Profit means making more money than you spend. Many confuse profit with income. As a result, they don’t understand why all their income isn’t getting them ahead; why no one wants to invest in their high-sales company; why the bank won’t extend their line of credit.
Let’s look at the most basic way to tell if your business is actually profitable, making money, not just recording sales.
Most small business people are very good at tracking their income. Each widget sale is recorded in a spreadsheet, and each payment from a customer or client is recorded in the checkbook. Each is totaled frequently.
Actually, that’s not what you made. That’s income, not profit. It’s what’s coming in. In order to determine profit you have to subtract what is going out from what is coming in.
(PROFIT = INCOME – COSTS)
Calculating Costs
Your business has two basic types of costs; fixed and variable. Fixed costs are costs that don’t change based on your level of business activity, such as rent. Whether you produce 100 widgets per day or 150, your rent will stay the same. Variable costs are directly tied to how many units of goods you produce. If you need $10 of screws to produce 100 widgets, you will need $15 worth of screws to produce 150 widgets. The cost of screws is a variable cost.
Fixed Costs
For the most part, fixed costs can be closely estimated at the beginning of the year and accurately projected for the next 12 months. For example, you know the rent on your facility is $5,000 per month. You may know of, or expect, a rent increase in April to $5,500 per month. As a result, your fixed cost for rent will be $64,500 for the year (3 months at $5,000 plus 9 months at $5,500).
Fixed costs include things like rent, depreciation, licenses, equipment lease payments, some taxes, and indirect labor.
Variable Costs
Variable costs are those that depend on your production level. As the production volume goes up, the variable costs go up as well. If I make lamps, I have to purchase one lamp pole, two light bulb fixtures, a lamp shade and five feet of wire per lamp. If a lamp pole cost $3 and I need enough to make six lamps, my lamp pole costs will be $18. However, if I need to make 20 lamps, my lamp pole costs will be $60. I can estimate variable costs at the beginning of the year, but my estimate will not be as predictable as was my estimate of fixed costs.
Variable costs include such expenses as cost of materials used in manufacturing, certain utilities, some taxes and fees, and direct labor.
Telling the Difference Between Fixed or Variable Cost
Some costs the business incurs, such as labor will have to be split between fixed costs and variable costs. The wages you pay production labor, called direct labor, is a variable cost. It is tied to how many units you produce. Other labor costs, such as the salary you pay your administrative assistant, are fixed costs. These indirect labor costs are not tied directly to production levels. If your production increases from 100 widgets per month to 150 widgets per month it is unlikely you would hire an additional administrative assistant.
Utilities are another cost that is split between fixed and variable costs. Your phone bill, for instance, probably won’t change much as production increases or decreases. However, the demand for electrical power, and the cost of it, will increase as production lines run longer and lights stay on further into the night because of increased production.
Income
When someone pays you that is income. Income is usually related to production levels, but is not tied to it directly.
You may produce more or less than you sell. For instance, if you have 100 widgets in the warehouse when you receive an order for 150, you only have to produce 50 additional widgets. If you make widgets for skis, you may make 20 widgets every month during the summer even though you don’t sell any, just so you have enough in the warehouse when winter arrives.
So income is when you actually get paid, not when you make the product you are going to sell. Total income is just the total of all your payments received during the year.
Break-Even Analysis
The break-even point is the production level where your income for a certain number of units produced equals your fixed costs plus the variable costs for that number of units. For instance, you have fixed costs of $500, variable costs of $20 per widget, and you sell the widgets for $25 each, so your break-even point is 100 widgets.
If you reduce your fixed costs to $400, your break-even point is 80 units. Or if you cut the cost per unit from $20 to $15, your break-even point drops to only 50 widgets.
Profit
Any sales beyond the break-even point are profit. In the final example above (fixed cost $500, variable cost $15 each, income $25 each) your break-even point is 50 units. If you produce 50 units and sell 50 units you will break even. Your costs will equal your income. You will have a profit of $0. If you sell less than 50, you will have a loss. If you sell more than 50 you will have a profit.
For example, if you sell 70 units your fixed costs are $500 and your variable costs are $1050 ($15 x 70), so your total costs are $1,550. Your income is $1,750 ($25 x 70) and your profit is $200 ($1,750 – $1,550).
Bottom Line
To make a profit, you must be able to sell each unit for more than it cost to make it and you must be able to sell it for a price high enough to cover both the variable cost of making it and its share of the fixed costs.
This is true whether you are selling widgets, boxcars of apples, dance lessons, or hours of financial consulting.
