Understanding Revenue and Profit for Small Business
Are you looking at the right numbers when it comes to assessing your business goals? Do you know the difference between revenue and profit and where your business hangs in the balance?
Grasping this concept can be a tricky topic for lots of business owners.
There are lots of misleading indicators that might suggest you have a profitable business when that’s not the case.
Increasing invoices, quoting tons of clients, and even expanding your staff and crew payroll might make you think you’re printing money.
But, your expenses may be growing in these cases too. Rent, employee labor, materials, equipment, and even low profit or unprofitable jobs all need to be accounted for.
So, where do you stand when it comes to revenue and profit? We spoke to an experienced accountant to get the low-down for you, so you can make smart decisions moving forward.
In this article we will cover:
1. The difference between revenue and profit
2. Smart ways to gauge business health
3. Strategies to control your profit margins
Interested in learning more about profit margins?
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About our contributor:
Shabir Ladha, CPA, CA, and partner at KBH Chartered Accountants, has worked with clients with $50,000 a year in revenue, all the way to large-scale manufacturers with $200 million in revenue.
He’s an expert in financial best practices; breaking down revenue, pricing, profit; and more essential financial definitions.
The following are excerpts from our interview with him. You can watch the full Facebook Live interview on our Facebook page.
1. The difference between revenue and profit
Revenue and profit are not the same thing. Shabir explains it this way:
“Revenue or sales is that number that you invoiced. So think: ‘how much did I sell?’”
If it’s a product based business, how much product did you sell? If it’s a service based business, think of lawn care, furnace repair, of plumbing services, in this case it would be services that were sold or completed in a period of time.
Revenue is the top number on an income statement or a profit and loss statement.
“Profit is the number you get after subtracting all expenses. So think: ‘how much does rent, payroll, and materials cost me?’ These are the things you would subtract from revenue.”
What you would do is take your sales number, your revenue, and deduct off all your costs. Costs can include:
- Wages for your employees.
- Your own salary.
- Fuel for driving your truck or equipment.
- Equipment, like parts and materials needed to complete a plumbing or electrical job, for example.
- Costs are what’s required to run your business during the month.
What’s left over after that deduction is your profit.
It’s ideal that you will still have a profit at the end after all those costs are deducted.
The profit is really how much you made. The revenue is how much you sold.
Pro tip: profit margin is the number at which your profit exceeds (or does not exceed) your revenue (i.e. your sales). It is used to indicate how many cents of each sales dollar generates profit for your business.
Helpful revenue and profit terms and definitions
|Revenue (sales)||Also known as sales on an income statement, revenue is the income dollar amount you’ve generated from operating your business, selling goods, and selling services.|
|Gross Revenue||This number is all the income from a sale that is made in total. This does not account for the cost of goods sold, operating costs, or other expenditures you have made to create the good or service (such as payroll, or materials).|
|Net Revenue||This number is calculated by subtracting the cost of goods sold from gross revenue, and any adjustments you’ve made on goods or services sold (i.e. refunds, price matches). Net revenue does not include other business operation expenses like payroll, rent, and utilities, for example.|
|Profit||This is the absolute dollar amount of money you made as income after subtracting the cost of goods sold, expenses, and payroll.|
|Gross Profit (profit, sales profit, gross income)||The profit made after deducting the cost of goods sold (COGS), expenses, the cost of operating, and payroll.|
|Net profit||This is a ratio expressed as a percentage. Net profit shows how much of each dollar collected as revenue is actually considered profit. For every dollar generated in sales, the net profit is the amount that you actually keep as profit.|
|Profitability||Profitability is a relative term. It's an indicator of how profitable a business is in relation to its size. Profitability indicates business efficiency and can indicate that a business is worth investing in.|
How to calculate gross profit:
Gross Profit Margin = Net Sales – Cost of Goods
How to calculate revenue:
Sales Revenue = Units Sold x Sales Price
2. Smart ways to gauge business health
Don't rely on your bank account to understand revenue or profit
“Looking at your bank account is a bad way to manage your business. Many entrepreneurs do it because that’s the only piece of information they have,” Shabir explains.
“Having the right bookkeeping or the right information is vital for business health.”
You need to understand what your revenue is on every single financial period. That can be a week, month, quarter, or a year. Then subtract your expenses so that you know your profit.
You can have money in the bank when you look at your bank statement:
- You could have done a bunch of work
- You could have collected payments (so your accounts receivable could be great)
- You could have a very small amount of money you’re waiting to come in for unpaid invoices
But money in the bank does not show visibility into the stack of invoices that you have to pay. For example:
- Your fuel bill
- Your employees or contractors
- Your repair bills for equipment
- Your credit card bill
So, if you have lots of money in the bank, that’s wonderful. But when you add up all the bills and some of that money in the bank has to go towards those expenses, then there isn’t so much money in the bank anymore.
However, if you look at your revenue and expenses, then you can actually see your profit and know if you’ve made money.
Should you hire an accountant or bookkeeper?
If you’re wondering who does what and which you need we have the answer.Find out
Set smart business goals
“It’s great to grow your top line revenue number, but if it comes at the expense of profitability, wages to the owner, business health, or quality of life, then it’s kind of pointless.”
You could hit a million dollars in revenue but only make $20,000 profit because your expenses were higher than your revenues. That’s problematic.
It’s much better to do $450,000 in revenue if you’re making $50,000 a year in profit.
The lesson learned is that going after a revenue target for the sake of the target doesn’t really make a lot of sense. It has to have profitability baked into the plan.
