How Managers Use the Income Statement

 Originally Posted on 3/30/2010

In the previous post we saw the classic, but I'd rather say the "accountant's" form of the Income Statement. Income Statements do not come always in this form, there are many other forms, each one focuses on different company facts. 

In a production company, for example, the P&L will look like:

 

Income statement sample for a manufacturing company

 

A manufacturing company focuses on issues like the manufacturing costs or the finished goods warehouse (it has impact on taxation and crystallizes money into something that sits on a shelf, but this is an entirely different matter).

Once more, this form gives an informative view on the company as a whole but does not tell a lot about what a manager can directly influence; it is not providing any form of actionable insight.

So, one of the first things that are often getting implemented in a BI project is a data-mart that gives you back something like this.  

 

Managerial P&L example

Managerial P&L example

This statement appears to mix various things but, at a closer look, you'll find some interesting points.

First, costs are split between direct, that is costs which can be associated directly to the product sold and Indirect, which can't. This method to classify costs is named "Direct Costing".

Second, note that each row is closely related to a specific function. In J&B computers there's someone who's in charge for selling HW, someone who sells consulting services, someone who checks that travel expenses do not balloon unexpectedly and so on.
This point is very important, the managerial income statement is split according to a principle of accountability. There should be someone who's in charge of the figures in a row. This is not the only principle, but the most relevant to understand why a specific cost structure is chosen. Third, it ends with Margin and not with Income. Margin is what remains after all the costs and expenditures have gone into effect to produce the sales. Is it the same as the Income? Absolutely not, they're "cousins" but they are calculated in different ways. The margin tells you that the major ongoing operations produced more money than the amount burnt to produce the sales. If you have a global negative margin, sooner or later you'll have to borrow money. If the margin keeps being negative, you're toast. 

Be aware that the rows may vary, depending on what you need to keep an eye on. A manufacturing company will likely have a detailed production cost breakdown, even with some cost allocations. Others, which heavily use coupons and special prices may have those as a cost. Designing a managerial income statement suited to the company is one of the tasks those management consultants paid twice than you are appointed to do but that can be done just asking the right questions to management .

 

So now you see a report, and I know many among you already know how to implement it by their favorite BI tool. Before closing the post I just want to point out that this report sucks. It sucks because no number has a meaning if it is not compared to another number. It may be the budget or (worse) the previous year same period, but your report need to look like this. 

comparison P&L

 

Here 2009 and 2008 are side by side. For each year, each row shows the percentage respect to Total Sales. We already said that this is a scalar report, so a manager reads it to learn how many point are "eroded" by a particular row. This makes comparison non dimensional thus showing efficiency gains or losses. The comparison between the two years is made on the percentage points gained or lost. 

For example the warehouse and logistics which handle the HW have slightly lost efficiency, having lost .2 point in 2009.Administrative expenses have been well polished, because they are down a point out of 5 and a half in 2009. 
If you have to choose an area to work on to improve margins, just work in obtaining better discounts from HW vendors because HW purchases make 40 points alone and they're up 3 point from 2008. This is the kind of analysis a manager does.
Now watch consulting labor, it is down 2.61 points, which sounds good, but consulting is down by 5.6 points, so you actually lost 3 points of efficiency! All of this, while total consulting value grew!

Anyway, everything summed up, your margin is up 3.53 points and the world is beautiful. I hope I have given an idea of what managers do with your income statement. In the next post we'll see how to implement it and how to add dimensions to the analysis.

Stay tuned and, please, share this post with your friends and coworkers