How to Make Profits
The Making Business Fun Podcast, Episode #107
# 107 Making Profits
As a business owner, and I say this quite often, it is your job to choose what kind of business you want to have. So, today, we are talking about profits, and therefore we are going to talk about your relationship to profits and the relationship they have on the business that you want to run.
I am reminded, often, and I will remind you here, that making a tremendous amount of profit is not the most important thing to all business owners. Some owners of small businesses are perfectly content to break even, and just enjoy their life of stress-free entrepreneurship. Typically these are the kind of people who are running a retirement-stage-of-life coffee shop, art gallery, or wine shop. Or, they are simply in circumstances where money, or rather making money, is not of the upmost importance.
Either way, it's important that we fully understand the concept of profit, the importance it plays on your business, and your relationship to profit. From there, you could then decide what your profit strategy is going to be, and move your business in that direction.
What is Profit?
Conceptually, profit is easy to understand. It is simply the difference between what it costs to bring your product to market, and what revenues you will gain from selling it. Or, computed another way, it is a set percentage of gross top line revenue that an entrepreneur peels off and put into the profit pocket, right off the top, leaving the rest of the money in the kitty to run the business.
Let's start by looking at the four categories of money and profit as it flows through your business. These four categories are top line revenue, gross profit, operating profit, and net profit. Let's look at each of these in detail right now.
Let's start with revenue. This is also be called top line revenue, and it represents the total of all the money that your company takes in, from sales and services. If you are running a used furniture shop, and you take in $10,000 in sales for furniture, $2,000 for repair services, and $1,000 in delivery fees, then all of this totals up to your total top line revenue for the period: $13,000. Again, top line revenue is the total of all the money that comes into your company during a specific period of time. And often, your top line revenue could look like an awful lot of money, but please understand that the top line revenue can often be deceiving, because the top line revenue is certainly not profit, because from the top line revenue, we subtract all the costs of operating the business. We're gonna do that right now.
Next category, after top line revenue, is the gross profit. And the gross profit, is your total revenue minus the cost of goods sold. For your reference, cost of goods sold is often abbreviated as COGS. For a retail shop, the cost of goods sold is the wholesale cost of the merchandise you are selling. If you are making products or selling services, then the cost of goods sold are the costs directly associated and actually incurred in bringing that product or service to market. For example, for a product in manufacturing, the COGS can include raw materials, the labor costs, and all other directly associated costs.
Bear in mind, that the cost of good sold only includes the cost directly related to bringing the product to market. For example, in a retail shop, the labor costs of the retail employees are not part of the cost of good sold because they work the shop, but they don't make the merchandise. However, in a manufacturing situation, the labor of a manufacturing worker directly associated with making the products that are being sold, would be included in the cost of good sold.
Now, closing this concept out: gross profit is the top line revenue minus the costs of the things that were actually sold. Remember our used furniture store? Imagine, in the span of a month, we sell $10,000 worth of used furniture. The wholesale cost of that used furniture was, say, $4000 to us. Our cost of goods sold is then therefore $4000. So our gross profit, again which is revenue minus cost of good sold, is $10,000 minus $4000. Which equals $6000.
$6000 is our gross profit. Keep this figure in mind, because in the next session we're going to refer back to this.
The next category is operating profit, or net operating income. Note here, that net operating income is commonly abbreviated as NOI. This category is what’s left over when you take your gross profit and subtract the operating expenses of the company.
What are operating expenses exactly? Operating expenses are all the other expenses that a business must occur to function as a business that are not directly associated with stocking the products or services that a company sells. For example, this includes things like rent, insurance, utilities, professional fees, and payroll for general staff. By general staff, I mean those who are not directly associated with making products for sale.
So, back to our used furniture business, let's say all of our operating expenses, our rent and utilities, our sales and marketing, our legal, accounting and professional fees, and our generalized payroll, add up to $3000 a month. Do you recall that just a moment ago, for our used furniture shop, that we said our gross profit was $6000 a month? Well from our gross profit, we subtract our operating expenses of $3000, and we arrive at our operating profit, or net operating income, of $3000.
