Chapter 20 - Let Your Profit and Loss Statement Work for You

Importance and problems of planned expense programs | The break-even point – definition | formula for determining | problems of accurate determination | use of the profit and loss statement for determining break-even points | graphic analysis | increased cost variations | increased sales valuations | purchasing or building an operation

The preceding chapter described how the incorporation of three basic rules transformed a simple one-page financial statement into a dynamic management tool. Mention was made of the importance of the organized data not only in determining managerial efficiency and departmental productivity, discovering reasons for sales and cost fluc­tuations, and establishing forceful sales promotion campaigns but also planning expense programs. This section elaborates on the theme of planned expense and points out the enormous value a properly designed comparative operating statement can have for any food service operator.

The importance of a planned expense program cannot be over­emphasized. Many successful food service owners throughout the United States are operating with a satisfactory profit margin because they analyze the expenses of the past period, determine the reasons for the cost's existence and institute cost control systems that are designed to reduce or eliminate those costs. In essence the planned expense concept states that the time to control or eliminate costs is before the costs are incurred, not after.

This is a vital distinction. In times of severe competition or economic depression, the difference may mean survival or bankruptcy!

If we agree that it is wiser to direct our efforts so that costs are eliminated or controlled before instead of after they are incurred, then we are simply saying that a system of information must be installed that will enable us to predict the minimum necessary expense at each variation in sales level and to create a planned program of budgeting based on this determination.

Can this system be installed?

Will it be practical in terms of time, effort, and expense?

Will the system do what it's supposed to do?

The answer to all of these questions is "yes." Not only can it be installed, but in all instances where a properly designed profit and loss statements exists, the system has been installed!

To plan expenses properly we must know the answers to three im­portant questions:

1.  At what level of sales will the revenue obtained from sales equal the total costs—how many sales dollars must be obtained before I begin to make a profit?

2.  At what level of sales will the revenue obtained from sales equal the additional amount of money spent to obtain the sales
volume—how much additional money must be spent in order
to open my doors for business on any one day?

3.  At what level of sales will my profit be $100, $200 or any given amount—with the existing cost structure how much sales volume do I need to make a given amount of profit?

The first question is answered by the break-even point. This point is defined as that level of sales volume where total sales are equal to total cost. Every operation has a break-even point. At that particular sales volume, since every cent that comes into the operation as sales goes out of the operation as costs, there are no profits and no losses.

If sales drop below this point for a sufficient period of time, the operator will lose his business. If sales are higher than the break-even point, he will make a profit. Finally, all things being equal, the higher sales volume is above this point, the greater the amount of profit that will be gained from operations.

There are many formulas for determining the break-even point. All the formulas, however, require detailed analysis of fixed, variable, and semi-variable costs. This analysis examines the relationship of each cost to sales. If costs stay the same as sales fluctuate, they are called "fixed." If the costs vary in the same proportion and direction as sales, they are called "variable." If the costs vary in the same direction as sales volume fluctuates but not in the same proportion, they are called "semi-variable."

The following example should make this clear.

	January	February	March
Sales	10,000	15,000	8,000
Food cost	4,000	6,000	3,200
Labor cost	2,000	2,700	1,760
Rent	500	500	500

In the example preceding food cost is a variable cost. As sales in­creased in February and decreased in March, food costs not only moved in the same direction—an increase in February and a decrease in March—but also moved the same, proportionally. In each instance food cost is 40 percent of sales.

Labor cost is a semi-variable cost. As sales increased and decreased, labor cost fluctuated in the same direction; however, not in the same proportion. The labor cost in January is 20% of sales; in February, 18% of sales, and in March, 22% of sales.

Rent expense remained $500 a month regardless of the changes in sales volume. Therefore, rent is a fixed expense.

