Businesses don’t become successful by accident.
The success of your business will depend on how well you plan (and execute!) in several key areas.
Starting today and continuing in the coming months, we’re going to focus on one of our favorite topics – the importance of planning in your business. For this post, we’ll cover planning for a profitable business.
In its simplest terms, Profit = Revenue – Expenses. Your goal is to make more money than you spend, right? And yet, far too many businesses of all shapes and sizes focus their efforts on planning to create revenue, and assuming, hoping, or trusting that profit will result.
That’s often not the case.
It’s easy to identify businesses which are enormous yet unprofitable – Amazon.com is an obvious example. Established in 1994, this industry behemoth grew revenue by leaps and bounds but didn’t consistently report profit until 2015. They were able to grow without profitability because they are a publicly traded company and have enjoyed decades of outside investment.
At Clara CFO Group, we believe growth without profit is not a sustainable business model for small businesses. While large businesses may have backers and resources to help capitalize them through the lean times, that’s not often the case for small- and medium-sized businesses. As a result, our goal is for all small businesses to turn a profit from year one.
And that won’t happen without planning for profit.
So, if the formula for profit is the simple “revenue minus expenses”, why do so many businesses fail to profit? There are several reasons:
- Costs were estimated or planned in an unrealistic manner
- Demand for the product and/or service at the offered price point was inaccurately predicted
- Goods and services were not priced to cover costs
IT’S NEVER TO LATE TO START PLANNING FOR PROFIT
Ideally, every business owner would begin planning for profit before they opened the doors of their business. Yet most of you reading this are already business owners – and perhaps you’re wondering how to increase the profitability of your business.
The great news is that it’s never too late to make changes that will increase the profitability of your business. And small businesses, by nature, are less burdened by bureaucracy – allowing them to more quickly adjust when needed.
Let’s look at four categories you’ll need to review to achieve profitability in your business.
#1 – YOU ARE A LEGITIMATE BUSINESS EXPENSE
Chances are, you didn’t start your enterprise to employ others while never bringing home a paycheck yourself.
How much income do you want, and need, from your business? This is one of the first questions you must answer.
We encourage our clients to answer the following question: “If you had to hire someone to do everything you do in your business, what would you have to pay them?”
Whatever that number is, you should be paying yourself that same amount (if not more). Although it may be unrealistic to pay yourself an ideal salary from day one, it is wise to start planning for the salary you want to be earning.
Planning to pay yourself first is so critical that it will be the topic of an entire upcoming blog post.
#2 – IT TAKES MONEY TO MAKE MONEY
In business, it’s practically impossible to make money without spending money. The question for you should be this: how much money will you need to make the revenue (and ultimately, profit) you need.
Business owners with a P&L (profit and loss report) will find it simple to identify expenses. As you’re reviewing the expenses on your P&L, ask yourself these critical questions:
- Are these expenses necessary to create revenue?
- If necessary, could these expenses be reduced?
- Are there existing expenses that could be augmented, to increase revenue?
- Is there something completely missing that could increase sales?
- Will these expenses remain steady for the coming twelve months?
Once you’ve determined the expenses that will best support the profitability of your business, review each line of your P&L and create your best possible estimate of what each line item will average every month.
Now you should have a true cost of doing business.
Take off your rose-colored glasses for this exercise! You’ll want to plan for the worse case scenario when estimating costs. If your cell phone bill is normally $250 per month, but occasionally drops to $220 per month, use the higher cost.
One word of caution: don’t assume you’ll be able to reduce costs in all categories and still maintain your profit margin. Eliminate or reduce costs that won’t negatively impact profitability. Reducing costs simply for the sake of reducing costs could lead to less profitability – and that’s not the direction you want to head.
#3 – GOALS AND GROWTH
The bulk of the money coming into your business goes back out of your business in the form of expenses, owner pay, and taxes.
Yet most businesses also have other money-dependent goals. Achieving these long- and short-term goals requires you to have a plan to achieve them.
For example, if your business has $20,000 in debt, and you want to pay that off within a ten-month period, you’ll need an additional $2,000 per month to make that happen.
If you can’t find the needed funds through reduced expenses, then the extra cash flow will need to come from the business profits.
Regardless of the goals you’re trying to achieve, you’ll need to know the financial impact to your business so you can build solutions into your profit plan.
#4 – PRICE WITH CLARITY
Now that you know what your expenses are (or should be), and you know what you want to pay yourself, you can reverse-engineer your profit equation to determine desired revenue.
Here’s the formula:
Owner’s Pay + Expected Business Expenses + Business Goal Savings = Minimum Viable Revenue
Let’s apply that to a real-life situation:
- Desired owner’s pay = $5,000
- Costs to run business = $13,000
- Needed to reach goals = $2,000
- Minimum revenue required each month = $20,000
Note that this simple model doesn’t consider your tax obligations; for this example we’ll assume you are saving for taxes out of your $5,000 owner’s pay.
The nut you need to crack each month is $20,000. Is that feasible? You can help to determine that by answering these questions:
- How many clients can you serve each month?
- How much product can you sell each month?
- What is the maximum value of those products and services to your customers?
- What is the minimum you can sell each product or service for?
- What is the best day in sales you’ve had? The worst? What’s the average?
- How many hours does it take to serve a client? To sell a product?
- How many hours are you willing to work?
The answers you arrive at will define the realistic quantity you can sell.
And once you have a handle on quantity, you can solve the price question.
Quantity x Price = Revenue
Revenue / Quantity = Price
Let’s look at both a service-based business and one based on the sales of physical product, using the data from above.
You’ve answered the questions in the pricing section, and determined you have the capacity to service 10 clients each month.
Your price per client needs to be at least $2,000 to pay yourself and have the profit you need to run a business that achieves your goals.
Revenue required ($20,000) / Quantity (10 clients) = Price ($2,000 per client)
You’ve answered the questions in the pricing section and determined you can sell your product for $10.
You must sell a minimum of 2,000 units per month to sustain your business.
Quantity (2,000) x Price ($10) = Revenue ($20,000)
While this all seems pretty straightforward in our simple example, the reality is your business has complexities that may make profitability more challenging.
That’s the case for most businesses.
If you’re ready to explore enhanced profitability in your business, we invite you to have a Discovery Call or Clarity Session with one of our highly skilled CFOs. We specialize in helping small businesses earning up to $5 million in annual revenue create sustainable profitability through proactive planning.
Disclaimer: This blog and the linked videos are intended for educational purposes and should not be taken as legal or tax advice. You should consult with your financial professionals about your unique financial situation before acting on anything discussed in these videos. Clara CFO Group, LLC is providing educational content to help small business owners become more aware of certain issues and topics, but we cannot give blanket advice to a broad audience.