Expenses and Earnings (AKA Income or Profits)
Part 2 of the Basics of your P&L (aka) Income Statement
Last week we began our review of the Income Statement and continue our review in this post. Recall that your Income Statement records the sales and expenses over time. The formula is:
Revenues – COS – Operating Expenses – Nonoperating Income (or Expense) – Taxes = Earnings
Cost of goods sold (COGS) and Cost of Services (COS)
These are sometimes known as “direct” costs because they are the costs directly involved with producing the product or delivering a service. Accountants sometimes categorize them as and product (or service) costs. You may also hear them referred to as “above the line costs.” Your direct costs vary depending on sales and tend to be variable. For example, crew labor and material costs vary depending on the project sold. The Gross Margin tracks how much of every sales dollar is spent and we can see what will be left over to cover fixed costs and profit.
No “standardized” rules for COGS
It is important to note that interpretations in which costs are included in COGS will cause discrepancies when comparing one company to another in this category. Some companies will include vacation and holiday pay for crew labor as part of the “burden” on direct labor, and others won’t. Most will include Workers’ Comp premium on those direct labor dollars, but some don’t. It’s important to understand what your numbers include before you begin evaluating ratios for comparable companies. If you are comparing your results to industry benchmarks, be sure you know what the source numbers include and for what period.
Operating expenses or indirect costs
These expenses typically don’t vary based on sales. They are sometimes known as “below the line” expenses or operating expenses. Some companies categorize them as Selling, General and Administrative (SG&A) expenses. You may hear them referred to as Overhead Costs. These indirect costs tend to be fixed and are not subject to major changes due to sales in the period. For example, rent is an indirect expense. Your rent would not increase or decrease based on the number of sales you have in the year. Similarly, your General Manager’s salary won’t fluctuate because of sales. What happens to companies with high % of fixed costs when sales drop? Profit declines.
Accrual Basis (in 000s)
Cost of Goods Sold 1,200
Gross Profit 1,200
Gross Profit Margin 50%
Indirect Expenses 640
Total Indirect Exp 802
Net Income 398
Net Income Percent 17%
Gross Profit Margin – Gross Profit / Sales = 1,200/2,400 = 50%
Net Income Percent = Net Income / Sales = 398/2400 = 17%
In this example 50 percent of every sale dollar will be left over to pay for fixed costs and profit. 33 percent of the dollar will contribute to indirect expenses and 17 percent will be available to add to profits.
Next week we will see how taxes affect the bottom line and how the depreciation and amortization expense can make a HUGE difference in the bottom line. We’ll also review how to calculate your EBITDA (Earnings Before Income, Taxes, Depreciation and Amortization) or, if you are a “Main Street” sized company, the more commonly used SDE (Seller’s Discretionary Earnings – similar type of measure). From there, we will continue to an overview of cash flow.
Would you like to discuss what a buyer would like to see in your financial results? Do you have a solid understanding of how revenue and expenses are recognized in your company? Thinking about how your company can maximize its value? We’d be happy to have a confidential complimentary conversation with you about these or any other exit/sales/buying issues.
You can reach me via email: [email protected] or on my cell phone a: 224-688-8838.
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