The Income Statement | Quick! Show Me Your Value

On the income statement, information about revenues (incoming funds) and expenses (outgoing costs of doing business) are added and subtracted. Ultimately, the addition and subtraction creates what is known as the bottom line, or the net profit (or loss) for the organization.

Figure 4-1 displays the income statement for the fictitious company ABC MediCompany.

Figure 4-1: A sample income statement for ABC MediCompany.

Notice that the income statement is split into four parts . Each part reflects a separate profit line that must be carefully managed in order for the organization to thrive. Table 4-1 explains the four profit lines.

Table 4-1. The four profit lines that appear on an income statement.
Profit Line	Calculation
Contribution Profit Margin	Net sales (revenue) minus COGS and other revenue-driven expenses
Operating Earnings	Contribution profit margin minus fixed operating expenses
Earnings Before Income Taxes	Operating earnings minus interest expense
Net Profit (or Loss)	Earnings before income tax minus income taxes

Both the top line (net sales or revenue) and each of the subsequent three profit lines must be constantly monitored by Senior managers to ensure that the organization meets its goal for the bottom line ‚ the fourth profit line (net profit or loss). On the right-hand side are three profit ratios, or a calculation of how big that profit line is compared to the size of the top line of net sales (revenue).

For companies that are publicly traded, there is a great deal of attention paid to the profit margins, with investment gurus such as David and Tom Gardner of ‚“The Motley Fool ‚½ (www.fool.com) recommending that they prefer to see margins that stay even or slightly and consistently rise as one of the key indicators of good stock performance (Gardner and Gardner, 1996). This puts a great deal of pressure on Senior managers.

A Picture Is Worth a Thousand Words

Many WLP professionals find a list of numbers , even one as simple as ABC ‚ s sample income statement, difficult to relate to. Because revenue, profit lines, and profit ratios are so important in communicating value, let ‚ s put the income statement into a picture. Figure 4-2 paints a picture of how ABC ‚ s Senior management did within the analogy of a profit yardstick.

Figure 4-2: Sample revenue and profit line chart.

What These Numbers Mean

The first thing to notice in the bars in figure 4-2 (or if you prefer, in the numbers in figure 4-1) is that what started as a large amount of revenue at the top ended as a rather small sliver of remaining net profit. Many people believe that for-profit businesses keep a huge percentage of their revenues as profit. This is rarely the case. A few exceptional organizations can manage to keep as much as 10 percent of their revenues as net profit. The majority of businesses, though, are closer to the 5 to 7 percent net profit range (Tracy, 1996).

In ABC ‚ s case, the net profit is 5.6 percent, or $560,000 of the original $10 million. Is this a good net profit for ABC? It ‚ s hard to say without comparing ABC to its competitors . Given current conditions in ABC ‚ s industry, making 5.6 percent profit is very respectable. Still, with a net profit of this size, there ‚ s not much room for error. If ABC keeps its revenues the same next year, the rising cost of inflation alone would eat approximately 2 percent of ABC ‚ s net profits next year. If there were a sudden shortage of a key material or an aggressive new competitor in ABC ‚ s market, it would not take much to push ABC into a net loss instead of a net profit. For successful Senior managers, there is no time when they can reduce their diligence about the bottom line. For the struggling Senior management team, there is even less rest for the weary.

The next thing to notice is how large some of the expense bars are in relation to others. Senior managers must manage every profit line, but they will spend their time and attention in proportion to the size of each expense bar in order to make sure that the entire organization is managed well.

Important ‚

Senior managers will spend their time and attention with you in the same way. If it is possible for you to do so, prioritize your value communication to make the most connections to where you already know your Senior managers will be focusing large portions of their time.

The Top Line: Revenue

The first bar to at look in figure 4-2 is the top revenue line. Bringing in sufficient revenue is crucial. Without enough revenue to start with, Senior managers will have to take drastic steps by cutting expenses elsewhere.

But, not all revenue is created equal. Senior managers and high-level sales and marketing managers spend a great deal of time making sure that they have the right sales mix of products and services, price and volume. In a manufacturing business, too high a price for a product drives customers to the competition. Too low a price raises volumes but will also raise the corresponding expenses needed to produce that volume. The lower price may bring in more volume, but that volume may also raise expenses to the point where the business loses money on every sale.

The appropriate sales mix is also critical in maintaining or improving the very important measure of market share. The organization with the largest share of the total market for an industry enjoys considerable power within that industry. Many companies are very concerned about any slip in market share and will constantly adjust their sales mix to protect or improve their market share position.

