Three Ways to Evaluate Expenses
Last month, we took a deep dive into the revenue portion of the profit and loss statement (P&L), but that is only half the equation (pun intended). As discussed, revenue is always where any financial analysis should begin because business owners and CFOs need to know how much money is coming in before they can start looking elsewhere. But a close second is then understanding how much money is going out of the business.
Just like with revenue, looking at expense line items on the P&L is simply not enough. The expense numbers listed only tell one portion of the story, just as revenue did. Remember that to truly understand what is happening in any business, we must know how the numbers actually got to the P&L. In an effort to help business owners better understand what is going on with the expense side of things, we’ve compiled the following best practices. While this list is not exhaustive, it will help in gaining more in-depth insights about where money is going and why.
Three Ways to Evaluate Expenses
- Look at Expenses by Account and Amount
Most business owners have an understanding of where money is being spent and costs overall. They may know a rough total of what they need each month to break even or make some profit, but a total doesn’t tell very much of the story. Rather, each expense should be handled individually by looking line by line on the P&L to determine how much is being spent in each account.
Once it is all separated, we recommend focusing on what is most material (i.e., where the business spent the greatest amount). This is not saying we shouldn’t look at every expense. It is saying, however, that we all have a limited time to work with, so prioritizing where we are spending say 50%-80% of revenue rather than 5% may be a better use of that limited time. Essentially, the smaller adjustments can wait while the larger ones are sorted out.
- Compare Year vs. Year
While there is an enormous amount of information found in the current state of expenses, there is even more found when we analyze them over time. To that end, we suggest comparing the current P&L to last year’s P&L to look for any fluctuations between the two. Specifically, are the variances positive (cost less) or negative (cost more)? Was there more of an emphasis on marketing this year? Did payroll increase but revenue stay the same? These are just some of the questions and considerations we want to ask ourselves as we begin comparing the two years.
The comparison report will also highlight any metrics on business model shifts. For example, if payroll decreased while the cost of contractors increased, from a high level, it would appear that the business is shifting to a more outsourced services model. In this analysis, it’s important to look not just at dollar amounts but also at percentages. It can be jarring to see an expense jump from 5% to 20% within a year, but it will be even more jarring if we don’t know the reason for it. This comparison simply provides more insights about which direction expenses are going and helps increase familiarity with all aspects of the business’s spending habits.
- Review Budget vs. Actual Expenses
While budgets are an effective tool for planning purposes, they do not represent what is actually happening in a business. Ideally, we forecast well enough that the actual is closely aligned to the budget, but it doesn’t always work out that way. There are times we must make exceptions or have unexpected expenses come up that we never could have predicted.
In this analysis, it’s important to make sure to leave room in the budget for the unknown and build some flexibility into spending. For example, look at vendor accounts to see if there is any flexibility in payment terms (i.e., from net 30 to 45) to help with cash flow. Or take this time as an opportunity to evaluate the relationship overall. Is it a strong one? Do they seem as if they could be in trouble financially? Should a replacement be located? Are there any volume discounts available? This analysis will provide invaluable information regarding the state of vendor relationships and their associated costs.
Taking a deep dive into the financials is imperative to a business’s success, as it helps to ensure that the focus remains on the future and how to do better. By taking a more in-depth look at expenses, we have the ability to make more informed spending decisions that are based on facts and reports, rather than assumptions and vague ideas.
At Agile Planners, we provide strategic guidance and outsourced CFO services to companies of all sizes. We can help provide the strategy your organization needs for the growth you want. We understand that no two organizations are the same. And with our experience and financial knowledge, we can help develop the right strategic plan for your business to grow and reach its goals. Simply, we’ll be your trusted partner, so you can focus on running your organization. Contact us today to learn more about how we can help.