Using the P&L as a tool for Operations

When helping a client, we had a discussion about the P&L.

Is one of the first things I ask to look at.

And they presented a P&L that is presented to the authorities.

Not a managerial P&L.

Let′s call the customer, Ben.

Me: Ben, which decisions can we drive from this P&L?

(I am not really good at the Socratic method, but still tried...)

Ben: well, our profits are going down, so we are loosing money.

Me: ok, but that′s not really a decision, that is more an interpretation of what happened, or?

Ben: true... well, fixed costs didn′t move much... so they are not the problem.

It looks like sales stagnated, we are less at the same level as last month.

But costs of goods increased... here we might have a problem...

Me: ok, from which products?

Ben: uhmmm. We don′t have that here. I see where are you going to...

What was the problem?

That yes, we could have some idea of where to put the focus.

But not in a straight way.

We could not take any decision on the spot about what to do next.

(other than investigating, of course).

And that′s the thing. The time spend reviewing the P&L should be to drive decisions.

What happened? (as it is in reality a report of the history, not even the present).

What can we do? (we can use forecast models to simulate scenarios).

What we decide to do? (in essence, where we put focus on).

So, what do we want from this document?

Here′s my view on it.

FIRST THINGS FIRST

I read P&L′s the other way around.

I start at the bottom, and go upwards.

Why?

Answer this: what is the end goal we are looking at?

Making money, right?

So that is the first thing I want to look at.

At the end, is back to what I shared before:

The financials are feedback tools. They tell us, if what we decided to do, had any positive effect or not.

Once that is answered, I read all the way up to get the "story" of what happened.

Focusing on two groups:

• Operating Expenses
• Revenue

More on those groups down the line.

I know, it seems like a basic thing, but looking it in that way you change your mental framework.

Let me explain.

If you start with revenue, and go down, the story sounds something like this:

"We've sold that much, so from it, we had those costs... and we have this fixed operating expenses... and this is the end result". The result, goes last.

Instead we want this:

"We′ve hit our target, and the explanation for the result is that we′ve got this much in expenses compared to that much revenue...".

The goal, the end result, is put first.

TRENDS

Another thing I always like to see is trends.

The progression of the P&L over the last periods.

Why?

Because it helps to remove punctual deviations.

That is for both positive as well as negative deviations.

Not that you want to ignore them, but notice them.

For example: you had a great month compared to other months.

Two questions:

1. What has driven that change?
2. How we can maintain it over time?

On the contrary, you had a bad month compared to other months:

Two questions:

1. What was the cause of the problem?
2. Is this being repeated, so it is a real risk to consider over a long run?

And this information helps you build models, to simulate future scenarios.

With it, you can drive decisions.

In general I prefer to see last year's and the current year on a monthly split.

CONTRIBUTION MARGINS

On Ben′s conversation, what I was looking for was, contribution margins.

In a second why.

But first, what is a contribution margin.

Contribution margin = Revenue - Total Variable costs.

See this graph:

What we can take from it?:

• If Contribution Margin > Fixed Costs -> we have Operating Income.
• If Contribution Margin < Fixed Costs -> we have an Operating Loss.

It is so basic, yet so powerful.

But here′s the challenge (and why many companies do not calculate them):

• You need to do it at product level. With many products and references, that is challenge. (you can do it grouped, but again, at the expense of insights).
• Variable costs are a definition. But what is not in some way or another a variable cost? So the discussion is usually how to classify each element.

For the first point, you need the right systems in place. That′s it.

And yes, it takes some time, but is worth.

For the second point: you need to agree on something, and there are many standards already in place. Use what works for you.

In general the recommendation is to include what drives the most as variable costs being: materials, direct labour*, variable overheads (like utilities if are related with consumption, for example).

Without overcomplicating things.

*On labour: we will talk next week, but for throughput accounting, is not considered unless you pay only, for parts produced (seldom happens).

Now on the why to spend the time on this anyways?

Well, because it is a fantastic tool to focus:

1. You can compare products between each other, and see what happens if the product mix changes.
2. You can decide to not focus in some products and focus on others.
3. It is directly related with the Throughput Accounting we mentioned in the previous edition. How?:

Throughput = The rate at which customer sales are generated less truly variable costs. Rings a bell?

Profit = Throughput ? Operating Expenses. Rings another bell?

More on that in the next edition, as we will make a point on Variable Costs and this metrics. But do you see the relation?

What else we can do with it?

Calculate break even points and give clear targets for the whole company.

Look at this:

Based on volumes you can see at which point you will reach break even.

In this example: 1500 units/month (random revenue of 100usd/unit)

There you go, a clear target for the team: "we need to reach 1500 units/month, to at least, cover our fixed costs".

You can also work with different scenarios (make/buy) for example, or different product mixes.

This is a fantastic way to analyse what is going on and get insights to make decisions.

FINAL NOTES

The P&L is a fantastic feedback tool for your operations, but you need to use it as such.

Remember that you can′t use it alone, the cash-flow statement and balance play their role.

I strongly recommend that you do the exercise to work with the contribution margins and see what is going on.

In Ben's case, helped a lot to identify opportunities and also remove focus for several obsolete, non-performing products.

Thanks for reading me!