Important ‚

Every WLP professional needs to understand the revenue of his or her target organization because so much of the rest of the financial language around profit is discussed in terms of how much of the original revenue the organization gets to keep for its efforts. If you are a WLP professional working with sales or marketing, it is also critical to understand the desired sales mix to make sure the correct knowledge and behaviors are supported by your interventions. A small miscalculation in behaviors can create a big difference in final profit. Move behavior to the optimum mix, and you enhance revenue at minimal cost. Encourage suboptimal behavior, and the organization may struggle mightily with controlling costs and maintaining market share. Struggle too long or too much and the organization no longer exists.

For further discussion of the advantages and disadvantages of various sales mix scenarios for product or service businesses, see John Tracy ‚ s book Budgeting ƒ La Carte: Essential Tools for Harried Business Managers . It ‚ s listed in the Additional Resources section of this book.

Another way in which revenue is not created equally is when the organization records revenue from a one-time transaction such as the sale of a large asset or division of the company. For this discussion in communicating the value of WLP interventions, the focus is on renewable revenue generated by ongoing sales or other continuing activities.

To see how revenue breaks into cascading measures through an organization and how those measures can be translated into value chains, take a look at figure 4-3.

Figure 4-3: Revenue measures and a sample financial value chain.

Important ‚

To help draw a visual link from the financial value chain to WLP interventions, the financial value chains in this and subsequent profit, position, and cash examples have possible WLP interventions depicted.

Where to Place Your Value. In the top half of figure 4-3, starting on the left-hand side, are examples of revenue measures for each type of audience, ending on the right with examples of WLP interventions that may improve those measures.

The closer you get to the Individual level of your audience the longer and more varied the list of possible measures and interventions becomes. The list of measures and possible interventions in this example are not restricted to what our fictitious ABC MediCompany might use. The list of measures and possible interventions is also by no means exhaustive in covering every type of organization in every industry. The point of the example in figure 4-3 is not to give you an exhaustive list, but rather to show you how such a list can be created so that you can use this format to build a list ideally suited to your target organization.

Finding Your Value. Note that at the bottom of figure 4-3 is an example of how one set of revenue measures has been formed into a chain that links the development of negotiation skills to revenue and a very important profit margin ‚ the contribution profit margin.

In the ABC MediCompany example, let ‚ s assume that the salespeople are negotiating discounts that exceed the industry average and that ABC is in danger of losing too much profit if this trend continues. The sales training manager for ABC has done an excellent job of determining the root cause of the problem. An investigation has determined that the company ‚ s salespeople lack confidence in their sales skills and jump to offering a discount much too quickly in order to get the sale. This issue is widely spread across ABC ‚ s sales regions . The practice is bringing down the total net sales for the company. Negotiation skills training with a subsequent reinforcement program is the selected intervention.

The connection from negotiation skills to revenue and the contribution profit margin may seem a little too obvious for some. But, using an easy example allows you to focus on the format of the example itself.

Profit Line #1: Contribution Profit Margin

When managers refer to their profit margin, the contribution profit margin line is the one they are usually talking about. Contribution profit margin is calculated by adding together all of the incoming net revenues for a organization and subtracting out the

costs of the materials or labor used to make the products, otherwise known as the cost of goods sold (COGS)
operating expenses that are dependent on and driven primarily by revenue-generating activities.

If you want to calculate what is known as the gross profit, take net sales and subtract out only COGS. Looking back at figure 4-1, you can see that the CPM for ABC would have been calculated by taking net sales ($10,000,000) and subtracting COGS ($6,000,000) leaving a remainder or gross profit of $4,000,000. Then, taking gross profit ($4,000,000) and subtracting other revenue-driven expenses ($1,500,000) leaves a CPM of $2,500,000.

Once again, different types of organizations subtract different types of expenses from their revenue to determine CPM. Service organizations, for example, may not have a line called cost of goods sold.

Take a look at figure 4-4 to see what savvy WLP professionals might suggest for measures involving COGS.

Figure 4-4: Cost of goods sold measures and a sample financial value chain.

In figure 4-4, some possible measures for cost of goods sold have been listed. Exactly where a measure falls between the Mid, 1st/Ops, and Individual levels may shift depending on the size of your organization. As you create your own charts for your unique organization, where you place your measures will depend on your experience, your research, your best judgment, and the advice of others. There is rarely one right answer.

