trying to operate a business according to a plan that is no longer realistic because conditions have changed.
Advantages vs. Disadvantages
Despite the limitations of profit planning, the advantages far outweigh the disadvantages. A realistic plan, established yearly and re-evaluated as changing conditions require will provide performance guidelines that will help you control every aspect of your business with a minimum of analysis and digging for financial facts.
Guide Objectives
In this guide, you will learn how to do the following:
* Develop a forecast for sales and gross profit, considering all of the various internal and external factors that are relevant to the forecast.
* Develop budgets for operating expenses to quickly detect excessive expenses so that corrective action can be taken and purchasing commitments held within budgetary limits.
* Estimate net profit so that you can determine whether or not the projected return on your investment is satisfactory. You will also be able to determine how much cash will be generated from operations either for reinvestment in the business or to compensate owners for their investment.
Forecasting Sales And Gross Profit
Development of your profit plan should usually begin with a forecast of your expected sales and gross profit for the coming year. The sales and gross profit must be considered together since they are so closely interrelated. Gross profit percentages are determined by pricing policy, which also affects expected sales volume. A decision to increase the expected gross profit percentage will usually tend to decrease expected sales, while reducing the expected gross profit per*centage should increase sales.
A second major reason for beginning the profit plan with a sales forecast is that the volume of expected sales often determines a number of other factors such as the following:
* Expected changes in variable expenses, those expenses that tend to change in direct proportion to changes in sales. These could include expenses such as sales commissions or delivery costs.
* The impact of the added sales volume on the various fixed costs of operating your business. These costs, by definition, do not tend to vary in direct proportion to changes in sales volume. However, substantial increases in sales over an extended period can force an increase in many fixed expenses. For example, a sales increase realized through the addition of many new accounts could affect bookkeeping and credit costs.
* The ability of present resources such as storage space, display area, delivery capability, or supervisory personnel to accommodate the added volume.
* The need for funds to invest in increased inventory or accounts receivable to accommodate sales increases.
* Cash generated from operations to meet current operating needs as well as expansion requirements, debt repayments, and owners' compensation.
Realism
A realistic sales forecast must rely on careful analysis of market potential and the ability of your business to capture its share of this potential. The forecast should not be based upon "what you would like to do" or "what you hope to do." It must be "what you can do" and "what you will do."
Any forecast of a sales increase must be supported by realistic expectations for stronger market demand and specific marketing steps that will be taken to capture a share of this market.
The key to successful forecasting is realism. You only fool yourself if you reject reality in forecasting. Such fore*casts serve neither as a realistic planning basis nor as a reliable means of performance evaluation.
Your forecast can be the basis for important decisions such as decisions to add personnel, lease additional facilities, or increase promotional costs. If these decisions are based upon unrealistic sales expectations, any money expended on them will be wasted.
Forecasts are often presented to lenders or potential investors to guide them in their decisions. If they lack confidence in your forecast, they will certainly be reluctant to commit their funds to your business.
Every forecast should be supported by carefully considered, specific action plans. It is inadequate to forecast a sales increase of 20% or 30% without plans for specific actions to achieve the increase. These actions could include the intro*duction of new products, opening of new branches, market expansion, commitments from new customers, increased require*ments from existing customers, additional salesmen, or an intensified promotional effort to attract new customers.
Analysing Current Sales and Gross Profit
Your sales and gross profit forecast begins with analysis of current performance. Sales are usually divided into various categories. Each category is examined individually to deter*mine expected sales for the coming year.
Selecting Sales Categories
The selection of categories will depend upon the nature of your business. For example, a food broker selling to a large number of relatively small accounts might be interested pri*marily in analysing sales by product. The owner of a single retail store might choose to analyse sales by selling depart*ment, while the owner of a retail chain would probably be interested in analysing sales by outlet. An insurance broker with several agents might categorize sales by agent. An individual wholesaler might consider sales by sales territory.
Factors Affecting Sales
After categories have been selected and current sales divided among them, the various factors which can affect sales in each category must be considered. These factors could be either internal or external. Internal factors are those that you can influence. External factors are those that affect the market served by your business, but are generally beyond your control.
