It’s Sunday afternoon and instead of relaxing with friends or reading a great book, you are terrified for the
week ahead. You have a presentation to pitch a new internal idea on Monday, you are giving performance reviews for the first time as a new manager on Tuesday, and the sales team as asked you to join them to develop and present a proposal to a huge new prospective customer on Thursday. Plus, you still have all your other work!
One of the reasons that you are not looking forward to the week ahead is that you feel you are lacking financial literacy skills. Financial literacy being defined as ability to understand at a detailed level how your company makes money, how your customers make money, and how your competitors make money.
To help the readers of this blog, I’ve taken some of the content and business simulation data from our award-winning Business Acumen programs and consolidated the key points as a useful learning tool. Here are five things you need to know about financial literacy to avoid the Sunday Scaries:
Revenue
Revenue (also know as Sales or Sales Revenue) is how much money the company has generated by selling products/services to customers at a price. Revenue typically sits at the top of the Profit & Loss Statement (P&L) which is also known as the Income Statement.
In a very simple example, if ABC Pharmaceuticals sells two products (Goodular and Sweetulate) and their prices and volume look like this, then they have generated $6,836,000,000 in revenue.
|
Product |
Net Price |
Units Sold |
Revenue |
|
Goodular |
$169 |
20,000,000 |
$3,380,000,000 |
|
Sweetulate |
$288 |
12,000,000 |
$3,456,000,000 |
|
Total Revenues |
|
|
$6,836,000,000 |
Cost of Goods Sold (COGS)
The COGS is how much it costs you to physically make the products that have been sold and are available for sale. The “math” is similar to revenue but here we are focused on how much it costs to make the products including materials, packaging, and other physical attributes.
As I continue the example, you see how COGS is calculated. In this case, the total COGS is $1,788,000,000.
|
Product |
COGS per unit |
Units Sold |
Total COGS |
|
Goodular |
$42 |
20,000,000 |
$840,000,000 |
|
Sweetulate |
$79 |
12,000,000 |
$948,000,000 |
|
Total |
|
|
$1,788,000,000 |
Gross Margin
Business leaders love Gross Margin because it provides your first insight into the profitability of a business and its products. You get Gross Margin by subtracting the COGS from Revenue. The Gross Margin % is one of the most important metrics in all of financial literacy.
In the example below, the total Gross Margin for this business is 74%. Another way of thinking about Gross Margin is for every one dollar of revenue the company makes, they create 74 cents of Gross Margin which is good (and average) for the pharmaceutical industry. Every industry has their own benchmark of Gross Margin averages. In Retail, the Gross Margins are a lot smaller and high tech then can be in the middle.
|
Product |
Gross Margin |
Units Sold |
Total Gross Margin |
Gross Margin % |
|
Goodular |
$127 |
20,000,000 |
$2,540,000,000 |
75% |
|
Sweetulate |
$209 |
12,000,000 |
$2,508,000,000 |
73% |
|
Total |
|
|
$5,048,000,000 |
74% |
Operating Expenses
Revenue tells you how much money in sales was generated and Gross Margin (the revenue less the cost of goods sold) tells you how much money you are making on each unit sold before you account for the Operating Expenses of the business. The Operating Expenses are the expenses of operations and include things like Marketing, Sales, Administration, R&D, Manufacturing, and much more.
Continuing with the example, the Operating Expenses of this business are the following and total $4,067,000,000.
|
Operating Expense |
Previous Year |
Common Size |
Current Year |
Common Size |
% Change YOY |
|
Marketing |
$699,000,000 |
10.23% |
$720,000,000 |
10.53% |
3.00% |
|
Sales |
$606,000,000 |
8.86% |
$644,000,000 |
9.42% |
6.27% |
|
HR |
$89,000,000 |
1.30% |
$114,000,000 |
1.67% |
28.09% |
|
Production |
$88,000,000 |
1.29% |
$77,000,000 |
1.13% |
-12.50% |
|
Medical Affairs |
$734,000,000 |
10.74% |
$796,000,000 |
11.64% |
8.45% |
|
Research & Development |
$1,357,000,000 |
19.85% |
$1,440,000,000 |
21.06% |
6.12% |
|
Depreciation |
$260,000,000 |
3.80% |
$276,000,000 |
4.04% |
6.15% |
|
Total Operating Expenses |
$3,833,000,000 |
56.07% |
$4,067,000,000 |
59.49% |
6.10% |
You will notice that there are descriptions of the expense, last years expenses, this year’s expenses, the common size and the percentage change year over year. The common size provides insights into each expense (line item) relative to the total revenues. For example, this company spends about 10 cents on Marketing for every one dollar of revenue generated.
The percentage change of course shows you the differences of this year compared to last year.
Understanding Profit
Profit, (also called the bottom line or net income) is the difference between revenues and all expenses. In our example we know:
- Revenue is $6,836,000,000
- COGS is $1,788,000,000
- Gross Margin is $5,048,000,000
- Operating Expenses are $4,067,000,000
- Interest is $87,000,000
- Taxes are $337,980,000
When you subtract the Operating Expenses, the Interest, and the Taxes from the Gross Margin you are left with a Profit of $900,662,000
In summary, figuring out how a business makes money is really not that hard and certainly shouldn’t give you the Sunday Scaries. Hopefully these simple tools can give you the confidence you need to understand some of these foundational elements, models, and approaches to making the right business decisions.