ABC MediCompany spends 60 percent of its revenue, or $60 million dollars, on COGS. Another 15 percent, or $15 million, is spent on other revenue-driven expenses. In other words, a total of 75 percent of the revenue is required to fund the goods produced and the cost to sell those goods. This calculation demonstrates the first financial ratio shown in figure 4-1, the contribution profit margin ratio:

Dividing CPM by net sales leaves a CPM ratio of only 25% of revenue to fund the rest of the company ‚ s expenses and to retain a net profit. Look at figure 4-2 and you can see how large COGS and other sales-driven expenses are in relation to everything else on the income statement.

The COGS financial value chain in figure 4-4 draws the links between rework rate issues and the contribution profit margin. In this version, however, the recommended intervention is coaching skills for shift leaders .

At ABC MediCompany, the production line managers have been with the company for several years . They all worked their way up from doing the production jobs themselves . The line managers were very skeptical of the premise that teaching shift leaders to stop, take time, and make sure that new hires learned better techniques would actually lower rework rates in the long term . To them it only looked like a waste of time on unproductive talk. It slowed the production lines, not only because the new hires were taking time out for demonstrations , but also because the shift leaders were the most skilled and fastest workers on the line. To convince the plant managers to incorporate the training, the manufacturing performance director had to work out the business case of how much rework ‚ particularly on the part of new hires ‚ was costing the company in its profit margins and then convince Senior- and Mid-level management that this method would help fix the problem. Did it work? Yes. This example is based on a number of successful coaching programs offered by a company that specializes in this area.

Other Sales-Driven Measures. Depending on the type of organization that is being managed, other sales-driven expenses can vary greatly. Look at figure 4-5.

Figure 4-5: Other sales-driven expense measures and a sample financial value chain.

In the last year, ABC MediCompany has moved from a single-person sales strategy to a team sales strategy, but ABC ‚ s salespeople are having a difficult time adjusting to this change. They have been encouraged to be such fierce competitors with each other for so long that they are now having a very difficult time trusting each other as team members . The proposed intervention in figure 4-5 is a team-building event. Some sales managers may immediately dismiss such a recommendation as too expensive, risky, and emotionally awkward . The sales training director has done his homework on the effects of the lack of teamwork on poor communication, mistakes, and longer-than-average sales cycle times. Sales cycle time is defined as the average length of time it takes for a salesperson or sales team to close a sale. Longer sales cycle times result in higher sales-driven costs such as allocated salesperson salary per sale, extra administrative support, additional travel for customer meetings, and time spent making corrections in formal proposals. The teamwork issues were creating more cost to bring in the same level of order dollars or what is sometimes called the cost per order dollar (CPOD).

Is this sales training director going to be able to convince skeptical sales managers who hate potentially emotional events to fund an outdoor experiential team-building program based only on the financial numbers? Perhaps not. Using financial numbers is not a panacea for getting everything that you want. Remember that the salespeople who participated in the ROI study cited in chapter 1 said they were 30 percent more likely to win their deals, not 100 percent more likely to win everything. Still, 30 percent is a huge leap in creditability in sales terms, and the sales training director will definitely gain more respect by presenting his proposal with a clear financial connection. By creating a financial value chain, he leaves himself in a better position to propose alternative interventions if necessary or to come back later with the same proposal.

Profit Line #2: Operating Earnings Margin

As shown in figures 4-1 and 4-2, the next largest type of expense on the income statement is fixed operating expenses. Subtracting fixed operating expenses from the CPM yields the operating earnings profit line. The operating earnings profit line cannot be neglected. Senior management may have done an excellent job in managing the CPM only to blow it on fixed operating expenses.

In the ABC MediCompany example, operating earnings is calculated as follows :

Fixed operating expenses, or fixed expenses as they are often called, are more difficult to control or change in the short term. Fixed expenses can be adjusted, but at considerable effort, additional expense, and negative impacts on long-term working relationships. Once adjusted, the investments to reinstate necessary contracts, licenses, facilities, or equipment can be quite expensive to bear.

When operating earnings are being squeezed too thin, one of the first areas that can be cut is money for research and development (R&D). As every CEO knows , if R&D money is cut, eventually the life of the company could be in jeopardy. If a company cannot keep up with its competitors, then it can enter in a downward spiral of smaller operating margins and then even less money for R&D. Many stock investors recommend watching the percentage that an organization continues to spend on R&D year after year. If this figure takes a sudden drop, this could be an indication that the company is experiencing problems with revenue or expense control.

