Imagine if the dashboard in your car provided you with a display that included:
- Tyre pressure
- The water level in the windscreen wiper reserves
- The carbon monoxide level in the exhaust fumes
- The intensity of the headlights
Whilst these things might be interesting to know, they would soon take your attention away from the few “vital signs” you need to keep an eye on as you focus on driving your car safely from point A to B.
A Common Problem
This is the problem business owners and executives typically face with respect to the financial reports they receive about their businesses when it comes to managing expenses.
The default format for a profit and loss statement is a long list of expenses, presented in alphabetical order.
This is not very useful for business owners who need to be able to quickly:
- Listen through the noise (by separating the “important” from the “unimportant”)
- Monitor whether things are on track overall from a financial perspective
- Identify, investigate and remedy problems in a timely manner
- Communicate with various stakeholders about how the business is performing
The alternative is to create a set of core expense categories; a short list of numbers that provide a macro picture of how things are tracking.
Best Practice Principals
Here’s my simple approach, after having assisted a range of companies to implement such practices, on how to integrate this simple and powerful idea into business:
- Divide all your expenses up into a shortlist of categories (or buckets, if you prefer a more visual metaphor). The ideal number of categories is typically 6-10.
- Give each category a simple name so that any external party who has been asked to review your financials can easily understand and infer what is likely to belong to each category.
- Decide the order in which you’d like these categories to appear on your Profit & Loss Reports. By numbering each expense category, you can control their order.
- List all of your current expense accounts under one of these expense categories.
- Tell your accounting software to generate a sub-total for each major expense category.
Once done, your finance person/term will be in a position to help you modify the way your Profit & Loss Statement looks. In MYOB, this may involve changing your chart of accounts. In Xero, it may simply involve customising your report.
Selecting Expense Categories
Here’s a real example of a set of major expense categories one of our clients chose to adopt recently as we worked out way through the application of this idea:
- Salaries & Wages
- Employee-Related Expenses
- Marketing & Sales
- Interest Paid
- Interest Incurred
- Depreciation & Amortisation
- Income Taxes
For many modern businesses, controlling and managing Sales & Marketing costs is critical to their profitability and success. Let’s say you design a financial model that allocates a Marketing & Sales budget of 10% of your gross profit, which is comprised of a myriad of different expense lines (e.g. website, advertising, signage, promotional merchandise, corporate stationery, etc). In doing so, you can easily see whether you have under or over spent in this category, from month to month, YTD, etc
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