Very quickly, let's just take it from the top. In one month, our used furniture company takes in $10,000 in top line revenue. The merchandise that we sold during that time cost us $4000 wholesale. Therefore our top line revenue of $10,000 minus our costs of good sold of $4000 equals a gross profit of $6000. Then, from our gross profit of $6000, we subtract our operating expenses of $3000, and that leaves us with our net profit of $3000. 10,000-4000 = 6000. And 6000-3000 = 3000.
$3000 is our operating profit — or our NOI — our net operating income.
Top line revenue minus cost of good sold equals gross profit. Gross profit minus operating expenses equals operating profit — or net operating income.
And then the fourth and final category, is net profit. And net profit is your operating profit minus taxes and interest. Net profit is important, of course, because it is the real money that exists at the end of the day. But from an operations standpoint, the number to be concerned about is the net operating income, the NOI. And the reason for this is because, everything that determines what your net operating income is, it's based on how well the company is run. Meaning everything above operating profit is in your control. Beyond that, to get a net profit, we're only talking interest and taxes. And in most cases, taxes and interest are not within our operational control. Therefore, to determine the healthy state of the business, we are most concerned with the money as it goes through the system from top line revenue, to gross profit, to operating profit. It is within these three categories that you as a business owner, and your management team, can make decisions the best benefit the business.
Gross Profit Margin and Markup
Your profit figures are commonly going to be expressed in terms of dollars. However when we start looking at things like margins and markup, these numbers are going to be presented in percentages.
And what are these? Gross profit margin is the percentage of the top line revenue which is gross profit. And markup is the percentage of the wholesale cost that is added on top of the wholseale cost to determine the final retail price.
Now, to calculate your gross profit margin, you take your gross profit and divided by your total revenue. The resulting percentage will tell you what percentage of your revenues are actually gross profits. This percentage, your gross profit margin, it's an important indicator of how well your business profitability is structured.
So, what is a good gross profit margin? It depends, and it varies from industry to industry. It's important that you know what is a good, competitive, realistic, gross profit margin for your business. It's important to know whether you are operating at, above or below that commonly accepted industry-specific gross profit margin.
Let's step quickly back to our used furniture shop example. $10,000 of revenue and $4000 of cost of goods sold, leaves us with a gross profit of $6000. If we divide the gross profit, $6000, by the total revenue, $10,000, then that gives us a gross profit margin of 60%. And for a retail operation, a 60% gross profit margin is pretty acceptable.
Markup
The next percentage pricing metric that is critical to understanding your businesses profitability, is your markup. And your markup is calculated by taking your gross profit and dividing it by the cost of goods sold. Or rather, on a product by product basis, it is the retail price divided by the wholesale price. That is your markup. So for example, if we look at markup generally speaking across-the-board, for the monthly sales of our used furniture shop, then we see that we have made $6000 of profit on $4000 worth of wholesale cost of goods sold expenses. And therefore 6000÷4000 = 150%. That's an excellent markup for sure, but depending on how the business is structured, and where it is located in the competitive landscape, it may actually be too much of a markup for the customers to bare.
Let's talk about markup on a product by product basis. Let's say your company is selling, I don't know, a t-shirt. And that t-shirt, you sell it for $10, and you paid five dollars for it wholesale. So for every t-shirt that sells for $10, you make five dollars profit. And five dollars profit divided by five dollars cost of goods sold equals a 100% markup. Not bad.
It is common for the savvy business owner to understand what the typical mark ups are for the goods and services that the business sells. And, then based on that typical markup, the business owner can decide what the appropriate markup percentages are for their particular business. It is pretty common for similar businesses, directly in competition with each other, in similar segments and categories, to have similar profit margins. By that I mean, a fancy restaurant is going to have profit margins and mark ups that are similar to other fancy restaurants. And low cost family restaurants, are generally going to have similar profit margins and mark ups to other low-cost family restaurants. Generally speaking, McDonald's, Burger King, and Arby's, all have pretty similar profit margins and mark ups.