Setting revenue targets only make sense for your business when you’re trying to grow revenue for a specific goal.
For example, if you’re trying to grow revenue to take on employees, and factor in losing money because you need to do that to make more money down the line.
Down the line to reach that goal, you’ll have all the employees fully busy so you can push for that top line revenue.
In this scenario, there’s still some risk, but it’s worth it because you have a target for a reason–not just an empty target.
3. Strategies to control your profit margins
Ensure you have a full picture of your labor costs
“Pricing labor is an interesting one because when you look at the cost of labor, business owners often just look at the cost itself,” Shabir explains.
He provides an example:
“If I’ve got an employee and I’m paying them minimum wage at $15 an hour, I think ‘that costs me $15 an hour.’ But, I have to add into that the employer cost of social security, employment insurance, benefits (if you offer them), and training.
All of those things are payroll costs.”
There are a lot of costs related to labor that don’t always get factored in–this is one of the easiest mistakes to make.
But, when labor costs typically take away 30-35% of revenue on average, these are the types of mistakes you want to avoid making.
You might think: “Well I’m paying my employee $15 an hour. So, I need to charge them out, price the service at $30 an hour to the customer. That way I’m making 15 to cover all my other costs.”
“That’s actually incorrect. There’s at least a few percentage points above that $15 that disappears in other costs than what you’re probably thinking about,” he advises.
You really need to know what your labor costs look like before you start to add 10%, 20%, 50%, even 100% to the cost of the job. You can’t just use an industry to calculate your pricing for your labor.
Labor cost is a big one, and it needs to be accurate.
Want more information on how to bill clients and labor?
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Factor in your up-front costs
In the construction and home services industry there are a lot of up front costs. You need lot of materials and supplies in order to do a job.
Whether that’s framing a house, completing an interior plumbing job, or installing a new furnace, there are up-front costs associated with that.
You’ve got to pay for some of those up front.
Most businesses will add a mark-up of some kind to those materials. What that mark-up will be varies anywhere from 5%, 10%, 20% (or more). You must include mark-up in there for a number of reasons to account for money you’re spending to get those materials. For example:
- The amount of time it takes to run to the local hardware store to pick up those materials.
- The fuel cost involved in getting to a store or the jobsite.
- The wear and tear on a vehicle that’s involved in a job.
- The time you need to pay an employee to be doing some of that work.
- The cash you need available to purchase the materials
These items are considered cost drivers. They aren’t the real cost in your business.
Cost drivers aren’t just the dollar amounts doled for per employee, per hour, or per material. It’s much better to consider them as mark-up percentages. That way, you can adjust your pricing quickly and easily according to each job.
Identify your high-value, low-cost services for lower margins
“Every business has high value, low cost items and services,” Shabir explains.
“A house cleaner may spend more time when she does the windows.
But, if she thinks about the amount of work it is to do the windows versus the amount of work it is to clean the rest of the house, the time spent on the windows is not as much as the time spent on the house.
Despite that, the client pays almost the same amount for the windows as a house cleaning.”
This is an example of a high value service. It’s something the client really wants (and probably doesn’t want to do themselves), but comes at little to time and material cost sacrifice for the business owner.
Go through your service offerings and identify these low margin jobs. From these, start to think about how you can advertise or offer these services in addition to your regular service offerings.
Maybe you upsell them, market them as “add-on services,” or package them all together as a special offer.
Offering these services at a high volume is hard to do if you’re a service business. You’ll need to focus on some of the high margin work too. You just have to be careful that you don’t cut out the low margin work and sacrifice everything else.
“If you think about it and assess your invoices and revenue statements, you’ll probably find that a lot of times the low margin stuff gets you the high margin work.”
Be strategic with loss leaders
“A loss leader can be great. Once you get the client in the door, you need to upsell (not bait and switch them),” Shabir explains.
A loss leader is a type of pricing or marketing strategy that’s designed to get a customer in the door. Typically, a business will underprice a good or service to encourage more sales. When the customer is in the door, they may be more likely to buy more.
The point is to get someone in the door on an inexpensive service, and then make more money down the line.
What are examples of loss leaders?
For a lawn care business, a loss leader may include offering to cut a client’s lawn for the first month at $10 per week. But, the client needs to sign a six month agreement with you. After the first month, the price will go up to $40 a cut.
For an AC company, they might offer to do the inspection and the client’s first filter replacement for free. Upon the first inspection, technicians will change the filter regardless. Then for the rest of the year, the business can charge their regular price for continuing maintenance service with the filter change still baked into the service price.
Healthy revenue and profit is a short term and long term plan
While you may be focusing on what’s right in front of you, don’t forget about the road ahead.
Over time you’re going to have to ask yourself a few hard (but important) questions.
First and foremost, you’ll need to figure out if the business model you currently have is actually a profitable one. This underlies the rest of your business and its future.
It’s critical to know the answer first before you start tweaking other things that can improve your margins like salaries, routing efficiencies, and goods and services pricing.
Once you figure that out, then you can move on to the other questions that will help you plan longer term.
To cap things off, start asking yourself the following questions today and in the months and years to come:
- Can you become profitable?
- Can you get to a point where you’re paying yourself as the owner?
- Can you pay yourself and your employees fair market value working as much and as hard as you do? (Yes, that includes doing administration after hours.)
- Can you create entrepreneurial earnings?
- Can you pay everybody and yourself and still have profit beyond that?
- Can you eventually say you’re going to sell the business to get out?
- What’s your business worth, and will that replace your current salary, plus additional profit?’