98 Understanding the Numbers
New England Business Services Inc. (1996)
Noble Drilling Inc. (1991)
NS Group Inc. (1992)
Office Depot Inc. (1999)
Osmonics Inc. (1993)
Pall Corporation (2000)
Petroleum Helicopters Inc. (1999)
Phillips Petroleum Company (1990)
Pollo Tropical Inc. (1995)
Praxair Inc. (1999)
Raven Industries Inc. (2000)
Saucony Inc. (1999)
Schnitzer Steel Industries Inc. (1999)
Shaw Industries Inc. (1999)
The Sherwin-Williams Company (1999)
Silicon Valley Group Inc. (1999)
Southwest Airlines Inc. (1999)
Standard Register Company (1999)
SunTrust Banks Inc. (1999)
Synthetech Inc. (2000)
Textron Inc. (1999)
Toys “R” Us Inc. (1999)
Trimark Holdings Inc. (1995)
Tyco International Ltd. (2000)
Watts Industries Inc. (1999)
Wegener Corporation (1999)
NOTES
1. The American Institute of CPA’s Special Committee on Financial Reporting,
Improving Business Reporting—A Customer Focus (New York: AICPA, November
1993), 4.

13. APB Opinion No. 30, Reporting the Results of Operations (New York: AICPA,
July 1973), para. 20.
14. SFAS 4, Reporting Gains and Losses from the Extinguishment of Debt (Stam-
ford, CT: FASB, March 1975).
15. SFAS 15, Accounting by Debtors and Creditors for Troubled Debt Restruc-
turings (Stamford, CT: FASB, June 1977).
16. Exxon’s accident took the form of a massive oil spill in Alaska, and Union
Carbide’s was a release of toxic fumes in India.
17. Armco Inc. annual report, December 1998. Information obtained from Dis-
closure Inc., Compact D/SEC: Corporate Information on Public Companies Filing
with the SEC (Bethesda, MD: Disclosure Inc., June 2000).
18. Securities and Exchange Commission, Staff Accounting Bulletin No. 101
(Washington, DC: SEC, 1999).
19. Southwest Airlines Inc., annual report, December 1999.
20. This statement needs some expansion. With the exception of barter transac-
tions, almost all expenses involve a cash outflow at some point in time. In the case of
depreciation, the cash outflow normally takes place when the depreciable assets are
acquired. At that time, the cash outflow is classified as an investing cash outflow in
the statement of cash flows. If the depreciation were not added back to net income in
computing operating cash flow, then cash would appear to be reduced twice—once
when the assets were purchased and a second time when depreciation is recorded,
and with it net income is reduced.
21. To keep the books in balance, the recognition of the loss in the income statement
is matched by a reduction in the carrying value of the investment in the balance sheet.
22. SEC Reg. S-X, Rule 5-02.6 (Washington, DC: SEC, 2001).
23. SEC, Staff Accounting Bulletin No. 40 (Washington, DC: SEC, February 8,
1981).
100 Understanding the Numbers
24. Handy and Harman Inc., annual report, December 1997. Information ob-
tained from Disclosure Inc., Compact D/SEC: Corporate Information on Public

37. A hedge of foreign-currency exposure is achieved by creating an offsetting
position to the financial statement exposure. The most common offsetting position is
established by the use of a foreign-currency derivative. These issues are discussed
more fully in Chapter 12.
38. These alternative translation methods are discussed and illustrated in Chap-
ter 12.
39. Dibrell Brothers Inc., annual report, December 1993, 35.
40. Ibid., 14.
41. Arthur Levitt, The Numbers Game, speech given at the NYU Center for Law
and Business, September 28, 1998 (available at: www.sec.gov/news/speeches
/spch220.txt).
42. The earnings of a subsequent period are increased by reducing the previously
accrued restructuring charge on the basis that the accrual was too large. The amount
by which the liability is reduced is also included in the income statement as either an
item of income or an expense reduction.
Analyzing Business Earnings 101
43. Office Depot Inc., annual report, December 1999, 57, 56.
44. SFAS No. 130, Reporting Comprehensive Income (Norwalk, CT: FASB,
June 1997).
45. Translation (remeasurement) gains and losses that result from the application
of the temporal (remeasurement) method continue to be included in the income
statement as part of conventional net income. Only translation adjustments that re-
sult from application of the all-current translation method are included in other com-
prehensive income. Recent changes in the accounting for financial derivatives also
result in the inclusion of certain hedge gains and losses in other comprehensive in-
come: SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities
(Norwalk, CT: FASB, November 1998).
46. An annual survey conducted by the AICPA reveals the following pattern of
adoption of the alternative reporting methods of SFAS No. 130 for 497 firms: (1) a
combined statement of income and comprehensive income, 26 firms; (2) a separate

