Sunday, April 26, 2020

How Small Business Owners Should Use a Profit and Loss Report - Cost of Sales

We Made A Sale... That's A Good Thing, Right? 

Yes... and no. In continuing our conversation on how small business owners should use the profit and loss report as a key tool for operating their business, we're talking about the cost of sales section today. Sometimes, this section of the report is called the Cost of Goods Sold. Not to get too technical with the accounting terms here, but there are several ways to value the cost of what a business sells. Here's the important take away for this section of the profit and loss report: are you making a profitable (and hopefully sustainable) margin on the products and / or services you are selling? How do you know if you are or not? Remember, business's live or die on margin

What's All This Talk About Margin? 

By now you ought to know it doesn't mean a whole lot just to make a sale. Don't get me wrong; selling is a vital foundation of building and growing a great business, but it doesn't mean a whole lot when you're selling at a loss. In order for the sale to mean something, it has to come at a profit meaning that it has to cover its own cost in addition to leaving a cushion or margin for covering other expenses, growing a reserve for reinvestment, or at least a modest return on the invested capital of the owner(s) and / or investors. For example, when consulting restaurants, I've noticed that food costs (which are the primary costs in operating a restaurant) are typically marked up by a certain amount depending on the section of the menu the food item is found. Here's the key difference between a restaurant that thrives and the one that dies: thriving restaurants know their margins intimately incorporating this knowledge into their advertising and marketing plans while dying ones only guess at it. This key in understanding and knowing margins applies to every business no matter the industry. If you don't know your margins, you're doomed to fail BIG!!!

So, How Do You I Use the Cost of Sales Section to Operate My Business More Efficiently 

Similar to the Sales section of the profit and loss report, you have to ask several questions when observing the detail of the cost of sales section. First, let's start with the total amount reported. It's not enough to know the total amount sold for the period whether it's a day, week, month, quarter, or year. You need to know specifically what products and / or services sold and from whom or where these products and / or services were purchased? Were they made internally or externally? At what degree were they made internally or externally? Were purchase discounts given or earned and if so, why and how? Maybe not available on this section of the profit and loss report, but you could investigate a little deeper and be aware of the methods or processes of how the business goes about purchasing the products and / or services it sells. Ultimately, whenever you're analyzing the cost of sales section of the profit and loss report, you are conducting a cost analysis to ensure the business isn't losing any unnecessary money from having loose controls and a lack of monitoring just because hey, we're making sales, right? 

For our next post, we'll talk about gross margins and why when used in comparison to previous periods and even budget plans, can become a great indicator of your small business's future profitability and sustainability. Stay tuned...