Improving Profits (Explanation Part 1)

Introduction to Improving Profits

A company’s accounting records and financial statements are based on accounting principles, concepts, detailed rules, etc. (To learn more, go to Explanation of Accounting Principles and Practice Quiz for Accounting Principles.)

For example, because of the cost principle and the monetary unit assumption a company’s accounting records consist only of items that were acquired in a past transaction. Those guidelines also mean the recorded items are usually reported at an amount that is no higher than their cost at the time of the transaction. While this may be convenient for auditors, who can verify past transactions instead of determining current values, it is not helpful for people who must make decisions.

Decisions—including those to improve profits—involve the present and the future. (No decision can undo the past.) Accordingly, the decision maker needs current and future amounts. Always keep in mind that the numbers in a company’s general ledger are all past, historical, or sunk amounts. Some of these historical amounts may be completely irrelevant, while others may be useful if they are adjusted to the present and future.

Fortunately, only a limited quantity of numbers may be necessary in order to make the correct decision. For example, if the executive team’s compensation will not change if the product line is expanded, then the executive team’s compensation is not relevant and does not have to be brought into the analysis on the expansion.

We will use short cases to illustrate the relevant amounts necessary to make decisions for improving profits. You should also be mindful that people from disciplines other than accounting may have different solutions for the situations. Lastly, slightly different situations could result in vastly different outcomes than those presented.

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Past Amounts May Not Be Relevant

As stated in the introduction, all decisions (including the ones that will lead to improved profits) involve the present and the future. No decision will undo the past. Since the amounts in the company’s accounting records are history, you need to be careful when using them to make decisions.

Story #1: Replacing a Recently Purchased Printer

We will use the following story to illustrate the point that past amounts (including those in the company’s general ledger) are usually irrelevant when making decisions. Several months ago, a one-person company bought a very unique, state-of-the-art printer for $2,000. We will refer to it as the “original printer.” The owner spends two hours out of her 10-hour day using the original printer to generate significant profits. Today a more advanced model of the printer has become available. The advanced model sells for $2,100 and it will cut the owner’s time in half from two hours to one hour per day. Other costs to operate the printers are identical.

The owner believes that she needs to personally operate the printer (as opposed to delegating the operation to another person) in order to maintain the company’s reputation for superb quality and customer service. If the owner obtains the advanced model, the hour saved each day will be used to generate additional revenues from existing customers.

Numbers contained in the company’s general ledger:

• Cost of the original printer: $2,000.
• Perhaps a small amount of depreciation on the original printer. (If the company prepares financial statements only at the end of the year, it is probably too soon to find any depreciation recorded.)
• The salary and benefits expense of the owner if the company is a corporation. (If the company is a sole proprietorship, there will be no compensation expense for the owner. Rather, there will be a balance sheet account to keep track of the owner’s draws.)
• Expenses of operating the original printer.

Important numbers not in the company’s general ledger:

• The value of one hour of the owner’s time. (The additional profit earned from the additional hour.)
• Money that will be received from disposing of the original printer.
• Expenses of operating the advanced model.
• The future salary of the owner.

Analysis:

• The original printer works as well as it did when it arrived.
• The original printer is somewhat obsolete due to the technology built into the advanced model.
• The $2,000 paid for the original printer is gone; it is history. No decision will undo the purchase of the original printer.
• Today’s option is to obtain the advanced, more productive model by paying up to an additional $2,100. (The amount could be less than $2,100 if the company receives money for its original printer and/or receives a tax benefit on the disposal of the original printer.)
• The hour of owner’s time saved each day in the printing operation is expected to convert into $100 per week of additional profit from the additional revenues generated.

Decision for profit improvement:

• The decision is relatively straight forward: Should the company spend up to $2,100 (assumes that the original printer cannot be sold) in order to free up one hour per day of the owner’s time? Freeing up one hour of the owner’s time is expected to generate $100 per week of additional profit. $100 per week is $5,200 per year of additional profit on a $2,100 investment. This is an enormous rate of return.

Irrelevant numbers that confuse the decision:

• The past cost of the original printer, $2,000. This cost is sunk. Don’t think about it; it is history.
• The owner’s salary. Because the owner’s salary will not change if the advanced printer is purchased, her salary is not relevant to the decision.
• The expenses (other than the person operating the printer) of operating the printers. These expenses are irrelevant because they are going to be identical whether the original printer or the advanced model is used.