At the most basic level, a profit & loss (or income statement) is a report that shows your income less expenses. Hopefully, this results in a profit, not a loss.
However, if you look a bit closer, a profit & loss (or income statement) is an important tool for managing your business.
This post looks at a few warning signs that you might find and suggests what to do next.
To keep things short, I’m going to stop writing “profit & loss (or income statement)” from here and just use “profit & loss”.
An example profit & loss
To help illustrate the warning signs, I’ve prepared the below example profit & loss:
Click to see a larger image, or open it in a new tab so you don’t have to scroll so much while you read.
If your bookkeeping isn’t up to date and/or you don’t have a profit & loss to review every month, then maybe it’s time to take a look at your bookkeeping processes.
Gross profit and quoting/pricing
Gross profit is your sales less ‘direct expenses’, i.e. materials and labour used directly in creating/providing the product or service that you sell.
When many businesses prepare a quote, or work out their pricing, they usually use one or both of the following two methods: bottom-up pricing and top-down quoting. Neither is better than the other, but my personal preference is the first.
To calculate a price using the ‘bottom-up’ method, here are the typical steps:
- Start with the materials cost, e.g. $400.
- Add the labour cost, e.g. 4 hours x $40 per hour = $160.
- The total cost so far is $560.
- Now add a markup, which could be a percentage, or a set amount, or a random number based on variables like how much you like the customer. Let’s say we add 20% of the cost, i.e. $112.
Voila! The price on your quote is $672.
To calculate a price using the ‘top-down’ method, here are the typical steps:
- Decide how much the total price will be, based on your competitor’s pricing, or how much you think the customer will pay, or increase last year’s fee 3%, or some other method. Let’s say $799.
- Subtract a margin, say 20% or $159.80.
- The remainder ($639.20) you can use for the cost of your product/service.
- Find a materials supplier that will give you a low-enough price. Say you find the materials from one supplier cost $441.20.
- Find a contractor or employee that will provide the labour for a low-enough rate. Say you find a contractor who quotes $255.
- Add the materials and labour costs together and compare this to step 3. Oops, your costs from step 4 and 5 are higher than the result of step 3.
- Repeat steps 4-6 until your costs are low enough. Restart from step 2 or step 1, if needed.
Voila! You have a price to quote to the customer.
Warning sign #1: Declining gross profit
Either method works in the beginning stages of your business when you personally oversee every quote/price and you monitor the costs on every job. You get feedback on your quoting/pricing and can adjust accordingly.
But as you grow, eventually you can’t keep such a close eye on the individual quotes, prices, or jobs.
In the example profit & loss above, you can see that the gross profit goes down each month. This is the warning sign.
If you were only looking at the sales figures, you might think that the business is growing well, but it’s not. The costs are increasing faster than the sales figure, and by a particularly big leap between September and October.
There are two solutions to this warning sign.
Solution 1: Examine your costs
The first is to look closely at your costs and see if they are actually increasing and why. Are your materials costing more than they used to? Is the productivity of your workers declining? Are your contractors charging more?
Solution 2: Charge your customers more
Yes, there is a risk that they might not buy from you. But would you want someone to buy from you if you lost money every time?
There’s a lot more to write on quoting, gross profit, margins and how they limit the size of your business, but I’ll save those for a future blog post.
Marketing and Sales
It is generally accepted that it’s hard to grow a business, or even keep it alive, without spending money and/or time on marketing sales. Since time equals money (your time or someone else’s), then logically a business needs to spend money on marketing and sales to survive and thrive.
A reasonably common rule of thumb for spending on marketing and sales is 10% of your sales revenue. You can choose any number you like, but make sure to pick something above 0% and get a good return on the money you spend.
Warning Sign #2: Marketing & sales expenses less than 10% of sales revenue
The warning sign in your profit & loss is seeing your marketing and sales expenses as less than 10% (or your preferred number) of your sales revenue. The lower the number on your profit & loss, the more seriously you should take the warning sign as it is a rough indication of how much revenue you can expect in future.
In the example profit & loss I provided above, you can see the Advertising expense account increasing from 4.7% in October to 5.6% in November. It looks like the business doesn’t have enough profit to spend any more, because they’re still working on increasing their gross profit (see previous section).
I’ve touched on some topics that are too broad for this blog post: getting a good return on your marketing, why you should spend money on it in the first place, and how to calculate your ideal percentage. We’ll find a marketing/sales expert to go into greater depth on these points in a future blog post.
Don’t work for free
I’ve left the most worrying, and most insidious, warning sign for last: YOUR pay.
Your pay amount should be much higher than the minimum wage and unemployment benefits in your area. The amount should also be higher than any job you could do.
I can see value in taking less pay in the beginning; you’re investing in your vision of the future. Just make sure that you don’t build yourself a job, especially one that has low pay, long hours, no employment benefits, and a crazy workaholic boss. I’ve done it, and it sucks. The key to avoiding this is to make sure you have enough margin to pay someone else to do the work.
In the example profit & loss above, the Wages and Salaries expense line increases each month. This could be one or more employees and/or the business owner. To decide whether this is a good amount, we would have to compare it to the work they’re doing in the business, e.g. doing most of the work themselves, supervising contractors, making sales calls, managing the office, or relaxing on a beach.
Profit is not your pay
Anyone in business eventually comes across the expression “a business owner wears many hats.” Well there’s a similar concept that isn’t as well-known:
You should be paid for the work you do in the business, just as if you were an employee. You should also get a return on the business asset that you own, like any other investment.
This will help you avoid building yourself a stressful job instead of a business because it forces you to build in enough profit margin to pay someone else to do the work.
It’s also a critical concept if you ever want to sell your business because you’ll get a much higher sale price if the new owner can pay someone else to run the business, or if they can consider the profit as an extra-high wage for themselves.
Warning Sign #3: Profits Down, Wages & Salaries Up
In the example profit & loss, the profit is declining rapidly. The owner of the business should be very concerned, particularly if it’s because the CEO is paying themselves rapidly increasing wages.
Note: this discussion does not include consideration for the most optimal wage/profit ratio for income tax purposes. See your tax accountant for that.
These are just a few warnings signs to look out for in your profit & loss. To keep this post to a reasonable length, I’ve left a few for a future blog post.
Important note: your bookkeeping needs to be up to date and accurate, otherwise you won’t be able to see the warning signs. Or worse, you’ll see the wrong warning signs!
Latest posts by Ben McAdam (see all)
- 7 powerful ways to minimise tax (legally!) - 14 June, 2016
- 3 Warning Signs In Your Profit & Loss (Income Statement) - 24 February, 2016
- 5 Lesser-Known Xero Features - 15 October, 2015