Maintenance
Part of Reading a profit and loss statement: gross profit, operating profit, and below operating profit
Profit and loss statements metrics worth tracking, and the ones to ignore
Profit and loss metrics that change decisions: gross margin, contribution per unit and breakeven revenue, plus how to split a movement into price, volume and cost.
Most profit and loss metrics are just lines from the statement read aloud, but a metric earns that name by answering what the statement cannot.
How much of the next sale do you keep, and how much must you sell before the month is safe? Did a change come from price, volume, or cost?
Those three questions need arithmetic, not a report. The arithmetic is short. All the figures below are invented so the steps can be followed. None is a benchmark, and none should be compared with anyone else's business.
What to take away
- Gross margin, contribution and breakeven are the three that change decisions. Everything else on this page is diagnosis.
- A movement in profit should always be decomposed into price, volume and cost before it is explained. Two of those are decisions and one is weather.
- Compare against your own prior periods and nothing else. Any outside figure carries a different definition of cost of sales, which makes the comparison arithmetic dressed up as insight.
The three that drive decisions
Gross margin. Gross profit divided by revenue. Say revenue of 400 and cost of sales of 260, giving gross profit of 140 and a margin of 35%. The number tells you what share of the next sale survives to pay for the business. It is the input to almost every pricing conversation, and it is meaningless unless the line between cost of sales and overheads is drawn the same way every month, which is the point of the profit and loss statement structure.
Three decision metrics
- 35%Gross margin
- 315Contribution per unit
- 240Breakeven revenue per month
Contribution per unit. Price less the costs that only occur because that unit was sold. If a job sells for 900 and costs 585 in materials and subcontracted labor, contribution is 315. Contribution answers the question a margin percentage cannot: is this particular piece of work worth taking, given that the rent is being paid anyway.
Breakeven revenue. Fixed costs divided by gross margin. With overheads of 84 a month and a margin of 35%, breakeven revenue is 84 divided by 0.35, which is 240 a month. Below that the month loses money regardless of how busy it felt. This single figure changes how owners think more than any other on the page, because it converts a percentage into a target they can see against the sales they already have.
Recompute breakeven whenever overheads change. A new hire is not a cost of 30; it is a lift in the revenue you must reach every month before anything is yours.
Decomposing a movement
Profit moved. Before explaining it, split it. Suppose one period shows revenue 400, cost of sales 260, gross profit 140. The next shows revenue 480, cost of sales 336, gross profit 144.
Price, volume, cost split
Period 1
- Revenue
- 400
- Cost of sales
- 260
- Gross profit
- 140
- Gross margin
- 35%
- Volume
- Base
- Average price
- Base
Period 2
- Revenue
- 480
- Cost of sales
- 336
- Gross profit
- 144
- Gross margin
- 30%
- Volume
- Up
- Average price
- Flat
Gross profit rose by 4, on revenue that rose by 80. That is the finding, and it needs three separate questions.
| Question | What to compute | In this example |
|---|---|---|
| Did we sell more? | Units or jobs, period to period | Volume up, which lifted revenue by 80 |
| Did we charge more? | Average price per unit or job | Flat, so none of the 80 came from price |
| Did delivery cost more? | Cost of sales per unit or job | Up, since margin fell from 35% to 30% |
An 80 rise in revenue that produced 4 of profit means the extra work was taken at close to cost. Whether that was a deliberate decision about a large customer or an unnoticed drift in material prices is a question only the business can answer, but nobody asks it while looking at a profit line that went up.
Overhead measures worth taking
Overheads as a share of revenue, over twelve months. Read as a trend on your own history. Rising while revenue rises is normal to a point; rising while revenue is flat is the early signal of a structure that has outgrown the work.
Overhead measures to take
- Overheads as share of revenue, 12 months
- Overhead per month, absolute terms
- Cost lines changed by set currency amount
- Check treatment of new cost kinds
Overhead per month, in absolute terms. The blunt version, and the one that matters for breakeven. Percentages hide a fixed cost that has quietly doubled.
Cost lines that changed by more than a set amount. Set a threshold in currency, not a percentage, and list every account that crossed it since the same period last year. A percentage flags the small account that doubled and hides the large one that crept. If a line has grown because the business started buying a new kind of thing, check how that kind of cost is meant to be treated before reading anything into the trend; the federal guide to business expense resources is the reference for that, not an article.
Measures to treat carefully
- Net profit margin on its own.It combines trading, financing and one-off items into a single number, so a movement in it can come from six unrelated places. Use it as the summary, never as the diagnosis.
- Revenue per employee.Moves with how much work you subcontract, so two identical businesses can differ by half on it.
- Any figure quoted as a typical margin for your industry.The definition of cost of sales behind it is not yours, and it may not even be stated.
- Month against month, with no adjustment.Different numbers of working days, different holidays, and one supplier who invoiced late. Compare the same month last year, or a rolling twelve, or both.
The check to run before trusting any of it
Every metric on this page fails silently if the period is wrong. A month missing a supplier invoice shows a better margin than it earned. The correction lands in the next month, which then looks worse for no reason.
Checks before trusting metrics
- Cut-offassign transactions to right period
- Profit agrees with retained earnings movement
- Grouped accounts mean what group name says
Cut-off comes first, and how to get it right is the subject of the expense recording guide. Which period a transaction belongs to at all depends on the method the books are kept under, set out in the federal guide to accounting periods and methods.
Second check: the profit shown must agree with the movement in retained earnings on the balance sheet. If it does not, something reached a profit and loss account without passing through the ledger, and every metric above is being computed on a number that is not the profit.
Third, make sure the accounts you are grouping actually mean what the group name says. Cost lines that drift between groups make margin move for reasons that have nothing to do with trading, and keeping them stable is a chart of accounts discipline rather than a reporting one.
