The income statement.
Your income statement should be an indispensable tool for you. A source of insight into how you can improve the profitability of your business. In fact, if you are not skilled at organizing and mining your income statement for information of value in managing your business, it's likely your biz isn't very profitable.
The income statement is one of the three reports known collectively as "financial statements" The other two are the balance sheet and statement of cash flows. Financial statements serve three very important purposes:
1. Information for Management: Data that the directors, officers and managers can use to make smart and effective management decisions.
2. Information for Creditors: Data that presents to creditors (such as bankers and insurance companies) a true and accurate picture of the financial strength and performance of the business. Creditors have a right to accurate, timely and informative data about the entity to which they extend credit.
3. Information for Investors: Every business is owned by investors, also referred to as "stockholders," "owners," "members" or "equity holders." Clearly, the owners--current and prospective--want and need accurate data regarding performance, i.e., profitability, and position, i.e., liquidity, value, assets, debt, equity and leverage. They use the data to evaluate the performance of the directors, officers and managers and to decide whether to make changes and whether to continue as owner (or whether to invest in the first place).
The income statement is commonly referred to as a "profit and loss statement" or "P & L" A company's income statement is a record of revenue and expense over a period of time. Of course, when you subtract the expenses from revenue, what is left is the profit or loss. What sometimes causes confusion is people using various terms interchangeably as follows:
Revenue = Gross Revenue = Sales
Cost of Goods Sold = Direct Expenses = Direct Costs
Gross Profit = Contribution
Gross Margin = Contribution Margin
Operating Expenses = Indirect Expenses = Sales, General and Admin. Expenses (SG&A)
Profit = Earnings = Income = Net Income
Useful and effective financial statements have the following basic organization:
- Direct Costs
= Gross Profit
- Operating Expenses
= Operating Profit
+ Other Income
- Other Expenses
= Net Profit
The above organization is useful because it isolates and reports the gross profit of your business--a critical number. Gross profit is what drives the profitability of your entire business. Every business must earn a gross profit that is sufficient to pay the overhead expenses (i.e., operating expenses). If revenue can be increased via sales that are profitable on a gross profit basis and overhead can be held stable, bottom-line profit will improve. Here is a review of each section of the income statement and some tips for organizing them effectively.
The key is detail and categorization. You need to be able to run reports of revenue in a variety of categories: by customer, product, investment, geographic region, industry, salesperson, or whatever categories you think might provide valuable insight. The key is to find from where the revenue is coming and what the revenue trend is for each class. The data might surprise you. It might lead you to change the way you do business or prompt you to respond to unwelcome but previously undetected changes.
Today's accounting software makes it easy to break revenue down in multiple ways. Not all revenue, however, should be recorded on the "top line" (or top area of the income statement) as some forms of income are best placed at the bottom of the income statement--right after operating profit. This is where "non-recurring revenue" or revenue not associated with how the business actually earns revenue and income on a daily or weekly basis, such as interest income or income from the sale of a fixed asset, is recorded.
Cost of Goods Sold
Most sales/revenue streams have directly associated costs. For example, if you manufacture books, your direct costs might include royalty expenses, pre-press labor and materials, press time and materials, post-press cutting and gluing, shipping and handling, etc.
All costs associated directly with the delivery of a product or service should be matched with and expensed against the customer to which the product or service is provided. The customer or job should also be coded into its pertinent groups (customer type A, salesperson #8, region 5, etc.). This will allow each job, job type, customer, customer type, salesman, etc. to be evaluated for profitability. It will also allow you to run gross profit reports for each view, segment or source.
Gross Profit and Profit Margin
Gross profit is simply what is left over after direct costs are subtracted from revenue.
Revenue--Cost of Goods = Gross Profit
Example: $100--$50 = $50
The profit margin is simply the percent that the gross profit is of revenue.
Gross Profit divided by Revenue = Gross Profit Margin
Example: $50 / $100 = 50%
There is more here than meets the eye. The profitability of a business is very sensitive to its gross profit margin since it is the gross profit that must cover all overhead or operating costs of the business. As such, it is important to recognize the effect changes in gross profit margin can have on operating profit.
To illustrate, if a company has a 40 percent gross profit margin (i.e., cost of sales takes 60 percent of revenue) and a 10 percent operating profit margin, a 10 percent increase in the cost of goods sold will reduce operating profit by 60 percent. Here's the math with percentages:
Actual Adjusted Percent Change Sales 100% 100% Cost of Goods Sold (60) (66) 10% Gross Profit Margin 40% 34% SG&A (30) (30) Operating Profit Margin 10% 4% (60%)
The next time you look at the bottom line of your income statement and wonder what happened, look at your gross profit and gross profit margin. You might find some answers.
