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Do your accounts make you feel like a parachutist?

Home > Money With Melanie > Business Development

27 / May / 2010

Unfortunately, many businesses see their accounting system as an evil necessity, there to record sales, purchases, wages and expenses just accurately enough to satisfy tax requirements. Expenses are often shown from A-Z, with the main costs, materials (or purchases) and labour (wages) just taking their place in alphabetical sequence.

Instead, your accounts should be a management tool, enabling you to make informed decisions to increase profit and cash flow.

A good place to start is working out your break-even point. This requires you to understand your margins and cost structure.

You may need to rearrange the expenses in your Profit & Loss Account. We’ll use a company manufacturing parachutes as an example.

Sales are usually straightforward. Your system should tell you sales by product and product type.

The first cost is Direct Materials – this is the cost of all the materials used to form part of the finished product – such as the canopy, harness and instruments.

The next cost is Direct Labour – the total wages and “on-costs” (super, payroll tax etc) of all staff making the parachutes.

General production costs can come under a heading of Factory Overheads – including supervisors, share of rent, machinery maintenance and depreciation.

Next come Marketing Expenses – including sales staff (total cost including cars), advertising, trade shows and website.

Administration expenses include expenses such as management and accounting staff, telephones, stationery, IT costs, bank charges and bad debts.

Finance expenses (interest paid less received) are normally shown separately.

A summary Profit & Loss Account may now look like this. (The figures are hypothetical)

Item no. Description $ % sales
1 Sales 2,000,000 100.0%
2 Direct materials 700,000 35.0%
3 Direct labour 500,000 25.0%
4=2+3 Cost of sales (variable costs) 1,200,000 60.0%
5=1-4 Gross Profit 800,000 40.0%
6 Factory overheads 250,000 12.5%
7 Marketing expenses 120,000 6.0%
8 Admin expenses 310,000 15.5%
9 Finance expenses 20,000 1.0%
10=6+7+8+9 Total expenses (fixed costs) 700,000 35.0%
11=5-10 Net Profit before income tax 100,000 5.0%

There is now a grouping of like costs with their percentages of sales. From this, the Break-Even Point of the business can be calculated – where sales and costs are the same.

Costs need to be segregated between “fixed” and “variable”.

Direct materials and direct labour tend to vary in proportion to sales and so are called variable costs.

The factory, marketing, administration and finance expenses tend to stay the same regardless of sales (unless there are major fluctuations). They are fixed costs.

The break-even point above is $1,750,000. (The calculation is fixed costs divided by Gross Profit %. In this example, $700,000/40% = $1,750,000)

With this information, your product (or service) costs are easier to calculate and check. That can help you optimise your pricing.

With the new financial year approaching, ask your accountant about restructuring your P & L in a similar way to the above. The example above is very simplified so always obtain professional advice tailored to your business. (It works in any business, not just manufacturing)

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