to catch up to his latest business idea. She dialed the number from memory.
He was as lively as usual. “Hi, Abbey, I was just going to call you.
How’s the new bird book coming?” [Of her many grandchildren, he had the most
irresistible charm.] How she loved his ability to make her feel young—and his
ability to remember never to call her anything that began with Grand
“Actually, Stephen, that’s why I’m calling. I was just reviewing my retire-
ment portfolio, and I think it’s time for me to renegotiate my royalty structure
with my publisher. I could use some help from a bright business mind.”
“Love to help you. What’s wrong with the current contract? Haven’t you
been with them since the beginning?”
“Yes I have, but things have changed. In the old days, they provided me
with many services. They brainstormed projects with me, suggested different
Cost-Volume-Profit Analysis 103
ideas such as the Baskets of Nantucket best-seller, and edited my work word-
by-word and frame-by-frame. They worked hard for me and earned every
penny they made on me. I was not the easiest artist to put up with.”
Stephen was interested. “Go on.”
“Well, now I barely talk with them. I am at the point where loyal readers
suggest many of my projects. I design them myself, edit them myself, and even
help my publisher prepare the promotion materials. They don’t work so hard
anymore. I think I have paid my dues. I want a bigger piece of the pie.”
“That could be a problem, Abbey. I just finished a case study on that in-
dustry, and it is very competitive. There are many parts to the industry value
system that ultimately ends with someone buying a book (see Exhibit 3.1). It
starts with people like you who have the intellectual capital. The next piece of
the system is the publisher, who manages the creativity process, supplies the
editing, prints the book, and markets it. Wholesalers like Ingram add value to
this system by buying books in large quantity from publishers, warehousing
them, and selling in smaller quantities to bookstores. Of course, the last piece
is the bookstore, where in-store promotion and the final sales process takes

Are you familiar with the World Wide Web?”
“I spend a good part of the day corresponding with friends on it.”
“Good. What you just said to me is that you don’t see too many pieces of
the publishing system adding value commensurate with the value they extract.
How about setting up your own Web site and selling your latest project your-
self? We would have to contract with others to provide the necessary parts of
the chain, but selling the book through our Web site is possible. It could fail,
and you would have one very unhappy publisher.”
Abbey thought she was now getting somewhere. “As long as you are get-
ting credit for it, why don’t you develop this idea further. See if it’s possible
and what my risks would be. I might even give you a piece of the action.”
COST STRUCTURE ANALYSIS
A month later Abbey met Stephen for lunch in Boston. He was excited.
“Abbey, this is what I have found so far. Setting up a Web site is very easy,
but maintaining it and keeping it fresh and exciting so that people want to re-
visit it is the challenge. Neither you nor I want to do that, trust me. I have
talked with a number of companies who offer this type of service. Many of
them were excited when I showed them copies of your past books. To set up
and maintain the site, the offers ran anywhere from a low of $25,000 a year to
four times that. The high-end ones also charge a 5% fee on all revenues gener-
ated. I think we want a high-end site that is creative, custom designed, and ex-
citing so I lean toward the more expensive ones. They are good.”
Abbey liked how he used the word we. And being an artist, she too
thought that her Web site should be exciting, creative, and different. “Go on.”
“I also found a number of printers who specialize in small run sizes, typi-
cally less than 50 books in any one printing. Their technology is called print-
on-demand, and they also work with photographs. I brought some samples of
printed photos.”
Abbey was impressed with the quality. It looked no different than her
previous books. “What would they charge?”

“Sure have. You’re still thinking about a price of $80 for this book?”
“My others have sold for that, and I think the demand for this might even
be greater. So $80 is a good assumption.”
“Okay. First, all business models have only two types of costs, variable
and fixed. Each is defined by the behavior of the total cost function. Variable
costs are those that increase proportionately with volume—basically, the more
books we sell the higher these total costs will be. They can be expressed either
on a per-unit basis or as a percentage of the selling price. Notice we have both
types. Our printing and logistics costs total $45 for each book sold—$35 print-
ing plus $10 logistics. Our Web-site sales referral cost of 10% and Web-design
cost of 5% for every dollar of revenue are examples of the latter kind of vari-
able cost. For the targeted price of $80, these costs come to $12 for each book
sold ($80 × 15%). Note this type of variable cost is a little more complicated
than the simple $45 per book—here if we change selling price, the variable
cost will change. Given the $80 selling price, the total variable cost per book is
then $57 per unit ($45 + $12). Unlike these costs, the Web-site design cost is a
mixed cost
1
and has to be broken into a variable and a fixed component. We
have already treated the 5% variable cost component. There is also a fixed
charge per year of about $100,000 if we go high-end. Note the difference in
behavior of this cost. Here the total cost is not dependent on a volume factor
such as “books sold.” Fixed costs are often called period costs since they are
time dependent. So in summary, we have a time-dependent fixed charge of
$100,000 per year, which remains the same regardless of the number of books
sold, and a variable cost, which is better understood on a per-unit or, in this
case, per-book rate of $57. I made a graph of this—what businesspeople call
cost structure (see Exhibit 3.2).”
2
106 Understanding the Numbers

600
800
1,000
1,200
1,400
1,600
1,800
0 5,000 10,000 15,000 20,000 25,000
Dollars (thousands)
Units
Relevant range
Cost-Volume-Profit Analysis 107
Ex
hibit 3.4). On my graph, this is the point where the revenue line intersects
the total cost line and is called the break-even point. After that, you are cor-
rect. For any additional book we sell, the $23 contribution per book is all profit.
So, as I see it, there is little risk since you are sure that we will sell at a mini-
mum 10,000 copies per year.”
Abbey became a bit uncomfortable. “Actually, I think this book will sell
about 20,000 copies per year at a minimum. But isn’t my alternative to stay
with my publisher? And if so, shouldn’t we be talking about whether I would be
better off with the Web site?”
Stephen was suddenly not so cocky. Abbey thought that maybe some re-
medial work on those tuition dollars was needed. “I have some work to do. Why
don’t you get back to me on that, Stephen?”
Two nights later, after faxing her two charts, Stephen phoned Abbey. “I
sent you a different type of chart, called a profit chart, which shows the two
EXHIBIT 3.3 Web site CVP analysis.
Dollars (thousands)
Units

−=
=
== books
Sales Revenue Fixed Costs Variable Costs=+
=+$$,$80 100 000 57xx