Accounting For Growth – The Model P&L

Accounting for Growth – The Model P&L

 

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As anyone knows, building a business takes a major effort of time and having more things on your to-do list than you can seem to move to your to-done list.  Most of the focus of an entrepreneur in building their business will around your product, your customers, and driving sales. The needs of the back office, such as payroll, human resources and accounting, will tend to get at best secondary attention.  After all, these are just the mundane requirements to keep the business going. Activities that just need to get done as simply and quickly as possible so you can go back to running your business. In this manner, spending time to setup and maintain a proper accounting system would seem a low priority.  However, an entrepreneur who ignores the accounting side of their business risks making poor decisions, or worse, making decisions based on inaccurate information. In this short article I will show how accounting can help you optimize your business through the use of a model P&L.

A quick primer on the Profit & Loss Statement (P&L) is in order.  The P&L statement of a business shows if the operations over a specific period of time are generating a profit or a loss.  The concept is simple, start with revenue then subtract your operating costs to arrive at gross margin. From here you would subtract your business expenses to arrive at your pre-tax income.  This provides a view of the profitability of your business. Important note; pre-tax is accounting income and should not be confused with your cash flow, which is another financial statement.

Building a model P&L requires that your spending be further subdivided into spending categories, typically tracked in your accounting system by their related department.  While the exact type of categories will vary by industry these are the generic types:

 

Typical Spending Categories

Cost of Goods Sold:

This would include the costs of supporting the revenue.  For a manufacturing or retailing firm it would be the cost of the inventory or product when sold.  Service companies would include the cost of the labor to provide the services. Your customer support costs would be included here as well.  Note that many times a service or software company will refer to this as “Costs of Revenue”, as they don’t have any actual physical goods being sold.

Operating Expenses:

These are the expenses of the company.  Think of these are activities that in general do not vary in direct relation with sales.  Yes, I know that is not completely true, for now we’ll keep this in the format most used by accounting

Engineering: This includes the costs of developing new products.  This will typically be primarily labor, i.e. the costs of the engineers.  Note than in many financial statements this is labeled as Research & Development (R&D)

Marketing: Your costs to market your product and generate inbound leads.  This includes marketing programs, advertising, marketing staff, and public relations.

Sales: The marketing department would be nothing without their winged monkeys, the sales team.  This includes the cost of your sales staff, commissions and related direct sales costs

G&A: General & Administrative expenses are the overhead of the business.  Typically, this would include the costs of back office such as HR and accounting.  General expenses such as building rent, insurance and legal fees as well as the executive team such as the CEO would be in this category.

 

The model P&L provides the executives an understand how spending is being invested in each of the key areas of the business, as well as a comparison of how this investment compares to other peer companies.  Using this information, you can determine if you are investing in a manner that other successful companies in your same industry have taken. The concept is simple, it starts first with generating your P&L for a specific period, normally on an annual basis.   I have used a hypothetical example for a software/SaaS company that has $5M in revenue. See Figure 1 for the annual P&L statement for this mythical firm, Company XYZ.

While the standard P&L statement is in dollar terms, the model P&L uses ratios.  Spending is put in terms of percent of revenue, with revenue fixed at 100% as shown in Figure 2.  By converting category spending to % of revenue you can compare your spending levels for each category against industry benchmarks, regardless of the exact dollar value spent.  Think of this as showing how much of each $1 of revenue you spend in each area of your business. If the model P&L for your business shows 33% for engineering (as in this example) you are spending $0.33 of every dollar of revenue as an investment in your product development.  Certainly, good information to have!

 

Once you have your P&L ratios you can then compare how you are investing your spending against peer standards.  For a valid comparison you should obtain metrics from companies in a similar line of business to your own. It is also important to use P&L ratios from peer companies that have similar revenue levels.  A $5M revenue company will have a far different P&L ratio structure than a $500M revenue company, as they are at different levels of their growth stage. Comparable ratios may be obtained from a number of sources.  One is to review initial public offerings. These contain five-year financial histories, allowing you to pick a time frame when a peer company was at a revenue level close to yours. Investment banking firms may also have surveys and access to financial information.  Of course, you can also ask friends in your network for help.

For this example, I have used an illustrative benchmark of a typical SaaS company in the $5M to $10M revenue range for comparison.  Note that you may not be able to obtain benchmark comparisons in the same level of detail that you track in your own P&L. In this example Company XYZ tracks marketing and sales in separate categories while our benchmark combined both into a single sales & marketing category.  I have combined sales and marketing for Company XYZ into one category, so we can compare against the peer benchmark. The comparison analysis is shown in Figure 3.

 

It is important to understand that your company does not need to look exactly like a peer comparison.  The best use of a model P&L is to review where your investments are significantly different from the peer model and then understand if this is valid for your specific business.  In my review two areas jump out. Company XYZ is spending more of its resources on a comparative basis in two categories, sales & marketing and G&A. It would appear that Company XYZ has a very high overhead cost structure.  Reviewing the spending in this area for reductions is in order. I would have discussions to understand if we are overinvesting in sales & marketing. Perhaps our spending is this area is not returning sufficient new business to generate revenue.  You may have inefficient marketing programs, or your sales efforts are not generating sufficient results. Perhaps you are in a unique niche area that requires higher sales & marketing efforts than a typical firm and this higher spending is justified.  The model P&L provides you guidance on where to focus your attention.

If you use the correct comparisons you can see what level of investment it took for other companies in your industry to become successful and how your investment stacks up.  The use of a model P&L to compare against industry peers is a powerful tool to manage your investment spending for success.

Your comments and questions are welcome.