How do you define your business success? Is it simply having enough money in your bank account to pay your staff, your suppliers and provide a decent wage for yourself each week? Do you get your accountant to prepare your year-end accounts just to keep the Taxman happy?
Perhaps you use a more sophisticated system and measure your business success with benchmark ratios and base your pricing on highly detailed costing spreadsheets?
Having worked with many different small-businesses, I see a variety of ways that business owners relate to their finances. It is rare to find one who understands the complete picture of their finances, unless they have a commercial accounting background.
You may understand the principles of bookkeeping, or comprehend what your Profit and Loss and Balance Sheet reports are telling you. However, when we begin delving into the detail behind those figures, do you become lost in a sea of numbers? You’re not on your own! But there is a lot you can do to make your reports be more meaningful.
Don’t lump it all together
Too many businesses fail to isolate the revenues and costs for different products and services. They do enough to enable accounts to be produced for the Taxman, but very little to help the owner run his business. If all the revenues appear in one account, how will you know how well an individual income stream is doing? It is possible to split the sales of each product, by using sales codes which differentiate between them.
If all the material costs are lumped into one account, any attempt at working out the cost for each product will rely on estimates. Estimates are often flawed and fail to take into account the actual costs, where spoilage, reworks and price variations have an effect. By separating material costs for different products, or by setting up management systems to record usage of common materials against different products, you can find out the real costs for each.
For a manufacturing business, it is also critical to separate wage costs between production and sales/administration staff. Production wages and other labour on costs are part of the cost of bringing goods to their final state before they are sold to the customer. The costs of machinery used in the production process should also be included. These costs can be allocated to different goods sold on the basis of time or per unit.
Similarly, in a service business the cost of sales should include the wages of operators who go out to customers, together with related travel costs and equipment expenses. These costs can be allocated by job.
Once these steps are taken to split income and material costs by product or service, the Gross Profit margin can be measured for each item, or by each category.
An example of financial analysis
Let’s take a simplistic look at the sales in a business with two products:
Product A 900 units sold @ $500 @ 40% Gross Profit $180,000
Product B 2300 units sold @ $750 @ 20% Gross Profit $345,000
Total Gross Profit $525,000
Overhead Costs $525,000
Net Profit NIL
Without a proper accounting structure, we would lack the analysis to give us the Gross Profit margins by product. All we gain from these figures is Total Sales are $2,175,000 and Total Cost of Sales are $1,650,000 when we multiply the number of units sold for both products. How could we determine what was required to achieve a profit? Without knowing our profit margins, we would lean towards selling more of the higher priced product.
In contrast, armed with the Gross Profit margins, we can determine that we are better off if we put more effort into selling more of Product A, even if this means a small reduction in sales of Product B:
Product A 1500 units sold @ $500 @ 40% Gross Profit $300,000
Product B 2000 units sold @ $750 @ 20% Gross Profit $300,000
Total Gross Profit $600,000
Overhead Costs $525,000
Net Profit $75,000
The benefit of financial analysis
We have taken you through a very basic example and in reality analysis of business finances will be a lot more complex. However, the message remains the same. With the appropriate reporting structure set up for your business, you will have a more incisive picture on what is really happening. The Gross Profit margin for each product or service can be measured month by month to show you the trends – the effects of sales discounting, higher material costs, volume changes, etc. – much quicker than you would otherwise find out. With this information at your fingertips, you will have better control over your business. The decisions you make will be more timely and will be based on actual results, rather than gut feeling. This will greatly enhance your chances of running a successful business.