“Profit is not something to add on at the end; it’s something to plan for in the beginning.”
The profit and loss statement, sometimes called P&L, shows where your income or revenue or turnover has come from and what it cost you to deliver those sales – and ultimately what your profit is. There are different elements of your profit and loss – sales, cost of sales, overheads, interest and tax to name but a few.
Sales less cost of sales (sometimes called COGS, cost of goods sold) results in Gross Profit, which when expressed as a % is called Gross Margin.
Thereafter deducting overheads which will usually include staff, premises and marketing costs, results in your Operating Profit. When tax and interest are deducted, the result is your Net Profit.
The number of different “profits” might be a bit confusing. Businesses often experience a step change in overheads when their business grows. Knowing your numbers allows you to be prepared for this and the impact on your cash flow.
“A salesman minus enthusiasm is just another clerk.”
Harry F Banks
Income/Sales/Revenue
Revenue is often called income, sales or turnover and many businesses get obsessed with levels of turnover, but it’s important to remember the saying:
Turnover is vanity; profit is sanity.
If you can be selling a product for £100, but if it costs you £105 to produce it then you’re making a loss on every single item. A push for more sales in this scenario is an accelerated route to ruin. Understanding your margins (gross, operating and net margins – see more on margins later) is critical when you are growing sales volumes for exactly this reason.
We’re just going to stick with revenue for the moment.
It’s worth a quick note on VAT and timing.
VAT
All your revenue sales or turnover numbers should exclude VAT. I often hear people quoting their turnover, including VAT. This gives the illusion of a higher turnover but is a misrepresentation because you are including funds that are collected on behalf of HMRC. Your revenue should not include VAT or any other added taxes.
Timing for Reporting Revenue
Sales are only recognised when they have been completed – when legal title has been transferred. A promise by a customer to buy something in October cannot be recognised on the day the order was received (in May for example), though a payment in part or full may be received from the customer in advance of the sale being completed.
You may hear this referred to as the accruals principal.
Cost of Sales
The biggest expense is opportunity cost.
Your cost of sales is, at its most simple, the cost of delivering the sale and nothing more. It does not include marketing costs or the costs of acquiring the customer in the first place.
Cost of sales is the cost of either producing or delivering whatever has generated the sales value. This can include:
- some staff costs, if they are directly related to the production of the product sold or the services delivered.
- the direct and attributable cost of components if you’re building or manufacturing something.
- the cost of delivering a product or service i.e. shipping costs, travel and fuel.
For example: if you are training company then the cost of sales will be the trainer for the day, the cost of materials associated with the training and the cost of the travel associated with the training.
Cost of sales is anything that would not have otherwise been incurred cost wise if that particular revenue or sale had not occurred.
“It doesn’t cost anything to be nice to people.”
Unknown
Gross Margin
Gross Profit is calculated by deducting the cost of the sales, which is the variable costs of producing, or providing services from the revenue, (sometimes known as sales, turnover or income). You’ll often see this converted into a percentage and described as Gross Margin.
Gross margin % = Gross Profit x 100 all divided by Sales
Take revenue to be £100, deduct £35 cost of sales and the resulting gross profit is going to be £65 and the GM percentage will be 65%.
Your revenue less your cost of sales is gross profit.
EXAMPLE
Sales £ 100
Less:
Cost of Sales £ 35
Gross profit (GP) £ 65
Gross margin (GM) 65%
Usually, you would expect the gross margin to remain constant over a period of time. If your revenue doubles, then the business will have to buy twice as much to sell, and the cost of sales will also double.
Looking at the variability of gross margin will often tell you whether your business is on track or not. Regular accounts will allow trends to be tracked and identify if something is going wrong quicker.
“Many receive advice; only the wise profit from it.”
Harper Lee
Overheads
A company’s overheads are all those costs that are incurred even if you didn’t sell anything this month. This will usually be your office costs, rent, rates, utilities, stationery, the cost of internet and telephones. It will include staff costs including admin and support staff. Overheads are any cost that would have been incurred regardless of the volume of sales activity.
