Lessons from a recession veteran: Profit awareness

 

We are all in business to make money, but it’s not enough just to make a profit. You need to be aware of everything that you are doing that will contribute to, or prevent you from making a profit. The reality is that it’s often hard work.

In its purest form, whatever you sell, less your costs of stock, labour and other overheads (rent, rates, light, heating etc) gives you a profit. Simple!  But I watch the entrepreneurs on Dragons’ Den and most of them seem to be living on a different planet when it comes to numbers. You see people who have been in business for three years and don’t understand the difference between net and gross profit; don’t know what their overheads are; and don’t really know what their sales are -- I despair.

Making a profit is easy, isn’t it?

Imagine a man standing on a market stall selling teapots. He buys a teapot for £10 and sells it for £12 and he’s made a profit hasn’t he? If he bought the teapot for a tenner and sold it for 15 he’s made even more profit.

So let’s look at these examples and try to understand what is involved in making a profit that is sustainable and repeatable, versus how to lose money, even though you think you are making a good margin

Gross profit

Cost of goods (COG) = £10
Sold for £12 = £2 gross profit
Gives a gross profit margin of 16.66%. (Sale price - COG) / sale price x 100

So gross profit is your revenue, minus how much you directly spent to make that revenue (the cost of goods in our example). Though an incredibly simple figure, Gross Profit Margin (GPM) is a fantastic indicator of a business’ performance, as it calculates the efficiency of a company’s use of its raw supplies.

A higher, and rising, GPM indicates a company adding value to its product, either by making the product offering appear unique or negotiating lower buying costs. So in my teapot example, if this seller manages to find an amazing USP for a teapot, something no other teapot has, he might be able to charge £14 instead of £12, giving him a much higher 28.6% gross profit margin - he’s making more for his money from the exact same cost of sales!

A diminishing GPM shows a decrease in efficiency, for example the cost of products is increasing or the uniqueness of the product is being diminished (most likely due to increased competition). Imagine someone sets up right next to our teapot seller, selling the same teapots but at £11, forcing your seller to price match. Now, instead of £12, you’re making £11, leaving you with a measly 9% GPM.

Worked out your percentage but confused what it means? Here’s an easy way to remember:

Your GPM is how many Ps you get back for every £ you spend. Our stall guy with a 9% GPM? Every £1 he spends he will receive 9p gross profit.

GPM doesn’t paint a full picture though, and totally excludes overheads and business running costs, so you need an additional figure called Net Profit to paint a picture of the business’ health.

Net profit

Revenue 10 x £12    £120

COG                10 teapots x £10 each = £100
Wages             £8 per day
Stall rent          £5 per day

Total costs       £113 per day
Gives a net profit margin (NPM) of 5.8%.  (Revenue - COG + overheads) / Revenue x 100

But if our market trader has sold all his 10 teapots at various prices during the day -- some for £20 and some as low as £9 (to clear some stock), so that his average price was £15, then:

Revenue 10 x £15 = £150
Costs                    = £113
Net profit              = £37
Gives a net profit margin of 24.6%.

Again, the simple rule is your NPM is how many Ps you get back for every £ you spend. Our stall guy with a 24.6% GPM receives 24.6p net profit for each pound.

If his NPM is this high then our teapot man is happy, and goes on Dragons’ Den to demonstrate that he knows the difference between gross and net profit and has his fortune laid out in teapots!

Get help

If you are unable to manage your day-to-day accounts, find a local freelance book-keeper and ask your accountant to review your situation on a quarterly basis. A good accountant or book-keeper will be able to explain how the figures relate to your business and what you can do to improve them. Remember you are here for the long term (the ‘big Daddy’ in cricket terms) not just a few months of feverish activity followed by bankruptcy.

When I started my first business back in 1982 accounting was all paper-based. We had day books and ledgers, the VAT had to be accounted for separately and everything had to be written down (in pencil) and calculated by hand. There were no computers, no spreadsheets and no accounting programs. It was double-entry book-keeping (invented by a monk (Luca Pacioli) in the 15th century) -- what a nightmare! In these days of QuickBooks and Sage there is absolutely no excuse or need not know the ins and outs of your accounts on a monthly basis. For many it is a time-consuming and tedious process, but if you want your business to still be running in ten years, you need to do the boring stuff!

And remember, as I explained in another article, 'Cash is King', you can be making a super profit, but if you don’t have cash in the bank to pay your suppliers, landlord, HMRC, and of course your wonderful staff, then you won’t have a business.