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The following excerpt is from franchise expert Mark Siebert’s book The Multiplier Model. Buy it now.
When I hold exploratory meetings with clients, I typically ask about various items on the profit and loss (P&L) — also called an income statement — without actually referring to the document itself. I’ll usually ask about the cost of goods sold, their labor, or some other charge.
Here’s how the responses can drastically differ: Type A” business owners usually give me a very specific number — often down to the decimal point. “Type B” owners usually give me a range — sometimes narrow and sometimes not. “Type C” owners may simply give me a shrug. So where do you fall on the list?
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The components of your income statement
The P&L is essentially broken into three parts:
- Revenue (sales)
- Expenses (costs)
- Profits or losses (In other words: income, which equals revenue minus expenses.)
Essentially, a P&L can help you understand several important principles that you should grasp from the start of opening your business.
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Understanding your potential revenue
On the revenue side, you need to understand how you will generate sales. You should ask yourself some basic, yet important, questions.
- Do you expect repeat customers?
- Will you sell add-ons?
- Will there be a membership component?
- Will your revenue grow over time?
- Will you run into capacity issues?
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Diving into your expenses
On the expenses side, it’s crucial to understand the relationship between your fixed expenses and your variable expenses.
- Fixed expenses represent the costs you’ll have every month, regardless of whether you make a sale. Your rent and the salaries you pay staff are good examples of fixed expenses.
- Variable expenses represent the costs you only incur with a sale. By subtracting your variable expenses from your selling price, you get your contribution per sale.
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Start making calculations
Once you grasp fixed and variable expenses, you can calculate a hypothetical break-even point for your business by making certain assumptions about pricing and variable costs.
Simply divide your fixed expenses by your contribution per sale, and you can get a better idea of how many sales you’ll need to make to break even.
If you want to achieve a certain level of profitability, add that profit to your fixed expenses and recalculate. Then you’ll know what level of sales you’ll need to achieve to get there.
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The complexity of income statements
The vast majority of businesses don’t sell just one product or service. Plus, each product or service will have its own associated price. And the price for each product or service will not have a consistent margin either.
For example, take a fast-food restaurant, where you can buy a burger for $1 and a large soft drink for $1.50. You can easily see that the cost of different products is not consistent across every product sold. So the “product” you sell and the “price” of that product will depend on your product mix, and perhaps on value pricing or discounting as well.
Then there are labor costs. In some businesses, where labor is hired on an as-needed basis to complete a job, production labor is all a variable cost. In other businesses, some labor functions are overhead and some may be partially overhead and partially variable.
Again, using a food-service operation as an example, during the slowest times of each shift, you can never have fewer than one employee in an open restaurant. But you will need to increase your staffing to meet your service requirements at different parts of the day, on different days of the week, or even depending on different weather patterns. So while you will treat restaurant labor as a variable cost, at least some portion of it is essentially “fixed.”
Once you start to account for some of the minutiae — like credit card processing fees or shipping and handling costs — a “simple” income statement becomes much more complex.
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Take your time
This may sound incredibly daunting if you haven’t done it before — but once you get used to it, the process becomes second nature. And once that comfort sets in, you’ll be well on your way to running a profitable business and making day-to-day decisions to improve or solidify your bottom line.