Your marketing costs are part of your overheads too. You should be able to split out elements of your overheads into groups such as premises, staff, marketing, IT and administration costs. Tracking these numbers allows you to see if your costs are increasing and understand why. More importantly, it means you can take corrective actions quickly.
Additionally, by knowing your costs, you can assess the return on your investment in various activities, such as marketing.
EXAMPLE
Sales £ 100
Less:
Cost of Sales £ 35
Gross profit (GP) £ 65
Gross margin (GM) 65%
Less:
Overheads £ 25
Operating Profit £ 40
“The best investors look for undervalued companies with low overhead costs, long-term growth potential, solid earnings and low debt.”
Mark Hing
Break even point
It’s essential to know exactly what your costs are, along with your Gross Margin. This allows you to see clearly how many sales you need to break even.
The break-even point is the levels of sales the business requires to cover their costs and make zero profit (but more importantly zero loss!). In the above example, the business is selling enough units for revenue to cover costs. If costs increased, more sales would be required.
Overheads = Gross Margin % divided by £ break even
EXAMPLE
In the example above the overheads are £25, and the gross margin is 65%, so the number of sales required to break even is £38.
Sales £ 38
Cost of sales (35%) £ 13
Gross profit (65%) £ 25
Overheads £ 25
Operating profit £ 0
If your overheads increase, the breakeven point increases. Establishing the breakeven point means a business can plan the levels of production (and sales!) it needs to be profitable.
“Don’t leave it to the law of averages to make you break even.”
Mike Caro
Operating Profit
When you deduct overheads and staff costs from your Gross Margin you’re left with Operating Profit. This can be identified as a £ value but also is frequently shown as a % value too.
Operating margin = Operating Profit x 100 divided by Sales
Tracking the Operating margin % trend shows where your business efficiency is – the operating margin increases when your business benefits from economies of scale.
Net Profit
NET PROFIT is often called the Bottom Line. This is the calculation of profit that the company has generated after all the costs of the business have been deducted, including tax and interest. Expressed as a percentage, it is known as NET MARGIN.
In a similar way to the operating margin, you would expect the company to increase its net margin as it grows because it’s benefiting from the economies of scale. Fixed costs should grow at a lower rate than revenues.
EXAMPLE (Economies of Scale)
Sales £ 100,000 £200,000
Cost of sales (35%) £ 35,000 £ 70,000
Gross profit £ 65,000 £130,000
GROSS MARGIN 65% 65%
Overheads £25,000 £ 40,000
Operating profit £ 40,000 £ 90,000
Less: interest £ 10,000 £ 10,000
Less: tax due £ 6,000 £ 16,000
Net Profit £24,000 £ 64,000
Net margin 24% 32%
“Those who do not manage their money will always work for those who do.”
Dave Ramsey
The Difference Between Profit and Cash
Operating Profit represents the total sales achieved, less the total costs incurred.
One of the principal differences between Profit and Cash is timing – of money paid for the products or services to make sales and money received for the products sold.
You can make profit without generating cash.
And you can also generate cash without making profit.
You need to be very clear that you are both making profit and generating cash. A profitable business that does not generate cash and does not have additional funding will still go out of business due to lack of ability to pay its staff and suppliers.
“Money is not the only answer, but it makes a difference.”
Barack Obama
Sales are recognised when they are earned, not when the cash is received. Costs are recognised when they are incurred, not when the cash is paid.
“Never take your eyes off the cash flow because it’s the lifeblood of business.”
Sir Richard Branson
Do you feel like you have no control or don’t understand your numbers? Discover how you can feel more in control of your business, make your business worth more AND make it easier and more fun to run. Click here to contact Christine by email alternatively, you can book a call with the Business Mentor of the Year 2020, author and speaker. Who helps business founders get their businesses in better shape so they can enjoy a happier, richer future. She saves them THOUSANDS and increases the value of their businesses by MILLIONS.
