The Ultimate Profit & Loss Statement
Nobody in their right mind would take on such a job. But guess what? Most PHC contractors do something just as silly when it comes to running their businesses.
A Profit & Loss Statement (P&L) is the business world’s version of a construction blueprint. I am amazed at the number of contractors I meet who: 1) don’t know what a P&L is; 2) maybe have a vague idea, but don’t bother to keep one for their own business; 3) do have their accountant produce a P&L, but one that is inadequate for good financial management.
Based on my travels and seminars around the industry, I suspect that well over 90 percent of the contractors in the PHC industry fall into one of these three categories. I will try to correct this with a two-part article on P&L statements running this month and next.
The purpose of a P&L is to give you, the owner or manager of a business, a clear picture of all the income and costs entailed in running a business, and how they stack up as a percentage of income. I’m sure you are familiar with the term “bottom line.” This is, literally, the last line of a P&L, which shows the amount of profit generated by your business — or, how much you lost.
A good P&L will divide costs into two broad categories: direct and indirect costs. Direct costs are costs that vary with each job, such as labor and materials, as well as things like permits, subcontracts and equipment rental. Direct costs also can be thought of as “known” costs, even to those lost souls who don’t bother to crunch their business numbers the way they should. For instance, you know exactly how much material goes into each job, and you know how much you have to pay for labor.
Indirect cost is another term for “overhead.” It consists of all the expenses you incur in running a business that cannot be applied directly to a given job, but must be shared by all jobs. Contractors tend to make two basic mistakes in constructing a P&L:
1. They mix up direct costs with indirect costs.
2. They do not adequately itemize their indirect costs. The more line items you can come up with, the better picture you have of your business — within reason, of course.
For instance, in most cases you wouldn’t need to break down the “small tools” category into expenditures for pliers, wrenches, screwdrivers, etc. On the other hand, you might want to do so if you suddenly found your small tool expenses growing to an unusual extent. (More likely, you’d want to establish a better tool control policy.)
What you want to avoid, however, is creating a “miscellaneous” category where you end up dumping every expense not clearly defined. Never put “miscellaneous” into a P&L. If you can’t fit a given expenditure in any of the existing categories, create a new one describing that expense.
On the pages that follow, you will see three different P&L statements. Let’s examine them.
Statement I: This is an actual PHC contractor’s P&L statement (p. 24) covering his fiscal year 1997, and created by his CPA. It is actually a better P&L than most of the ones I see, but nonetheless not as good as it should be.
Statement I contains several items that should be moved from the “Direct Cost” section to “Overhead,” and vice versa. They are bold faced.
Service manager’s wages, warehouse wages and truck maintenance wages all should be assigned to Overhead, because all of these expenses get spread among all the jobs you do. Conversely, Equipment Rental and LIC/Permits/Bonds belong under direct cost of sales, because they can be assigned to individual jobs. (The LIC portion, standing for “Licenses,” would be itemized under Overhead if it stood apart. This contractor chose to lump it together with permits and bonds to avoid a line item amounting to very little. This is acceptable, in my opinion.)
One glaring shortcoming of this P&L is the absence of any retirement plan funding for the owner and his faithful associates. The Wall Street Journal reported that two-thirds of small businesses lack retirement plans, and I’m sure the figure is much higher in our industry. It’s time we put a stop to this tragedy.
Statement II: It’s notable that Statement I was produced by a CPA. My experience has been that most accountants are unfamiliar with the PHC industry, and thus frequently make such mistakes. The P&L statements recommended by CPAs tend to be generic and too vague to be of much use to PHC contractors.
Statement II, (p. 24), contains my amended version of what items should be listed under Direct Costs and Overhead. What difference does it make? It’s important to correctly assign costs because Direct Costs, for the most part, are not very controllable. Overhead expenses are what a businessman must focus on to keep his costs under control.
You do that by regularly checking your P&Ls — at least monthly — to see which cost factors are rising at a significant rate. Then you seek to find out why, and if there is no reasonable explanation — such as a large one-time expense — it’s time to devise a company policy to rein in the growing expense.
Statement III: This is what I call the “Ultimate Profit & Loss Statement.” It adds several columns to this contractor’s original two-column P&L statement, as follows:
Column 3. This calculates the selling price of items in Column 1. It is derived by dividing the direct and indirect cost items in Column 1 by 97.67 percent. Why? Because each item in Column 1 equals 97.67 percent of the selling price. Why? Because net profit equals 2.33 percent of the selling price. Together they must necessarily equal 100 percent, i.e., the selling price.
Column 4 shows the net profit that derives from multiplying Column 3 by 2.33 percent.
How can this be? How can one make a profit from expenses? Well, if you peg desired profits as a percentage of selling price, then it turns out that the higher your expenses, the larger your selling price, and profit dollars emanate from all the components of a selling price, including the expenses that go into building it.
It’s a concept that shocks some people, but I use it exactly because of its shock value. In an industry where everyone incessantly scrambles to reduce their price in order to remain “competitive,” people should know that every time they reduce a cost, they also reduce their potential profit.
Column 5 shows sales per billable hour. To compute this number you need to know the number of billable hours sold each year. In this case, the contractor’s annual billable hours totaled 9,576. If we add up the sales per billable hour for Direct Cost ($111.89) in Column 5 with the Overhead sales per billable hour of $161.12, we find the actual sales per billable hour being $273, covering all costs and profit.
Column 6, net profit per billable hour, is derived by dividing Column 4 by 9,576 billable hours. Bottom line net profit per billable hour adds up to $6.36.
Column 7, relevant only to the Overhead section, is one of the key numbers in all of contracting. It shows overhead dollars per billable hour, derived by dividing all overhead items by 9,567 billable hours. This contractor’s bottom line shows $157.36 of overhead for every billable hour sold.
It’s interesting to note that this contractor’s direct cost of labor, including all fringe benefits, totals $31 per hour. So when he adds the $31 to $157.36, his break-even charge for labor is $188.36. His selling price for one hour of labor, however, built into his flat rate pricing system, was $186 an hour. So this contractor was losing $2.36 for every hour he sold. Only the markup on materials enabled him to eke out a 2.33 percent overall net profit.
Next month, we’ll go even beyond the “Ultimate P&L Statement.” Stay tuned.