Internal Factors
The following are typical internal factors that could influence your sales forecast:
* Promotional plans
* Expansion plans
* Capacity restrictions
* New product introductions
* Product cancellations
* Sales force changes
* Pricing policy
* Profit expectations
* Market expansion to new customers or territories
External Factors
Among the external factors that must be considered are the following:
* Business trends
* Government policies
* Inflation
* Changes in population characteristics
* Economic fortunes of customers
* Changes in buying habits
* Competitive pressures
Analysing Gross Profit Percentages
It is often useful to begin a sales forecast with an examina*tion of your current gross profit percentage (mark-up percentage or gross profit percentage). The gross profit percentage is usually the best indicator of pricing policy which can have significant impact on sales volume. To some extent, the gross profit percentage will also reflect the buying economies of your business. However, the range over which costs of pur*chased goods will vary is not ordinarily as wide as the possible range of prices you may seek for your products.
Three Bases of Comparison
Examination of current gross profit percentages can indicate the need for pricing policy revisions to meet competition or closer attention to purchasing costs in order to provide extra gross profit without increasing prices.
The evaluation of gross profit percentages requires comparison of current performance with three bases:
* Objectives originally set for the current year, if available
* Other businesses in the same industry
* Results of prior years
Comparison with objectives permits you to determine how well you have done compared with your original expectations. Assuming that these objectives were realistic, this is often the best single performance indicator. Deviations from objectives can quickly be identified and explored in detail to determine the cause of the deviation.
Comparison with industry averages permits identification of areas where the experience of similar businesses indicates room for improvement in your own.
Unfortunately, businesses are often too quick to dismiss the applicability of industry averages to their own operation, claiming that "Our circumstances are different." Such an attitude is self-defeating. It prevents you from taking advantage of the experience of others to improve your own sales and profit. A far more productive attitude is to say, "If everybody else can realize a gross profit of x percent, then we should be able to." Until specific circumstances are identified that make it impossible for your business to be consistent with industry averages, every attempt should be made to bring performance in line with the experience of others.
Comparison of current operations with performance in prior periods permits detection of trends so that progress, or the lack of it, can be identified. It also permits evaluation in light of those specific considerations that may be unique to your business. For example, if your gross profit as a per*centage of sales is low compared with the industry, analysis of your historic performance may reveal the cause of this apparent deficiency such as reliance upon a major customer where severe competition restricts the available gross profit percentage.
Evaluating Gross Profit Percentages
Refer to the table below, which is an analysis of gross profit percentages realized by My Appliances in the year 2002. Percentages are shown for cost of sales, gross profit, total expenses, and profit before taxes as follows:
* 2002 actual
* 2001 actual
* Industry average
* 2002 objective
Each basis of comparison provides a different viewpoint of the company's operations.
MY APPLIANCES, Pty Ltd. Profit Percentage Analysis
2002 actual 2001 actual Industry average 2002 Objective
Sales 100.0% 100.0% 100.0% 100.0%
Cost of Sales 80.0% 80.5% 81.8% 80.7%
______ ______ ______ ______
Gross Profit 20.0% 19.5% 18.2% 19.3%
Total Expenses 17.9% 18.6% 14.7% 17.2%
______ ______ ______ ______
Profit Before Taxes 2.1% 0.9% 3.5% 2.1%
In 2002, My Appliances' gross profit was 20.0% of sales. This represented an improvement over their 2001 performance of 19.5%, the industry average of 18.2%, and their 2002 objective of 19.3%. By any of these measures, this should be considered favourable. Apparently, they were able to control their pur*chasing costs and realize adequate prices in order to improve upon their own previous gross profit performance as well as the industry average.
Conflicts
Sometimes financial analysis can lead to conflicting conclusions derived from identical facts. Comparing My Appliances' 20.0% gross profit with the 18.2% industry average could raise questions. If My Appliances were more com*petitive in its pricing, could it capture a larger market share? A reasonable answer to this question would depend upon thorough knowledge of their operations and the experience of their sales personnel in dealing with specific customers. Perhaps their pricing is fully competitive in their area or local retailers are willing to pay slightly more because of the superior services they offer. If this is the case, price cutting might only trim profit margins with no realistic hope of additional sales volume to offset the effects of the price reduction.
On the other hand, if their gross profit percentage is below that of the industry, a number of other questions would be raised, such as the following:
* Are they purchasing at prices that are too high to provide an adequate gross profit?
* Is their pricing structure so low that adequate gross profit margins cannot be attained?
* Are salesmen too quick to cut prices?
* Is their marketing effort too heavily concentrated in those product lines that offer a relatively low gross profit percentage?
* Is their marketing effort directed toward those high-volume accounts that are so highly competitive that gross profit must be trimmed to an unrealistically low level?
Analysis of Sales Performance
The table shown below, analyses the 2002 sales of My Appliances by account. Actual sales, gross profit, and the gross profit percentage are shown individually for major accounts and as a group for smaller accounts. These are reported on the bottom line and represent 50 small retailers served by My Appliances.
