Getting Clarity – Profit Equation (Part 1)
Most business owners avoid looking at their financial results. This happens because it is unclear what they are looking at and they don’t know why they should do it. The first part of this blog series will explain how to have more clarity when analyzing your business results. This can turn your financial information into a profit equation, which is the most powerful tool in driving success in your business.
Increased clarity comes from simplifying the information, and then reviewing that information on a purposeful and sustainable schedule.
Simplify the Information
Standard financial statements are designed to report your income to the government. Each different expense type is detailed on a line-by-line basis. There is a lot of information without much direction. This standard format does not help you understand your profit equation and, more importantly, how to adjust it.
The typical income statement starts with revenue, followed by the direct costs, and then finally the selling, general, and administration costs at the bottom. Indirectly, it prioritizes in our minds what is important, without highlighting the general drivers of the business.
By simplifying the expense types into three categories, you can start to identify the drivers of your profit equation.
The first cost category is comprised of marketing and selling costs. This cost drives your revenue. Revenue is not the driver, but rather the result of the marketing and selling activities. To better understand the relation, the marketing and selling costs should be shown directly after revenue and not tucked in with the rest of the administration cost.
The second category is the direct costs. These are all the expenses that develop and deliver your product or service. If you cannot trace back a cost to a specific sale then it is not a direct cost. This cost is one of the main drivers for setting prices. Direct costs are variable costs which means they increase or decrease depending on the sales volume.
Administrative costs make up the final cost category. These are all the remaining costs. They support the operations of the company and change very little from month to month. Admin costs are fixed in nature and do not correlate as much with changes in the sales volume, but rather with changes in the company’s operations.
Simply put, marketing and selling costs secure the work, direct costs complete the work, and admin costs support the work being done.
Financial information needs to be reviewed frequently. At times, business owners start to review their financial results but can easily become overwhelmed. They look at all the individual detailed expenses at every review, which can be onerous and time-consuming. A review rhythm sets up a schedule that dictates which expense categories are reviewed and how frequently.
Marketing and Selling costs – These costs are reviewed most frequently. The length of the sales cycle will help determine how frequently these costs should be reviewed. The shorter the sales cycle, the more often the review should be completed. Marketing and selling costs should be reviewed every one to two months.
Direct costs – These costs are typically a percentage of sales and should be reviewed on that basis. As long as the direct costs are at or very close to the expected percentage of sales, there is no need to review the detail frequently. When the direct costs are different than expected, they should be looked at more closely. Direct costs, as a percentage of revenue, should be reviewed at least every three to six months.
Admin costs – These costs are reviewed least frequently. Admins cost are not reviewed on a percentage of revenue basis but rather on a month to month actual amount comparison. If the costs amount does not change, there is no need to review the detail. This is not to say that the admin costs are not reviewed, but a routine detailed monthly review is time consuming and provides very little benefit. Admin costs should be reviewed at least twice a year.
Gaining more clarity on the main drivers of your profit equation is the first step. Once you know what you are reviewing, adding purpose to the reviews will change how you manage your business and build strategy going forward. Read Part 2 of this blog series here to learn how to find more purpose in your financial reviews.
Need tailored advice on creating your profit equation? Contact us and we’ll walk you through it.
*Be sure to check out our next blog here to learn how to find more purpose in analyzing your financial information