P1M2 What Is Profit

The full title of this second module in Pillar 1 Your Key Numbers is:

What Is Profit? And How Much Should You Make?

In this important module I am going to challenge your thinking with the aim of getting you to step out of your comfort zone.

I believe many small business owners hold themselves and their businesses back because they don’t challenge themselves.

Answering the question “Do you want to make more profit?” with a strong YES is a no-brainer on the surface.

Of course you want to make more profit…only a fool would want less profit wouldn’t they?

But I believe many small businesses earn low profits because the owners accept low profits. They don’t push to earn more.

It’s easy to talk about increasing profit but what does it really mean?

Are you clear in your own mind about what profit is…and what it isn’t?

I ask for two reasons:

  1. Accountants and economists disagree about what profit means.
  2. Definitions across countries can very. While profit is commonly used in the UK, in the US business profit is often referred to as net income.

Let’s clarify the definitions.

The Accounting Definition Of Profit

Think of Accounting Profit as the difference between revenue and costs for a particular period of time.

Read Accounting Definition of Profit

The Economics Definition of Profit

The Economics definition of profit is the additional profit you gained over and above your next best alternative.

In particular I want you to think of it as the difference between the revenue you receive and your opportunity costs of time and resources.

This may sound theoretical but it is an important mind-shift I want you to make.

Read: Economics Definition of Profit – it also includes a definition of opportunity cost.

What Do Your Costs Mean

The costs your accountant uses to calculate your accounting profit are the costs of transactions collected in your books and are not market rates.

This can distort things.

No value is put on your efforts in the business because many business owners pay themselves from what is left at the end of the year or taken out an arbitrary salary each month.

Since, you are the main driver of your business… and perhaps the only person in it, the profit reported in the accounts doesn’t tell you what you need to know.

The Accounting Profit takes no consideration of:

  • How much your time and energy is really worth or
  • How much money you have invested in the business

And that means you are not recognising the sacrifices you make to be your own boss.

I want you to imagine what would happen if, your business was owned by a big group, how they would look at the performance of the business and apply pressure to improve results.

Opportunity Cost Of Your Time & Money

Lets take a cold, hard look at your business and its results if you are paid a market rate for your time and money invested in your business.

Imagine that you didn’t own your business and you had to be given the appropriate rewards.

This could be a severe wake-up call.

Read: The Opportunity Cost of Your Time

Read: The Opportunity Cost Of Your Money

The Death Spiral Of Profit

The reason I want you to calculate your opportunity costs of time and money (and any other resources your business uses) is because a combination of your business and mind play a cruel trick on you.

It’s what I call the death spiral of profit and it’s based on accepting much less than you should be earning because you continually lower your expectations.

It’s a problem of being your own boss and having the ability to trade money for having an easier life and allowing yourself to give in to self-limiting beliefs.

Read: The Death Spiral Of Profit

Reversing The Death Spiral

The death spiral can be terminal.

Both business resources and personal resources run down to a level where, when the business owner decides something must be done, there is little time or money left to make the changes.

It’s best stopped at source… when the problem first starts happening and excuses are made for poor performance.

Read: Reversing The Death Spiral

How Much Profit Should You Make?

There are benchmarks for how much money an average business should make based on size and industry type.

These help you to compare what you’ve got with what you should have.

However I haven’t yet seen a benchmarking study where I’ve felt sure the data is consistent and that I’m comparing like with like.

Read: How Much Profit?

Market Cost Of Your Time And Money

The approach I favour rather than looking at unreliable and inconsistent benchmarking data (assuming you can get it) is similar to the approach I used when evaluating acquisitions.

I’d ignore what the business owners actually paid themselves (whether it was too low or too high) and instead adjust back to my estimate of a market rate.

So you should do the same and look at your business as if it was paying the market rate for your time and money.

Only then can you see if you are really making a profit or loss.

Read: Market Cost Of Your Time And Money

A key lesson from this article is that to earn more, you need to do more high value work.

It sounds obvious but it’s not what I see in practice.

Profit Extraction: A Business Owner’s Benefit

It is your right to structure your business so you pay the least tax.

What would be crazy is to let any accounting niceties to fool you on your assessment of business performance.

Read: Profit Extraction – this is more food for thought than any definite advice since what you can and should do depends on local laws.

Since tax laws change over the years, I want you to focus on your profit before any profit extraction, salary, bonus, pension or benefits.

Your focus is on increasing the pot of profit rather than trying to deal with the complexities of the tax system and how it impacts on what you do.

What To Do: Comparing Your Actual Profit With What You Want

I want you to get specific…in particular, I want you to get specific about the gaps between how much you earn and how much you want to earn.

First, Estimate A is how much profit your business currently makes before the owners’ profit extraction.

You’ll probably want to come back to this and revise your estimates after you have finished Pillar 1 when you understand much more about profit.

Estimate B is how much profit your business should make if it was to reward you and any other part-owner fairly for your time and efforts and the money you have invested.

Finally I want you to make estimate C to capture how much profit you want your business to make.

Now look at the numbers.

The difference between C (how much profit you want) and A (how much profit you have) is the Profit Gap.

That can be split between:

B minus A, that’s the profit you should be making minus the profit you are making. This is your under-performance.

I want you to get angry about this under-performance number and commit to doing whatever is necessary to close this gap.

This is the cost of you being your own boss…in cold, hard numbers.

There is a certain irony in asking you, a business owner, to think like an employee – or if you do lots of different types of jobs, like many employees.

An employee wouldn’t accept doing a hard days work and not getting paid at the end or only earning 70% of what he or she could earn down the road.

So why should you?

The last gap is the difference between C and B – this is the difference between the profit you want and the profit you should be making. This is your target for Super Profits.

And Super Profits come from your special innovations which attract more customers to you who are willing to pay higher prices or special ways you’ve developed to provide your products and services at lower costs.

It comes from being clever in your business…because one of my aims is for you to work smarter and not harder.

Read: Example Of Calculating Your Profit Gaps

Calculating Your Profit Gaps

Now it is your turn.

Don’t worry about estimates.

I want you to be approximately right and not precisely wrong.

Follow the logic in the example and sense check your answers, perhaps by doing the calculations one day and going back to look at them the next.

I want you to get angry about your Under-Performance Profit Gap (the difference between what you should have based on time and money and what you do have) and to be inspired by the Super Profit Gap.

The more emotion you can build into your business and this program, the more likely it is that you will take the actions and see the successful results available.

Entrepreneurial Super Profit

These super profits will only happen if you think like an entrepreneur.

You need to move from input thinking like an employee:

“I worked for 40 hours this week so I should be paid  X thousand.”

To output thinking.

The business created so much value for customers this week that we made a profit of X + Y  thousand.

Success in business comes from creating great value for customers and then making sure you capture a fair share of that value. Much more about this idea in Pillar 3 on Your Strategic Marketing Position.

How To Close The Profit Gap

Our challenge is to close the profit gap.

The Eight Pillars Of Business Prosperity is a structured business development program to help you to close any under-performance gaps and then move to super profits.

But you must take action.

I’m going to keep saying it because the more you do the exercises, go back through the lessons for a second and third time and take action, the better your long term results will be.

I’m helping you to learn about business and business success and especially I want you to learn more to earn more.

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