Listen to the podcast here:
If you have ever been confused about what net profit is you can take comfort in knowing that even the great Sir Richard Branson admits that understanding net profit can be tricky (click here to read more). I have had numerous conversations over the years with entrepreneurs and individuals running businesses that have done a great job explaining how their business generates gross revenue from the products they sell or the services they provide but can’t easily sketch out how the business earns net profit. It can be tricky but it can also be the difference between having a great business and a business that barely gets by or seems to never have enough cash.
Here is the basic math that every business follows:
A. Product or Service is sold to a customer and revenue is earned
B. There are costs that are directly related to the sale such as sales commissions or materials
C. When you deduct your direct costs you then are left with money to pay for the general costs of the business such as rent, salaries, office supplies, etc.
D. When you deduct your direct costs and general costs you are left with net profit (the good stuff)
There are two things you should know about your business without needing to be an expert accountant or finance major: 1) what does it cost you every time you make a sale in terms of direct costs such as sales commissions or materials, etc.? 2) what does it cost you every month to run your business? With both of these things in mind you should know how many products or services you need to sell every month to break even and how many are needed to generate net profit.
Why is this concept confusing?
Many people will have many different opinions on why this concept is confusing. I believe it has to do with timing. Monthly costs are easier to understand because they happen every month. Rent is rent. Payroll is payroll. These general costs are easy to track and understand but the costs associated with sales are more complicated. This is because they tend to change based on the amount of the sale being made. Sales commissions are usually percentages of the amount of the sale or the materials needed to fulfill an order are often times spread out over multiple orders making it difficult to calculate in real time.
What can I do to reduce my confusion?
My suggestion would be to look back over the past few months and take a look at your revenue and the direct costs that were paid to generate that revenue. Over a few months you will begin to notice a trend and more importantly will be able to see how revenue is left over to pay for the general costs of your business. If you notice that there is no trend then that is probably an indication that something is wrong with either your accounting process or your pricing. If you do notice a trend you should memorize the percentage so when you are doing rough math in your head you know that “when I sell $1,000 worth or products or services my direct costs are around $300 which leaves me $700 for the other costs of my business”. Knowing that $300 on $1,000 of revenue is 30% is the beginning of understanding how to change your net profit. If net profit is too low then increase your prices or reduce your direct and general costs.
Remember that cash in the bank does not mean your business is generating net profit. If this concept of cash in the bank versus profit is causes you anxiety or frustration, let’s connect so we can chat about it.
mlenow.ca was created to help businesses that are looking for $250,000 to $10,000,000 in financing. Our team gets up every day to help businesses that find themselves in this position. Let’s chat and connect if you (or someone you know) needs some help.