Profit
is the positive financial gain your business makes after you've
subtracted all your expenses. The ability to generate profit is crucial
to the survival of your business. It is about more than just making
money - it's also about the ability to grow your business in the future.
Profit
is not the same as cash or sales, and it's not the money in the bank or
on hand. Profit is represented 'on paper' in your accounting system.
To
be more profitable you need to understand the concepts of profit
margins and profit drivers. You can then develop strategies to increase
your profits, including ways to increase your sales revenue and decrease
costs.
You can use the
tools, diagrams and tables in this guide to help calculate your profit
goal, minimum sales requirement and to chart the most important products
for your profit margins.
This
guide explains how to make your business more profitable by helping you
identify and understand the financial factors that affect it.
Calculating profit margins
Your
gross profit margin is a key indicator of your business's overall
health. The gross profit margin shows whether the average mark up on
your products or services is enough to cover your direct expenses and
make a profit.
To calculate your business's gross profit margin, you first need to calculate gross profit.
Gross profit
Gross
profit is a valuable measure of your pricing policy, sales volume and
cost of goods sold. Your trading account will show gross profit using
the following formula:
Gross profit = sales revenue - cost of goods sold
Gross profit margin
Gross profit margin is gross profit expressed as a percentage of sales. Use the following formula:
Gross profit margin = (gross profit ÷ sales revenue) x 100
Example: calculating gross profit margin
Below is an example profit margin for a bakery that sells sweet rolls, savoury rolls and a variety of bread loaves.
For
each of their products, the cost of goods sold (cost to make), sales
revenue (sale price), gross profit (sales revenue minus cost of goods
sold) and gross profit margin are listed.
Product
|
Cost to make
|
Sale price
|
Gross profit
|
Gross profit margin
|
Sweet rolls
|
$0.50
|
$2.00
|
$1.50
|
75%
|
Bread loaves
|
$1.00
|
$3.00
|
$2.00
|
66%
|
Savoury rolls
|
$1.50
|
$2.00
|
$0.50
|
25%
|
Product
|
Daily target
|
Gross profit
|
Gross profit margin
|
Daily gross profits
|
Sweet rolls
|
106
|
$1.50
|
75%
|
$159
|
Bread loaves
|
180
|
$2.00
|
66%
|
$360
|
Savoury rolls
|
100
|
$0.50
|
25%
|
$50
|
Totals
|
386
|
$569
|
As a business owner
this is a useful exercise to understand what your most profitable and
unprofitable products lines are. You may even decide to stop offering
some unprofitable lines and concentrate on your most profitable
products.
Setting a profit goal
Your
profit goal is the amount of money you need to meet a number of
predetermined commitments that are important to both you and to the
future of your business. profit drivers) to reach your target.
To set a profit goal, you will need to consider the following:
- costs (both fixed and variable)
- owner's annual income
- operating expenses (fixed and variable)
- return on borrowed capital
- return for risk
- return for future growth.
Fixed (overhead) costs
Your
fixed costs (also called overhead costs) are indirect costs that stay
the same regardless of your production output - this includes things
like rent, utilities, maintenance costs for your work facility,
licensing fees, insurance and accounting.
Variable costs
Your
direct costs, such as labour and cost of raw materials, are only
incurred when you're creating or manufacturing a product, so they're not
counted as fixed costs.
Owner's annual income
When
calculating your income, you should use an amount you would pay an
employee to do the work you're doing. It should include superannuation,
but shouldn't be an inflated salary.
Return on borrowed capital
Return
on borrowed capital refers to an adequate return on the capital you
have invested, at least equal to long term bank interest as well as an
additional return based on the level of risk.
Return for risk
This
is the return you'd expect, allowing for the associated risks - running
a business has more risk than putting funds in a bank.
The
return for risk should be calculated in direct proportion to the risks
involved. For example, if you invested in a very speculative business
venture with a low likelihood of success, you'd expect a very high rate
of return if it did prove successful.
Return for future growth
This
is the amount you need to invest for future growth and development of
your business. You may need to expand your premises after a few years,
develop an innovative way to provide a service or new products, or
develop a new marketing strategy.
Achieving your profit goal
To achieve your profit goal you need to calculate your minimum sales requirement. That is, you need to work out the level of sales (turnover) that will produce enough revenue to cover your operating costs plus your personal financial commitments.Turnover
Your turnover is essentially composed of:- volume of sales
- selling price (i.e. cost price + profit margin).
For every product you sell the money you receive will go into covering your variable costs (materials and direct labour) as well as contributing towards your fixed costs and profit goals.
Minimum sales requirement
The minimum sales requirement is the point where both your fixed costs and your profit goal are covered by your gross profit.Minimum sales requirement = (fixed costs + profit goal) ÷ gross profit margin
It's often useful to express the annual minimum sales requirement in terms of weekly, or even daily, units you need to sell. If your business is not capable of trading at the minimum sales requirement, then it will not be capable of meeting your profit goal.
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