My APPLIANCES, Pty Ltd. Sales Forecast, xxx3
2002 Actual 2003 Forecast
Account Sales Gross Profit % Sales Gross Profit %
Giant Discount $ 300,000 $45,000 15.0 $323,500 $45,300 14.0
Appliance Mart 150,000 27,000 18.0 174,000 31,300 18.0
TV Centre 120,000 21,600 18.0 159,000 23,900 15.0
Whitney Brothers 80,000 15,200 19.0 100,000 20,000 20.0
Packer Electronics 70,000 14,000 20.0 40,400 8,100 20.0
Consumers Outlet 40,000 7,200 18.0 50,000 9,000 18.0
Other (50stores) 440,000 110,000 25.0 553,100 142,400 25.7
__________ ________ _____ __________ ________ _____
Total $1,200,000 $240,000 20.0 $1,400,000 $280,000 20.0
Let us consider Appliance Mart, one of the major accounts shown.
In 2002, My Appliances' sales to Appliance Mart were $150,000. These sales generated gross profit of $27,000, or 18.% of sales.
In 2003, My Appliances expects a general price increase of 5% with no change in the discount structure available to them from their suppliers.
Appliance Mart's business in 2003 is expected to be affected only by general economic conditions such as the 5% price in*crease and an expected 10% industry growth in consumer demand for electrical appliances.
Appliance Mart operates a chain of discount stores in an economi*cally stable suburban area. For 2003, they have no plans to add or eliminate any stores. There are no changes expected in My Appliances' relationship with them that would materially affect sales.
Therefore, the only factors affecting the sales forecast for Appliance Mart would be the planned 5% price increase and the general 10% increase in demand. Sales to Appliance Mart in 2003 could then be forecast as follows:
2002 Sales $150,000
+ 5% Price Increase 7,500
_______
= Subtotal 157,50
+ 10% Demand Increase 15,750
_______
= Total $173,250
This amount, $173,250, has been rounded to $174,000 and entered in the 2003 sales forecast column.
Since there is no planned change in My Appliances' dis*count structure from its suppliers, nor is there any indication that competition for Appliance Mart's business will be any more or less severe, My Appliances probably should assume that gross profit as a percentage of these sales will remain at 18.0%, the 2002 level. The gross profit expected on these sales could then be calculated as follows:
$174,000 x 0.180 = $31,320
This amount has been rounded to $31,300 and entered in the gross profit forecast column.
Subdividing Sales Categories
It is often useful to subdivide sales into more detailed classifications in order to develop a more precise forecast such as potential sales to a single customer. As an example, refer to the table below, My Appliances' sales summary by product line to Giant Discount, its major customer in XXX2. Sales, gross profit, and the gross profit percentage are shown by product line so that each line may be considered separately to determine a realistic forecast for 2003.
My APPLIANCES, Pty Ltd. Customer Sales Analysis - Giant Discount
2002 Actual 2003 Forecast
Product line Sales Gross profit % Sales Gross profit %
Television $160,000 $16,000 10.0 $184,800 $18,500 10.0%
Automotive radios 20,000 6,000 30.0 -- -- --
Table radios 30,000 6,000 20.0 34,700 6,900 20.0
Stereo 40,000 7,000 18.0 46,200 8,300 18.0
Small appliances 50,000 10,000 20.0 57,800 11,600 20.0
______ ______ _____ _______ _______ ______
Total $300,000 $45,000 15.0% $323,500 $45,300 14.0
Development of the 2003 forecast will assume that Giant Dis*count's various stores are located in areas that are represen*tative of the general economy and therefore will reflect the industry's expected sales growth of 10%; the price increase of 5% will have no significant effect on Giant Discount's sales; and competition among appliance wholesalers for Giant Dis*count's business will prevent My Appliances from increas*ing its gross profit percentage in any product line.
The first product line on the table above, television sales, could then be forecast as follows:
2002 Sales $160,000
+ 5% Price Increase 8,000
_______
= Subtotal $168,000
+ 10% Demand Increase 16,800
________
= Total $184,800
Assuming that the gross profit percentage of 10.0% on television sales is maintained in 2003, the forecast for gross profit can then be calculated as follows:
$184,800 x 0.100 = $18,480, rounded to $18,500
Giant Discount plans to discontinue its sales of automotive radios in 2003. Therefore, sales, gross profit, and the gross profit percentage for all are shown as zero on the table above.
