Profit and Loss Statement Article

Maximizing Profits in Your Business – Profit & Loss Fundamentals, Analysis and Strategy

This Article will show the business owner how to understand and analyze an Income and Expense Statement; perform a Maximum Profit Analysis; plan for Profits; and apply Profit Maximization Principles. Having a good Business Plan in place to successfully run your business is key 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

Note: We use a Manufacturing Company as the example.

A. Major Components of an Income Statement:

1. Sales and Revenue

2. Cost of Goods Sold/ Cost of Sales (COGS)

a. Material

b. Direct Labor

c. Manufacturing or Factory Overhead

3. Operating or Gross Margin (GM)

4. Expenses

a. Engineering

b. Marketing

c. General & Administrative (G & A)

5. Pre-Tax Profit

B. Revenue / Sales:

1. Breakdown of all Products & 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 & 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 & 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

E. Expenses:

1. Engineering

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 & 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.

5. Good Relationship with Suppliers:

a. Suppliers experiencing low capacity offer better discounts.

b. Suppliers can suggest different methods, processes, materials or manufacturing tolerances to help you save money.

c. Pay your bills early or on time to receive Supplier incentive discounts. Late payments will result in higher cots being levied in the future.

d. Have excellent communication lines established with your Suppliers which can be very helpful when you hit a downturn in sales and find meeting obligations difficult.

e. Develop a Supplier Business Plan.

D. Direct Labor Cost Savings Strategies

1. Direct Labor on average for a manufacturing company should cost about 9 cents of each sales dollar; of this cost, new equipment is 7 cents and spare parts is 2 cents.

2. Keep personnel turnover low, which reduces training costs.

a. Skilled, trained labor can accomplish the same task at a lower cost, with fewer errors, along with, better efficiency & productivity.

b. Proactive Employee Incentives is much more effective than trying to retain employees through fear tactics.

c. Provide good working conditions and don’t overwork your experienced employees. Use temporary or flex workers for short-term production gear ups and upturns.

3. Locate production facilities in less expensive parts of the region which offer tax incentives and lower labor costs for highly skilled laborers.

E. Manufacturing Overhead Cost Savings

1. They key in this area is Management Control. Overhead typically accounts for about 14 cents per sales dollar.

2. Good Control Mechanisms executed from the outset can keep costs in check without Budget cutting.

3. Overhead Cost Management is divided into three areas:

a. Facilities, Communications & Data Management

b. Indirect Labor

c. Operating Expenses

4. Facilities: Immediate space requirements should have expansion options which meet your Company’s Strategic Plan Goals.

a. Ensure your Facility is designed to minimize utility costs and located in an area which has reasonable utility rates.

5. Communications: Bundle your communication needs into a package for maximum cost minimization, better company integration and superior operating results.

a. Bundle your communications with a Company that offers excellent customer service as that keeps expensive down-time to a minimum.

b. Bundle a maintenance contract with your Communications package to minimize long-term costs.

6. Data Management: Utilize a Consulting Firm to customize a Data Management system to your Company’s products and operations. This should be carefully linked to the Marketing and Strategic Planning Departments, while also fully integrated into the Company’s procurement, inventory, sales and operations areas.

7. Indirect Labor: Typically the second largest expense of operations departments in manufacturing companies. This is an area where maximum Control can be utilized.

a. Weigh the costs of trained labor verses inexpensive labor and determine a cost effective, yet productive mix of the two.

b. Utilize strict employment level management. Indiscriminate hiring and firing has detrimental long-term effects.

c. Foster strong Employee communications, mutual trust and relations, which ensures efficiencies and lower overall labor costs.

8. Operating Expenses: The least expensive operational category for a manufacturing concern.

a. The key here is avoiding waste.

b. Satisfied employees, who understand how waste negatively affects their pay and benefits through lower productivity and higher per unit costs, will reciprocate in adhering to Waste Management Procedures.

