Reverse Engineer Your P&L

Every business generates profit in a similar manner. They have sales, costs that vary depending on sales volume called “variable expenses” and costs that are consistent every month regardless of sales volume called “fixed expenses”. 

Traditional P&Ls start with sales, subtract all the expenses and profit is at the bottom, the last line of the list, implying it’s insignificance. On the contrary, profit is the most important number on the P&L. Without profit the business can’t expand and create new jobs. It can’t provide raises or improve benefits. A business with no profit eventually will be no business at all.  

I’m going to show you how to reverse-engineer your P&L to start with desired profit then back into how much sales you need to generate that profit.  There are three key numbers you’ll need to use: 

1. Desired Operating Profit 

2. Variable Expenses

3. Fixed Expenses 

Variable Expenses

The variable expenses are completely dependent on sales volume. More sales = more variable expenses. Less sales = less variable expenses. Variable expenses are expressed as a percentage of sales. These variable costs vary based on what type of business you are in but may include: cost of goods sold, credit card fees, commissions & royalties. 

Fixed Expenses

Fixed expenses are ones that are the same every month and don’t change based on sales volume. These include rent, property taxes, health & liability insurance, utilities, software subscriptions, office supplies, salaried payroll, debt payments & more

Note on Payroll 

Payroll can be considered both a variable cost and/or a fixed cost depending on how you structure your employees compensation. If you’ve got a sales team that is 100% commission only then all of their payroll cost is variable. If you’ve got strictly salary employees who get paid the same no matter what then it’s a fixed cost. You may decide to allocate a portion of your payroll to variable expenses that changes with sales and the salary portion to fixed expenses. This really depends on how granular you want to be in your analysis.  

Contribution Profit

Contribution Profit is your profit after variable expenses are subtracted from Sales, before subtracting fixed expenses. Contribution Margin is the Contribution Profit expressed as a percentage of Sales. 

Let’s say the variable expenses for a business are 55%, giving them a Contribution Margin of 45% (100% - 55% = 45%). This means for every $1 in sales, 55% or $0.55 goes to pay for these variable expenses, leaving us with $0.45 in Contribution Profit for a Contribution Margin of 45%.

Another business has variable costs of 67%, giving them a Contribution Margin of 33%. For every $1 in sales they are generating $0.33 in Contribution Profit remaining to pay fixed expenses and generate a profit. 

Backing Into Your Profit

Once you’ve got your Fixed Expenses & Contribution Margin you can back into how much sales you need to generate to hit a desired profit number. You can flip the traditional formula around to start with Operating Profit & end with Sales:

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Example:

• Desired Operating Profit = $10,000

• Fixed Expenses = $15,000

• Variable Costs = 60%

• Contribution Margin = 40% (100% - 60% Variable) 

$10,000 (Operating Profit) + $15,000 (Fixed Expenses) = $25,000 (Contribution Profit) 

You need $25,000 in Contribution Profit to generate an Operating Profit of $10,000 and cover your $15,000 in Fixed Expenses. To figure out how much sales you need, divide Contribution Profit $ by Contribution Margin %: 

$25,000 (Contribution Profit) / 40% (Contribution Margin) = $62,500 (sales)

Answer: You need $62,500 in monthly sales to generate an Operating Profit of $10,000

DIY: Grab Your P&Ls

To put it all together grab your P&L’s for the last 12 months. Cross out all non-cash expenses such depreciation, amortization and any others. Identify the variable expenses that are directly related to your sales volume and take note of the percentage of sales. All the remaining expenses that are fixed which should include rent, software subscriptions, liability insurance, etc. 

With a 40% Contribution Margin, once your Fixed Costs are covered, $0.40 of every incremental $1.0 sale goes straight to the Operating Profit line. Note how the change in Contribution Profit is equal to the change in Profit. Once your Fixed Expenses are covered. Every Contribution Profit dollar becomes Operating Profit.

If you can accelerate your sales while maintaining your Contribution Margin & Fixed Expenses you can really pour gasoline on the Operating Profit fire. A sales increase of 20% leads to a 80% increase in profit. A 100% sales increase leads to a 400% increase in profit. 

Improving Your Margins

Once you’ve got a baseline of your Contribution Margin and Fixed Costs the next step is to improve them. 

Contribution Margin is improved by reducing your variable expenses. There are some variable costs that you simply cannot change such as franchise royalties if they are calculated as a percentage of sales. You can however affect what are most likely the two biggest costs for many businesses: cost of goods sold & payroll. 

You can reduce your overall cost of goods by increasing the sale price, finding a lower cost vendor, and by shifting your sales mix to higher margin products/services. Your payroll cost percentage can be improved by increasing the rewards for performance and reducing the guaranteed hourly/salary. Your employees incentives should align with the company’s goals, which for many is growth. 

For every $1 million in sales you are doing, every 1% increase in Contribution Margin leads to a $10,000 increase in Operating Profit. A few small changes in process to increase your Contribution Margin leads to significantly increases in your Operating Profit, especially with large organizations. 

We can also increase Operating Profit by reducing our fixed expenses. Some things we have less control of like rent and health insurance. Other things we have control over such as utilities, subscription service, and office supplies. There are some expenses that we can have a HUGE impact on, such as liability insurance. Reducing your insurance claims through training & following best practices can significantly lower your cost. 

Summary

You can take this reverse P&L approach anytime when analyzing a new business, expansion of existing one, or impact on changing expenses. Take some time to apply it to your own P&L. We’ve gone as far to adjust our P&L in Quickbooks to categorize every expense as variable or fixed. This helps when comparing multiple locations or time periods.

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