Many companies offer a mixture of services that are usually complementary, however, have different cost bases and margins. While the sales for these different services are allocated separate categories the expenditure is quiet often group together. This practice may appear to save time and make the P&L look easier to understand there is an inherent problem with this.
A Profit and Loss Statement is usually an historical document created for the Tax Office, Partners and/or shareholders. This document should not be used when assessing margins or cash flow. A good P&L will include deprecation, bad debit and other deductible items that are related to expenditure but not necessarily an expense. What I mean by this is depreciation is related to an expenses but not an actual expense, the expense was maybe an automobile purchase or lease. If we assume the expense is am automobile lease then the payments are noted under motor vehicle expenses, the deprecation relates to the reduction in value of the automobile over time. If the P&L is used to assess margins then some of the expenditure for the vehicle have been doubled up.
The other issue with grouping expenses together means that you do not get a true picture of how each department is traveling from a profit point of view. The business overall may be making money but is each department.
I have two clients, one who uses the P&L to assess margins. The other has a company that offers one on one training services and group classes in a studio. The client who is using the P&L to assess profit margins first approached me because they believed that their margins we much lower than other businesses in their field. They knew they could not put prices up so where looking to reduce expenditure but were not sure how to do this. The first thing we did was to analyse how they were assessing their margins. The issue was they were taking depreciation into account when working out their profit margins, once this was removed it immediately added 4% to their profit margin. This meant that cost reduction was not necessarily the right answer, as they have a problem with resources but understanding the actual profit on the services they offered was the issue. Now that they understand the true margins on their goods and services we can implement accurate financial modelling to achieve profitable growth.
The second client is operating on dollar cost averaging as the basis of their margins. While dollar cost averaging is important it can hide the real profit margins on different goods and services. We are working with them to establish accurate individual margins for all of the goods and services they offer. Once this is completed we will have the tools required to assess the true financial health of their business.
Remember “Turnover is Vanity, Profit is Reality and Cash is King!”
Quote – “Never worry about action, not only inaction” Winston Churchill
Copyright Celtic Management 2014