Explanation of the Topic...
|Part 1||Introduction to Improving Profits, Past Amounts May Not Be Relevant|
|Part 2||Amounts Unchanged Are Irrelevant|
|Part 3||How Expenses Change|
|Part 4||Business Stories #3 – #4|
|Part 5||Business Stories #5 – #8|
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 Drills 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.
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:
Important numbers not in the company's general ledger:
Decision for profit improvement:
Irrelevant numbers that confuse the decision:
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