What’s In Your Margin? Part I

Capital One asks, “What’s in your wallet?” Business owners may feel like “Not enough!”  Unless owners and managers know their income statement backwards and forwards, the unfortunate result may in fact be, “Not enough!”

This blog post is the first in a series that deals with how to utilize your income statement to make more money.  But before I dive into that, let me begin with a quick refresher.

The income statement (a/k/a operating statement, statement of operations, profit and loss statement and P&L), tells the story of how well you’re operating your business.  By operating your business, I mean generating sales, controlling expenses and maximizing net profit (a/k/a net income).  In short, the income statement is your report card grading how profitable you are.

Like school report cards, the income statement grades your performance over a period of time (month, quarter, year, trailing-twelve-months (TTM)).  It condenses all your sales and expense transactions into useful line items, which then enable you to price your goods or services adequately. Knowing what is included in each line item is vitally important to managing your profitability.

Here are the typical line items in an income statement.

Net Sales equals gross sales plus freight charged to customers less sales discounts given to customers less sales returns by customers.

Cost of Sales equals all direct costs (raw materials and labor) plus indirect costs (manufacturing plant and warehouse costs) required to get the products you sell produced or services you sell delivered.  In addition to these product costs is the cost of shipping such goods to the customer, which are also included in cost of sales.  In short, all costs directly related to your products or services sold are costs of sales.

Gross Profit is Net Sales less Cost of Sales.  It is the amount of money earned by delivering your goods or services and must be sufficient to cover the operating expenses of running your company plus earn you a profit.

Operating Expenses include research and development costs plus sales and marketing costs plus general and administrative costs (e.g., purchasing, customer service and accounting staff, office rent and supplies, legal and accounting fees).  In other words, these are costs of running your business as opposed to costs of producing and delivering your product or service (i.e., cost of sales).  It is commonly referred to as overhead due to the pressure, I suppose, that owners feel having all these expenses hanging over their heads and needing to generate enough sales and gross profit to cover them.

Operating Income equals gross profit less operating expenses.  It differentiates income derived from operating your business as opposed to non-operating income and expenses.  It is the number used by banks to determine how much debt-service your company can pay.

Other Income and Expenses includes non-operating P&L items such as interest or dividend income, extraordinary income or expense, and interest expense.

Companies group things differently.  One company might include an expense in cost of sales that another company includes in operating expenses.  There is no absolute right way to do it, but I recommend that you group things similarly to your competition so that comparisons to their numbers and industry data are as apples-to-apples as possible.

Enough terminology.  Are you ready to add to your wallet?  Then visit my next post where we’ll take financial management to the next level.

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  1. What’s In Your Margin? Part 2 | CFO & Co. - April 15, 2013

    […] a comment What’s In Your Margin? Part 2Categories: Case Studies, Uncategorized My last post began the climb to a higher understanding of your income statement and how to use it to make more […]