F. Cost of Goods Sold (COGS)

1. Understand that COGS is the sum of Materials, Labor and Overhead. COGS can amount up to 61% of each sales dollar, so just 1% saved here can make a significant impact on Pre-Tax Profits.

G. Gross Margin (GM)

1. The difference between Sales and COGS. For a Manufacturing Company, a good target goal is 50% GM, as break-even is often in the 25-30% range. While 50% GM can be a difficult goal, ensure you have at least a 10% cushion between GM and Break-Even to ensure profitable operations during slow periods or unpredictable circumstances.

2. How do you maximize GM?

a. Effectively managing your Company’s Engineering Costs and G&A expenses.

b. Realistic and integrated Market Planning.

c. Any costs minimized in Engineering, Marketing and G&A adds significantly and directly to Pre-Tax Profits.

3. Manage Engineering Costs:

a. Consider Engineering as an Investment and should be integrated closely with your Company’s Strategic Plan. The most expensive cost initially, stabilizing to @ 9 cents per sales dollar.

b. Accurate Statement of Work: Engineering Manager divides each project/ product into components of skill, time, skill hours, labor requirements, labor costs, benefits costs, supply costs, material costs and so forth.

c. You cannot manage costs until they are broken down, identified and quantified.

d. Engineering Cost Management should be closely aligned with the Strategic Planning Department’s Budgeting Process and Controls in order to fully maximize cost reductions in this area.

4. Marketing Expenses: Generally the highest of the three Expense Categories for Manufacturing Companies. 10 cents per sales dollar is typical for a stabilized Manufacturing Company.

a. Areas to Analyze: Salaries and commissions of sales people; manufacturing reps commissions; product managers salaries; service and administrative personnel salaries; advertising and travel costs; communication costs; supply costs.

b. Understand how Bonuses and Incentives can significantly increase the productivity value of your Marketing Expense bottom line.

5. General & Administrative Expenses (G&A): Typically the least expensive expense category for a manufacturing company. 7 cents of each sales dollar is a good goal.

a. Components Include: CEO, Executives, Finance, Accounting, Personnel and Support Staff.

b. Primary expense item in this category are salaries, so Competitive Salary Structures should be monitored regularly to ensure the 7% goal is maintained.

6. Total Expenses: For a manufacturing company, total Expenses normally account for 25 cents of each sales dollar. The remainder is Pre-Tax Profit, which should typically be in the 15% range or 15 cents per sales dollar.

H. Pre-Tax Profit: Pre-Tax Profits can only be effectively maximized through a step by step Analysis of a Company’s Income Statement, ensuring it is closely aligned with a Company’s Income Statement, ensuring it is closely aligned with a Company’s Marketing Analysis, Marketing Plan and Strategic Planning. The resulting strategy will significantly minimize Expenses, which has a direct effect on Pre-Tax Profits. This should be a comprehensive, cumulative approach in order to achieve maximum Profitability.

I. After-Tax Profits: In a 30% tax bracket, after-tax profit is 10.5% or 10.5 cents per sales dollar.

1. Higher or lower resulting tax brackets can significantly affect After-Tax Profits, so utilizing an Accounting and Tax Firm specializing in your business is highly important.

2. Average after-tax profit for Manufacturing Companies runs about 5%.

3. After-Tax Profits are vital to a Company’s Growth and Investment, resulting in more Retained Earnings and higher Cash Flows and needed when opportunities arise in the market.

4. Cash Accumulation allows for better leverage and terms when negotiating funding to expand and grow your Company.

J. Summation of Components: The Income Statement Analysis illustrates how sales dollars are distributed and how to minimize costs in order to maximize profits. Central to this step by step, cumulative Analysis is to determine how each Income Statement Component’s percentage of cost contributes to the Sum Total, as adjusting each component has an exponential effect on Profitability. Profits can only be maximized by clearly understanding and managing its parts.

Now that we have discussed the Fundamentals of the Income Statement and performed a Maximum Profit Analysis, let’s look at how to effectively Plan for Profits.

