Profit of the company and its use - how confusion easily leads to incorrect decisions

Small introduction

As a consultant in management accounting, corporate finance and budgeting, I often encounter a variety of profit and loss accounting methods and holivars in choosing one or another P&L report model, which uses different theories from textbooks and references to authorities that they do well for them. ”

In practice, experts say the impossibility of a unified management theory is considered and a great many of them are considered, depending on various factors of their applicability and effectiveness.

But nevertheless, there are fairly general grounds for assessing both one's own managerial competence and the quality of the designed management reporting in the sense of its convenience for substantiating management decisions.

And these common grounds are all the more useful the more at an earlier stage companies are realized and consciously considered.

The difference between the sources of profit and the purposes of its use

The most common problem, leading to disputes, erroneous decisions, misunderstanding and dissatisfaction, lies in a clear dilution in management accounting of costs that generate profit from expenses that are made at the expense of profit, but do not reduce it.

The main principle here is that the costs that form the profit cannot be reduced without reducing the proceeds. They are closely related to the concept of "cost of production."

Without going into deep details and various studies, you should arm yourself with only common sense and a small cheat sheet.

First of all, it is necessary to structure the report on the formation and use of profit at the highest level, so that in the future there will be no problems with clarifying the nature of certain expenses.

Analytically, there are only four sections in our report that clarify the analysis and lead to the most informed management decisions.

Section 1. Profit (or loss) from operational commercial activities
Section 2. Use of profit to support current business activities
Section 3. Adjustment of profit (or loss) from current financial operations
Section 4. Use of profit to ensure investment expenses (company development)

To the group costs forming the profit from operational business activities include the following categories:
- Direct costs directly related to how each specific product unit generates yruchku
- Direct costs that are not directly related to certain units of production, but can be attributed to them on an economically viable basis
- Overhead costs that cannot be attributed on an economically viable basis to groups or categories of products (mainly because of the limited possibilities for detailed accounting ), but we understand that these expenses are related to cost and we can make a decision about the proportion to which group of units of production it would be fair to attribute them.

It is very important to remember that in this category and we take into account only those expenses that directly determine the profit from sales, regardless of the current administrative and financial burden

Here we can easily calculate the “unit economy”, understanding the necessary grounds for decisions about the possibility of scaling a business. This is a process-oriented budget, and it is focused exclusively on the process of reproduction of sold “units”.

All other expenses should fall into the remaining three sections, since they, in fact, use the generated profit, and by themselves cannot form it. These are supporting processes, only supporting the core, but not replacing it.

Failure to understand this often leads to the impossibility of good management, since reports mixing the main and supporting processes do not allow to make informed decisions.

However, in order for the quality of managerial decisions to be the highest, one should also consider the structure of these, in fact, auxiliary sections.

The structure of the second section should primarily reflect the management’s assessment of the effectiveness of the expenses incurred, so the following categories should be distinguished:
- Use of profit to cover economic expenses whose efficiency
is doubtful
- Use of profit to cover economic expenses recognized ineffective

The structure of the third section reflects changes in the profit (loss) in essence committed by financial bulk operations and includes categories:
- Increase of profit due to management of fixed assets
- Use of profit to cover planned financial costs
- Use of profit to cover forced unplanned financial costs
- Use of profit to cover financial losses due to erroneous decisions

Finally, the structure of the fourth section reflects how the use of profit was reflected in its reinvestment in development business and contains the following categories
- Increase (return) in profit from current investment operations
- Use Profit leverage to cover planned business development expenses

A few points about the important, but not mentioned above

Most often, such an analysis is done on the basis of financial flows (i.e. cash flow or Cash Flow). This approach is justified if changes in assets and liabilities at the beginning and end of the period are insignificant. If some assets or liabilities of a business change significantly, these changes should be correlated correctly with the recorded costs (and income).

Such an analysis can be done continuously (i.e., on an accumulative basis from the very start of a business) or split into various periods convenient for analysis (per week, month, quarter, year)

You can draw conclusions about the effectiveness of maintaining a managerial account of income and expenses in the proposed structure yourself, based on your experience and satisfaction with the results. Of course, “the devil is in the details” and you may have questions about how to apply all this in practice, in the current conditions of a particular company. I promise to prompt as they arise in the comments