Profit 101 – Cash Flow Is Not Profit and Other Financial Realities
Above all else, plan your business to be profitable.
Your road to success is paved by profit. After all, you aren’t starting a business just to while away your hours. No, you want positive financial results.
Whether you sell a product or provide a service, whether you are for-profit or not-for-profit, it is imperative that your revenue exceed all your costs. While that sounds easy enough, there are many ways to be tripped-up on the road to profitability. Here we’ll look at two of the chief culprits that pave the road to red ink.
Cash flow is not profit
In our electronic world, it’s easy to “think” we are profitable. Too often, what feels like profit is simply cash flow. The money coming in, your revenue, may be covering your expenses and that makes it feel as if you are profitable. Watch out, that may not be true. Conversely, your revenue may not be covering your costs and you fear that you’ve become unprofitable. Maybe or maybe not. In both cases, you need more information before you know whether you are profitable.
Planning your cash flow and checking it monthly protects you and your firm. When you plan cash flow, you are planning how and when your clients pay you. You are also planning how and when you pay your expenses.
When you plan your business, you decide on the price(s) you will charge. Then you plan when customers will pay you. For many companies, customers will pay at the time of the purchase. Other firms will ask their customers to pay when the product or service is delivered. Still others will offer terms that extend payment over a specific period. In addition, when you plan your business, you plan how you will be paid. You may be a cash-only business. Will you accept checks? It may be you’ll accept credit cards. Each of these decisions has cash flow implications.
Imagine, for example, an insurance broker’s cash flow. Let’s assume they operate out of an office with a staff. That means there are monthly expenses. Then, think about their product. Many types of insurance policies are sold on an annual basis. If each customer pays their auto policy in-full once a year, how would you make that revenue flow across the whole year so you can pay your monthly expenses?
Perhaps yours is a seasonal business with peaks and valleys. Or, you have a client who is late paying their bill. How will you handle your costs when revenue is seasonal or late? Planning ahead means you are prepared for revenue surprises.
Why does it “feel” as if your firm is profitable? It’s likely you know the answer. Operating your own business can be intense. Under stress, we often make snap judgments based on how things feel. Sometimes that works. Other times, it puts you at risk.
In addition, it is sometimes difficult to gauge profitability when some of your revenue is paid by credit card. In those instances, the money goes straight to your bank electronically. Payment by cash and check are more physical, requiring a deposit into your bank. While both forms of revenue feed your firm’s expense needs, your greater question is, are you profitable? Don’t wait to uncover a surprise. Instead, monitor your cash flow and your profit & loss. Every month, compare your actual cash flow and profit & loss to your plan.
Click here to download free Cash Flow templates from Microsoft Office.
Break-even means there is not a gain or a loss. The income for a break-even business, for example, is equal to that firm’s expenses. In other words, there is not a profit or a loss.
You, of course, want yours to be a profitable business. Why would you be working so hard if your outcome were a break-even business? To get to profit, it’s necessary to know your break-even point – the point at which there is neither profit nor loss. To do this means you will complete a break-even analysis, an analysis that shows the point at which your income/sales are equal to your costs.
All you need to complete your break-even analysis is your costs - your variable costs and fixed costs.
- Variable costs are all your costs to produce a single unit of your product or service. Variable costs include raw materials, manufacturing and the labor/salary costs directly related to the production of your product or service. Add up all your variable costs for a specific period – a month, a quarter or a year. Then, divide your total variable costs by the number of units produced in that period. The result is your unit cost.
In other words, to find the cost to produce a single unit of your product or service, you done this: Total Variable Costs ÷ Number of Units Produced = Unit Cost.
- Fixed costs are the costs to your business whether you make a sale or not. These are the costs that are not directly related to your product or service. Fixed costs don’t change or have very little change over the course of a year. Fixed costs include rent, phone, insurance, salaries, advertising and more.
You are now ready to calculate your break-even. Start with the unit cost you calculated under “variable costs” above. Subtract the unit cost from the sales price you will charge for that unit. The result is the money that will cover your fixed costs – the result is called Unit Contribution Margin.
What you are doing here is looking at a single item, one unit of product or service, and subtracting your costs to produce that single item. The remainder, the amount of money left over, is the amount of money you have to cover your fixed costs and, ultimately, your profit. This is what this step looks like: Sales Price – Unit Cost = Unit Contribution Margin.
It’s now time to find out how many units you will need to sell to cover your fixed costs. Here you divide the total of your fixed costs for the period (month, quarter or year) by the unit contribution margin you’ve just calculated. The result is the number of units you need to sell to break-even.
What you have done here is Total Fixed Costs ÷ Unit Contribution Margin = Break-Even.
The result of these calculations is the number of units you must sell to cover all the fixed costs of your business before making a profit. Naturally, your goal is to exceed break-even, your goal is to be profitable. Your break-even gives you important information that will get you to profit.
What will a break-even analysis do for you? Several things – all intended to maximize your profitability.
- It will tell you how many units of your product or service you must sell to break-even. Once you know how much you have to sell to break-even, you can then calculate how many you’ll need to sell to achieve your expected profit. Is it a realistic number? Will you be able to sell at that volume?
- When you know the break-even for a product or service, you can test different price points. What would be the break-even if you charged a lower price? Remember that when you charge a lower price, you will bring in less money. You’ll need to look at how many added units you will need to sell to break-even when you are charging less? Alternatively, test a higher price. Here, you will be paid more money and that means you’ll need to sell fewer units to break-even. How many will you need to sell to reach your projected profit? Again, is it possible to sell that many units?
- When you know the break-even for a product or service, you can look at what would happen if you added to or subtracted from the cost. Think about any enhancements you might make to grow the value of the product. Add the cost of the enhancements you are considering to the break-even analysis. Is the added cost worth the potential increase in sales? Alternatively, look at the consequence of taking out a cost. What does that do to your break-even? If you take cost out of your product, will the change affect your customers’ favorable perception? Will it change your competitive position?
- Finally, break-evens help you to find the best price/cost balance for your product or service.
Complete your break-even analyses when you are planning your business and when you are “tweaking” your product or service to generate more revenue. Once you have your break-even for each product or service category in your firm and you have tested price and cost variables, you will then decide on the optimal balance of product or service categories. Your goal here is to make yours a profitable organization.