If you can’t answer this question with hard numbers, then you don’t really know. The most successful companies have systems in place to make sure that profit is prioritized, expenses are controlled and stakeholders are regularly updated about about progress.
Here are seven ways to see how much you’re really spending and earning:
1. Review your chart of accounts
Your chart of accounts is a listing of each account that you use for transactions as well as the account number. In order to track your expenses and profitability, your chart of accounts needs to be both comprehensive and easy to understand.
If you don’t review and update the chart of accounts each month, your financial statements may not be clearly stated. The balance sheet, for example, should separate assets into current and long term categories, and an income statement must separate operating income from non-operating income. The chart of accounts helps you generate the right information for these two financial statements.
The importance of this cannot be understated. Assume, for example, that Patty manages Marshall Landscaping, a business that generates $10 million in annual sales. Marshall’s work includes landscaping, tree services, and fence installation, and Patty considers these three areas to be profit centers.
If Patty’s chart of accounts uses the account number #7000 for total revenue, for example, Marshall should have sub-accounts for each profit center. Assume that account #7100 is landscaping, #7200 is tree service, and fence installation is assigned #7300. Every revenue and expense category should have a sub-account for each profit center, so that Marshall can calculate the profit of each service it provides.
Each revenue and expense account should also have a specific description, and no expense accounts should be labeled as “miscellaneous”. This policy forces management to assign each expense to a specific category.
2. Automate your income & expense tracking
Use accounting software that allows you to link your bank account and credit card activity directly into your accounting records. This task is important because it ensures that you’ll capture all of your business activity for the month.
Entering information manually can be a problem, since it’s a time-consuming process. Given the amount of input required, many businesses put off entering monthly transactions until after the month is over. This delays the firm’s ability to generate month-end accounting reports and financial statements meaning that you might not discover problems until much later. Manual input also increases the risk of human error.
3. Use accrual accounting
Maintaining the chart of accounts allows the business to use accrual accounting to track expenses and profit. Accrual accounting posts revenue when it is earned and records expenses when they are incurred. Revenue transactions are matched with the expenses that were incurred to generate the revenue.
This is different than cash basis accounting, which posts transactions based on cash inflows and outflows. Every business should use accrual accounting, because cash basis accounting can create misleading financial results.
Marshall, for example, uses accrual accounting for its June month-end payroll. Workers will not be paid for the last week of June until July 3rd. To properly account for payroll on June 30th, Marshall posts a $70,000 debut to wage expenses and a $70,000 credit to accrued wages payable. When employees are paid on July 3rd, Marshall debits (reduces) accrued wages payable $70,000 and credits cash $70,000 to pay employees.
Accrual accounting posts the wage expenses to the period when the work is performed (June). Cash basis accounting, on the other hand, posts the wage expenses when the payroll is paid in cash (July). Accrual accounting posts revenue and expenses to the proper time period, which allows Patty to track profitability.
4. Use variance analysis to find opportunities for improvement
Every business should have a formal budgeting process that produces a budget for the upcoming year. Many companies start the budget process before year end, but don’t complete the process until after the new year starts. But in order to track every dime of expenses and profit, the budget must be in place on January 1st of the new year.
Successful companies also compare the budgeted amounts to actual results at the end of each month, and use that analysis to make improvements to the business. This process is called variance analysis, and it helps the business stay on track during the year.
An owner should review variances and investigate the largest dollar amount variances first. This strategy allows the owner to make changes that will make the biggest financial impact.
5. Correct pricing & estimates on a regular basis
Assume that Marshall purchases mulch for landscaping. When Marshall bids on landscaping work, it includes a mulch cost per square foot. Patty reviews her landscaping costs for May and notices that the actual mulch cost per square foot is 15% higher than the budget.
Patty investigates the variance and finds that some new workers are using too much mulch on each job. Patty can train her employees and reduce the mulch expense to the budgeted amount going forward.
6. Study your profit-margin ratio
Performing variance analysis will keep a business on track, and increases the chances of reaching the budgeted profit total. After Patty reviews all of the variances, she can analyze profitability by profit center. If, for example, the tree service business generates a 15% profit, rather than the 12% budgeted profit amount, Patty should be able to find out why. It may be that tree service labor costs have declined below the budgeted rate per hour, which generates a higher profit.
Profit margin is a great tool that allows you to compare profitability between profit centers. Profit margin is defined as (net income) divided by (sales), and this ratio measures the amount of profit earned on each dollar of sales.
Assume, for example, that the landscaping division has a $400,000 profit on $4 million in sales, and that the tree service division earns a $450,000 on $3 million in sales. The landscaping division has a 10% profit margin, while the tree service division earns 15%.
The profit margin ratio allows you to compare the profitability of product lines with different levels of sales. Since the tree service profit margin is higher, Patty may decide to shift the firm’s marketing focus to the more profitable division.
7. Automate your accounting
Managing a business requires you to make dozens of decisions each day, and it may be difficult to monitor your financials. If you don’t stay on top of your expenses, however, your business profitability may suffer.
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