We probably all have a basic understanding of a Profit and Loss (P&L) statement.
However, do we know how to use it to drive profitability in our businesses on a monthly basis?
In this blog and linked blog Kevin will explain why you need 2 sets of books (!) and why Gross Margin doesn’t get enough respect! He will propose a ‘Smart’ P&L that will help you to drive profitability in your business as you scale up.
This is going to be a little harder than some of our other blogs. Whenever we cover something on one of these blogs we are trying to sift out theory for theory’s sake and focus on things that really matter and are relevant to SME business owners trying to scale their business. This is no exception We are however going to be talking accounting and numbers and even if you struggle I urge you to review it and try to apply it to your thinking.
This topic will be less relevant if you running a lifestyle business and have no intention of scaling up the business beyond you. If you are turning over £200k or more though and growing then it is perfect for you! Much of this blog is based on ‘Scaling Up’ By Verne Harnish and his team at Gazelles.
The main weakness of firms looking to scale is marketing – the second is accounting.
Most of us see accounting as a necessary evil and something to keep the tax man away – and most of us do little more than glance at our P&L.
We tend to see paying for accounts and bookkeeping as an expense to be avoided and would rather spend money on making/ delivering or selling stuff.
However, the returns in terms of profits and cash of investing a little more time (whether internal or outsourced) and attention on accounting can be significant – and for a business trying to fund growth and give the owner a decent pay packet essential.
So let’s take a look at the P&L – the profit & loss statement.
We’re all I hope familiar with a basic P&L – and as a minimum will have been shown ours by our accountant at the end of the tax year. Some of us will be producing a monthly P&L and keeping an eye on the top and bottom lines – and may be one or two items inbetween.
- Revenue/ Sales
- Direct Costs
- Gross Margin £
- Gross Margin %
- Operating/ Fixed Costs £
- Pretax Profit £
- Pre-Tax Profit £ (% of revenue)
But a P&L can look quite different between two identical businesses – depending on how you treat different items of expenditure. And a P&L produced by your accountant is aimed generally at meeting the HMRC requirements or equivalent tax authorities – and potentially to minimise tax or to some other agenda. But the point is the P&L may not have been put together with the aim of helping to make business decisions – it is likely to have been put together to meet reporting requirements. This means it can be distorted – or have distortions in it.
There are two key distortions in SMEs
- The way the owners treat their income
- The way Gross Margin is calculated
So the first thing we need to do if we want to be able to make business decisions is to clear the distortions.
That is why we need two sets of books – for the right reasons! Not to hide anything – infact quite the opposite. We want to reveal what is hidden in the numbers.
Taking owners compensation first. Most of us take a mix of salary and dividends and in addition most of don’t pay ourselves at full market rate. Both of these things can distort the P&L – leading to an incorrect picture of the true profitability. We may kid ourselves that we have made a 20% profit but in reality if we had to pay someone else the market rate to do our job then we may have made a much lower profit. If we really want to build a business that will scale, we have to see the true profitability of the business. If we kid ourselves we are making a 20% profit we probably won’t make as much effort to improve the profitability as if we see that in reality we are only making 3%.
What is more, if you ever think about valuing your business or selling it, then you would get a misleading valuation if you didn’t do this. You may have heard a business might be worth typically 3-4 times EBITDA – well EBITDA needs to be corrected to allow for market rate salaries of owners – after all a buyer will need to think about having someone in your place and paying them.
So the first thing is to restate the P&L using market rate wages for the owners – and then asking ourselves the hard questions about how we get the profit to where we want it to be whilst being able to pay us at market rate salary!
The second distortion is around Gross Margin.
Nearly every business owner I know talks about revenue. They know the saying that revenue is vanity – but we still focus on it.
A distributor turning over £4m of product and making a 5% commission is clearly very different from a service firm turning over £4m – which in turn may be very different from a manufacturer turning over £4m.
Instead of focusing on revenue we should be focussing on a redefined version of Gross Margin – and why redefined? Because again we can have very different stated Gross Margins depending on how we define it. For external discussions then fine – talk about revenue if you like – but for internal discussions and decisions talk about Gross Margin.
Gross Margin is typically sales/ revenue minus variable or direct costs – any costs that vary for every £ of sale you make. So if you buy a widget for £5 and customise it by working on it and incur £2 of labour per widget in doing so and sell it for £20, then your COGS are £7 and your GM is 13/20 or 65%
The trouble here is we have mixed Cost of Goods and Labour – so we can’t measure and work on the efficiency of our labour.
