Gross Profit, Profit Margin & Markup, OH MY!

April 27th, 2015 by Doug Boswell No comments »

Gross Profit, Margin & Markup

The terms Profit Margin and Markup are often used interchangeably to mean Gross Profit Margin, but they are not the same. A clear understanding and application of these concepts and calculations can provide the information you need to better impact your bottom line.

First of all, a very valuable calculation you’ll want to perform for understanding your business is Gross Profit, and then, the tool that you use to maintain gross profit, called Markup.

The gross profit on a product is:

Sales – Cost of Goods Sold = Gross Profit

To understand gross profit, it is important to know the difference between the expenses we call Cost of Goods Sold and the expenses we call Operational Costs.

Cost of Goods Sold are those expenses that are incurred as a direct result of producing the product. They tend to be variable costs such as:

  • Materials used
  • Labor directly involved in production
  • Sales commissions
  • Packaging
  • Freight
  • Utilities, or power costs, for production equipment and or facilities
  • Depreciation expense on production equipment
  • Machinery

Operational Costs are the more fixed costs such as:

  • Rent
  • Insurance
  • Professional fees
  • Office expenses such as supplies, utilities, a telephone for the office, etc.
  • Salaries and wages of office staff, salespeople, officers and owners
  • Payroll taxes and employee benefits
  • Advertising, promotion and other sales expenses
  • Auto expenses

While the gross profit is a dollar amount, the gross profit margin is expressed as a percentage (Gross Profit as a percent of Sales). It’s very important to track since this allows you to keep an eye on profitability trends. This is critical, because a business can get into financial trouble with an increasing gross profit that coincides with a decreasing gross profit margin.

The gross profit margin is computed as follows:

Gross Profit / Sales = Gross Profit Margin

There are two key ways for you to improve your gross margin. You can either increase your prices, or you can decrease the costs to produce your goods. Or both, if you can.

An increase in prices can cause sales to drop. If sales drop too far, you may not generate enough gross profit to cover operating expenses. Price increases require a very careful reading of inflationary rates, competitive factors, and basic supply and demand for the product you are producing.

The second method of increasing gross profit margin is to lower the variable costs to produce your product. This can be accomplished by decreasing material costs, or making the product more efficiently.

Volume discounts are a good way to reduce material costs. The more material you buy from a supplier, the more likely they are to offer you discounts.

Another way to reduce material costs is to find a less costly supplier. However, you might sacrifice quality if the goods purchased are not made as well.

Whether you are starting a manufacturing, wholesale, retail or service business, you should always be on the lookout for ways to deliver your product or service more efficiently.

And all the while, you also must balance efficiency and quality issues to ensure that they do not get out of balance.

Let’s look at the gross profit of Rapid Printing & Copy Company as an example of the computation of gross profit margin. In Year 1, the sales were $1 million and the gross profit was $250,000, resulting in a gross profit margin of 25 percent ($250,000/$1 million). In Year 2, sales were $1.5 million and the gross profit was $450,000, resulting in a gross profit margin of 30 percent ($450,000/$1.5 million).

It is apparent that Rapid Printing & Copy earned not only more gross profit dollars in Year 2, but also a higher gross profit margin. The company either raised prices, lowered variable material costs from suppliers or found a way to produce its print jobs more efficiently (which usually means fewer labor hours per product produced).

Rapid Printing & Copy did a better job in Year 2 of managing its markup on the products that they print.

Business owners sometimes get confused when relating markup to gross profit margin. They are related in that both computations deal with the same variables. The difference is that gross profit margin is figured as a percentage of the selling price, while markup is figured as a percentage of the seller’s cost.

Markup is computed as follows:

(Selling Price – Cost to Produce) / Cost to Produce = Markup Percentage

Let’s compute the markup for Rapid Printing & Copy Company for Year 1:

($1 million – $750,000) / $750,000 = 33.3%

Now, let’s compute markup for Year 2:

($1.5 million – $1.05 million) / $1.05 million = 42.9%

While computing markup for an entire year for a business is very simple, using this valuable markup tool daily to work up price quotes is more complicated. However, it is even more vital.

5 Ways to Avoid Tax Audits

March 19th, 2015 by Doug Boswell No comments »

Tax Audit 1When you’re self-employed filing a Schedule C with your tax return, your chances of being audited are greater than if you were a wage earner.