III. Profit Planning

A lack of accurate Cost Estimation and Analysis results in Profits of unknown quantity and often Loss. Some Companies who are profitable still fail. Why? Profits are not necessarily in the form of cash, such as Accounts Receivable which may presently be uncollectable. Focusing just on Net Income can be a mistake unless contingent variables are considered. It is vital that a Company sets and monitors certain Benchmarks in its Strategic Planning which performance can be measured against.

A. Profit Relationships and Components:

1. Net Income (Profit) = Revenue (Income) minus Expenses (Costs)

a. Revenue comes in the form of Cash and Accounts Receivable.

b. There are Two Types of Expenses: Fixed and Variable

i. Fixed Expenses: incur periodically, regardless of operational effect and include items such as Rent, Insurance and Depreciation.

ii. Variable Expenses: Vary according to the level of Operations. This includes items such as Product Labor and Material, Sales Promotion and Cost of Delivery.

c. Profit Expressions:

i. Gross Income = Net Sales minus Cost of Goods Sold (COGS)

ii. Operating Profit = Gross Margin

iii. Net Income Before Tax

iv. Net Income After Tax

v. All of the above expressions of Profitability indicate a certain relationship between Revenue and Expenses. A decline in Profit Margin should be the catalyst to search for a cause, such as an increase in expenses; discounting or pricing errors cause a decline in per unit sales revenue; or a change in business operations.

B. Plan for Profit:

1. Keys:

a. Liquidity provides maximum flexibility.

b. Income Statement is viewed in relation to the Balance Sheet and the Cash Flow Statement.

c. Managed, under control Growth -> Planned Growth.

d. Short and Long Range Business Planning which has clearly integrated relationships between Product Development -> Market Planning -> Strategic Planning -> Financial Management.

2. Steps for Profit Planning:

a. Step 1: Profit Goal

i. A target value based on the realistic, developed results of your Company’s Strategic Plan.

b. Step 2: Planned Sales Volume required to make the Profit Goal.

i. Utilize Operating and Sales Budget Forecasts

ii. The Forecasts influence decisions on Materials Purchasing, Production Schedules, Financial Resource Acquisition, Plant and Equipment Procurement, Personnel Enumeration, along with Employment and Inventory Planning.

iii. Forecasts derived from well developed, realistic determinations of Market Conditions, Market Trends, Industry Trends, Competitive Analysis, Competitive Edge, Market Segmentation, Promotion Strategies, Pricing Strategies, Distribution, Inflation and so forth.

iv. In other words, Sales Volume Forecasts which are achievable and accurate come from the previously prescribed development relationships between:

a) Product Development

b) Market Planning

c) Strategic Planning

v. Picking arbitrary numbers for steps 1 and 2 will result in faulty Sales Forecasts, tainting the process from the beginning.

c. Step 3: Expenses Estimation for the Planned Sales Volume

i. Use previous years’ numbers if an existing company. For start-ups, analyze similar companies in the industry and tap published research to come up with realistic estimates of Expenses.

ii. Adjust Expense Projections based on:

a) Change in Economic Conditions

b) Ratio of Expenses to Sales Level Change

c) Production Methods Improvements and Efficiencies

d) Reasonable salary levels

e) Materials to produce your goods

f) Labor to produce your products

iii. Establish a Cost of Goods and compare it to the industry average for accuracy.

iv. Figure in expenses which vary directly with changes in Volume.

d. Step 4: Estimated Profit

i. Estimated, projected Sales Income minus Expected Expenses

e. Step 5: Compare your Estimated Profit with your Profit Goal (step 1).

i. If there is a wide discrepancy between estimated profits and your profit goal, continue with the subsequent steps.