So here’s how you should redefine Gross Margin:
GM = Revenue minus non labour direct costs.
If you are a service company and you subcontract some of your direct labour then this is effectively a cost of goods and should also be taken off of the revenue to give your Gross Margin (So if I’m an accountant and I subcontract the bookkeeping for my clients – this should be treated as a cost of goods. Clearly if I subcontract general admin then this is a fixed cost not a variable cost.
So now we have a measure of Gross Margin free of distortions and we have removed the distortion of owner salaries – so we have a true measure of profit and can start thinking about setting our profit targets. We should focus on gross margin and net profit rather than sales. We also need to decide whether to calculate our profit as a percentage of revenue or of gross margin.
This may sound strange and most of us will have always thought of profit as a percentage of sales. However, as we’ve already seen there are some industries where revenue doesn’t represent the true income to the business. In these cases it makes much more sense to calculate profit as a percentage of Gross Margin. Typically if your gross margin is below 40% then you should relate profit to gross margin.
Why does this matter?
Well here’s what has been found (by Crabtree in ‘Simple Numbers’) across businesses if you calculate profit in this way:
- 5% or less pretax profit then your business is on life support!
- 10% the business is doing well but has some untapped potential
- 15% the business is in great shape
- Over 15% indicates you should make hay whilst the sun shines – it will not last as the market will figure it out and you will see increase competition
So this gives us a framework to focus our scaling up. If we are not at 15% profitability then scaling up is risky – certainly taking on more staff. The focus should be to prove that we can get to 15% with the volume we have – then we can add staff which will drop our profit margin back to 10% or so, so we focus on getting back to 15% and then repeat.
Effectively we are saying that “10% is the new breakeven”!
So here is what we should be looking at as a summary P&L
- Revenue/ Sales
- Direct Costs (Materials and Outsourced direct labour)
- Gross Margin £
- Gross Margin %
- Direct Labour costs (internal)
- Contribution Margin £
- Contribution Margin (% of revenue or GM)
- Management Labour Costs £
- Sales Labour Costs £
- Other Operating/ Fixed Costs £
- Pretax Profit £
- Pretax profit (% of revenue or GM)
- Labour efficiency ratios
- Direct Labour GM/DLC
- Sales Labour CM/SLC
- Management Labour CM/MLC
Note the ratios at the bottom. So this gets us to the number one driver of profitability – labour efficiency – or in other words how much do we get back for every £ we spend on labour? This is a ratio – not simply how much we spend on staff costs.
So if we look at an example, we have framework for scaling up.
In this example we are turning over £500k and making a 6% net profit. – so we are barely off of life support according to Crabtree’s definitions
So first we need to get to 10% net profit whilst holding the costs constant – we don’t try to spend our way towards 10%. This means a focus on productivity and may mean changing one or two employees – solution is simple but implementing it is hard!
But this is where the work we’ve talked about before comes in around finding ways to improve productivity and profitability – remember the 7 financial levers – and for a business at this stage this is where the focus has to be rather than simply trying to add more at the top end
When we get to 10% we review our people and see if any are not able to stay with the programme. Reset and keep going until you hit 15%
Then you can think about adding staff costs where you see stress points – this may be new people or it may be salary increases or bonuses – just keep the same level of productivity. Limit it so that you don’t go back below 10% net profit and repeat
As you do this you will see the Labour Efficiency Ratios change at each level of profitability – and you will begin to develop a real perspective on how your business model operates. You will know when you are over-heating and need to add people and likewise when you are running slack and need to make other adjustments
So a key lesson here in scaling up is take it slow – add one key role at a time and get back to profitability (15%) before adding the next one!
So we’ve covered a lot in this one and as I said at the beginning – if you struggle I urge you to listen to it back and try to apply it to your thinking.
So what have we learned?
Standard P&L’s have distortions in them making it hard to make sound business decisions
- Owners Compensation
- Gross Margin Distortions
So we need 2 sets of books – or at least 2 P&Ls
We also need to re-define Gross Margin to help us reveal our direct labour efficiency – it mixes labour and non-labour costs
We should get to 15% profitability before taking on more staff costs – and treat 10% as the new break-even!
- CM is the equivalent of accountants GM – but it mixes labour and non labour costs and mask labour productivity
- Anyone that spends 50% or more of their time delivering the product or service/ doing the doing goes into direct labour. The rest into management unless you have a sales team – in which case break them out separately.
- Do not split employees across groups
- Don’t confuse it by including payroll taxes and benefits