This is because the IRS catches many such individuals that attempt to either hide income or write off personal expenses as business deductions. When all you are reporting on your tax return is income from a W2, what’s there to audit? Even if you enter the numbers wrong, the IRS will match it up with the copy it got from your employer and send you a correction letter along with the adjustment. So, with scrutiny of the self-employed on the rise, here are 5 things you can do to reduce the chances of an audit:

1. Use professional software such as QuickBooks

Track the income and expenses of your business with accounting software. Your credibility increases in the eyes of an IRS agent if your tax return is based on professionally-prepared financial statements, especially if maintained by an outside firm.

2. Document sources of all income

If you are audited, the first thing the IRS agent will do is add up all of the deposits from your personal and business bank accounts. If more money went into the bank than was declared on your tax return, the agent will want to know where the money came from and whether or not the income is taxable. If you use QuickBooks for your personal and business books, you will automatically tie out this income, but you still need proof. If the income you record is not taxable (e.g. gifts, inheritances, loans, transfers from personal funds) keep a copy of the check or document that accompanies the income to prove the source is not taxable.

3. Let a professional prepare your income tax return

Self-prepared returns are more likely to be audited because the IRS thinks a nonprofessional has limited knowledge. Tax law is complex. And if you are self-employed, no matter how small your business, your tax return is now a complex creature.

4. Rethink your legal form

Corporations, LLCs, and partnerships are less likely to be audited, but that should not be the sole reason to incorporate. Discuss this option with a tax professional and your attorney before making any changes.

5. Document the Red Flags

You are allowed to deduct all ordinary and necessary business expenses which means thinking in terms of “Would I make this purchase if I didn’t have this business?” If the answer is no, than you more than likely have a deductible business expense. But it’s important to know the rules and to have proper documentation to substantiate the deduction.

Some expenses receive considerably more scrutiny than others:

Automobile expenses

Taxpayers are required to keep a mileage log if they want to take these kinds of deductions, which can be a lot of work. The IRS loves to investigate these because very few business owners will bother with this. Fortunately there are other ways to substantiate the deduction to the satisfaction of the auditor.

  • If you use an appointment book or calendar, save it along with your copy of the tax return. A mileage log can be reconstructed from those pages.
  • Save vehicle repair receipts as the odometer reading is recorded on them and total mileage for the year can be extrapolated if there is more than one receipt.
  • Record your beginning and ending odometer reading in your appointment book on Jan. 1 and again on Dec. 31.
Travel, meals and entertainment expenses

These are also very common when it comes to tax audit scrutiny. Go to www.irs.gov and read Publication 463 to determine what you can and can’t deduct.

  • Travel, especially to vacation destinations like Las Vegas or Hawaii should be documented with more than purchase receipts to prove the business intent. Save anything that can substantiate your claim that you were traveling primarily for business; such as flyers advertising the trade show, or the continuing education seminar, or letters from prospective clients at that location in your tax file.
  • Write the name of the person entertained and a brief note describing the business purpose on receipts for meals and entertainment.
Home office expenses

These are another red flag for the IRS to take a closer look at your expenses.

  • Take photographs of the house and the office area. The photos will serve two purposes: they will show the proportion of the business area compared to the personal living area to substantiate the amount of space claimed as well prove that there is in fact a business area.
  • Know the rules: The home office must be your principle place of business and must be used exclusively and on a regular basis for business purposes.

 

Sole Proprietor Start-Up Tips

February 26th, 2015 by Doug Boswell No comments »

Sole Proprietor

When starting a new business, many aspiring entrepreneurs will launch it as a side venture to their current career employment, a.k.a. their day job. So there may not be a big rush to create a complex and expensive legal entity such as a Corporation. In many situations a simple sole proprietorship is the most appropriate way to go.

 

KISS

Keep it simple starting out. The simplest form of entity for running your new business is a sole proprietorship. This form of ownership requires no special communication or filings to the Internal Revenue Service until you start paying employees and/or taxes.

Sole Proprietor

As a sole proprietor you are the owner of a business that might only need a business license/permit if your county or city requires it. If you are the owner of a business that sells items that require sales tax, you will need a reseller permit, and are liable to remit all state and/or city taxes on retail, and maybe wholesale, sales your business collects. Service businesses and most cross state sales are exempt from state sales tax.

Liability Insurance

If you are concerned about personal liability, then the simplest thing to do is to buy a personal liability umbrella policy. Additionally, the best way to avoid liability is to learn your trade well and keep accurate accounting records.

