We all know what profit is: the excess income left over after expenses are covered. Profitability is the measure of profit generated continuously. Earnings are generally measured in dollar terms; profitability is measured as a percentage of sales. You need to focus on both.
For many small businesses, profits are equal to the owner’s paycheck. If the profitability of your operations does not generate enough cash flow, you do not get paid. The first step is to figure out how much you need to pay yourself, to cover your basic needs and desired lifestyle, savings and retirement, and to pay your taxes. Then calculate how much money your business needs to cover its expenses and pay this amount.
This is an eye-opening experience for business owners. Your initial reaction may be one of dismay: “How can I generate so much income? Am I doomed to survive?” But, given your financial goals, you can start to seriously consider restructuring your business to provide what you need financially, or get out of it and do something else.
The profit is more than your salary
Even if you’re a sole proprietor, learn to see “earnings” as separate from what you pay yourself. Imagine that your company is a corporation, where you earn a regular salary and which generates profits beyond that. You get paid to work there and as the owner you expect a profit dividend.
Profit is more than money
This is how small businesses should view profitability:
o The benefit is ROI: return on investment. You (and perhaps others) put capital into your business and hope to recover it one day at an adequate rate of return. For an established but vulnerable small business, a suitable ROI may be 20% to 30% per year.
o The benefit is ROE: return on effort. Many people start their businesses largely through sweat, putting in thousands of hours of their own, unpaid time to get the business up and running. Will he ever get his time’s worth back?
An owner-managed business should view profit as the financial return per unit of its effort. For example, suppose he works 2,000 hours in a year and his company’s profit is $250,000. For that year, he might say that he earned a return of $125 for each hour he invested. If you want to trade more easily, make sure you don’t increase profits by dint of working harder and longer hours. More on this in Chapter 11 of my book “How to Grow Your Business Without Going Crazy” in the section on “Leverage Your Effort.”
o The benefit is a tuning fork. It tells you how well tuned your trading instrument is. When you are doing the right things, working productively and profitably, selling the right things to the right people, serving your customers well, treating your own people well, profit is the measure that amply demonstrates it.
The opposite is also true. When your business isn’t tuned in right, the jarring notes of low productivity, dissatisfied employees, shrinking customer base, and mounting losses sound. The benefit is the recognition that the business is on the right track.
o Profit is flow. The profit provides the surplus that helps you weather the tough times. Earnings allow you to be generous.
o Gain is energy. Many small business owners say they are more interested in achieving their vision than making big profits. But without adequate profitability, you burn out, burn out, and get discouraged.
An unprofitable business fails unless outside money is continually pumped in. You can’t make the contribution you want without making a nice profit.
The uses of profit
As your attitude toward profits changes from (a) a scrap you use to pay yourself, to (b) a resource you use for critical business needs, you can plan your operations so that they regularly generate profits beyond your budget. who pays for himself. You can create an “earnings budget” to calculate how much you need to cover things like:
o Fund for extensions or improvements. How much do you need to set aside each year for early upgrades and expansions?
o Cushion to cover the dips. How much should you set aside each month to provide an insurance policy against short-term financial setbacks?
o Fund for bonuses and economic incentives and profit sharing. What proportion of sales revenue should you allocate to incentives and bonuses to motivate top performance?
o Retirement programs. What proportion of wages and salaries should you set aside to fund retirement plans for you and your employees?
o Payment of taxes. How much should you set aside each month to pay taxes on the gain you anticipate?
o Reimbursement of debts. How much after-tax cash flow must be available to pay off your debt, including paying back the money you invested in the business?
Calculate all these amounts that belong to you and add them up. This is the amount of trading profit you need each year. If you divide this sum by your projected revenue, you get a percentage that shows what proportion of each dollar of sales revenue should be available for these uses. One of the most important uses of this percentage is to set prices that ensure the desired level of profitability.
Your accountant may gnash on the above paragraph, correctly pointing out that many of these items are business expenses, not earnings. I agree. However, for small business owners who are trying to transition from a break-even mindset to a surplus-building mindset, developing this profit budget is invaluable. These are the very elements that you might not otherwise consider in your planning, your projections, and your pricing decisions.
Need help?
Several of our books, workshops and electronic tools help you increase your profitability and determine how much profit you need. These include:
o How to grow your business without going crazy, esp. Chapter 13, “Building a Culture of Profitability” and Chapter 15, “Calculating Benefit and Cost.”
o “Building a Culture of Profitability” available as e-book and tel-online workshop.
o Template “Sources and Uses of Cash”. A crucial tool in cash flow projection.
o The “Success in 2007” plan workshop helps you put profits in the context of all other facets of your business.
