“If you treasure it, you should measure it!” This old adage is more commonly known among bookkeepers and financial consultants. Not to throw accountants and CPAs under the bus, but their primary concern is to be able to prepare a tax return at years end for you to see how much taxes you may owe. It’s kind of a backward thinking proposition. But shouldn’t YOU know if you’re making any money WHILE you’re making it?
Let’s use your car as a metaphor here; how do you know if you’re low on gas? If your car is going is running too hot? If your oil pressure is at a dangerous level that might shortly damage the engine? You look at your dashboard. There is a series of lights and gauges that help you decide when something is okay or worse, if something isn’t. It provides you with information to make a decision; get gas soon, add coolant to your radiator or add oil. In your business, your “dashboard” is your accounting system, if it is set up properly.
If you use QuickBooks or any small business accounting system there are several reports that you can download or look at. There are 2 major reports that every business owner should pay attention to.
The Balance Sheet gives us a snapshot of our business at any point in time. We look here typically to see our bank balances, accounts receivable (who owes us money), and our accounts payable (who we owe money to). I won’t spend a lot of time on Balance Sheets but a balance sheet can also tell us how much equity the business has by subtracting Liabilities from the Assets.
But most of the day-to-day decision making can be done by knowing how to analyze the P&L a.k.a. the Profit and Loss Statement or the Income statement.
The P&L tells us what has happened over the course of a period of time. It tells us what revenues we earned, how much we spent to get those revenues, and how much we spent on our overhead.
While typical periods of time to look at may be a month, quarter, or year they can be run for any custom time period you need. This was not always true, because in the old days we posted and closed our books each month. But QuickBooks and other accounting programs, if kept up to date each day, will provide accurate reports for a week period, 10-day period, or whatever you need or desire.
The first part of the P&L shows us all of our Revenue or the proverbial “Top Line”. There may be more than one type of revenue as you will often see Sales Revenue, Interest Revenue, and Other Revenue. But there may be other types of revenue as well. In fact, if your business has very different types of Sales Revenue, for example you do printing, but you also sell advertising I would recommend having a revenue line for each. Because, as we are about to talk about, they have very different costs associated with each type of revenue.
The second part of the P&L shows us our expenses, and if we set our accounting up properly it will show both COGS (Cost of Goods Sold, or also more recently known as Cost of Goods and Services) which is also known as Variable Expenses, and our Fixed Expenses, also known as Overhead.
The reason it is important to have these two things segregated is so we know how much it cost to serve our customer with goods and/or services (labor, materials, etc.), and how much it cost just to have our doors open for business (rent, insurance, management labor, etc.).
If your P&L does not reflect COGS and Fixed Expenses separately you may want to work with your bookkeeper to fix this issue. Without the segregation your books are good for tax purpose, but not very useful for managing your business.
The last part of the P&L is the Profit (Loss) line, or “The Bottom Line” which tells us during this period how much money was left from the Top Line Revenue after we paid the Variable and Fixed Expenses, and may be a negative number if we did not bring in enough Revenue or we paid too much for some Expenses.
Sniff Test:
When I look at a P&L I first look at the Fixed Expenses to see if any of them are significantly different than in previous months. If they are, then then I immediately look into finding out why. I also look at each line of Fixed Expenses periodically to see if we are paying for “want to haves” or “need to haves” or for alternative sources that may be cheaper.
Next, I look at Variable Expenses or COGS. To look at these properly we cannot compare to other months on a dollar-to-dollar basis, we must first convert the dollar amount to a percentage of revenue.
Word of caution here: If you have several types of revenue that are significant or material then rather than dividing the expense by the Total Revenue, you should divide by the corresponding Sales Revenue that created those COGS expenses. This will provide the most accurate picture of what it cost to create those sales.
Once you have an accurate percentage for each of the COGS expenses, then you can compare those percentages to other months to see if something is JDLR (Just Doesn’t Look Right).
A simpler way to track this is with the Contribution Margin method. Here we take the total of our COGS and divide by the corresponding Sales Revenue to obtain how much it costs us to make a dollar. We then reverse that by subtracting that amount from a dollar to find out how much we keep out of every dollar before considering Overhead.
Simple example:
Total Revenue for period = $100,000
Total COGS for period = $65,000
Therefore, it costs us $0.65 to make $1.00
Or put differently we keep $0.35 out of every Sales Revenue dollar to pay our Overhead and contribute to Profit.
The reason I like the Contribution Margin calculation is:
- I can track it each month and compare to see if our operations are getting more or less efficient.
- I can do the calculation mid-month (usually matching a pay period).
- I can use the Contribution Margin to divide into my Overhead to obtain my Break-Even
- I can determine how many Revenue dollars (additional sales) it will take for me to pay for a rent increase, a new hire, company car, new computer, etc.
- I can share the number with department heads or line personnel to provide a measure of efficiency.
- I can use it in my ROI calculations for investing in a new piece of equipment.
- I can use it in calculating pricing for goods and/or services.
For people who hate numbers, as well as people like myself that enjoy the numbers, this can be the most useful “One Number Tool” for managing your business.
Last Thoughts:
After all the money you spend to keep the books up to date, wouldn’t it be nice to have them be a very useful tool that helps you manage your business, rather than an expense just to have to have accurate taxes?
Information is ONLY as good as the decision you can make from it. With this brief overview of the key performance indicators from your P & L and balance Sheet, you can make more informed decisions about the operation of your business. After all, it’s not how much you make, it’s how much you keep!
Take it from someone who hates accounting, you don’t need to be an accountant to make good use of your accounting. It costs the same amount of money to keep your books up to date as it does to do it all at the end of the year for the Tax Man (and maybe less). So why not get a better return on the accounting expense by making sure it is a useful tool for your day-to-day decision making?
Happy Motoring! And please reach out for more detailed information.