No Company Taxes, Just Yours

Profit from a sole proprietorship is reported on your personal tax return. The IRS won’t even know your company exists until after you file your first personal income tax return. This will include a Schedule C which reports all of the revenue and expenses your business has incurred. In most states, including California, certain state minimum taxes are not require of sole proprietorships. You will, however, have to pay any sales tax you have collected from your customers. And since sole proprietorship losses will offset income from you day job, you might even receive a tax refund. So concentrate on building your business, not communicating with the IRS

Just a Personal Bank Account Will Do, But Don’t

Although advisable as a sound business practice, you are not required to have a separate bank account which is a necessary compliance for a LLC or Corporation. As you get your business set up you could pay your startup costs out of your personal bank account, but once you’re in business and making sales, file a Fictitious Business Name Statement and use the paperwork to open a business bank account. Keep complete and accurate records so you can be sure to get the best possible tax advantage from those early-stage costs, and not get them mixed up with your personal expenses.

Simple to Start, Simple to End

Over 85% of small businesses fail or change ownership within the first five years. Plan your business to thrive but if it fails as a sole proprietorship, you simply stop doing business. No communication or special forms with the IRS, no additional taxes to get your investment returned and no high accounting fees to close out your company. Just mark the Schedule C in your next personal tax return as “final”.

Getting Paid

In a sole proprietorship you just take the money out as a draw. No payroll taxes or quarterly forms needed. Many startups lose money for the first year, and maybe longer, so keep your day job to pay your living expenses.

Evolving Beyond the Sole Proprietorship

As your business becomes profitable talk with a CPA about another entity type that might save you taxes. Just a simple bookkeeping entry transfers all of the business assets from the sole proprietorship into the new entity without any tax penalties.

Growing Your Small Business: Consider This…

January 16th, 2015 by Doug Boswell No comments »

Coffee Shop OwnerAs a small business owner, you may have plans to grow your company. Before you put your foot on the accelerator, take the time to decide whether (and how much) you should grow your company.

What do you really want?

You believe you have the entrepreneurial drive to build your business into a larger one? Do you want to scale a business? Have more employees to help carry the weight? Have the potential to make more money? Create something that is worth a great deal of money, or that changes the world?

Do you need to grow to appear competitive in your market? To have the budget to get the word out, make more sales, and become an industry leader?

Can you be successful as a “boutique” operation? Sometimes less is more.

Do you want a business that comfortably supports you and also leaves time for you to be with family, pursue other interests or take vacations? You may want to grow but to control the growth so that you can enjoy what some people call a lifestyle business. While this term has been used condescendingly in entrepreneurial circles, there is also an increasing recognition that a solid lifestyle business can indeed be a great business to run.

Potential

What potential does your business have to grow? Some businesses are like finely tuned sports cars. They aren’t working at full capability unless they are on the track, racing forward. They are built to move fast and make things happen. Other businesses are engineered for steady travel instead. How about your company? And are you happy with that Chevy or Lamborghini your company is today? Or do you want to reengineer your business for a different driving experience?

Responsibilities

In a very small business, you do nearly everything yourself. As your business grows, you will delegate some tasks. As you grow even more, or scale the business, your responsibilities are likely to change from doing or a blend of doing-and-managing to higher level managing.

Before putting your dreams of growth into practical steps, consider whether you like doing or managing or some blend of the two, and also whether the satisfaction you get from business is from the rush of entrepreneurial growth or from the day-to-day running of the company you have today.

Money

Depending on how you grow and what type of business you have, you have the potential to make more money as the company gets bigger. Generally, this is one major motivation for growing a company.

It should be recognized that there are times when the larger business is not more lucrative for its owner. As you take on more employees, more infrastructure and more risk, you also have more potential areas for poor performance and resulting reduced financial returns. Which brings us to risk.

Risk

Big leases, big loans, shared equity, a larger staff, and other potential demands of a growing business carry with them higher risk alongside higher prospective reward.

A fast-growing business typically brings some loss of control as well as challenges maintaining quality, assuring profitability, and managing your (potentially also large) competition.

Be aware not only of your best-case scenario but also your worst. Are you ready to deal with risk?

Saleability of company

What will you do with your company when you are ready to retire or move on? Will your children run it? Will key employees buy it or take it over? Will you sell it? Will it end when you stop working?

