This article will show the business owner how to understand and analyze an income and expense statement and perform profit analysis. Having a good business plan in place to successfully run your business is important but implementation of that plan is necessary to reap its benefits. One aspect of implementing your business plan into your company’s operations is through good income statement analysis, planning and application. As your strategic plan tracks and implements your profitable operations, it is important to understand what your income statement is telling you, how to realistically project your future profit potential and how to effectively maximize company profits.
I. INCOME STATEMENT FUNDAMENTALS
Let’s first understand what is in an Income Statement and what the various components of it represent Profit Engine Scam. Note: I am using a Manufacturing Company as an example.
A. Major Components of an Income Statement:
1. Sales and Revenue
2. Cost of Goods Sold / Cost of Sales (COGS)
b. Direct Labor
c. Manufacturing or Factory Overhead
3. Operating or Gross Margin (GM)
c. General and Administrative (G & A)
5. Pre-Tax Profit
B. Revenue / Sales:
1. Breakdown of all Products and Services and the resulting Revenue for each category.
2. Last Line should be the overall average: Units sold times the Average Unit Price.
C. Cost of Goods Sold/ Cost of Sales:
1. Cost of providing a product or service for sale.
2. In a manufacturing Company it comprises of:
a. Material: Raw material and parts required to build a unit. A significant part of each Revenue Dollar, i.e. 40% of each sales dollar on new equipment and 15% for spare parts.
b. Direct Labor: Labor cost in manufacturing a product. Typically, 7 cents of each Revenue Dollar for new equipment and 1.5 cents for spare parts. Note: Material and Direct Labor costs are Variable, varying directly to the quantity produced.
c. Manufacturing or Factory Overhead: Costs which don’t contribute directly to the production but necessary to build a product. For example, Employees of the Purchasing Department, Material and Production Control Planners, Clerks, Quality Assurance Inspectors, Manufacturing Department Personnel, etc.
Note: Overhead is a Fixed Expense, not fluctuating appreciably with output.
D. Operating Margin: Sales minus Cost of Goods Sold
2. Marketing: Usually the highest expense.
3. General & Administrative: Usually the smallest expense.
F. Pre-Tax Profit: Operating (Gross) Margin minus Expenses
II. MAXIMIZING PROFIT ANALYSIS
A. Market Analysis and Marketing Plan:
1. Must have an accurate Analysis to determine what the Market is willing to pay.
2. Understand clearly your Competitor’s pricing and develop a successful Pricing Strategy for your Marketing Plan.
3. Price War Considerations:
a. Pricing below your Competitor’s pricing may go too far and set off a Price War.
b. Competitors respond by reducing prices below market values to recapture market share lost.
c. Customers can become accustomed to the lower fair-value price, making it hard to return to pre-war pricing. Gross Margins of a profitable 50% can quickly erode to the breakeven point, typically about 30%.
d. An Accurate Market Analysis and an effectively implemented Marketing Plan understands both the Customers and Competitors responses to certain price levels.
B. After Market Sales: Spare Parts
1. Most profitable product line: 70% Gross Margin (GM), representing about 12% of Sales Revenue.
2. Cost of Goods (COGS) on Spare Parts is normally about 30 cents of each Sales Dollar when operating with a 70% Gross Margin.
a. COGS on new equipment represent about 60 cents of each Sales Dollar and a resulting 40% GM.
3. Key: Keep a high ratio of spare parts to new equipment for Maximum Profits.
a. Package Spare Parts when you sell New Equipment with a GM range of 70-95% on the various parts, discounting the New Equipment.
C. Cost of Materials:
1. Although Materials (all the parts, components and sub-assemblies of a product) is a cost that is fixed on a per unit basis, it can be manipulated for maximum profit potential.
a. Material for a manufacturing company typically represents about 38 cents of each sales dollar for new equipment and about 1.5 cents per sales dollar for spare parts, for a total average of about 39.5 cents per sales dollar.
2. Value Engineering: Designing and re-designing products for the lowest cost without performance compromises.
a. Each part and sub-assembly is analyzed to determine if comparable function can be achieved at lower costs by utilizing different materials, components, manufacturing processes or lower cost vendors.
i. An example would be adjusting a component’s tolerance from 5% to 10%, provided the design analysis finds the substitution acceptable.
ii. Simply cleaning a part during the machining or assembly steps can lower costs.
b. Examine production procedures to reduce waste and spoilage.
3. Raw Material Management: Strongly contingent on good Market Planning & Forecasting. If the forecast is too optimistic, then too much material is purchased, which unnecessarily raises inventory costs. If the forecast is too conservative or too low, then too little material is procured, which can result in late product delivery, customer dissatisfaction and lost sales, which in turn causes an increase in effective material costs.
4. Inventory Management:
a. Minimize costs through volume purchase agreements with suppliers.
i. Contract with a supplier to buy a maximum number of parts over a fixed period, normally 1-2 years.
ii. The buyer stipulates minimum and maximum monthly quantity limits in its purchase order, which allows the buyer to adjust inventory levels within the set range and to known production requirements at the time.
iii. Again this system only works well when the Marketing Forecast is accurate within reasonable levels.
iv. This also helps suppliers as they can optimally adjust their inventory and labor levels, which enables them to pass savings on to the buyer as discounts.
v. Bill-Back Clause Protections for the supplier: Protects the supplier if the Buyer doesn’t meet the minimum purchase level and/ or puts a premium or extra discount on purchases exceeding the maximum agreed level.
b. Use an integrated Computer Software Program, customized to your Company which tracks, manages, budgets and forecasts your Raw Material and Inventory needs. This system needs to be carefully integrated with your Marketing Department.