The owner of a well-run company receives an income statement and balance sheet within 10 days of the end of the month. This is nonnegotiable. It gets done each month without exception. An income statement or a profit-and-loss statement is a view of the company’s performance for a period of time. Normally there are two important periods of time viewed - the most recent month and year-to-date.
My experience as a business coach has taught me most contractors, even if they get a timely and accurate income statement each month, really don’t know how to analyze the company’s performance. Most contractors tend to look at the sales or revenue line at the top and then run down to the net profit at the bottom. If they make an acceptable amount of money, that is where the analysis ends. To determine if the month was a good sales month, they mentally compare the sales or revenue total to their historic averages or to their best month ever.
I see most contractors getting lost in the numbers once they start to get into the details of the income statement. In most cases, it’s because they have too many numbers - hundreds of cost categories. Their bookkeeping personnel are not always good at making sure like expenses get in the right bucket month after month, which further adds to the confusion.
What do they do? They look at the top line (revenue) and the bottom line (profit) and get confused with all the stuff in the middle. They finally default to their bank account balance as the trusted measure of their business’s health. Money in the bank is good. No money in the bank is bad. However, they have no idea why the money is there - or not there.
Reviewing your company’s financial performance is not difficult. Every contractor is capable of analyzing company performance (assuming they are getting accurate financial information)
Canary In The Coal MineYears ago, well before the advent of modern technology, early coal mines did not feature ventilation systems, so miners would routinely bring a caged canary into new coal seams. Canaries are especially sensitive to methane and carbon monoxide, which made them ideal for detecting any dangerous gas buildups. As long as the bird kept singing, the miners knew the air supply was safe. A dead canary signaled trouble and the need for an immediate evacuation.
Your income statement has several indicators (canaries) that will telegraph early warning signs well before the company starts to lose money or the bank balance starts to drop precariously low.
1. Declining sales. This is a very important review for every contractor every month. How do total sales compare to the same month in the prior year? There is natural seasonality in the plumbing, heating and cooling industry. Even plumbing, which is not anywhere near as seasonal as HVAC, has natural rhythms that move with the seasons. In plumbing, typically the fourth quarter is a strong revenue period. With HVAC, depending on where you live, the second, third or fourth quarters would be historically stronger than other periods of the year.
A plumbing company that compares October to September may get the false sense of security their business is improving when in reality it is nothing more than the market getting naturally stronger. To get a true measure of the health of your company’s sales performance, compare sales to the same time period a year ago.
Keep in mind extraordinary events that may have happened this year or last year such as exceptionally hot or wet weather or a single, large job that could have influenced the numbers. Always look at your year-to-date sales vs. last year’s year-to-date sales. This will take out the influences of a single extraordinary event and give you a good view of the sales trajectory for the company.
2. Gross margin dollars declining. If this is happening, the canary is very sick. This is one of the most important numbers on the income statement and is frequently a missing analytical point for contractors.
In Table 1, total sales are up 5 percent over the same month from the prior year. Profits are down. However, gross margin dollars (total sales minus direct labor and material expenses) are down both as a percentage and in dollars, with dollars being the most important consideration.
This company has fewer dollars to operate the company and pay overhead expenses. It is still profitable, but has started to get worse. This simple analysis tells us why. It’s not sales or runaway overhead expenses. It is due to cost overruns in the field in labor and material expenses.
From an income statement perspective, it is more important to increase gross margin dollars than total sales dollars. Keep this in mind every month when you review your income statement. A healthy, growing company has healthy, growing gross margin dollars.
3. Overhead expenses vs. gross margin. The only way to grow profits is to increase gross margin dollars faster than the growth in overhead dollars. Overhead expenses are essentially every expense in your business other than direct labor and material expenses, aka direct expenses.
Direct expenses are those expenses directly related to doing work in the field. In theory, a direct expense does not exist if a sale is not made and work is not performed on any given day. Overhead expenses such as rent, vehicle costs and office salaries are incurred even if billable work is not performed on any given day
Overhead is not a bad thing. Industry icon and former PM columnist Frank Blau taught us that you make money on overhead if you use cost-plus pricing (total expected expenses divided by expected billable hours = break-even selling price per hour). Frank used to say if you keep a sharp eye on your expenses and your billable hours to make sure they are in line with expectations, it is impossible to lose money. He is right.
Where you see the damage from having expenses higher than expectations is in your income statement. Overhead expenses will start to eat into your profits when they are growing faster than gross margin dollars.
In Table 2, look at the bold numbers under the variance percentage column, which is the difference between this year and the prior year as a percentage of prior year sales. You can see our first checkpoint is sales, which increased 5 percent. Great! Second, gross margin dollars are up $8,500 and 7 percent from prior year. Even better! Gross margin dollars are even growing faster as a percentage than sales dollars. This is very good!
The final checkpoint is overhead expense, which is up $12,000 or 12 percent and growing faster than gross profit dollars. This guarantees you will make less money than the prior year.
I heard, “Keep it simple, Jack,” from Frank on more occasions than I can count. If you keep these three simple checkpoints in mind each month when you review your income statement, you will stay in front of any negative trends and keep the canary in your business singing.