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Smart Money

Thursday, May 13, 2010
Everything You Need To Know About Profits
By Don Sadler

“It’s not what you make, but what you keep.”

While it’s not clear who first uttered these words of financial wisdom, anyone who’s been in business for any length of time can attest to their accuracy. Sales may be great, but business success ultimately hinges on your ability to earn a profit.

Profit is the amount of money that’s left over after you pay all the expenses incurred to manufacture and deliver your products or services and operate your business.

For such a simple concept, though, it’s surprising how many businesses get into financial trouble because of the owner’s misunderstanding of profit.

“I believe small-business owners and self-employed individuals often don’t understand the concept of profit because they haven’t had to deal with it before,” says Gene Siciliano, president and founder of Western Management Associates.

“Typically, an entrepreneur has an idea for a product or a business and believes that because the product is great, the business will naturally be successful,” he says. “However, it takes much more than a great product to have a profitable business.”

Why Profits Are Important
The ultimate goal of every business should be to earn a profit.

That’s not to say that there aren’t other reasons for owning a business, like contributing to the good of society or fulfilling the need to create and build something of value.

But without profits, none of these other goals can be realized.

“Business owners and entrepreneurs are entitled to earn a profit—it’s their reward for taking on risk in the marketplace,” says Siciliano. “Profits are used to buy capital assets, like computers and equipment, and as reserves to carry the business through future months when it might not be profitable.

“And they also provide the foundation for wealth creation that will enable owners to enjoy the fruits of their labor in the years ahead, whether it’s vacations, second homes or a comfortable retirement one day.”

Understanding profit—how to make it, how to track it, how to keep it—can help your business stay in the black, expand and grow. Here’s what you need to know.

Profits Versus Cash Flow
Micro-business owners, especially those just launching their ventures, sometimes confuse profit and cash flow. And that confusion can be detrimental to the financial heath of the business.

Profit is the money that’s left over after all your business expenses have been paid.

Cash flow is the movement of money into and out of your business. This includes money you collect from customers and money you pay out for expenses.

“Sometimes owners think that if there’s a lot of money in their bank account, they must be profitable,” says Marilyn Landis, president of Basic Business Concepts Inc., a financial consulting firm headquartered in Pittsburgh. “However, if they still have to pay expenses out of that money, the apparent profit can vanish quickly.”

Such a scenario is common for businesses that receive payment at the point of sale (like retail stores) and pay most of their expenses later. In this case, the cash in their checking account is just that: cash, but not profit. If there’s little or no cash left after expenses are paid, they’ve failed to earn a profit, and in fact may experience a loss.

“This can cause the all-too-common scenario in which a rapidly growing company is reporting profits but runs out of
cash because it hasn’t been paid by customers quickly enough to replace what they’ve sold,” says Siciliano.

“Companies can often work through short-term periods of unprofitability, but even a profitable business can fail if it runs out of cash.”

Distinguishing between profit and cash flow requires an understanding of the cash flow cycle that exists in most businesses. This is the time between when cash is spent (in the form of vendor payments, raw materials, overhead, etc.) and when it’s collected from customers.

“This time lag has to be accounted for if you want to determine your company’s true profitability,” says Siciliano.

The Role Of Financial Accounting

Proper financial accounting is required to track the cash flow cycle and determine profit. Without proper accounting, you’ll find it difficult to assign costs to the actual products you manufacture or services you deliver.

There are two primary accounting methods used in business finances: cash and accrual.

Cash accounting is the simplest method. Financial transactions are recorded only when funds change hands. In other words, a sale is recorded when the business receives payment, and an expense is recorded when the business pays its bills. Cash accounting may be appropriate for self-employed individuals (like consultants and freelancers, for example) who aren’t manufacturing products.

With accrual accounting, financial transactions are recorded as they happen, even if cash or funds change hands later. For example, a business would record a sale as occurring when it shipped a product and sent out an invoice, regardless of when the business actually received payment for the product. And the business would record an expense as occurring when it received goods or services, even if the business paid for those items at a later date.
For most businesses, determining profitability requires the use of accrual accounting. An example helps demonstrate why the accrual accounting method works best.