Furthermore, just as the overall profitability of a business is very sensitive to its gross profit margin, the overall gross profit margin of a business is very sensitive to the gross profit earned on the individual jobs/sales that contribute to the overall gross profit numbers. After all, the gross profit and gross margin earned by your company is simply the compilation of the gross profit and gross margin earned from your many customers, products, services, jobs, etc.
To illustrate, let's look at the impact that money-losing products can have on a company's overall profitability. Jack's Metal Treat, Inc. (JMT) has 20 types of jobs that it performs on a regular basis. JMT recently restructured their accounting system to report gross profit by customer, job and job type. Here is simplified 2012 year-to-date data:
* 2012 year-to-date revenue = $1,000,000
* The $1,000,000 of revenue was earned via 20 project types, each of which brought in $50,000, on average.
* Fixed overhead costs were, and will continue to be, $205,000 per year
* Operating profit was a negative $5,000
When the direct cost reports were run and analyzed, it was revealed that some job types required much more direct expense than others, primarily due to high labor time requirements. Two had combined direct expense totaling $150,000 on revenue of $100,000, for a $50,000 gross profit LOSS. If JMT had eliminated these offerings altogether and the labor associated with these projects, revenues would have been just $900,000 but gross profit would have been $50,000 higher, as would have operating profit. Here is the comparison:
2012 YTD Actual Proforma Revenue $1,000,000 $900,000 Costs of Goods Sold $800,000 $650,000 Gross Profit $200,000 $250,000 Fixed Expense $205,000 $205,000 Operating Profit ($5,000) $45,000 Operating Profit Margin (5%) 5%
As one can see, by simply eliminating 10 percent (two of the 20) of the jobs that lose money, JMT becomes a profitable company at a respectable operating profit margin of 5 percent. If fixed expenses could also be reduced then the bottom line would increase dollar-for-dollar and the operating profit margin would increase sharply.
Operating expenses are also commonly referred to as either "indirect expenses" or "sales, general and administrative expenses" (SG&A). Operating expenses are any expenses that cannot be directly attributed to the creation or delivery of a product or service. Common operating expenses are marketing, advertising, salaries of people that do not work directly on products that are delivered to the customer (such as "shop" personnel that fabricate a particular sign for a particular customer), legal fees, rent, utilities, phone, travel, bad debt expense and depreciation.
Operating expenses are necessary but should be minimized. Excess or unnecessary operating expenses rob your company of profit that could otherwise fall to the bottom line. Begin to manage your operating expenses more actively by putting each expense into meaningful groups. Then, study the trends in both dollars and percentage of revenue. Often, substantial reductions are possible by simply tracking the data and becoming more aware of the expenses that pilfer your profit.
Operating profit is simply what is left over after operating expenses are subtracted from gross profit. Operating profit reflects the "normal" profit or income generated from the operation of the business--a very important indicator of overall performance of the business. Like gross profit, however, operating profit is the product of more complex interactions of things that occur higher on the income statement. Track operating profit in real dollars and in percent of sales (margin), but look higher in the income statement for ways to improve operating profit.
As mentioned above, businesses will from time to time have expenses that are not associated with the ongoing operation of the business (such as legal settlement income or profit from the sale of equipment), are non-recurring (such as a very unusually high bad debt expense), or are related to the financial structure of the business (such as interest expense or income). These expenses are best applied after the operating profit line so as not to cloud the performance of the "regular and normal and ongoing" operation of the business.
You don't have to worry much about calculating the net income as it is simply the money left over after all expenses are subtracted from revenue. Like gross profit and operating profit, net income is the product of more complex interactions of things that occur higher on the income statement. Track net income in real dollars and in percent of sales (margin), but look higher in the income statement for ways to improve it.
If you are a business owner and your financial books are a bore or nuisance, you're missing the boat. You need to understand what an essential, powerful and useful tool your financial statements can and should be. Begin the process of studying your financial statements and they will come alive. You will find in them information that is life-giving and liberating to you and your business. However, you must first organize and keep them in a manner that will yield useful data. Luckily, the task is easier and cheaper than it used to be with today's accounting software packages. Talk to your accountant and develop a plan for creating and using your financials at a very high level. It literally might make the difference between mere survival and unabashed success.
Organization of an Income Statement Revenue from Product A Revenue from Product B Revenue from Service A Revenue from Service B = Gross Revenue Less: Direct Labor and Materials of Product A Direct Labor and Materials of Product B Direct Labor and Materials of Service A Direct Labor and Materials of Service B = Gross Profit Less: Indirect Selling Expenses Marketing Expenses Salaries (office administration and management) Facilities Rent and Utilities Professional Fees Travel and Entertainment Depreciation = Operating Profit Less: Non-Operating Expenses Non-Recurring Expenses Loss on Sale of Equipment Interest Expense Plus: Non-Recurring Income Non-Recurring Expenses Gain on Sale of Equipment Interest Income = Net Profit
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|Publication:||The Business Owner|
|Date:||Sep 1, 2012|
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