Profit Calculations and Analysis
We’re now at the final stage of the skeleton – we’ve seen how money comes in, how it goes out, and now get clarity on how much is left over.
Some people get concerned about the word profit, because they think it means profiteering and exploitation.
That’s not the case at all – our profits are just the surplus cash a healthy business creates.
This surplus can go towards pay increases, growing the organisation, donations, new equipment or a rainy day fund.
The important part is actually making a profit and not a loss.
We’ll look at a series of formulas that give you meaningful insights.
They’ll help highlight what’s working, what’s not, and make it easier to evaluate new opportunities in the future.
The first thing we want to understand is our breakeven point.
To start, we need to calculate our contribution margin:
Contribution Margin = Revenues – Cost of Goods Sold
e.g. these $100 shoes cost $30 to produce, so we have $70 per pair that goes towards our overheads.
Then we take our overheads, and divide them by the contribution margin:
Breakeven = Overheads / Contribution Margin
e.g. Our overheads are $3,100 per month, so we need to sell 45 pairs of shoes to break even ($3100/$70 = 44.3).
Now we have a breakeven figure for each month.
Anything above 45 pairs gives us a margin of safety – a buffer that will go to refuel the business and can help ride out the down months (e.g. over Christmas).
We can also declare a target profit figure, and determine monthly sales targets required to make it a reality.
e.g. to hit our target monthly profit of $2,000 we need to sell 74 pairs of shoes
(45 + ($2000/$70))
There are two important terms here; Gross and Net.
Gross Profit is your revenue minus the cost of goods sold (COGS).
Gross Margin is when you divide the Gross Profit by the revenue.
For example, you could have $150,000 in sales, with COGS of $40,000.
That would give you a Gross Profit of $110,000, and a Gross Margin of 73% ($110k divided by $150k)
The reason why we separate dollars from percentages is so we can see how strong the business looks.
If a $500,000 company makes a gross profit of $300,000, we’ll feel ok.
If a $10,000,000 company makes a gross profit of $400,000, we’ll be very concerned, even though it’s a bigger number than $300,000.
That’s the key – a business should make a healthy margin on sales, and when that margin evaporates the business is in danger – even if it’s technically doing billions of dollars’ worth of sales.
Net Profit is your revenue minus all costs (e.g. wages, rent, utilities).
Net Margin is when you divide the Net Profit by the revenue.
For example, you could have $150,000 in sales with a total cost of $125,000.
That would give you a Net Profit of $25,000 and a Net Margin of 16%
Your business lives or dies by that Net Margin.
That’s the amount of money left in the bank at the end of the day.
Every dollar of revenue leads to 16 cents of Net Margin, and you’ll need to defend that 16 cents from lots of small costs that sneak up over time.
At the bottom of your spreadsheet will be “The bottom line” – the profit (or loss) you’ve made in that month/year.
It’s worth adding in a line below that – the rolling profit (or loss) since the business started.
For example, you might make a $40,000 profit in your second year but a $100,000 loss in the first.
Context is valuable, because it changes the narrative – making a profit in year 2 is great, but it also suggests you won’t break even until year 3 or 4.
You can draw your own conclusions from that, but at least you have the information in front of you.
Core Business Health
If you’re an organisation that takes donations, it’s worth re-running your calculations without that extra help.
For example, if you are a charity that runs a business (possibly a social enterprise), you’ll want to know what surplus/loss was made in the business itself, and then what surplus/loss was made including donations/grants.
e.g. we made $35,000 surplus but had $60,000 of donations.
It’s important that your business works as a business.
A café should not lose money.
A retail store should not lose money.
A community housing organisation should not lose money.
These core businesses should be able to pull their own weight and cover their own costs.
If they can’t, then something is fundamentally wrong, and you have a limited runway to fix it.
Donations do not solve these problems, they buy time and potentially hide the real issues.
For this reason, it’s important to list the core business performance as well as the overall performance.
You’ll hear people refer to profits as EBIT or EBITDA.
This is an annoying acronym that means Earnings Before Interest, Tax, Depreciation and Amortisation.
Here’s why it matters – it separates how much your business earns before looking at your individual quirks and circumstances.
Think of it like this; let’s say you and your rich neighbour both take up a part-time job as census collectors, and you both get paid $45 per hour.
You’re in a lower tax bracket, so you get to keep roughly $30 per hour as net income, while your neighbour only keeps $23 per hour (a good problem to have).
We describe the job as paying $45 per hour, because we can’t possibly expect everyone’s circumstances to be the same.
EBITDA is similar – some entrepreneurs might pay more tax or less tax, more interest or less interest, depreciate their assets quickly or slowly, so measuring their cash profit is a bit misleading.
In the same way that your neighbour might feel like $23/hour isn’t a great rate while you love having $30/hour in your pocket, the proper measurement is the $45/hour payment.
EBITDA keeps things objective – measuring the businesses’ earnings and not the entrepreneurs’ unique situation.
One of the Dragons from Dragons’ Den is Theo Paphitis.
He has a great quote that most social entrepreneurs won’t like:
“Turnover is vanity, Profit is sanity”
In other words, your turnover might make you look like a successful business, but the figure that matters is the surplus cash your business has to play with.
This comes up quite a bit with my clients – they set targets for themselves based on revenue.
It seems a strange goal – why run a $300,000 per year business that barely breaks even when you can run a $200,000 business that makes $50,000 profit?
Sadly, the mentality seems to be bigger = better, even though it generally causes more headaches, higher stress levels and lower social impact.
Profits (otherwise known as surplus) keep you alive.
They buy you time and the ability to take risks.
If your business is not making any margin, then it will struggle to grow.
Try it out for yourself, tally up your net profit and net margin – which is hopefully greater than zero.
Once we have identified how your business makes that surplus, we can get creative in how we make it even larger.
Next, we’re going to look at how excel can make your life easier…