Sales, gross profit, and gross profit percentages have all been determined for the remaining product lines and shown on the 2003 forecast on the table above. You will note that the gross profit as a percentage of total sales in the 2003 forecast, 14.0%, is well below the 2002 experience of 15.0% even though the gross profit on each product line remains the same. This is due to the elimination of the highly profitable automotive radio line which produced a 30% gross profit but is being discontinued from Giant Discount's stores. In fact, the net effect of this discontinuation is that My Appliances will realize addi*tional gross profit of less than $1,000 on sales to Giant Discount despite a sales increase of almost $24,000. This important fact probably would not have been revealed if sales to Giant Discount had not been subdivided into individual product lines for analysis.
This negligible increase in gross profit will probably be more than offset by normal cost increases in various expense accounts required to handle Giant Discount's business in 2003, At this point, the owners of My Appliances would be well advised to take a hard look at their pricing strategy to see if more favourable prices can be realized in any product line without any significant sales loss so that the gross profit earned from this, its largest account, can be improved.
Developing Expense Budgets
After a realistic forecast has been developed for sales and gross profit, expenses for the coming year must be estimated in order to establish expense budgets and to determine ex*pected operating profit.
Comparisons
As with the forecast of sales and gross profit, expense estimating begins with a review of the current year's per*formance based upon comparison with the following indicators:
* Performance in prior periods
* Industry averages
* Objectives established for the current year
For purposes of comparison, it is often useful to express each expense as a percentage of total sales.
Comparing Variable Expenses
The use of percentages as a basis of comparison and forecast*ing is particularly applicable when analysing variable expenses. Variable expenses are those that tend to change as a result of changes in sales volume. For example, if salesmen's commissions are based upon a percentage of sales, the total dollar amount of commissions earned would increase as sales increase. If sales in a month were 20% higher than expected, commissions paid would also increase 20% as a direct result of the higher sales volume.
Comparing Fixed Expenses
On the other hand, fixed expenses are not directly affected by short-term variations in sales volume. Therefore, a 20% increase in the dollar amount of any fixed expense such as salaries or rent would normally be considered unacceptable even if sales for the period increased by 20%. When com*paring fixed expense levels with objectives or from one period to another, it is more realistic to make comparisons in absolute dollars rather than in percentages.
A business has sales and rent expense in January, February, and March as follows:
Rent expense
Month Sales $ % Sales
January $100,000 1,000 1.00
February 80,000 1,000 1.25
March 125,000 1,000 0.80
As a percentage of sales, rent expense was high in February and low in March. However, this does not indicate that con*trol of this expense was more or less effective in either month. It simply reflects the changes in sales volume. In all three cases, the actual rent expense was 1,000.
Long-Range Considerations
Despite the shortcomings of using percentages to evaluate fixed expense control within the business from month to month, they can be useful when making long-term comparisons or com*parisons with industry averages. These averages normally express expenses as percentages of sales, regardless of whether they are fixed or variable.
For example, assume that a business found that its rent expense as a percentage of sales was 2% compared with an industry average of 1%. This differential would have to be offset by better than average performance in gross profit or other expense classifications if the business expects to realize net profit equal to its industry average. Perhaps the reason for the high percentage is due to an exorbitant rental expense, or it may be caused by inadequate sales. In either case, certain questions must be answered. These could include the following:
* Are we renting more space than we need?
* Is our space too expensive for our requirements?
* Could a less elaborate facility be located that would be adequate for our needs?
* Would a less costly location be sufficient?
* Is our space utilization inefficient?
* Will expected sales increases be handled without renting additional space? Will this bring our rent expense per*centage in line with the industry?
* Can the terms of our lease be re-negotiated?
Similarly, when comparing long-term performance with prior periods, the use of fixed expense percentages can be helpful. For example, if you found that warehouse salaries jumped from 2% of sales to 4%, a number of important questions would be raised. These could include the following:
* Are we now using too many warehouse personnel?
* Are warehouse personnel less efficient?
* Has ineffectiveness crept into the warehouse layout or operating procedure?
* Are warehouse workers overpaid?
* Is warehouse supervision inadequate?
Identifying Excessive Expenses
At My Appliances, no objectives were available for 2002 performance. Therefore, excessive expenses can be identified only by comparison with 2001 results, and, in some cases, with industry averages.
