Ten Tips to Evaluate Your Income Statement
Top Down or Bottom Up?
When picturing a successful business, many people will judge based on size…the bigger, the better. This can be a misperception. It can also be a trap that businesses fall into, chasing growth at the expense of profit, which can ultimately lead to increased stress, and sometimes failure.
Bigger is Not Always Better
It’s easy to think that more sales equals better – more cash flow, more activity, more opportunities. But focusing on just the increased sales, without factoring in the increased cost to produce and service those sales, can be detrimental.
Why Net Income Is the Priority
To run your business effectively, regardless of your size, start with working from the bottom of your income statement and working your way up. The goal is to maximize your net income and make that number the priority, instead of maximizing the top line and trusting the net income will increase accordingly.
If you start looking up the income statement from net income, there is a section of general and administrative expenses, or your overhead, which consists of both fixed and variable expenses. Fixed expenses, such as rent, need to be paid regardless of your sales level so they need to be considered when determining the size of your business and setting your prices. Variable expenses rise and fall in line with your sales, for example delivery expenses. These can rise in lockstep with sales, or they can increase in jumps – for example, if you need a new truck and driver to handle the increased deliveries. Watch out for these.
Know Your Direct Costs
Moving up the income statement, the next section is cost of goods sold – these would be direct expenses to making your product or producing your service. For example, if you make pizzas it would be the cost of the ingredients. If the price of milk rises, it would quickly increase the cost of cheese, so being knowledgeable about factors that influence your direct costs are important so you can adjust prices quickly.
Then of course the top line of your income statement is your sales, or revenue.
Think About Your Costs to Grow
Now look at your client base and think about what it costs to produce different levels of sales – if you want to sell more pizzas, for example, you may need more ovens, but if you’re maxed out on space you may be thinking of a new location. There’s a huge difference in cost between a new oven and a new location.
If you have an equipment intensive business, such as a construction company, the cost of not only running the equipment, but repairs and maintenance, and interest on debt should be factored into the overall cost of the equipment, and added to your bid. Purchasing vs. renting equipment for a job is another cost that should be weighed.
Customer Profitability Analysis
There could also be customers that soak up more than others – more of your tangible costs, but also more of your time. This should be factored into how profitable different customers are. If you need to add people, factoring in not only their wages but the payroll taxes, health insurance and benefits could make some services you’re providing unprofitable overall.
Once you’ve done this analysis it should be easier to see which customers and services are the most profitable. The next step is to set goals, both short term and long term. You may decide to get more specialized in certain areas, which often commands higher prices. You may find that shrinking strategically is more profitable than growing in the short term and sets you up for even more profitable growth in the long term.
Growth by Acquisition
Acquiring another business is often considered a good way to grow your own. I would agree but add some caveats to think about beforehand. Expanding into a new geography can stretch management too thin with travel time and stress. Expanding into a new product or service line requires the same exercise discussed above, of figuring out how to maximize profit and finding economies of scale. Be careful of an acquisition that would that stretch you and your people too thin.
Know the Competition but Don’t Get in a Pricing War
As business owners, you always have a handle on what your competitors are doing – what products and services they provide, their reputation, and their prices. This is good information, but don’t let it rent too much space in your head. Pricing wars with your competitors will end up hurting you both. You’re better off not having that extra sale if the cost of providing it eats into your net income.
Define & Nurture Your Ideal Customers
Analyzing your current customer base will also help you develop a targeted marketing plan. We can’t be all things to all people, and not every customer is a good fit for your business. Spending time fine tuning your marketing plan to attract the customer that best matches your wheelhouse is time well spent. One of the key aspects of your marketing plan will be articulating your value proposition. Don’t assume prospects can differentiate you from your competition. If they can’t, price will be all they see.
Speaking of your best customers, spend more time with them. It is easier to increase sales with a current happy customer than to land a new one. If your relationship is a good one, they can help you in other ways too, such as providing feedback on your customer service, giving you ideas for new products and services, and referring you to other wheelhouse companies.
Establish Strategic Relationships
Strategic relationships can be a great way to grow your business profitably. You may not have the bandwidth to provide solutions to every client problem. Having relationships with other professionals can allow you to solve a client’s problem without exceeding your bandwidth.
Define Your Value Proposition
Find your niche, articulate the value of doing business with you, provide excellent products and customer service, and charge what you need to charge to make money. These steps will help you succeed no matter the age or size of your company.
This material has been prepared for general, informational purposes only and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. Should you require any such advice, please contact us directly. The information contained herein does not create, and your review or use of the information does not constitute, an accountant-client relationship.