“Let me show you how to manage your business, young fella,” said my very first business mentor.
“This here’s yer Income Statement. Money comes in at the top. You then pay this money to other people, and if you’re lucky you’ll have a bit of profit left at the bottom.”
Pretty typical, right? I mean, that’s exactly how an Income Statement is structured. And that’s about as much advice as many business owners get.
But it’s an awful way to manage a business.
First of all, many businesses in their first few years don’t have any profit. Trying to manage a young business by watching losses doesn’t make much sense.
Second, this model makes it seem like you don’t have much control over the money coming in. Other people (your customers) make decisions about giving you the money, and then it just appears.
Which means you only have control over the money going out. And if you want to improve your profit you can only do one thing: reduce expenses.
The problem is that you can’t sustain a business solely by trimming expenses. You can’t cut your way to growth.
Here’s a better way to think about your business: develop an investment mindset. The three steps to develop your investment mindset are:
FIRST, treat every expense as an investment that must show a positive return. Every expense must either:
a. generate sales,
b. be used to deliver your product or service, or
c. support either a or b.
You’ve got four basic kinds of expenses. Sales and marketing are clearly designed to generate sales. But now, think of them as an investment that must show a positive return in the short- or medium-term. Marketing campaigns MUST generate revenue that’s several times their budget. Same with each member of the sales team and every sales activity.
Research and development are longer range investments. These investments must result in new products and services that your customers will buy.
Cost of goods sold (COGS) are necessary expenses that are needed to deliver the products and services you sell. Think of them as investments, too: “I need to invest $20 in materials to deliver that $100 sale.”
General and administrative are necessary expenses that don’t fit into the above categories. They are things like rent and phones and bookkeepers. They must SUPPORT the above expenses.
SECOND, look at your income statement differently.
Start with your basic expenses. Imagine them as investments that lead directly to a financial return: sales. Your goal here is not to TRIM expenses but to TUNE (and even grow) them so they lead to an increase in sales.
Treat your COGS (cost of goods sold) as a special type of expense. Spend them as efficiently as possible to deliver your products and services.
STEP THREE: track your performance by gross profit.
Gross profit is a simple calculation: sales minus COGS. You improve it by making better investments that grow sales OR by increasing your production efficiency.
Let’s look at the income statement with fresh eyes. This time, let’s look at it over two months:
Here’s how to read it: Money invested in month 1 gets returned as sales in the future which are then delivered as efficiently as possible. This results in gross profit.
Several advantages here:
- You gain control over sales because they are a result of YOUR investment decisions, and not based just on external forces.
- You gain deeper insight into how to manage your expenses (investments):
- eliminate those that don’t contribute,
- trim those that need trimming, and
- increase those that are generating healthy returns.
Sharp-eyed readers may say, “But what about profit? Aren’t we supposed to keep an eye on our bottom line?” Sure, but using profit as a primary management number can be problematic for many businesses.
Profit (which is different from gross profit) is sometimes used as a measure of operational health. But it masks key things like how promptly customers pay us, and it doesn’t provide any insight into production efficiency or marketing effectiveness.
Other use profit as a proxy for cash flow. Again, though, there are many things that affect cash flow that are not reflected in profit. Many growing companies with healthy profit have found themselves out of cash. And, worse, management never saw it coming.
To summarize, develop your investment mindset:
- Treat every expense like an investment.
- Look at your income statement differently.
- Track your performance by gross profit.
You’ll become a better business owner.
Alex Glassey creates simple, integrated business framework specifically for business owners and entrepreneurs. Test out his latest product F2F.live. It’s free, and you can speak face to face with your entire audience in live streams, webinars, classrooms, meetings, and TEDx events. Keep in touch on Twitter and our brand-new YouTube channel.