A formula for determining the break-even point of an operation is:

Fixed costs + semi-variable costs + variable costs = total cost =
break-even point.
Substituting identifying letters:
FC + SVC + VC = TC = BP

Within a given range of sales, if an operation had the following average cost schedule: FC = $500, SVC = $1,000 and VC = 50% of sales, the break-even point could be determined in the following manner: $500 + $1,000 + 50% = Total Costs = 100% = breakeven point; we can eliminate TC and BP because things equal to each other are equal to the same thing. In this case, finding 100% is the same as finding TC or BP because both TC and BP are equal to 100%.

Consequently, $500 + $1,000 + 50% = 100%
and                 $500 + $1,000 = 100% - 50%
$500+ $1,000 = 50% $1,500 = 50%
therefore $3,000 = 100% = total cost = breakeven point

To prove the correctness of the formula insert sales levels above, below and at the breakeven point. Above the breakeven point there should be a profit; below, a loss; at the breakeven point, neither loss nor profit.

If sales are                                     $4,000               $2,000               $3,000
and FC - $500                                  500                   500                   500
average SVC = $1,000                   1,000                1,000                1,000
VC = 50% of sales                           2,000                1,000                1,500
                                                     ______             ______           ______
then total costs equals                     3,500                2,500                3,000
and profit (or loss) =                         500                (500) loss            - 0 -

Although the formula is relatively simple to work mathematically, its apparent simplicity is very deceptive. The principal difficulty in applying any formula is encountered in determining the exact nature and relationship to sales of every expense itemized on the Profit and Loss statement.

Food cost, for example, is considered by many to be a variable cost. But is it? At a given level of sales, say $10,000, food cost may be 42% or $4,200. However, as food sales increase, food cost will not neces­sarily rise proportionally. At a sales volume of $15,000 for example, the food cost could drop to 40% or $6,000 because of less waste, better utilization of food, a shift to heavier specifications for various food items, proportionally less cost for employee meals and other reasons. In the same manner, as sales drop, the dollar amount of food costs should drop, but percentage-wise food cost may very easily rise. Consequently, in a practical sense there are no strictly variable costs in a food service operation.

The analysis of semi-variable costs brings up other problems. Labor cost, for example, will stay fixed for a given range of sales. Thereafter, because labor is employed up to maximum productivity, any increase in sales will bring a disproportionate increase in labor cost.

To illustrate, suppose I have 4 waitresses that I am paying $1 an hour and each waitress is capable of serving 20 customers, during a one hour period. My average check per customer is $1.50. If in any one hour my sales are $120, my waitresses are working at maximum productivity, for each waitress can produce 20 times $1.50 or $30 in sales. Under these conditions my labor cost is 4/$120or 3⅓ percent. If my sales drop to $95, I will still need 4 waitresses, therefore my labor cost is still $4 an hour and my labor cost percentage becomes 4/$95 or 4.2%. If sales increase to $125, I will need another waitress, for each waitress can handle only 20 customers. Consequently, my labor cost percentage will shift to 5/$125 or 4%.

The specific problem illustrated above asks the question—if you were trying to determine the breakeven point of this operation, what figure will you insert in the semi-variable cost section of the formula? The dollar figure or the percentage figure? If you use the dollar figure, which figure should you select? If you use a percent figure, which per­centage will you choose?

There is an answer, but as you can see, the determination of the exact figures or percentages can be quite complicated. Is this intensive study of costs and its relationship to sales worth the time and effort of the manager? Yes, it has enormous value in planning an expense program, but is of little or no consequence in determining the break­even point.

There are two reasons why the average operator should not use the formula. First, the formula method of determination is only an average. Certain cost or percentage figures will be used because they are typical. Secondly, there is a much more simple method of determin­ing the break-even point.

The profit and loss statement can give you the same information in a few minutes with a greater degree of accuracy than a formula. All a manager needs is several consecutive profit and loss statements of his operation, a sheet of graph paper, a ruler and a pencil.