Increasing Your Profit
Let's talk about increasing your profit. Interestingly, there are really only about three ways that you could change your profitability. Just three things that you have control over which determines how profitable your business is or isn't. These three things are your sales volume, your pricing and your expenses. Meaning, to increase profits you could sell more, charge more, and cut expenses. Nothing else.
Selling More
Selling more, the first way to increase your profits, is of course the most important part about growing your business. And we are going to devote a number of future episodes to the idea of growing your business through selling more.
Selling more, month over month, season over season, quarter over quarter, and year over year, is the trick to sustained business growth. The key to attaining sustained business growth, is paying attention to what is working right, and then doing more and more of that. Additionally, over time, you can also diversify your revenue streams and add new profit centers. And, of course, you can always expand operations.
Take for example, our used furniture store. If we notice that used tables are out selling used chairs by 10 to 1, then it would make good sense to have more tables available to sell. That's a good example of looking at what is selling well at the company, and doing more of it.
Second, diversifying the revenue streams. If we suspect, and subsequently verify, that our customers are also interested in used furniture repair and restoration, then we could create a new profit center and revenue stream by offering repair and restoration services to our existing customers. This brings entirely new profits and operations into the business.
And third, if we suspect and verify, that our customer would be better served with additional locations, we can open additional stores around town. Or, around the region, or the state, or the nation, or whatever. If what works here, would work well there, then a great way to sell more is to open a location there.
Increasing Prices
Increasing prices is always an option. I mean, who hasn't thought about how great life would be if they could just raise prices 25%? But, as you probably expect, prices are very tricky situation. If you charge too little, then you will not make enough money, and you will go out of business. At the same time, if you overcharge, then customers will either shop elsewhere, where similar items are sold for less. That's why it is so important that you understand exactly what the typical profit margins and mark ups are for your industry, and that you stay somewhat consistent with those typical margins and mark ups. Also, determining your retail prices as a resulting functional output of calculated markups and margins, ensures consistent pricing across your entire product offering. Furthermore, relying on common margins and markups, also guarantees that as your costs of goods sold increases, your prices (and profitability) will also increase.
Let's go back to our T-shirt example. Remember, we were buying our T-shirts for five dollars wholesale and selling them for $10 retail. That represents a 100% markup and a 50% profit margin. We want to preserve both our markups and our margins during the entire time we are in the business. So let's say that things get inflationary, and our wholesale T-shirts stop costing five dollars and now cost us six dollars.
We are going to at this point have to raise our retail prices in accordance with our hundred percent markup and 50% profit margin, and therefore based on $6 cost per item wholesale, the new retail price for the T-shirt is going to be $12. What's interesting in this situation, is that our wholesale costs have gone up by a dollar. And by preserving our margins and mark ups, we have raised our retail price by two dollars. In this case, even though our wholesale costs have gone up, by adjusting our retail pricing appropriately, our profits have also gone up.
Remember, we used to make five dollars profit on every $10 T-shirt sold. Now, after the wholesale price increase, and the corresponding retail pricing adjustment, we are now making six dollars on every $12 T-shirt that we sell. Notice how by staying true to our profit margins and mark ups, wholesale and retail pricing become automatic, and self adjusting as things generally get more expensive over the lifespan of the business.
Now — Did you notice what just happened? We just raised prices, and also raised our profits.
Reducing Overhead
The last way to increase profits is by reducing your overhead. Otherwise, known as your operating expenses. And reducing overhead is by far the most common way of increasing profits. A lot of times this is called optimizing. When it comes to overhead, you typically want to keep overhead as low as possible for as long as possible, and preserve as much profit as you can. The exception to reducing overhead, is cutting costs in sales and marketing, and product development. The thinking behind that is, sales and marketing drives top line revenue. And product development generates the compelling products for you to sell in the first place. These represent a category of overhead expenses that are thought to be revenue generating expenses. And you never really want to cut revenue-generating expenses. Why? Because the result will be less revenue.
