There are some common mistakes that small business owners make when it comes to understanding and calculating what profit is. Profit is not sales, it’s not mark up and it’s not your salary. Profit is the net gain between what you earn less your expenses and operating costs.
1. Sales are Not Profit
Sales are not profit. If you don’t calculate your selling price correctly then there is a very real possibility that you could be operating at very little profit or worse still, operating at a loss.
You should only ever set your selling price after you know what all your costs are. The two types of main costs associated with running a business are fixed costs and variable costs. Fixed costs are known as overheads. These include things like rent, loans, vehicles, phone and internet, electricity etc. Regardless of what you sell, these costs must be paid monthly, quarterly or annually and you need to factor in these outgoings when setting your price.
Variable costs are the costs associated with raw materials or stock as well as the direct labour costs of producing your goods or supplying your services. These costs also need to be factored in when setting your price, although they will go up and come down.
Once you know your costs, you can set your selling price to ensure you are profitable. Setting your pricing and knowing your costs is certainly not a “set and forget”. It is something that you need to be reviewing on a regular basis to ensure that you remain competitive and profitable.
2. Mark Up is Not Profit Margin
A company’s profit margin is the percentage of revenue left after every expense has been deducted. It is calculated as follows:
- total price – total expenses / total price x 100 = % profit margin
A common mistake that many business owners make is that they pick a percentage of what profit they think they would like to make. Quite often this percentage is simply added to the cost price of the product or service.
Let’s say you want a profit margin of 20%. So, if the item costs you $100, it’s not just a matter of adding 20% to your cost price to give you a selling price of $120.
By using the correct formula to calculate profit, these figures show that you would only be making a profit of 16.67%.
- $120 – $100 / $120 x 100 = 16.67%
This is really your mark up. Each and every time you sell your product or service for $120, you are actually giving away 3.33% in expected profit.
The method of picking any old percentage is actually quite dangerous because you are giving away valuable profit. When setting your profit margin, you must decide on the minimum profit you need to sustain your business. By working backwards you can then set your selling price based on the number of products or services you need to sell to give you your desired profit margin.
3. Profit is Not Salary
Profit is definitely not your salary and nor should it be treated as your salary. Your salary should be included as a business cost so that any surplus left over is actually profit.
The purpose of profit is to sustain your business and to help grow it. In the first few years you may not make much profit or perhaps you may not break even. This means that you may not be able to draw much money from your business.
As time goes on and you become more profitable you can set yourself a salary of equal, or better still greater, than what you could earn if you were an employee elsewhere.
Profit is what enables you to stay in business. It is also what allows you to grow your business, develop new products and purchase the latest equipment and technology.
Does your business need a financial health check? Why not give us a call today to see how our business advisory services can help you.