This article talks about how to separate investment costs from your operating costs in the profit and loss statement so that you have good numbers from which to make meaningful analysis.
P&L Cost Buckets
In my P&L, I like to group operating costs into the following buckets: COGS, marketing, and operations. There are many expense line items under these buckets, but they roll up into each of the categories.
Below my P&L are my investment costs, which I separate into corporate investments and product investments. Investment costs are one-time expenses or paid over a short-period of time and do not recur. On the corporate side, they include costs with setting up legal entities, trademark filings, systems and office setup. These costs occur at the start-up stage or at key growth stages of a company.
Product investment costs are associated with R&D, development, customer testing, marketing and packaging development, copyright and trademark filings and any other costs to get a product ready for launch. If there are re-branding efforts after the product is launched (like new packaging), they would be grouped under product investment costs.
There will always be questions on whether some expenses belong in the operating or the investment buckets. For example, website development costs can be ongoing due to the addition of functionality and enhancements in our fast-changing technology environment. So, would they be considered an operating or investment cost? You’ll have to make that decision on your own, but my rule is to group minor changes as part of my operating costs and the addition of functionality or major layout/re-branding efforts to be grouped under investment costs.
Another example is personnel costs. The salaries you pay your people to develop a product, packaging and marketing is probably the largest investment expense. How do you decide what of their salary is investment expense and what is operations expense? I don’t like to generalize in answering this question by just taking some percentage and allocating towards investment and operations. I try to be more exact and take into account the time they spend in investment vs. operations activities. I need to be able to analyze my business with good data and its very easy to get bad data when you generalize.
I separate my costs as outlined above for 3 key reasons:
- Investment costs skew analysis of operating results and distort the true health of the business. If they are mixed in with operations, then it will be harder to determine how the core functions of the business are performing. You want to have a clean set of accounting numbers void of investment costs to do your margin analysis on your operations.
- Payback period. The purpose of healthy and sustainable profits in a product business are to help pay back your investment, fund future investment and provide free cash flow that is returned to the shareholders. Looking at your investment costs separate from operations makes this it much easier to determine how long it will take the business to pay back that investment with the profits.
- Investment costs remain transparent. Separating them from operations allows you to look at your investment costs in a clean and transparent way.