The Income Statement Explained for the Non-Financial Manager
This is an exciting time of year; full of optimism and hope. It is an opportunity to look back and see what worked and what didn’t and approach the New Year with confidence that using this knowledge will enable you to be even more successful in the coming year. But what tools can you use to evaluate your progress. One of the most important is your income statement. Set up correctly this document can provide you with a lot of useful information. So, what do I mean by setting it up correctly? It should look something like the one below:
Cost of Goods Sold
When I am working with my clients I like to show each line item (expense) both in dollars and as a percentage of sales. For review purposes, when I compare periods, I use the percentages. Using the percentages highlights more effectively both positive and negative trends, since the expense may have increased in dollar terms from one period to next but actually have decreased when expressed as a percentage of sales. I also recommend reviewing your income statements monthly. My rationale for this is that, if like many small and medium sized businesses, you wait until you take your books into your accountant to have your year end prepared, it can be up to twelve months or more from when problems started until you know about them. Looking at your income statement monthly enables you to identify and fix problems before they become major. Of course, all of the preceding presupposes that you are using accounting software and keeping it up-to-date. There is no excuse for you not to use accounting software to keep your records current, as there are several packages available to choose from all reasonably priced. Let’s look at what you can do with this information.
Of course, the first thing everyone looks at is their net profit and while this is important there are so many ways in which this can be adjusted to minimise the tax burden that it is often skewed. A better plan is to look at and review the expenses. These can be broken down into variable expenses and fixed expenses. Variable expenses are expenses that vary with the amount sold; if you sell nothing your variable expenses are zero. The most common variable expenses are inventory sold (calculated as opening inventory less closing inventory), variable costs for manufacturing is production wages etc. These variable expenses make up the Cost of Goods Sold. Fixed expenses are those expenses that the business has to pay out whether sales are zero or one million dollars. Typically, they consist of things like bank charges, rent, administration wages etc.
Sales – Cost of Goods Sold (variable expenses) = Gross Margin
Gross Margin – Expenses (fixed) = Profitability of the Company
The profitability of the company is first number most people look at, as mentioned previously, this number may or may not be realistic. In addition to the tax planning used, other things to look for are the “toys”. These are items that business owners include in their business that would otherwise be personal items but for which a case can be made that they have some use in the business. These toys are really another form of income that accrues to the owner and as such for evaluation purposes are more realistically included in the owner’s wages. After identifying these items, review the other expenses but don’t do a line by line review. Experience with many small and medium sized businesses has taught that the time spent looking for ways to reduce any expense that represents less than 5% of sales does not repay the time and effort spent looking for it. That’s not to say that reducing any expense is not desirable, since for every dollar of expenses that can be reduced profit increases by one dollar.
The most important item you will look at is the Gross Margin. This amount is the one that has to cover all of your expenses, repay any loans, and provide the ultimate profitability of your business. It is the difference between the income you earn and the variable costs required to produce the income. Examples of variable costs could be as follows: retail businesses - inventory sold and shipping costs, in a manufacturing business - production costs and raw materials, in a restaurant - food costs, in a service business - contract workers. These suggestions are by no means complete and you should discuss with your financial advisors what variable costs make up your Cost of Goods Sold.
The next item to look at is the pricing. While looking at the competitors pricing for guidelines is useful, the best advice is not to copy them. Your costs could be very different to theirs and your pricing should be based on your own situation. If this means your pricing has to be higher than theirs then so be it. It just means that you have to focus your marketing efforts on why your overall product is better than your competitors. A more important factor is whether you have included your overhead in your pricing formula. Overhead is the amount of fixed expenses that you have to cover with your gross margin such as rent, utilities, administration wages, etc. It never ceases to amaze how many businesses forget about this and then wonder why they aren’t making money. These expenses are allocated to your units of sales using a formula that applies these expenses in a logical manner. When the overhead is applied in this manner it is know as Allocated Overhead and in many case can be the difference between being profitable and loosing money. The formula can be based on hours worked, units, inputs or some other factor that makes sense when considering how much overhead is required to support each unit sold. Your financial advisor will help you determine what formula you should use. The important point is to make sure you do apply it. Another important point to make about pricing is, to make sure that you are constantly adjusting your prices to cover off any increases in the costs of your product.
Now let’s go back to the gross margin and what we can do with it. The first thing you can do is to compare it with your industry average. You can do this by looking at industry comparisons to see how you stack up against others in your industry. These numbers can be found by using Dun and Bradstreet Key Business Ratios or one of the other key business ratios; these can usually be found in your local libraries. When doing this remember that these are averages and you want to be doing better than the industry average. You should only be concerned when you are below the industry average. Most businesses stop at this point in their analysis but there are a number of ways in which you can use this number. Let’s say you want to add an expense of $100,000. The first thought that comes to mind is that I only have to sell $100,000 to cover this but if this is what you think, you are going to lose money. If your gross margin is 25% of sales the actual amount you have to sell is $100,000 divide by 0.25 or $400,000. This methodology gives you a quick estimate of how much sales have to increase for any expense you want to add. If you use the same formula for your total expenses this will very quickly give you your break-even sales figure.
As you can see reviewing your income statement on a regular basis provides an excellent management tool. Even better you don’t have to be an accountant to use it.