Achieving profitability targets can only be attained by holding everyone to their expense budgets.

Gross Profit — How Profitable Your Core Product Offerings Are

Gross profit is the first profitability metric you need to be tracking to understand how profitable your core products are before any selling, marketing, or other administrative costs come into play.

To illustrate an extreme case, if your gross profit is zero — this means you sell your products, food, or services for the same amount as it costs to produce them. Furthermore, a gross profit of zero means that you have no profits to cover your overhead, rent, insurance, marketing, or corporate payroll.

Alternatively, a gross profit of 100% means it costs nothing to produce the products you sell. For example, software companies often have high gross profit margins, but they will never have 100% margins. There is always some form of developer maintenance, patching, or cloud costs associated with software sales.

Inventory Unit Costs

Suppose you are in the consumer-packaged goods (CPG) industry and are an inventory-focused company. You created a 2023 sales forecast at the product level and determined that you are going to sell 100,000 units of inventory next year at a sales price of $1 per unit. This resulted in a $100,000 sales budget.

Now, how much does each of those 100,000 units of inventory cost, and how much does it cost to fulfill each order? The answers to these two questions lie in your Cost of Goods Sold (COGS).

The Percentage of Sales Technique

Modeling complex situations where unit costs cannot be readily determined can be solved by a few different techniques, one of which is the “percentage of sales technique.”

Say you’re trying to figure out how much it costs to fulfill each order. Maybe this is a more complex cost to budget out. Do you have a standard costing mechanism where each unit costs a flat $5.00 to ship? Or is shipping on each customer’s order calculated at checkout based on estimated package weight, zip code, speed of delivery, etc.?

If shipping costs are dynamic, you probably cannot model out the exact shipping cost matrix without significant effort. I would argue this is also not a valuable exercise to put yourself through either. Keep it simple, yet detailed enough to track actuals against.

Instead, look at last year’s total fulfillment COGS by month and divide by total sales. Do you notice any consistent trends? Say fulfillment COGS are consistently around 18% of sales. Essentially, this means that for every dollar of sales, you spend $0.18 in fulfillment costs. By linking the sales forecast each month to a COGS driver like this in a model, you can make your budget model more dynamic and show how changing sales targets impact fulfillment costs.

The art of budgeting is determining the level of granularity at which a value becomes de minimis. Budgeting should stop at the lowest point at which you can efficiently compare actuals.

Selling, General, & Administrative Expenses (Non-Payroll)

Consistent with the bottom-up approach, selling, general, and administrative (SG&A) costs should be budgeted at the vendor level whenever possible.

To begin the expense side of the budget process, start by looking at the trailing twelve months’ expenses by vendor. If possible, this should be sent out to budget owners in early October with a due date set to ensure timely return and integration into the financial model.

This process should absolutely include vendor rationalization.

Budget owners must justify every vendor they think they will need next year. Not every expense added into the budget will (or should) be approved. Department leaders will usually request more expenses than necessary, and it is up to management and the CEO to review and approve each request.

Payroll Costs and the “People Ops” Model

In every operating model I build, I always include a “people ops” section. Regardless of where payroll costs are located in a budget, they should always be accounted for at the individual employee and contractor level.

Companies may include payroll costs throughout their income statement or within the COGS category (for example, labor in manufacturing or restaurants). Budgeting at the individual employee level allows a company to compare actual payroll costs at month-end to the budget.

Your model should include:

• Current personnel on staff
• Future hiring needs by position

Budgeting using a “lookback” of trailing payroll expenses does not account for future headcount growth or turnover. A bottom-up budget method allows reconciliation at the employee level, making variance analysis significantly easier.

Earnings Before Interest, Tax, Depreciation, and Amortization (EBITDA)

EBITDA is the profitability milestone primarily used in most valuation exercises and the primary metric by which companies live and die.

EBITDA is determined by subtracting operating costs (COGS, Payroll, and SG&A) from sales and can generally be thought of as “cash profitability.”

Applying and Using Profitability Metrics

Included in every model that I build are the milestone profitability metrics shown as dollar amounts and as percentages. Each client and management team may have preferences regarding how they want to see their income statement.

• Gross Profit
• Contribution Profit (Variable Profit)
• EBITDA
• Net Income

It’s important to schedule a walkthrough of the budget model with management, reviewing the sales forecast and expense structure to interpret each profitability metric.

Contribution Profit

Contribution Profit can tell us how efficient marketing dollars are at generating profit over time.

[ Gross Profit — Sales & Marketing Expenses ] = Contribution Profit

Gross Profit tells us how profitable our products are, but Contribution Profit tells us how good we are at selling them. This metric highlights the efficiency of sales and marketing efforts.

Budget Process Summary

To wrap it up, here’s a checklist for running through a budget process:

Bottom-up budgets should provide value throughout the organization, but you need management and department leader buy-in from the start.

1. Begin the process in September or October and distribute materials across the organization.
2. Build a sales forecast from the bottom-up, linking it to KPIs.
3. Develop Cost of Goods Sold (COGS) estimates.
4. Outline Selling, General, and Administrative (SG&A) expenses by vendor and by period.
5. Build a payroll forecast at the individual employee level.
6. Add interest projections from debt or amortization schedules.
7. Estimate tax obligations (state, federal, franchise taxes).
8. Incorporate depreciation and amortization schedules.
9. Create relevant graphs to simplify executive review.
10. Establish reporting methodology to track actuals vs. forecasted performance.