The kind of overhead that you really want to cut back on is needless and bloated non-revenue generating expenses. And the extent to which you cut back on this is solely your decision.
A great example is flowers. A few years ago, I used to work at a company where they made an awful lot of profit for a number of decades, and when you worked at this company, once you got promoted to the point where they gave you an office, every week a florist would come in and put fresh cut flowers, in a little vase, on your desk for the week. And everyone who had an office, had fresh flowers all week long, week after week, year after year. If you weren't senior enough to have an office, then you could enjoy a pantry on every floor of the office building. And in that pantry, would be free snacks and drinks. Have as many as you like — the company was making plenty of money, and was happy to provide these creature comforts for its rank and file employees. Then, along came 2008, top line revenues sank as we entered into the great recession, and as revenues and profits declined through 2009 in 2010, the company responded by cutting back on overhead expenses. Specifically, non-revenue driving overhead expenses such as fresh cut flowers on office desks, and free snacks in the employee pantries.
I like this example because it illustrates how a company can decide to take a portion of its profits and invest it in its employees with morale boosting things like flowers and snacks. At the same time, when things get tight, this is a perfect place for a business to tighten its belt and reduce these non-revenue driving overhead expenses and protect their profits while times are lean.
A penny pinching profitability manager is very keen to look at all overhead expenses that are incurred by the company, and find ways to optimize operations and reduce those overhead expenses without impacting the fantastic things about the company that its clients customers and employees have come to love and appreciate. There are simply some things you cannot cut without the customer noticing and reacting negatively. A simple example: if McDonald's decided to cut costs by reducing its kitchen staff, and as a result started selling cheeseburgers that were not, in fact, cooked, thus meaning that the customers would have to accept raw burgers and take them home and cook them themselves, this would presumably diminish the enthusiasm from which customers would continue to flock to McDonald's.
You can typically safely cut back on your overhead by examining how much you are spending on supplies, taking a look at your facility and operations, and reducing their costs by subletting unused facilities or capacity, and maybe by buying raw materials and supplies in bulk. Also, over time, it is good form to look at some of the basic services that your company pays for, and consider getting fresh competitive bids from other suppliers. For example: janitorial services, trash removal, insurance, maintenance, groundskeeping, and a whole flight of other support services that are provided to your company can be sent out for more competitive bids and pricing, in a way that doesn't sacrifice anything in the customers eyes.
I remember a campaign that was run at a magazine publishing company that I worked for a while ago, where the bean counters had put posters throughout the company employee lounges, cafeterias, and common areas, that encouraged employees to report wasteful spending or instances of employee theft, of either time or resources. The thinking here was that employees across the company could see things, instances of wasteful spending, for example, that were not visible to the management team. Therefore by encouraging employees to be the eyes and ears of the penny-pinching initiative, management presumably found a whole bunch of places where they could cut costs and preserve profits.
Final Thoughts
At the end of the day, it is you, the business owner, who gets to decide how much profit you want your company to make. And, nobody can tell you what the right answer is to the profitability question. It is your decision to make.
However, it's important that you remember and understand the rules of pricing and profitability dynamics. Those are, top line revenue minus cost of goods sold gives us gross profit. Gross profit minus operating expenses equals operating profit or net operating income. And operating profit minus taxes and interest equals net profit. That's profit mechanics.
Your gross profit margin is the percentage of your topline revenue that is gross profit. And markup is the percentage of your wholesale cost, that you add to the wholesale cost to determine your retail price.
And when it comes time to increase your profit, there are really only three ways to do that, you can sell more stuff, you can raise your prices, or you can reduce your expenses. That's it.
There we have it, the nuts and bolts and A, B, C's of profit mechanics, profit margins and markups, and profit maximization. A little bit down the road we're gonna talk more and more about the ways you can sell more and more. That's things like sales and marketing, advertising, developing new revenue streams, opening new locations, and so on and so forth. Fun stuff.
But that's it for today, Episode 107 of the Making Business Fun Podcast, How to Make Profits.