21 Jan Business Alchemy Lesson 11–How Much Pie Do You Get? (Profit)
Okay, so this is the last post on profit. I want to address in this post the more familiar version of reporting profit, which is the Income Statement.
I have already explained how an Income Statement can be used and what it means. When you dissect this Statement a little bit more you can find some more useful information.
Going back to the Thanksgiving dinner analogy and my mother's pies, you remember that some of my siblings come with their families and some don't depending on what is going on with the in-laws.
Up until now there have been a few consistent people with my parent's Thanksgiving dinner and they are my mother, my father and my littlest brother. Regardless of who else comes, they are present. The rest of us are inconsistent.
So if you were to assume that I am there each year and I still wanted to know how much pie I would get, you have to adjust the method for figuring that out, and you have to wait until after everyone has had pie to be able to figure things this way. In other words, when analyzing profit from an Income Statement, you can only look backwards at what has happened, you cannot use it for projecting profit or determining break-even points.
Again starting with what I know, I can figure that my mother, father and brother will be there eating pie regardless of who else comes over. They will definitely be eating pie on Thanksgiving, so I can look at how much pie they ate and add that to the equation.
Another thing that I know is how much total pie was made and, because looking at profit this way is historical, I can figure out who else was there and add up how much pie they all ate. Obviously, the pie that is left is how much I get.
I break it down this way for a reason. You start with the total number of pies. You then subtract the pieces eaten by the family members that may or may not be there at the dinner. The result is the number of pieces of pie eaten by people that may or may not be there each year.
You then subtract the pie that my mother, father and littlest brother ate and the result is NET PROFIT--the amount of pie I get to eat.
The total pieces of pie made represents the total sales once again. The pieces of pie eaten by my family members that may or may not be there are the Cost of Goods Sold, and the pie left after they have eaten is the Gross Margin or Gross Profit. The COGS are costs on your Income Statement that only exist when you are producing things. They are a mix of fixed and variable costs and only 'show up' on the Income Statement if those products and services are produced during that time period.
Gross Margin is an important number because it gauges how efficiently you are producing goods or providing services. This number is best tracked over time and compared with the Gross Margin of other months, quarters or years.
The pie that my mother, father and littlest brother eat is called Overhead, otherwise known as Selling and Administrative Expenses. These costs occur whether product is sold or not. You see, if my mother were not to host Thanksgiving dinner, she would have to borrow or buy pie from somewhere else because they would still eat pie as part of their dinner.
These costs are frequently forgotten by new owners of small businesses. Gross Margin is not the profit of the company. You must subtract your Overhead first. Make sure you do not forget these costs when you are putting together your pricing. This is part of the reason why I recommend using the Contribution Margin format for determining the cost of your goods and services, then things are not left out.
Overhead is also very important to management because analyzing your Overhead expenses is a great way to be able to increase your NET PROFIT, and this helps your business to thrive because...
Your business is THRIVING on a solid Foundation!
(I have decided to use a more positive tagline.)