Better Information Leads to Better Business Decisions
Jan 27, 2020 by Roger Scherping
I met with a new client this week. They are an excavating company that clears, fills, and grades land before a building is built. The managers are all young and know their business very well. They want help establishing the systems and processes that they know they need to grow their business profitably.
There is one area in particular about which they knew very little, and that’s financial reporting. I don’t think any of them even knew what an income statement was. But since they understood their business so well, I knew I could walk them through understanding what financial information they needed to make better business decisions.
First of all, their income statement was being reported on the cash basis, and I thought it should be on the accrual basis. So I explained the difference to them like this. I said, you’re in the construction business, so let’s say you have a really busy month in July and bill out $100,000 in sales. Then say that you collect that $100,000 in September. The way your income statement works now, it will say that you had a really busy month in September (when the cash came in). So do you think it makes more sense for your financial statements to say that July was a busy month or that September was a busy month? They unanimously agreed that it makes more sense for July to show as the busy month, so we agreed on reporting on the accrual, not cash, basis. In other words, they wanted the financial statements to reflect when the work was performed, regardless of when the cash came in.
The next point I wanted to make was around how the company was doing on its construction jobs. They agreed that it was very important for them to know how much money they were making on their jobs. So I asked them what costs go into doing a job, and they said labor, materials, and equipment rental. They agreed those costs should be tracked together because these costs are directly related to running their jobs.
But I asked them, aren’t there other costs that also relate to jobs? What about things like equipment maintenance, fuel, permits, and small tools? They pointed out that those are all general costs that aren’t directly related to any one job. They agreed, though, that those are also costs of doing the jobs, but that those costs are sort of spread across all of the jobs. I agreed and called them indirect costs.
I continued. So if we take the direct costs (labor, materials, and machinery rental) and the indirect costs (equipment maintenance, fuel, permits, and small tools), then these make up all of the costs of the jobs. And if we deduct all of those costs from what we billed our customers on our jobs, that will be the profit we made on our jobs. That made perfect sense to them. I said we’ll call that gross profit, or gross margin.
Finally, I asked them about the remaining costs, things like rent, office wages, telephone, and bank fees. They quickly said, that’s all just overhead. I agreed and said let’s group those together, too, and consider them after gross margin.
We now have a dividing line called gross margin. Everything related to the jobs – billings and expenses – goes above the gross margin line, and everything else – the overhead – goes below the gross margin line.
I told them, gross margin is a report of how we did on our jobs for the month. Then if we deduct our overhead costs from gross margin we have net income, which is how much profit we made for the month.
In the end, this group of business managers had taken their extensive knowledge of their business and, with a little help, figurerd out how they wanted their financial statements to look to make sure they understood their numbers well enough to make good business decisions.
In my experience, this situation is very common. Most small business owners understand their businesses very well. They don’t understand accounting, but they know how the business works, what its costs are, and how to improve profitability. That’s why small businesses succeed even though the owner doesn’t have a financial background.
That’s exactly what drove us to create ProjectionSmart the way we did. We assumed that the small business owner didn’t understand accounting, and we didn’t want to force them to learn accounting. Instead we rely on their innate understanding of their business and just ask them questions about their business – questions that they could answer because they understand their business so well. Questions like: Do you plan to buy any new equipment this year? Do you have any debt payments? Do you plan to take any money out of the business?
Once we have their answers, ProjectionSmart takes care of all of the accounting for them and creates for them bank-ready financial projections based on the answers that they gave us to the straightforward questions that we asked them about their business.
ProjectionSmart is the best tool for the small business owner who doesn’t have a finance background and doesn’t have a controller or CFO on their staff. ProjectionSmart helps them make better business decisions by helping them understand the numbers of their business.
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