As the operations of the company expand and sales revenue increases, it is important to monitor how money and profits change over time. Does profit increase linearly with sales revenue? How do costs change at the same time? Tracking your company’s numerical data gives you valuable information on how to grow your business and profits steadily. Establish an effective reporting system to keep up to date with key indicators.
The goal – to increase profits
To increase your profits, you can do the following:
- engage in pricing policy
- control direct costs
- control overheads
- calculate the profitability of products/services, i.e. deal with cost accounting
- prepare a budget for the income statement and check that the activities are carried out as required.
If you have several products/services, it is very likely that their ability to make a profit, i.e. profitability is not the same. Therefore, it is important to look at the profitability of the company as a whole as well as the profitability of each product and service separately.
Let’s look at one example: A company offers three different services. The company’s gross profit in March (i.e. sales revenue minus direct costs) was 50% of sales revenue. The level of overheads was 40% of sales revenue and profit 10%.
The company’s goal is to increase net profit by 10% -> 20%. To this end, it was decided to first examine the profitability of each service. The objective was that the profitability of each service should be at least 50%.
The more detailed analysis indicated that the gross profit of one service was 90%, the other 50% and the third only 5%.
Proceeding from these results it was possible to start a cost-benefit analysis of the third service.
- is it possible to increase the price? (if so, what could the new sales revenue be? Will some customers give up?)
- is it possible to save costs? (without any loss of quality)
- and if neither option is possible ̶ should this service be given up instead?
The decision to give up the service should always be carefully considered, as there are a number of risks involved. If your customers are used to receiving multiple services from you, it is easy for customers to stop ordering also the others if one service is given up, as they are used to receiving services from one place.
Also, you should not immediately rush to give up a service in case of a low gross profit percentage – % may be small, but if the amount is large and helps to cover a significant amount of fixed costs, you should not give it up lightly.
The third risk of reducing the service package concerns the costs of your business and especially the price your suppliers and partners offer you. If the volumes are high, you will most likely be able to trade at a better price. But if you buy less, the price is higher, which in turn affects the profitability of your company as a whole.
How to calculate profitability?
To calculate profitability, sales revenue and direct costs should be divided between products/services. To this end, a “label” (project/cost/dimension, name in each accounting program) is attached to each sales invoice, purchase invoice of direct cost and, where applicable, payroll entry, which links this invoice to a specific product/service. The special report later enables to extract the revenue and expenses of this particular product/ service and make forward-looking decisions based on it.
To analyze profitability, you need to know
- what are the costs associated with a particular product, service or activity
- the period to which the specific costs belong
Cost accounting is a process that enables to calculate the costs associated with a product, service or activity and understand which products/services are profitable and which are loss-making. On the one hand cost accounting is related to financial accounting – past income and expenses should be properly recorded. On the other hand, cost accounting is necessary for reasonable pricing of products and for controlling and planning the company’s operations. Thus, cost accounting is more broadly also an important part of the management reporting system.
Recommendation for a smaller (and also a medium) company – focus on getting the sales revenue and direct costs (i.e. costs directly related to the product/service) correctly divided. The division of overhead costs is more a matter for large companies and the misallocation of overheads can cause loss rather than benefit.
Periodization of costs and revenues, i.e. placing costs and revenues in the correct month and, if necessary, estimated recording is a complex issue. But if you do not do the above, the result is meaningless and the conclusions are wrong.
Let’s look at three companies:
- Service company – the service is provided within one month
Revenue is recorded in the month of providing the service. The expenses related to the provision of the service are also recorded in the same month. If some invoices related to the provision of the service have not been received by the end of the month, the expense is calculated as estimated on the last day of the month. The amount is, to the best of our knowledge, an estimated cost which is never and should not be 100% accurate.
- Service company – the service is provided within longer period
In case of a long-term service, the revenue from the provision of the service is recorded on a pro rata basis in the same months as the costs associated with the provision of the service (percentage of completion method, read more in the article – how to record revenue when the service is provided).
Take, for example, a programming service. The programmer works four weeks in March and two weeks in April. The invoice will be submitted 100% in mid-April after the work is completed. The programmer’s salary is recorded at the expenses of the respective month.
At the end of April it is estimated that 4/6 of the revenue will be accounted for (to the best of our knowledge, how much is finally invoiced) so that the revenue and expenditure are in the same period. Otherwise, March would include only expenses and April all revenue.
NB! Construction companies have slightly more complicated accounting, see more detailed rules in RTJ 10.
- Trading company
The recording of revenue from the sale of goods depends primarily on the nature of the transaction and whether the risks and benefits related to ownership have been transferred from the seller to the purchaser or not. You can read more about this in the article about how to record revenue in selling goods.
Purchased goods are initially recorded in the trading company as inventory at cost.
Acquisition cost includes:
- purchase price
- transport cost
- other – packaging costs, repair costs, labelling costs, etc.
These costs should be recorded separately by types, included in inventories (not as an expense for the period) and allocated to product units. Depending on the business logic, the costs are divided evenly over all the units in the batch or for a specific item. When bulk packaging is repackaged into small packages, the cost of packaging is divided between the small packages. When cars for resale are repaired, the repair costs are linked to a specific car.
The cost of goods is recorded in the same month as the income from the sale of goods – there are actually different options depending on the industry and business processes. Discuss this thoroughly with your accountant so that everything will be clear.
Which report helps to analyze profitability?
The main tool for monitoring and analyzing profitability is income statement which indicates direct costs, gross profit and % of gross profit separately. Besides that, be sure to compare numbers with previous periods and budgets.
- If you are assessing the profitability of products/services, take a closer look at the upper part of the income statement up to gross profit, separately for each product and service.
- If the goal is to control costs, make a more detailed comparison of the cost lines of the statement with the budget.
Finally, if profitability is not analyzed, the company has no idea what is really going on with its profits. For example, the analysis may reveal that a product or service is making a loss for the company. To avoid such losses, management accounting and a proper reporting system will help you. This will help you to manage the company significantly better and make more profitable decisions for the company.