Industry Average Comparisons
Comparisons with industry averages are not available in all of My Appliances' expense accounts. However, this can be determined by examining those accounts on the company's income statement that can be combined for comparison with industry averages. For example, the industry averages show that office salaries for the industry were 4.9% of sales. Examining the operating expense accounts at My Appliances, the accounts that would appear to fall into this classification are the following:
* Salary - Office Manager 1.4%
* Salaries - Clerical 1.0%
* Salaries - Warehouse 1.8%
The total of these expenses, 4.2% of sales, compares favourably with the industry average of 4.9%.
Comparison with Previous Periods
The information permits comparison of all expenses in 2002 with 2001 results.
The only variable expense at My Appliances in 2002 is salesmen's commissions. These represented 2.0% of sales in both 2001 and 2002. Therefore, they would not appear to be excessive.
In the fixed expense accounts, sharp increases could be noted in the following accounts and would warrant review and pos*sible corrective action.
Account 2002 2001
Salary - Owner $24,000 $20,000
Salaries - Warehouse 22,000 18,000
Salaries - Clerical 12,000 10,000
Employee Benefits 8,000 6,000
Utilities 4,000 3,000
Telephone 4,000 2,000
Supplies 2,000 1,000
Travel and Entertainment 13,000 10,000
Comparing My Appliances' 2002 fixed expenses with its experience in 2001, significant increases are noted in almost every account. Some of these increases should be regarded with more concern than others and therefore given prompt attention. Reasons for the increases and possible corrective action must be determined.
Some increases were probably unavoidable, having been dictated by contract, legal requirements, or price increases beyond the company's control. Others could probably be reduced with closer control. For example, travel and entertainment expense jumped from $10,000 to $13,000, an increase of $3,000. This sharp increase should indicate that a closer look at all travel and entertainment expenditures is in order to determine whether or not all were necessary. Could some have been avoided by restricting salesmen's expense accounts? Could more economical means of travel have been used? Could the company eliminate unnecessary trips that resulted in costs far beyond any real value to the business?
Supplies expense doubled from $1,000 to $2,000 although the volume of business increased by only about 10%. This sales increase would not seem to indicate a need for such a sharp increase in supplies usage. Such an expense could be con*trolled by closer attention to purchasing procedures and supplies issued to employees, use of less expensive supplies where possible, and so on.
Determining Expense Budgets
Budgets for each expense must be established, considering both external and internal factors, as in sales forecasting.
From the standpoint of expense budgeting, the following would be considered internal factors:
* Corrective actions planned to bring excessive expenses in line.
* Policy changes such as new commission plans.
* Commitments such as equipment purchases, leases on new facilities, or professional service contracts.
* Planned salary increases.
* Planned changes in benefit programs.
* Additional personnel.
* Promotional plans.
* External factors could include the following:
* Inflation and its effect on price increases from suppliers.
* Tax rate increases including payroll taxes, local property taxes, inventory taxes, and so on.
* Utility rate increases.
Additionally, the interrelated effects of expense increases must be considered. For example, payroll increases will increase payroll taxes and, possibly, employee benefits. Rent on larger facilities can also involve additional utilities expense.
Initial Forecast
The table below shows My Appliances' initial forecast for 2003 operating expenses.
The owner's salary will be increased from $24,000 to $26,000.
The office manager's salary will be increased from $17,000 to $18,000.
Salesmen's salaries will remain unchanged.
The expected sales increase will cause salesmen's commissions, 2% of sales, to increase from $24,000 to $28,000.
Warehouse salaries will be increased about 5% from $22,000 to $23,000.
Clerical salaries will be increased about 17% from $12,000 to $14,000.
Payroll taxes, approximately 8% of total compensation, will increase to $10,000 as a result of the compensation increases
Employee benefits expense is expected to increase from the present $8,000 to $9,000. This increase is dictated by increased premium costs for employees' health insurance.
Rent expense will increase from $9,000 to $10,000 due to a tax escalator clause in the lease agreement and a proposed municipal tax increase.
Utilities expense is expected to remain unchanged at $4,000.
Telephone expense is expected to be reduced from $4,000 to $3,000 because of tighter controls introduced by management in response to the sharp increase in 2002.
New controls on supplies should hold this expense at $2,000 despite price increases.
To increase sales, the advertising and promotion budget will be increased from $13,000 to $15,000, a 20% increase.
Through tighter control, the owner expects to restrict travel and entertainment expense to the 2002 level of $13,000 despite the general increase in travel-related costs.
Freight expense will increase from $16,000 to $18,000 reflecting the increased sales volume and higher freight tariffs.
Professional fees are expected to remain at $5,000.