To illustrate, suppose that the following figures were obtained from your profit and loss statements and you wished to determine a daily break-even point for your operation:

	January	February	March
Monthly sales	8,525	8,540	10,850
Number of operating days	31	28	31
Average sales per day	275	305	350
Monthly profit	775	980	1550
Daily profit	25	35	50

All the steps taken to arrive at the breakeven point are listed below in proper sequence and illustrated on figure I.

1.  Place a zero at the lower left hand corner of the graph paper.

2.  Since $350 is the largest sales volume in this operation, start at zero and plot $350 horizontally. In this case, each square represents $5,
therefore $350 equals 70 squares. This is your sales scale.

3.  Beginning at zero again, plot $350 vertically. This is the cost scale.

4.  At right angles to the horizontal and vertical $350 figures draw a straight line to the point "S" where they will intersect.

5.  Connect "S" and "O" by drawing a straight line through these two points. This is the sales line "OS". For example, a hundred dollar sales figure can be illustrated by placing a point at "L" shown on the graph and reading down to the sales scale.

6.  Since a daily breakeven point is required, plot the average daily sales of $275, $305 and $350 as points on the sales line. On the graph they are shown as Si, s2 and s3 respectively.

7.  Deduct the amount of average daily profit from the sales of the same period by counting straight down from their respective sales the num­ber of squares equivalent to the dollar profit. For example, when average sales were 275, average profit was $25. Since each square is equivalent to $5, a point was placed five squares directly below its respective sales point. See Pi.

When all the profit points have been plotted, draw one straight line as close to or connecting all points. Extend the line from the right side of the graph to the scale on the left. This is a profit-cost line "PC". The squares below the line measure total costs at varying volumes of sales. The squares above the line to the sales line measure total profits at varying sales volumes. However, the number of squares do not have to be counted. For example, at sales of $305 point s2 on the graph, costs are at p2 and p2 is on the $270 line on the cost scales. Therefore, costs were $270 and profits were $35.

150                    200

SALES   SCALE

Notice at the $200 level of sales and costs the two lines, sales and profit-cost, intersect. At that point there are no squares above the PC line and below the sales line, therefore, there are no profits at this sales volume. Also, the cost scale indicates that at $200 sales total costs are $200. Consequently, at this point of sales volume total sales are equal to total costs. The breakeven point for this operation then is $200. The breakeven point for any operation is that point where the profit-cost line intersects with the sales line.

The graph of the breakeven point of an operation provides consider­able information to the owner. On the basis of any forecasted level of sales he can immediately see how much profit he will obtain, what his total costs should be in order to make this profit. Because of this knowl­edge he can plan an accurate expense program and determine per­formance standards for various cost and sales areas.

He also knows that under the existing cost-revenue relationships if sales drop for a prolonged period of time below $200, the breakeven point, he will fail in his business venture.

In addition he can see on the graph a visual presentation of what will happen under various hypothetical conditions. For example:

Situation I:

The owner plans to increase advertising expense $150 a month for three years. His sales volume is now $275.

Typical questions:

1. What will happen to his breakeven point?
2. How much increase in sales is needed to justify the expense?

Answers:

1. His breakeven point will change from $200 to $215.
2. At a minimum, sales should increase $15 daily.

Solution:

1.  To determine the change in breakeven point, consider the new cost. His proposed spending is $150 a month or approximately $5 a day. But $5 is an additional cost therefore it is a deduction from profit. Since profit is measured from the sales line to the profit-cost line and each square is valued at $5, the distance between the 2 lines must be shortened by one square. This is shown as point 1 on the graph (Fig. 2). From point one, if a straight line is drawn (2) parallel to the profit-cost line, it will intersect with the sales line at point 3. The intersection of the two lines marks the new break­ even point, in this case $215.

2.  In the past, at the $275 level of sales profit was $25 without the addi­tional advertising expense. Therefore, at a minimum, sales must increase so that at least the cost of advertising is absorbed and daily profits are $25. Considering the new profit-cost line as the line that would exist if advertising is increased, sales must reach at least $290, for only at the sales level are profits $25. (Measure distance between point 4 and price-cost line (2) on graph.)

