What is profit, really?
Welcome again to the Power of Profitability podcast!
This episode we are going to do an overview of what profit is and how you should be thinking about it. My clients (and probably yours) operate product and service businesses (and sometimes both), so we’ll be covering how profit is the same and different between these – and why that matters.
First, let’s start with the definition of profit that I like to use when working with clients which is also how we frame all the programs inside The CFO School. It isn’t quite the strictest textbook one or the IRS one, but it is one that I’ve found works and is the most meaningful to my clients in making better business decisions.
Profit is the income statement calculation of revenue less all expenses. That’s it. For any clients that have lots of non-cash expenses like depreciation and amortization, I like to look at profit before those but that’s a complexity for another time.
One thing to remember with that definition is that it is NOT the same as cash flow even if the business is on cash basis accounting. There can be timing differences and payments that don’t hit the income statement (like debt). I try not to use them interchangeably if at all possible because you can set yourself up to start explaining all kinds of things that makes your clients’ eyes glaze over. That’s exactly what we are trying to avoid!
As the expert, it will be up to you have you might want to then take that broad definition and make it fit your client. Remember – we are focused on giving your client actionable information so absolutely follow general accounting guidelines but don’t feel trapped by them. There are different types of financial reporting, and we are focused on more operational and profit reporting as that will benefit your clients the most.
Let’s start with a 100% service business. This would be most professional services like accountants, attorneys, doctors of all kinds, graphic designers, social media managers and the list goes on. For these businesses, they are largely selling time. The primary expense will likely be payroll. They don’t need to buy inventory or ship out physical products.
Their primary profit will be measured at the NET PROFIT level – meaning that it is the revenue less all the expenses. The expenses don’t need to be separated into cost of goods/services and overhead. What matters the most to these businesses is that they are likely to have most of their costs be fixed – they are the same month in and month out no matter what or how much revenue comes in.
In contrast, a 100% product business is any business that sells stuff whether that is completely resale or completely produced or a little bit of both. These businesses have some sort of storefront – a brick and mortar one, an Etsy or Facebook one or their own website. They may ship products to customers. They may or may not have employees. They often have inventory (unless they are 100% dropship).
Their primary profit level will be measured at the GROSS PROFIT level – meaning product sales/revenue less the cost of buying or making the product and then shipping it. The goal is to align the revenue with the direct cost of what is being sold. How much profit is being generated by the products? Sure this level of profit needs to “pay for” all the other business costs, but in a product-based business, it is important to separate the direct costs from the indirect ones. There are different types of decisions for these cost categories so mixing them together can mask what is really going on. Got a mixed cost? It goes to indirect – and I have an example of that in just a bit.
What is you have a company that does both? Well…this happens all the time. Examples: a hair salon that sells hair products. A spa that sells facial products. An HVAC company that sells service plans after they install furnaces.
Step one with these types of companies is to track the product revenue separately from the service revenue. That is critical – it is a “do not pass go” sort of thing. I am going to go so far as to say that it doesn’t even matter how small one is compared to the other. Even if it doesn’t seem to be a big deal today, it might turn into that and setting things up from the outset will pay dividends later. Trust. Me.
I can hear your wheels turning from here! All the “what if” and “what about” situations. Let me give you an example of one of our clients that had a both products and services as well as an online store and 3 physical locations. Frankly, this is about as complicated as it can get but we focused on getting and tracking information in line with the way the CEO made decisions and built from there.
The first thing we did was to figure out how the client thought about each part of their business. What did they already track and how did they think about that? For example, the way the viewed the retail stores was way different than how they viewed the part that resold a specific type of physical product. They also thought about all the retail stores as one and not 3, so we could treat them all the same.
We made sure that we had at least two revenue accounts to be able to track service and product revenue separately.
Then we determined what profit should be used for each part of the business – NET or GROSS. Then we determined what costs were direct and which ones were indirect. Unless there was a straightline to revenue, the costs were considered indirect. That means that Facebook ad costs were indirect. That means that the CEO’s payroll was indirect. That means any costs that benefited all parts of the business were indirect. However, ingredient costs for manufactured products were direct. Wholesale costs for the resold products were direct.
This example is a really good example also of profit focus being as much art as it is science. That said, once you make all the calculations, profit is profit. No matter what you call the subtotals or how you categorize expenses. It will all come down to the same final number so your inner highly detail oriented personality can rest easy. However, in between, you are providing way more insight and value to your clients – and their businesses are benefiting from the move to a profit focus.
I recommend taking the following first steps….
Review your client’s business to see if they are service, product or both
Review your client’s revenue sources and determine if you are tracking revenue on the service, product lines
Decide whether your client is best served by NET or GROSS profit
You can also start thinking about expenses as direct or indirect but I wouldn’t start moving things around just yet. Depending on where you are in your profit journey, you may need to do more learning and exploring first. It can also depend on your clients. If your clients are 100% service businesses, that is a much shorter cycle to full implementation. Be patient. Profit focus and all the related value adds that come from it is a long game, not a quick fix.
Remember – you can find even more resources at powerofprofitability.com that keep you moving on your profit journey.
Until next time!
How can you use this example with your clients (or maybe in your own business)? Grab our Profit Leaks checklist below. It’s free and will get you into action immediately.
