Entrepreneurs who do not have a background in accounting or finance often have a hard time reading and interpreting their income statement. After all, they got into business because they are passionate about the primary work of their business, not the numbers. They may even be a bit embarrassed to ask their bookkeeper or CPA to explain the documents.
Don’t sweat it. We can help you to understand some of the basics that will make your monthly financials more useful to you in running your business.
Let's start with one of the most important concepts: gross margin. Gross margin is defined as revenue, minus the cost of goods sold (COGS) or the cost of services provided. These are costs directly associated with producing the products or delivering the services that generated the revenue. Costs generally included in COGS include the materials, direct labor and overhead that is required to deliver the product or service.
Typically, these costs move in direct correlation with sales. If sales increase by 25 percent, COGS will also increase by 25 percent.
Costs generally not included in COGS are costs associated with selling, senior management, accounting, finance, human resources, etc. These costs are sometimes referred to as selling, general and administrative (SG&A). SG&A is typically more fixed in nature. If sales increase by 25 percent, SG&A might remain relatively constant. However, there are exceptions to this. For example, sales commissions, which are generally included in SG&A, frequently move in direct correlation with sales.
You should look at your gross margin percent (GM%) each month. GM% is calculated as follows: GM% = ([sales – COGS] / sales) X 100. GM% generally remains fairly constant. A significant decrease in GM% may signal a problem such as increases in labor or material costs or negative price pressure. A significant increase in GM%, while positive, should be investigated also. Management needs to understand the reason for changes in GM%. Calculating GM% at the company level, while necessary, is often not sufficient.
Companies that have multiple jobs need to track GM% at the job level. We worked with a home healthcare provider who did not do this. After some investigation, we discovered that there were multiple cases where caregivers were being paid more per hour than their client was being charged -- an obvious opportunity for improvement.
Companies that sell multiple products need to track GM% by product. Failure to do so can result in products that have a negative gross margin. That is, the cost of making the product exceeds the sales price. In such cases, companies might consider raising price or discontinuing the product.
There is an old adage in business that you can’t make up for negative gross margin by increasing sales volume. It’s true. If GM% is negative, selling more will further reduce profit.
In the same way, companies that offer different services will want to calculate the GM% for each line of service. For example, an auto repair shop will want to know how much it makes doing oil changes, tune-ups and valve jobs. This information will inform pricing and help the owner decide which services to advertise.
Finally, it is usually appropriate to track GM% by area of responsibility. For example, if you have multiple salespeople, it can be instructive to calculate GM% for each salesperson. This is particularly true if the salespeople have any influence on price. In fact, many salespeople are paid based on the gross margin that their sales generate.
Tracking monthly GM% at the company level is critical in almost any business. However, calculating GM% at the more granular levels described above can be invaluable also. The specific metrics that are needed will differ by business, but the tips above will help as you design the right ones for your situation.