Situation II:

The owner believes that if he were to install a tighter control system, he could maintain the same level of costs even if sales were to increase $600 a month or approximately $20 a day.

50                   100                    150                  200                    250                   300                  350

SALES SCALE

Typical questions:

1. What change will occur in the breakeven point?
2. How much additional profit will be gained?

Answers:

1.  The new breakeven point will change to $142.50—a difference of
$57.50.
2.  As long as the cost figures remain proportionally the same, the amount of additional profit will be $20 daily.

Solution:

1.  The new breakeven point may be determined by considering the rela­tionship of cost to sales. Since costs are going to be maintained at the same level, the price-cost line will not change. At the former $275 sales volume, the owner believes that he will obtain $20 more sales daily at the same cost, $250, see (5), therefore $20 is added to the sales line at that cost point, see (6). If a line is drawn from point 6 parallel to the sales line, it will inter­sect at 7, the new breakeven point.

There are many possible situations involving the use of the break­even point in the specialized food service industry. Perhaps one of the most interesting uses to prospective buyers of restaurant operations is the demonstration of the feasibility of purchasing or building an operation.

Let's assume that a prospective owner plans to build a food service facility and wishes to investigate the feasibility of his action. Analysis of various contractors', jobbers', equipment dealers', estimates indicate that total investment in the proposed operation will be $100,000 for the building, fixtures and equipment. The owner desires a net profit be­fore income taxes of 20 percent of his investment or $20,000 annually.

1.  What is the minimum sales needed to break-even?

2.  How much volume must be obtained to earn $20,000 annually in the form of net profit before taxes?

Solution:

Based on his previous experience and an investigation of typical operating costs in the area, the prospective operator determined that the following estimates of costs should be correct.

     Estimated Profit and Loss Statement
Recovery of principal (annual depreciation)                      10,000
Food Costs                                                    40%
Labor Costs                                                  28%
Administrative Costs                                        7%
Supplies                                                          3%
Repairs and Maintenance                                 2
Legal and Auditing                                          1
Utilities                                                           2

Advertising                                                     2
Other Costs                                                    3  .
  I. Total costs                                                         88% plus    10,000
                  Profits before taxes                                                 20,000
II. Grand total, costs and profit                                 88% plus    30,000

Since the breakeven point is that point in sales volume where total costs equal total sales, the breakeven point is equal to the total costs without consideration of the profit figure. The total costs of this opera­tion are 88% plus 10,000 (see I above);

therefore                 88% + 10,000 = Total costs = Breakeven point
and                         88% + 10,000 = 100%
consequently           10,000 = 100% - 88%
or                           10,000=12%
and by dividing        10,000 by 12%   
                              $83,333 = 100% = annual breakeven point

To determine the sales volume required to obtain $20,000 annually in the form of net profit before taxes with the existing cost schedule, profit must be added to the total cost figures. Because total costs plus profit is 88% plus 30,000 (see II above), total sales must equal 88%, plus 30,000;

therefore                 88% plus 30,000 = total sales required
and                         88% + 30,000 = 100%
consequently           30,000 = 100% — 88%
or                           30,000=12%
and by dividing        30,000 by 12% 
                              250,000 = 100% = total sales needed to obtain
                              $20,000 net profit before income tax

Is the prospective owner's plan feasible? The practicability of his plan will depend on the sales potential of the area. The analysis above states that with the existing cost structure, the operator will need $83,333 sales annually just to break even. He must obtain a minimum annual sales volume of $250,000 to make the profit he desires.

Knowing the annual sales volume required, the operator can now make a detailed analysis of sales potential in the area. By studying the direction, density, duration, type, sex, age, and income levels of the traffic at the proposed site, and investigating the past sales history of the particular neighborhood and relating this information to the average check, the type of menu and services he plans to offer his patrons, the number of operating days, he will be able to determine whether he should begin building or find another location.

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