Small Business Enterprise - SBDC November 2021

The income statement

What is it; Why should I care?

There’s an old saying that goes: “If you don’t know where you’re going, any road will get you there.” One way to find a road that will take your business to the most desirable place financially is to use what is called the income statement.

The income statement tells you where you are, where you are going and helps create a map to get there. The income statement is a very important tool in your business’ tool box, because aside from telling you how much money you have made, or lost, over a period of time, it contains useful information to help you manage your business. I have highlighted three useful calculations that will help you better understand your business and manage for sustained profitability not just survivability.

1. Cost of Goods Sold (COGS). This is an often-misunderstood part of the income statement because it’s confusing as to what to include. COGS are the variable costs associated with making a sale. It is most often the raw material costs when a sale is made. For example, in the case of a restaurant, the COGS will be the actual costs of the food served. This does not include the cup, plate, silverware, or even the cost of labor making the food; it is just the cost of the food itself. A helpful tip is to think of it as the cost of what is being sold, incurred only when you sell it. It is commonly represented by a dollar amount and as a percentage of sales.

2. Gross Margin (GM). The gross margin is a measurement that will tell you how much, or what percent, of total sales is used to cover fixed expenses. “Fixed” are expenses incurred regardless of whether something is sold. Marketing, insurance and payroll are common fixed expenses. The GM also can be referred to as the operating income. The GM is calculated by subtracting COGS from total revenue. Using the restaurant example, if the COGS was 30 percent of revenue, then the GM will be 70 percent of revenue. For every dollar of sales you generate, you will have $.70 of cash to cover your fixed expenses like payroll, marketing and insurance.

3. Breakeven Calculation. The breakeven calculation uses the COGS and GM to indicate how much in sales you will need in order to pay for all your fixed costs and breakeven. This is an important calculation because it can help business owners understand how much in sales they need to generate before the business starts making money. While the goal of a business may be to go above and beyond breaking even, using the Breakeven Calculation will provide a clear and tangible goal to reach before a business can start making a profit. The magic number is calculated by dividing total fixed costs by the GM percentage. To continue with the example of owning a restaurant, let’s say that total fixed cost in the first quarter was $10,000. Simply divide $10,000 by 70 percent (or .70). This calculation equals $14,286. This means the business has to generate $14,286 of sales, assuming $10,000 of fixed costs, at a COGS of 30 percent and a GM of 70 percent to breakeven. This calculation can be done at any point throughout the life of a business and can be used as a hypothetical to test changes in your fixed costs.

An understanding of these principles will help you manage your business instead of your business managing you.

Allen Godin is business banking consultant at the Illinois SBDC at Rockford Chamber.