Size is one consideration in this matter. Many small business advisors recommend that you fund your retirement while you are working, in the event that “you are the company” and that the business “dies with you.”

A business that is not overly dependent on you, and that can continue to make money after you move on, is typically a more saleable enterprise.

Unless you have a novel technology in hand, cash is king when it comes to selling a business, so if making a lot of money from the eventual sale of your company is a key consideration in your planning, you may indeed want to grow the business aggressively.

Small businesses that can run without you can be salable, too, since people frequently prefer to buy an existing business rather than starting their own. However, the proceeds are likely to be lower.

As a business owner, you have a unique opportunity to make conscious decisions about growth, based on the market for your services or products, and on balancing pros and cons of large versus small, considering your own management style, and reviewing how you want to blend business and life goals.

Whatever you decide, you have the privilege and the pride that comes with running a business. So many people would like to do what you are doing every day.

 

 

 

Tips for Starting a Service Business

November 17th, 2014 by Doug Boswell No comments »

Service Business 2Many entrepreneurs are people with specific marketable skills and know-how. Taking the step to self-employment by starting your own services business can take the value of those skills to an entirely new level. But starting and building a business requires an all together different set of skills and know-how. So, if you are thinking about being your own boss, here’s some advice to get off on the right foot.

Write down your business plan

Writing a business plan may seem like a pointless and onerous exercise, but don’t skip it. Putting your plan in writing will force you to think clearly about your new business, your opportunities and your challenges. It will help you set realistic goals and keep yourself accountable. A well-written business plan is also critical for securing financing for your service vehicles or other major expenses. One great resource to help you develop your business plan is the U.S. Small Business Administration. Your local chamber of commerce is another excellent place to ask for help.

Seek advice

Starting any business involves risk. You can minimize yours by taking advantage of the experiences of others. A good mentor, or two, can help you avoid the pitfalls, as well as show you best practices that will get your new service business on the right foot. Mentors can also introduce you to other influential people and help you establish your own business network.

Your business mentor can be a coach or consultant you hire, or a more seasoned businessperson who takes you under their wing. One excellent place to look for no-cost or low-cost expert business mentoring is SCORE, a nonprofit organization dedicated to helping small businesses.

If you are looking for advice specific to your type of service business, it pays to go online. Many professionals in your field will happily help you out on industry chat boards or LinkedIn groups. All you need to do is ask.

Track everything

Business is a numbers game, in more ways than one. Most new entrepreneurs know enough to track income and expenses at the very least. But the most successful ones don’t stop there. Tracking and analyzing everything in your business will allow you to make better decisions, avoid wasteful practices and realize greater profits.

One example of tracking used to advantage is your vehicle fleet. Instead of simply tracking expenses, take it a step further and track fuel economy per vehicle or per driver, time on the road and location of every vehicle. Knowing these parameters will allow you to manage your fleet for maximum efficiency and productivity.

Develop systems for your business

Imagine if your entire business ran at 100 percent efficiency. It would be so much easier to make a profit, wouldn’t it? No business is 100 percent efficient, but developing systems will get you as close as possible. Once you’ve figured out what works, write it down, and make sure every employee knows it’s standard procedure. If the procedure you’ve developed involves multiple steps, create a checklist for employees to follow. Even little things like making a habit of placing tools back in their proper spot when a task is finished can save countless hours of wasted time in your business.

Your business will probably have unique aspects that require you to develop some of your own systems. But look out for ready-made tools and systems that can help systematize your business. Accounting software is a good example. So is a GPS tracking system that can help you track and analyze your business fleet.

Don’t undervalue existing customers

As you acquire customers, take good care of them and keep in touch. Develop relationships and earn loyalty. It’s much easier to sell to existing customers than to someone who has never done business with you. Anything you can do in your service business to encourage customer loyalty will keep your repeat business flowing, and it will also bring in the best free advertising possible — word of mouth.

Expect to make mistakes

If you can’t acknowledge, learn from and apologize for your mistakes, then you’re doomed. Part of becoming successful is learning to handle and recover from mistakes. You will make them. If you think you won’t, you’d best keep your day job.

Starting your service business will require a lot of dedication and hard work. But by following business best practices you can avoid many of the pitfalls experienced by new entrepreneurs. Take these tips to heart, and you will improve your chances of developing a rewarding and profitable new enterprise.