How well do you know where your profits come from?

Spring comes with the annual ritual of tax filing and pulling together of financial records and such. I thought it would be a good time to look at your business financials in a way that will help you make better decisions going forward. Most businesses have decided that less is more as far as inventory, offerings, and space are concerned. To help make those decisions we will want to make sure we identify and build on those products/services providing us the highest profit (return on investment) – hey, if we are going to work all hours of all days, we might as well get the best return we can!

In this article we will look at your income statement in a new way that gives you the ability to understand and manage your business in a more informed and profitable way. Below I provide an example of the “standard/common” way of looking at your income statement; then I will walk you through a “new/ different” way of looking at your financial statement that will help you know and understand what parts of your business “contribute” the best and highest financial returns.

Let’s look at the income statement in the standard way

Standard Income Statement Sales

- COGS (Cost of Goods Sold/Cost of Sales)

= Gross Profit

- Operating Expenses

= Net Profit

The example above should look very familiar – now we will look at your income statement in a different way. To do this I want to introduce some terms that do not typically appear on your financial statements; these terms will provide you more of an understanding and insight as to how costs behave in your business.

How costs behave?

Fixed Costs = Do NOT change based on sales

Examples of fixed costs:

• Rent/lease

• Fire insurance

• Internet

• Salaries

Variable costs: CHANGE in proportion to sales

Examples of variable costs:

• Freight

• COGS

• Direct Labor

• Commissions

Looking at the income statement in a NEW WAY

Management (used for managerial decision making) income statement

Sales

- Variable Costs

= Contribution Margin (amount left to cover fixed costs and profit)

- Fixed Costs

= Break-Even

Here is a simple example: Penny’s Pen Company

Pens sell for $1 each

Pens cost 50 cents each

Commissions 10 cents paid on each pen sold

Variable costs 60 cents per pen

Variable cost % = 60% (selling price/variable cost)

If she sells pens for $1

Pens cost her 50 cents

She pays commissions of 10 cents per pen

Her variable costs are 60 cents per pen

She has 40 cents left to cover fixed costs and PROFIT

This is called the CONTRIBUTION MARGIN (the amount each sale is “contributing” to cover fixed costs and profits).

In this case the contribution margin is 40 percent as a percentage of sales.

She wants to know…

If her fixed costs = $800,000 how much in sales does she need to break-even?

Fixed costs = $800,000, Contribution Margin = .40 (40%)

For more Petrick, see page 13

Break-even = Fixed Costs/Contribution Margin = $800,000/.40 = $2,000,000

She needs to have sales of $2 million to break-even based on her fixed costs of $800,000 for the year. As in Penny’s case, it is VERY important for you to know your break-even sales number (which includes profits)!

BREAK-EVEN WORKSHEET: DOLLAR BASIS

Let’s go through a quick exercise to better align your financial reports to your decision-making processes:

Step 1: Classify Your Costs

Using your most recent income statements classify all costs as either FIXED or VARIABLE then total each category (planned profit should be treated as a FIXED cost – if you are in doubt about an expense treat it as fixed to be most conservative).

Actual Total Sales = $ ______

Total Variable Costs = $ _________

Total Fixed Costs = $ __________

Step 2: Calculate Variable Cost Percentage For every $1 of sales, what percent goes away to variable costs?

Variable Cost % = Total Variable Costs/Actual Total Sales = ____ %

Step 3: Calculate Contribution Margin For every $1 of sales

(after paying for variable costs), what percent is left to cover fixed costs…plus any targeted profit?

100% - Variable Cost Percentage = 100% - _____ % = ______ %

Step 4: Calculate Break-Even Sales How many “cents-es” does it take to cover your fixed costs?

Break-Even Sales = Total Fixed Costs/Contribution Margin % = $ _____

Step 5: Check Your Calculations Does the sales level you figured actually break-even or give you the profits your targeted?

Break-Even Sales ______________

(minus) Variable Costs* - _______________

(equals) Contribution $$ = _______________

(minus) Fixed Costs - _______________

(equals) New Profit = _______________

*Compute this figure by multiplying break-even (above) by the variable cost percent in Step 2.

Once you have taken this new look at your income statements you will have a different understanding of the dynamics of your costs as they impact your ability to generate profits. I hope you take a fresh approach to managing your finances and learn some new distinctions of how you can improve the performance of your business. The Small Business Development Center is here to help you with this and many other aspects of managing your business well.

This article was prepared by Jerry Petrick, MBA, senior certified business adviser with the Washington State University Small Business Development Center (SBDC). Jerry provides no-cost, confidential business advisory services by appointment. He can be reached via email jerry.petrick@wsbdc.org