1. The structure of the Profit & Loss Account

The Profit and Loss account (P&L) presents the results of the company's trade over the last financial year, also called the Income Statement,

Figure: Profit and Loss Account:

Principal items of statement :

Income :

Turnover (T/O)
Revenue
Gross sales
Sales

For most purposes the terms are interchangeable and it is the money value of goods sold over the past financial year, ie. the money value of the individual product times the quantity sold, therfore we will use turnover.

Turnover less direct costs gives the Gross Profit,

The direct cost also known as the prime cost or the variable cost, for manufacturers includes: the raw material that goes into the product as per the specification and the direct labour that operates the machinery in the factory.

Q? What are the typical % of materials & of labour of the selling price to the retailer for your industry?

The Gross profit less direct costs gives the trading profit.

The indirect costs are also known as the overheads or fixed costs. They include management salaries, rates, laboratory expenses, energy costs, telephone bill, engineering costs, storage , protective clothing, etc.

Q? Why is the electricity bill a fixed cost, when it is bound to rise when there is more activity, ie more sales and new business?

A: The issue is, that how can we distinguish those costs that can be directly associated with a particular product. For example, if the National Accounts manager makes a telephone call to the buyer at a major retailer, they may discuss a range of issues across the portfolio .

Trading Profit less interest gives Profit Before Tax ( PBT)

The important point here is that interest charges has a separate line and is different in kind than an overhead cost and so, if the business has borrowed £2.5m at an interest of say 8% then the annual interest charged to the profit and loss account is:

£2,500,000 x 0.08 = £200,000

this is the charge for the use of the loan, not anything to do with any repayment.

Q? In figure above. If the current interest is 8% and the rate comes down to 5%, what is the new charge to the profit & loss and by how much does the PBT change?

A? £2,500,000 x 0.05 = £125,000     Therefore PBT = £875,000

Profit Before Tax less corporation tax = Earnings

The PBT is the profit after all costs and charges have been taken from the revenue i.e. those expenses incurred during the financial year and will be taxed at the prevailing rate.

Q? From figure above. Determine the new earnings value if the corporation tax rate is reduced by 5%?

Current rate is 200 / 800 x 100 = 25%

New rate 20% of £800,000 is £160.000

Therefore the new earnings is £800,000 - £160,000 = £640,000 an increase of £40,000

Q? Why should the Manufacturing Manager be predominantly concerned with the profit & loss account above the profit before tax line?

Lets identify how the duties and responsibilities of the manufacturing manager impact on the P / L account:

a. Sales, issues of quality and service are significant aspects of customer satisfaction.
b. Direct costs, perhaps the cost items for which the mm has the most responsibility, eg. the raw materials and labour, that is no excessive usage.
c. Overheads, the control of overheads is a major issue in factory management, particularly for a company with seasonal activity.
d. Interest, the funding of a business is a decision for strategic financial management
e. Tax, obviously UK tax rates and how companies manage their liability is a specialist area.

Therfore a), b) and c) are profit and loss account lines effected by operation managements decisions.Because of the fact that tax rates vary from year to year and from country to country, then in order to assess trends and make international comparisons, we will only use measures based on:

Gross profit
Operating profit
and
Profit before Tax

Earnings:

Sometimes referred to as profits attributed to shareholders, in other words the revenue minus all the costs, expenses , interest and tax. If I was the owner of the business then I would be able to keep all this money for myself, assuming I had little thought for the future.

However most companies that we are concerned with have shareholders and require an annual return, known as Dividends. the dividends are distributed to shareholders, pro-rata to the No. of shares held.

The rest of the earnings are ploughed back into the business, known as retained profit. The retained profit is added to the Revenue reserves on the Balance Sheet.

The split between Dividend and retentions would be a matter of policy decision. But looking at some food companies over the years I find that dividends usually give about a 6% return on the current market price of the share. Other issues might be the opportunity cost of capital ie. interest rates and weather these rates are increasing or decreasing.

2 Margins

From the P & L account we can derive a set of measures ( ratios ) expressed as a %, these margins can be used both for monitoring performance and for setting objectives. For me an objective is something which is quantifiable,

i.e. I don't say: " next year we will increase sales " but " we will set the objective of £2m increase on T/O " or " an objective of a 5% increase "

In these cases we are in a position to say whether we have achieved the objective or not at the end of the year.

Gross Profit Margin ( GPM ):

Def. Gross profit / Sales x100. = …..%

From fig a: 2,400 / 6,000 x 100 = 40%

This margin, shows how much profit ( 40p ) for every pound of sale has been made after direct materials and labour, (From Fidure above)

Eg. a 40% GPM, means that 60p in the pound has been spent on direct costs.

Q? Identify the three ways in which the GPM might be increased?

A? 1 an increases in the price of the product.

A? 2 if either of the direct elements cost less.

If in your response you indicated an increase in volume, more sales then why might this not be the case?

Gross Profit exercise (P & L figure above)

Q? If materials are 75% of direct costs, & they increase by 10%, and there is no change in the price of the product what is the impact on the GPM?

Trading or Operating Profit Margin ( OPM )

Def. Trading profit / Sales x 100 = ….%

This margin shows how much profit ( …p ) for every pound of sale has been made after both direct and overhead costs. E.g. a 30% OPM means that 70p in the pound has been spent on direct costs and overheads.

In the case of Fig a. the OPM is approx 16%

i.e. 1,000 / 6,000 x 100 = 16%

Q? Identify the different ways in which the OPM might be reduced?