The Basic Accounts – Revenues, Costs, and Expenses
New and small-business owners tend to track their profit-related accounts more than any others. There’s a good reason for this: Without pretty consistent profits, no business can survive for the long haul.
There are three numbers that go into figuring out profits: revenues, costs, and expenses. Every business has revenues (hopefully) and expenses (definitely). Only product-based businesses have costs. In the profit equation, you start with revenues, then deduct costs and expenses. When the result is positive, you have profits. When it’s negative, your company has sustained a loss for the period.
ALERT
It’s very easy to confuse costs and expenses; after all, they seem like the same thing. In accounting, costs refer to the amount of money you have to spend to buy or make a product that you plan to sell to someone else. Expenses, on the other hand, exist whether you buy or make or sell anything.
In the profit equation, a product-based company with costs will see an additional and crucial subtotal called gross profit (when expressed as a percentage, it’s called gross margin). That number represents the revenue left over once you take out the direct costs of the products you are selling. The gross profit tells you how much you have available to cover all the rest of your expenses, ideally leaving some net profit at the end.
Fine-Tuning Your Gross Profit
There are two components that go into your gross profit: the price you charge your customers for a product, and the amount it costs you to buy that product from your supplier. While you do have some control over costs, such as switching vendors, that control is pretty limited. Prices, on the other hand, are set completely at your discretion. The bigger the gap between your price and your cost, the higher your gross profit will be. The trick is to set your prices as high as possible without scaring off your customers; sales at slightly lower prices are much better than no sales at all.
FACT
Gross margin percentages vary widely by industry. Some have very high margins, of more than 50 percent; others have very tight margins of 10 percent to 15 percent. It really depends on the type of item you are selling, and how much markup the customers are willing to bear. For example, the margin on luxury items is normally much higher than the margin on groceries.
To figure out how much of your sales are going toward general expenses and profits, divide your gross profit by your sales to get the gross margin percentage. Here’s an example: Suppose your sales are $20,000 and your costs are $15,000. That would give you a gross profit of $5,000 ($20,000 minus $15,000).
Now take that gross profit of $5,000 and divide it by the sales of $20,000 to give you your gross margin percentage; in this case, 25 percent. That means 25 percent of every sales dollar is available to cover your expenses.
If you are in a low-margin industry, keeping a close eye on expenses is a good way to ensure bottom-line profitability. The other way is to generate a very high level of sales volume, but that can be harder to pull off. Especially for new or small businesses, strict expense management can make all the difference between profits and losses.
Expenses Mean Tax Deductions
When tax time rolls around, many small-business owners begin searching everywhere for receipts and invoices not yet accounted for. They try to remember every trip they made in the name of the company, every meeting they attended, every client lunch. They do this to make sure that every one of their expenses makes it into the accounting records for the year, and for good reason: Every dollar of expense translates into a reduction of income, and less income means a lower tax bill.
More things count as deductible expenses than you might think. For example, if you have to take courses to maintain a professional license, save the invoices and deduct those fees. When you drive to visit customer sites, every mile you travel goes toward deductible expenses (the mileage rate varies from year to year based on federal law). Other commonly overlooked business expenses include reference books, alarm systems, bank charges, and dry-cleaning of uniforms.