Many of my entrepreneur clients struggle with understanding their monthly income statement, as they are not accountants/finance professionals. Often their profit & loss statement is sufficient for their tax preparer at year end. However it is not very helpful in providing data to make management decisions. The following are my top recommendations:
Gross Margin Percentage
Make sure you can measure Gross Profit and can determine your Gross Margin Percentage. Sales less direct labor, material and equipment required to produce those sales (direct or variable costs) will provide you with gross profit (This example will not address change in inventory, WIP, etc.). For simplicity sake, Sales equals $1.00 and the direct labor, materials & equipment to produce that $1.00 of sales is .60 cents. Therefore, Gross Profit is .40 cents ($1.00 less .60 cents). Gross Margin Percentage is Gross Profit divided by total sales. (i.e. .40 cents gross profit divided by $1.00 Total Sales equals 40% gross margin).
As a small business owner, always track your gross profit margin percentage. Look for ways to increase your gross profit margin by continuous improvements in people, processes, and strategy. Strive to build capacity to generate higher sales volume, without increasing direct costs by the same proportion.
Consider a sales price increase. Is a sales price increase warranted? Research and determine if the marketplace will support a price increase. Is my Gross Profit Margin in alignment with industry standards? If it is not, why and what corrective action needs to be taken, if needed?
The next section of your income statement should identify your indirect or overhead expenses (indirect or fixed costs), such as utilities, office rent, office salaries, office equipment and computers, etc. One way to think about overhead or indirect expenses is: Will I incur these expenses whether my business has a lot of sales or no sales? If the answer is yes, they are most likely overhead expenses.
These expenses are required to make a business function but they do not add direct value to the production of sales. If I have $1.00 in sales and .20 cents of total overhead expenses, my total overhead expense ratio is 20% (I.e. .20 cents divided by $1.00 or 20%). Overhead expenses should be budgeted monthly.
Businesses that have been around awhile tend to have some overhead expenses that accumulate things overtime, like closets, which no longer add value and should be eliminated. Consider zero based budgeting for these overhead categories. Assume the budget is zero, then look at last year’s overhead expense detail, consider this year’s needs and only budget back the overhead expenses that add value (this will help to clean out your overhead expense closet).
The goal is to increase capacity to generate more sales with approximately the same overhead dollars through efficiencies in people, processes and technology. It is also to ensure that all overhead expenses add some indirect value to the company’s bottom line.
Determine what an appropriate net income percentage is for your business. In this illustration if we have sales of $1.00, less cost of goods sold of .60 cents, less total overhead expenses of .20 cents, then we have net income of .20 cents or 20% (i.e. .20 cents net income divided by $1.00 sales equals 20% net income.
At the end of each month, run income statement reports that compare each income & expense item for the month to your monthly budgets as well as year-to-date income statement numbers to year-to-date budget amounts. Research numbers that are out of whack, make sure the explanations make sense. Look for ways to replicate these variances, if they are good news. Look for ways to error proof or prevent these variances if they are bad news.
Know your Profit Centers
If your business has multiple locations or product service offerings, considering setting up appropriate profit centers, so you know through the income statements which location or service offering is doing well and which ones are not, therefore, needing attention or modification.
Make efforts to review monthly income statements by the tenth of each month, blocking out calendar time to accomplish. This financial report along with the Balance Sheet and Statement of Changes in Cash Flow will serve as the primary tools to monitor the financial well-being of your business.