f. Step 6: Determine Alternatives to Improve Profits

i. Change Planned Sales Income:

a) Increase Sales Promotion

b) Improve Product Quality

c) Improve Access to Product’s Availability

d) Alternative Product Uses

e) Analyze Unit Pricing Strategy to determine Best Pricing Policy for your defined Target Markets

f) Better Service

g) More Product Reliability

h) More Integrity in your Sales Process

i) Better Updating/ Upgrading Strategy

j) Better After-Market Sales Strategy

ii. Decrease Planned Expenses:

a) Better Control Systems for Product Development

b) Minimize Losses

c) Increased Productivity of People & Machines

d) Product Re-Design, Re-Branding, Re-Packaging

e) Product Improvements

f) Cost Reduction Analysis and the resulting integrated strategy

g) Better Budgeting Control Mechanisms

iii. Reduce Unit Costs:

a) Add other products in the mix to offset costs

b) Using idle capacity and assets innovatively

c) Make certain parts internally if more efficient than purchasing from Vendors

d) Kaizen Costing: Advance Cost Targets in all aspects of Product Design, Development and Production. Each Company Department and Cost Center set specific Cost Reduction Plans for each quarter.

iv. Subcontract Certain Work and Outsource

g. Step 7: Determine how Expenses vary with Sales Volume changes

i. Experiment with Expense levels in selling fewer or more units with the information obtained in Step 3, understanding the relationship of fixed and variable Expenses to find the optional mix of Products and the Unit Sales of those Products.

ii. Beware:

a) Analyze Limited changes in Sales Volume as High Sales Volumes are costly and expend a lot of effort and Low Sales Volumes results in extra costs due to idle capacity, lack of volume discounts, underutilized highly trained and expensive labor force and so on.

b) Changing conditions: Economic shifts, Inflation, Deflation, Customer Shifts, Competitive Products, Market Shifts and Shifting Factors causing changes in Unit Costs.

h. Step 8: Understand how profits vary with Sales Volume changes

i. Use different Sales Volumes to determine the resulting Break Even Point and the Profitability Vector.

i. Step 9: Analyze Profit Alternatives

i. Using the information generated in Steps 6, 7 and 8 consider profit increasing alternatives:

a) Sales Prices Changes

b) Change Advertising/ Promotion Strategy

c) Reduce Variable Costs

d) Increase/ Decrease Quality of Products

e) Find the right mix of Products

f) Illuminate Low-Margin Products

g) Bundle High Margin Spare Parts with New Equipment and so forth…

j. Step 10: Finalize the Strategic Plan and Implement

i. Measure the Strategic Plan’s implementation over time to keep track of your Company’s resulting Pre-Tax return on Equity and Pre-Tax Profit Margin.

ii. Implement Tax Savings Strategies to retain more Earnings for future Opportunities and Expansion.

Note: In the Appendix to this Article, please refer to the Profit Planning Worksheet for a duplicate able Profit Planning, step-by-step Process for your Company.

IV. Applying Profit Principles to Real Life Situations

A. Overview:

To review, we have discussed in detail the Fundamentals of the Income Statement; How to Analyze an Income Statement to Maximize Profits; and a step by step process on how to Plan for Profits. To conclude this article, we want to give some real life examples of how good Profit Principles made for success and the flip side of that scenario (and the reasons why the companies were unprofitable). We will present three real life scenarios of Manufacturing Companies which had good profitability, mediocre profitability and one which failed. All three companies were in the same industry.

B. Successful Company: Company A

In examining Company A’s Income Statement, there are many clues as to why it was a successful company:

1. Market: Established a market by determining a market need and effectively filling that need.

a. In a five year period sales grew from $11K to $60m in relation to a market that grew from $413M to $510M.

2. Expenses: Expenses were reduced as a percentage of sales over the years, with Engineering and Sales Expenses at year 5 three percentage points below the industry average.

a. The lower engineering costs were attributable to high caliber engineers who designed a superior product which required fewer development changes and allowed employees to concentrate on innovation in the subsequent years.

b. Marketing Costs were low due to using a network of Distributors to sell the products rather than using a large sales force and manufacturing reps.

i. The small sales force was used to concentrate on high volume accounts, giving the company a big return for its investment in its sales people. This alone added 7 percentage points to its bottom-line profits.

ii. Cost of Sales was maintained at 62% of sales during the 4^th and 5^th years of operation which provided a 38% Gross Margin. This GM is about 10% above the average Break Even Point for similar companies, giving Company A a good cushion of profitability.