Suppose a business spends $1 for materials and $2 for labor during June to manufacture a widget. It sells the widget for $6 in July.

Cash accounting would show a $3 loss in June. But accrual accounting would reflect a more accurate increase of $3 in inventory.

In July, the company sells the widget and sends the customer an invoice with payment due in 30 days. Accrual accounting would replace the inventory with an accounts receivable of $6, reflecting a $3 gross profit. However, cash accounting would continue to show a $3 loss, since the money still would not have been collected from the customer.
Cash accounting wouldn’t recognize a profit until the customer pays, 30 days after the sale.

In this example, cash accounting would reflect a $3 loss in June, a break-even point in July and a $6 profit in August.

“But in fact, this isn’t what happened at all,” Siciliano explains.

The accrual accounting method would more accurately reflect the cost of goods, changes to inventory, sales—and profits.

“This example helps demonstrate why businesses that really want to understand whether they’re making a profit or not have to use accrual accounting,” says Siciliano.

Gross Profit Versus Net Profit
There’s a difference between gross profit and net profit.

And business owners who don’t understand the difference run the risk of calculating profit prematurely, before all of their costs are subtracted from the money they collect.

From an accounting perspective, there are two different kinds of costs: direct and indirect.

Direct costs are those directly related to the manufacture and delivery of a product or service. They include raw materials, inventory and labor in a manufacturing company, and the owner’s and employees’ time in a service business. Direct costs are often called cost of goods sold, or CGS.

Indirect (or operating) costs include all other business expenses. These costs—such as mortgage or rent, utilities, marketing, taxes and others—are often called overhead. Indirect costs are necessary for the ongoing operation of your business, but they don’t directly contribute to making products. For example, you have to pay a mortgage or rent to occupy an office space for your business. But that expense doesn’t tie directly into manufacturing a product or delivering a service.

Use these formulas to figure gross and net profit:
  • Gross profit = Sales – CGS
  • Net profit = Sales – CGS – overhead
Direct costs will fluctuate based on sales volume. The higher your sales, the higher your raw material and labor costs or your time (if you’re a service business) will be.

“Owners need to carefully identify cost of goods sold and separate these expenses from overhead,” says Landis. “Otherwise, it’s difficult if not impossible to forecast expenses and determine true profitability.”

There’s another key to accurately gauging your profitability. You must record all cost of goods sold in your books during the same time period (i.e., the same month or quarter) as you record the revenue that’s derived from those costs.

“Otherwise, you won’t know if you’re making money or not even if you’re doing a good job of tracking cost of goods sold,” says Landis.

In the past, cost of goods sold was primarily tracked by manufacturers and retailers, Landis adds.

“But today, more micro-businesses and self-employed service providers are identifying and booking cost of goods sold to help them determine if their business model is truly profitable, or if excess overhead is eating away at their profits.”

Profit-Boosting Strategies
There are only two ways to increase profits: reduce your costs or increase your revenue. Consider these ideas:
  • Watch the little expenses. Small costs like miscellaneous bank fees can go unnoticed and slowly eat away at your profit margins.
  • Streamline and automate. Look at all of your business processes for ways to maximize efficiency and lower costs. Technology and the Internet allow automation of many tasks that have traditionally been done manually, and lower costs in the long run.
  • Upsell. Develop ways to charge extra for upgrades to existing products or services. Ideally, these upgrades should cost you little or nothing, like expedited order processing or shipping, for example. But they can boost your revenue significantly.
  • Raise prices. This must be done carefully, especially in a tough economy. Try to provide additional value at the same time so customers experience more of an enhancement than a price increase.


Don Sadler is a business freelance writer based in Atlanta, Ga. As a service provider, he tracks the time spent on each project to determine his cost of goods sold and the profitability of his business. Reach him at don@donsadlerwriter.com.

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