The Traditional Approach: Expenses First, Profit Last
A consistent income stream might be your end goal as a business owner, as this gives you the ability to pay off expenses like labor costs but most quickly come to understand that profit planning is what truly leads to financial health and success.
A profit and loss statement or an income statement, is calculated using the formula: Income – Expenses = Profit. This equation is widely recognized and used, as it is both logical and in accordance with GAAP (Generally Accepted Accounting Practices). When applied to budgeting, most people use a variation of this equation to first figure out expenses and then calculate income to see what is left over for profit. But have you ever thought about flipping that equation on its head? What if we figured out the income first and THEN DETERMINED THE PROFIT? Imagine if you planned for profit, taxes, savings, and larger owner distributions from the start. How would that change your business and personal life? The answer is clear, you would most definitely be happier.
The Typical Growth Path of a Business
Starting a company can be done in countless ways, but the typical growth path follows a recognizable pattern. Initially, you find yourself launching your small business from your kitchen table, reusing old file folders to save a trip to Office Depot, and managing operations from a laptop that’s seen better days.
Soon, you acquire some clients and start seeing the first inflows of cash. This growth prompts you to hire additional help, as handling everything on your own becomes increasingly difficult and time-consuming. With an expanding client base, your home office no longer suffices, pushing you to rent office space. As you gain more customers, your revenue increases, allowing for upgrades like a new computer and sophisticated CRM software. This technological advancement enhances your ability to track current and prospective clients, further accelerating revenue growth. At which point you realize you need a new website so you can reach more people. That is fine, as you signed that great client last week, which will pay for the new website.
With the new website live, you witness a surge in customer acquisition, affirming the potential of your business. Encouraged by this success, your web guy suggests boosting your online presence through SEO. Sure thing! No Problem! Now, you have new clients rolling in every month and you think to yourself, we have money, and we are making more than I ever thought we would, I have to hire another couple of team members to take care of all these new clients. Before long, you outgrow your current space and move into a modern, impressive Class A building space that will impress all of your clients (who never come in to see you) and that your employees will love. And as long as all of this money is coming in, you start taking some for yourself. Of course. You earned it, look at this awesome company you have created from scratch.
The Cash Crunch
But there is generally another side to the story. The cash crunch. You have all this money coming in and new clients signing with you all the time, but every time you get a new client, it seems that some new expense speaks for the money before the ink is dry on the new contract. You are covering all of your expenses, but you still have to hold your breath on the 12th and the 28th, worried that you won’t have enough cash for payroll. At first, you get through those dates and can still take some for yourself, and then another couple of days go by and you begin to worry again that the checks may not come in as fast as they need to go out, but you constantly remind yourself how much you are making.
Everybody is looking at the top line but you aren’t admitting the truth about the bottom line, even to yourself. You know that you are spending EVERYTHING you are bringing in which causes you to wake up at night in a cold sweat because you remember that you missed a deadline for Mr. Jones, and if he gets upset about it he might fire you and you will be short. How will you pay the rent and payroll when you have no savings? And then the year ends and your accountant calls and says you have a huge tax bill. How can you possibly owe that much in taxes, you only have $2,384.56 in your bank account. Can’t they see you didn’t make any money? Unfortunately, despite feeling like you haven’t made any profit, the tax authorities are demanding their due, largely because of the distributions you took to maintain your lifestyle.
Most business owners can readily identify with this scenario. Almost all have lived through it and some learn the hard lessons and change their ways. Others pay off the IRS and keep doing what they have been doing while waiting for a different outcome. However, the different outcome (profit) doesn’t have to be elusive. You simply have to plan for it.
How to Plan for Profit
To avoid a cash crunch and ensure your business remains profitable, it’s essential to plan for profit from the start. Here are some steps to guide you:
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Research Industry Standards
Start by asking yourself, what portion of your income should go straight to profit? Don’t know? Do some research. Go online and search public companies in your industry, look at some of their financial data, and see what percentage of their income remains in profit. (Profit/Gross Revenue = %)
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Consult Experts
Talk to other business owners in your network to learn about their profit margins and consult with your accountant to get a professional opinion on what your profit percentage should be, then apply this percentage to your revenues.
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Set a Profit Target
Based on your research, set a realistic profit target. For service-based businesses, we generally like to allocate about 30% of your income to profit.
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Calculate Your Projected Revenue
Once you have your target profit, calculate your projected revenue. This will help you understand how much you need to allocate to profit and what remains is what you have to spend to run your company.
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Prioritize Profit and Savings
As soon as revenue comes into your account, immediately move the profit portion into a separate account and do the same with your business savings. And again, that money is not so you can go buy the flashy new binders with your company logo on them. That is for the new computers you know you will need in the coming year or for when you miss a deadline for Mr. Jones and he fires you.
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Evaluate and Adjust Expenses
- Carefully evaluate your business expenses and look for ways to optimize spending to ensure your budget supports your profit goals. Do you need that Class A office? Are you spending $3,000 a month on Google AdWords and SEO and still haven’t gotten a client from the internet? Have you planned for some business savings to pay for computer upgrades or to give you a buffer in case you lose a client? What percentage of your revenue is going to go towards investing in the long-term objectives of the company and ensuring that you can survive hard times?
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Plan for Future Investments
Create a business plan to allocate a percentage of your revenue towards investing in the company’s future. This includes setting aside funds for potential growth opportunities and ensuring you can survive during tough times.
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Maintain Financial Discipline
Avoid the temptation to borrow from your profit or savings to cover unexpected expenses. Treat these funds as sacrosanct. By maintaining this discipline, you ensure your business remains financially healthy and prepared for the future.
Benefits of a Detailed Profit Plan
Once you start planning for profit, you will notice several significant benefits. Firstly, you’ll start to have more fun with your business. Once a quarter, you can disburse money from your profit account, watching it grow each month and planning exciting uses for it, like a trip to Disney or a new kitchen table. And you know that when you make the disbursement, part of it is automatically going to Uncle Sam, so you won’t have the tax problem next April that you had this year.
Next, you start sleeping better at night. Why? Because you know your savings account balance is also growing, providing a financial cushion for unexpected expenses. Now, even though Mr. Jones might fire you, it’s OK. You have realized that he is not a profitable client and that your staff would be happier without him. You might take a hit for a month while you find a new client to replace him but knowing that you have set aside money for expenses like labor costs, fixed costs, overhead costs, and variable costs, gives you that luxury.
Improved business discipline is another advantage of prioritizing profit. By enforcing a more disciplined approach to managing your expenses, you ensure that your spending aligns with your financial goals rather than reacting to immediate needs and opportunities. This discipline promotes sustainable growth, preventing the common trap of expanding too quickly and running into cash flow issues. By making informed decisions based on a detailed plan, you can avoid unprofitable ventures and stay focused on your profit goals.
Ultimately, cash crunches become a thing of the past because you are planning more wisely and working within a budget targeted toward a profit objective. Isn’t that what it’s all about?
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