C. Mediocre Company: Company B

Company B was a six year old company and was located in a region of the country that offered lower labor and overhead costs.

1. Sales Success: Company B had very aggressive pricing strategies and undercut its Competitors to achieve large volume orders.

a. Profit was not the motive; dominance was the underlying strategy.

2. Aggressive Pricing: In relation to its closest competitor, Company B’s sales were three times larger, material costs 15 percent lower and labor 5 percent lower.

3. Overhead: This is where Company B made its mistake. Overhead expenses were 27%, causing Cost of Sales to increase to 76%, leaving a Gross Margin of only 24%, which was Break-Even in the best of circumstances when accounting for Engineering, Marketing and G&A. This was a ripple effect which greatly reduced Company B’s profitability, causing the parent company to sell it. An acquiring company quickly corrected the Overhead issue and installed a new General Manager to institute better profitability controls, which helped it recover over time.

D. Company Failure: Company C

Company C captured 27% of its market, yet failed to stay profitable.

1. Management: Plagued by severe management problems.

2. Spending: Flamboyant and expensive habits.

3. Product: Poor Design and low manufacturing quality.

4. Staff Reduction: As a result of poor management, financial losses and product failures, Company C reduced its staff of 600 to 400 employees. The Company subsequently fixed its design issues, increased its market share from a significantly lower share of 2% to 4% and grew employment to 150 employees. The Company was climbing back and barely keeping its head above water.

5. Turnover: Company C experienced severe top-management problems, and as a result, lower-management, along with the technical and production ranks, suffered from excessive employee turnover. In a year period, employee turnover was over 100%.

a. Company C as a result experienced a bad reputation in the Region’s labor pool causing it major difficulties in attracting quality employees.

b. As a result of its low quality labor force, Company C’s product quality declined and customers were lost.

c. The high employee turn-over created a situation that made it impossible to reduce product costs.

d. Company C was constantly in the training mode and the domino effect of catastrophic events forced it to cease operations.

6. The Numbers: COGS amounted to 84%, leaving only 16% for Engineering, Marketing, G&A and Profit. This is clearly out of wack by 20%. Material Costs totaling 53% could not be reduced due to high employee turn-over, which created a loss of purchasing continuity and poor procurement strategies. Slow payments to Suppliers contributed to higher material costs since the suppliers increased their prices to compensate for the added costs of doing business with Company C.

a. Company C strove to make improvements, but the improvements were made in the wrong places.

i. Labor Costs were reduced from 8% to 4% and overhead from 10% to 5%, using the same products and predicting inflation rate of 13%.

ii. G&A at 3% was reduced dangerously low.

b. The combination of indiscriminate cutting of costs, poor labor quality, poor product quality and very expensive material costs ultimately combined to doom Company C.

E. What can be Learned?

By applying the principles laid out in the first three sections of this article (Income Statement Fundamentals, Maximum Profit Analysis and Profit Planning), we showed how real world companies successfully and unsuccessfully applied these profit principles. The Income Statement is a good place to start your Profit Analysis as it shows how a company has spent its money in years past and what it projects its spending to be in the future, along with whether the proportions of its revenue streams and expense/cost levels were healthy or unrealistic.

By understanding what an Income Statement is telling you, how to properly Analyze it for maximum Profits and how to successfully and realistically plan for future profits, you can significantly increase and retain higher Cash Flows. However, the process should not stop here. As you have planned to Maximize Business Profits and implemented it successfully through your revised Strategic Plan, Cash Flow Management becomes the next step in the Profitability process. In order to better understand how your Income Statement relates to your company’s Cash Flow Statement and how to effectively manage your Cash Flow, please refer to our article on Cash Flow Management.