Managing Your Business Part 1 – Understanding The Numbers – Profit and Loss
Once you understand and have set up processes to manage your tax business obligations, it’s now time to focusing on how to manage your business. That means understanding your numbers.
First key point: Be honest and open with everything related to your business. Understand your sales, gross profit and your bottom line (net profit). The numbers are more meaningful if you are clear on what is truly a business expense and what is personal.
Key Numbers:
- Sales
- Gross profit (and cost of sales)
- Net profit
You need to understand how these are calculated. All are better understood as a trend over time but for this blog we will focus on the definitions and how to calculate them.
Sales: (also called revenue) – is the easy part. This is the amount you invoice and will collect from your customers for providing product or services to them.
Gross Profit: Sales less cost of sales
Cost of sales: this can be a bit tricky – but for simplicity our definition is any expense that you have to spend to deliver to your customers. For example: the product, materials, direct labour/subcontractors, cost of vehicles for technicians, machinery.
Note: direct labour are the staff that actually make the product or deliver the service you are selling. You usually have these staff as permanent staff but sometimes you might have contractors you only get when you need them.
Gross Profit margin is gross profit divided by the sales and is expressed as a percentage.
Simple example:
- Sales are $1000
- Cost of sales are $500 (and include $200 for labour, $200 for product and $100 for vehicles)
- Gross profit is therefore $500
- Gross profit margin is 50% (500/1000)
Gross margin gives you some idea of the health of your business and shows how much you have to contribute to the overheads. This is the margin that should reflect your pricing, but be aware that this can be impacted by volume (i.e. how much you sell) especially when you have fixed costs such as wages direct labour (see above). To know what gross margin you need to make, understanding benchmarks and analysis of your competitors, and overheads cost are important. (This is where your advisors around financial analysis can really make a difference)
Net profit: Gross profit less overheads
Overheads: All those costs that you need to run your business but not directly related to the delivery of the sales to your customer. Examples include building leases, administration staff, telephone, electricity, accounting software and professional fees. These costs are incurred to run the business but are not essential to sales – and in fact if you don’t have sales, you still have to pay these costs.
Net profit margin: Net profit divided by sales – is expressed as a percentage.
Simple example:
Key Takeaways:
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Sales, Gross profit and Net profit are key to understanding your business – take the time to understand how these are calculated in your business.
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Be honest about true business cost versus tax choices/personal costs – what does the business really need to run?
Rest assured that this effort is worth it. Knowing your numbers helps you plan and manage your business well.