Depreciation expense will increase from $6,000 to $8,000 due to the addition of new receiving equipment being purchased at a cost of $10,000 and depreciated over 5 years.
Total operating expenses will increase from $200,000 to $218,000. Profit before interest and taxes will be $62,000, an increase from $40,000 in 2002
MY APPLIANCES, Pty Ltd. Sales And Expense Forecast July 1 To June 31, 2003
Revised
2002 2002 2001 2001 Industry 2003
Actual (% sales) Actual (% sales) (% Sales) Forecast
Sales $1,200,000 100.0% $1,080,000 100.0% 100.00% 1,400,000
Cost of Sales 960,000 80.0% 880,000 81.5 81.8 1,120,000
________ _______ _______ _______ _______ _________
Gross Profit $240,000 20.0% $200,000 18.5% 18.2% 280,000
Operating Expenses:
Salary-Owner $ 24,000 2.0% $ 20,000 1.9% 1.7 26,000
Salary-Office Manager 17,000 1.4 16,000 1.5 18,000
Salaries-Salesmen 12,000 1.0 11,000 1.0 12,000
Commissions-Salesmen 24,000 2.0 22,000 2.0 28,000
Salaries-Warehouse 22,000 1.8 18,000 1.7 23,000
Salaries-Clerical 12,000 1.0 10,000 0.9 14,000
Payroll Taxes 9,000 0.8 8,000 0.7 10,000
Employee Benefits 8,000 0.7 6,000 0.6 9,000
Rent 9,000 0.8 9,000 0.8 0.7 10,000
Utilities 4,000 0.3 3,000 0.3 4,000
Telephone 4,000 0.3 2,000 0.2 3,000
Supplies 2,000 0.2 1,000 0.1 2,000
Advertising and Promotion 13,000 1.1 12,000 1.1 15,000
Travel and Entertainment 13,000 1.1 10,000 0.9 13,000
Freight 16,000 1.3 16,000 1.5 18,000
Professional Fees 5,000 0.4 4,000 0.4 5,000
Depreciation 6,000 0.5 5,000 0.5 0.5 8,000
________ _____ _______ ______ _______ _______
Total Operating Expenses 200,000 16.7% $173,000 16.0% $218,000
Profit Before
Interest and Taxes $40,000 3.3% $27,000 2.6% $62,000
Interest 15,000 1.3 12,000 1.1 17,000
________ _______ _______ ______ _______ _______
Profit Before Income Taxes 25,000 2.1% $15,000 1.4% 2.5% 45,000
Income Taxes 6,000 0.5 4,000 0.4 15,000
________ _______ _______ _______ _______ _______
Net Profit $19,000 1.6% $11,000 1.1% $30,000
Re-evaluating the Plan
Once an initial plan has been established, it is often useful to review it in order to identify areas of further improvement.
In the example of My Appliances, the expected profit before income taxes, 3.2% of sales ($46,000 : $1,400,000), is well above the industry average of 2.5% and no extensive re-evaluation appears needed.
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Summary
Too often, the owners of small businesses rely upon their eyes and ears to tell them whether or not the performance of their business is up to par. Unfortunately, our eyes and ears often betray us. The sales representative with the glib tongue and quick wit may appear to be your star performer while the facts, actual sales and profit, may show that someone else is doing a far better job. The secretary who constantly appears busy may be far less efficient than another who works in a more organized fashion with fewer errors and less need for duplicate effort.
There are also many aspects of a business that our eyes and ears cannot always sense. Changes in the market, shifts in customers' economic fortunes, and gradual but seemingly irreversible increases in costs can develop into crises unless they are detected at an early stage and effective action is taken promptly.
Performance Evaluation
The establishment of a profit plan permits you to evaluate performance in your business based upon facts, not upon random observations. Certainly, there is no substitute for the "gut feel" of the small business owner in making these important decisions that affect the prosperity of the business. However, the effectiveness of the owner's gut feel, when combined with facts, can dramatically increase the accuracy of management decisions.
Profit Plan
With a well-considered profit plan, out-of-line conditions can be detected at the earliest possible date. Corrective action can be taken promptly, eliminating the erosive effect of continuing losses as well as the need to react in a time of crisis. The profit plan also permits the owner to agree upon specific responsibilities with all employees who are in a position to influence sales or costs. Their performance can be evaluated and any deficiencies brought to their at*tention so that they can participate in the development of corrective action plans. As a further plus, the disciplined thinking about the future will permit you to foresee many problems before they occur and assist you in anticipating opportunities in your market that will permit you to build your business for greater sales and profit.