Important ‚

As a WLP professional, in addition to pointing out your value in controlling fixed expenses, you may also want to keep an eye on R&D expenditures. If they are being squeezed, you can look for even more ways to help the company increase revenue or reduce costs.

ABC MediCompany ‚ s operating earnings profit ratio is 10 percent. This means that after COGS, other sales-driven expenses, and fixed expenses are removed from revenue, only 10 percent of the revenue is left.

Figure 4-6 provides some examples of possible fixed expense measures and interventions to address training issues in managing fixed expenses. Once again, this is not an exhaustive list, merely a sampling of the types of measurement cascades you will find related to operating earnings and fixed expenses.

Figure 4-6: Operating earnings measures and sample financial value chain.

In the operating earnings sample value chain, the recommended intervention is an e-learning module on handling hazardous materials.

At ABC MediCompany, management has mandated that every manager must find a way to reduce fixed expenses. Legally, the plant training staff must deliver a certain level of hazardous material training to every employee in each plant every year. The manufacturing performance director was having a hard time convincing Senior managers to invest in what they saw as an extra expense in moving to on-demand e-learning based solely on making more efficient use of instructors. By connecting the new format to cuts in a fixed expense ( prepaid fire insurance premiums), the manufacturing performance director was able to make a stronger case that the e-learning module reduced costs while still meeting legal (and insurance company) requirements.

Profit Line #3: Earnings Before Income Taxes

The next profit line is known as earnings before income taxes.

For ABC MediCompany, interest charges are now removed from operating earnings. ABC ‚ s interest charges are an aggregate of all of the various interest rates that ABC is paying for its different types of loans or other debt. ABC had $150,000 of interest charges. Senior managers must closely watch this line to ensure that they are getting the best use of the money for the cost of any debt they incur. CEOs value any reductions in interest charges. One of the most overlooked areas that can have a huge impact on these expenses is the cost of capital or the finance charges an organization must pay to get the cash to cover payroll, seasonal fluctuations between revenues and expenses, or other extraordinary items.

Important ‚

As a WLP professional, if you can show how your WLP interventions reduce the cost of capital for an organization, you have a great story to tell when communicating your value. CEOs and CFOs value programs that cut costs or raise revenues not only for the obvious effect on profit margins, but also because these interventions save interest charges that the organization does not have to pay. It improves the overall credit rating of the organization if it does not have to rely on as much credit! When calculating the value of your interventions, services, or programs, don ‚ t overlook the cascading effects of cutting costs or raising revenues on other parts of managing an organization.

In reality, there are also often accounting changes or other adjustments that also need to be accounted for. This is also sometimes referred to as earnings before interest, taxes, depreciation, and amortization (EBITDA). It is calculated just as the name implies, by looking at earnings after COGS, other sales-driven expenses, and fixed operating expenses have been removed from revenue, but before interest, taxes, depreciation, and amortization are taken into account.

Calculating EBITDA is especially helpful when a company has a large amount of depreciation, such as for machinery- intensive manufacturing organizations, or a large amount of amortization, such as for purchases of patent rights or other intangible assets. Removing depreciation and amortization reduces the distortion of these numbers and allows creditors, investors, and industry analysts to compare within and across industries. EBITDA is more likely to be used in large companies with significant assets or debt financing (Investorwords.com, 2003). EBITDA may be a term you hear used by senior executives. A WLP manager at a large company reported that when his firm was bought by outside investors, EBITDA became the new buzzword . Everyone ‚ s measures were aligned to improve EBITDA.

Profit Line #4: Net Profit (or Loss)

The final profit line is known as net profit (or loss). This is the proverbial bottom line on the income statement. Net profit is calculated by removing income taxes from earnings before income tax. Income taxes will vary depending on where a company is headquartered and where it operates facilities or sales offices, especially if it is based in multiple countries .

ABC MediCompany has only $560,000 in revenue from the original $10 million in revenues. The net profit ratio is calculated by dividing the net profit by net sales and multiplying the result by 100. In this case, the net profit ratio is 5.6 percent:

Important ‚

Knowing how to calculate ratios can be important when you are communicating value. Executives sometimes use the ratios as a quick way to discuss whether the business is in or out of balance. If ratios are frequently used in your target organization, you can sometimes use a value chain that references the ratio instead of the profit line itself.