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Where does profit fit into a business: A Guide for Consultants and Freelancers
In our ongoing journey through the Five-line Business Framework, we explored the essential components contributing to a successful business. Today, we focus on the fifth line of our framework—profitability. While profitability holds significant importance, especially in pricing your offerings to avoid losses, it is crucial to recognize that cash flow takes precedence, particularly in the early stages of a small business.
During this phase, your focus should primarily be on generating revenue. New businesses commonly invest more than they earn as they lay the groundwork for growth, which may not immediately reflect profitability in their financial records. The key stages of business development encompass survival, growth, and, ultimately, thriving. Thriving doesn't necessarily equate to massive growth or a large workforce; rather, it entails having reliable, high-paying clients who promptly compensate you, ensuring your business's survival and prosperity.
To recap, the Five-line Business Framework consists of the following:
- Revenue from product/service sales (which must exceed costs)
- Cost to make or buy the product/service (your time, including materials and contractors and also referred to as Cost of Goods Sold)
- Cost of selling (marketing, advertising and selling costs)
- Cost of running the business (rent, insurance, utilities, subscriptions and administration)
- Profit (revenue less costs)
Profit, often called the "bottom line," remains after all your costs are subtracted from your revenue.
Profit is More Than Just Numbers
Profit is an indicator of your business's financial health and efficiency. It's an accounting metric that gives you an idea of how your business travels.
Accountants refer to two types of profit:
1. Gross Profit
After you subtract the costs directly related to the production of your goods or services (line 2 of our framework) from your revenue, gross profit is what you have left. Accountants would use the term Costs Of Goods Sold for line two, which means the same as the cost to make or buy your product or service.
2. Net profit
This is the final line of our framework.
After subtracting all your costs (lines 2, 3 and 4) from your revenue, it's what you have left. And to be honest, if you are running a small business like mine, you’re accountant may record a profit on your accounts, but seeing it is something else. That’s because your business will depend on the cash coming in and out of your business. As cryptic as this sounds, it is not always there to see in your bank account.
Increasing Profit: It's Not Just About Making More Money
Enhancing your profit entails increasing revenue and effectively managing and reducing costs—a dollar saved directly contributes to your bottom line. As an example from my own experience, running my marketing services business, 13th Beach Marketing, involves serving around 15 clients by overseeing their websites and providing diverse services and advice.
Since many of my services and subscriptions are paid in US dollars, fluctuations in the Australian dollar impact my costs. The stronger the American dollar, the higher my expenses, directly affecting my business's revenue and overall profitability. However, continuously raising prices for certain services may render them less competitive, potentially leading clients to seek alternatives.
Consequently, analyzing the profitability of specific services prompts me to consider adapting the nature of my business. Strategic foresight can be gained by comprehending the insights provided by the five lines, aiding in decision-making and adaptability.
Strategies to increase profit include:
Upskilling: By improving your skills, you can offer more value to your clients, justifying higher rates.
Package services: Consider bundling your services into packages rather than charging by the hour. It's often an easier sell and can improve your earnings.
Reduce direct costs: Take a hard look at your suppliers. Can you get a better deal somewhere else? Remember, time is also a direct cost. Can you be more efficient?
Marketing efficiently: We discussed this in our article about the cost of selling. Be strategic and measure the return on your marketing spend.
Control administrative costs: As explored in the last article, keeping these costs under control can significantly improve profitability.
What to Do with Profit
Firstly, it is prudent to retain a portion of the profit as a buffer to address where cash flow may be slower than anticipated or to invest in essential areas such as acquiring new equipment, implementing effective marketing initiatives, or pursuing professional development opportunities that enhance the efficiency of your business operations.
Pay yourself: Remember to reward yourself for your hard work! Determine a fair salary and stick to it.
Save for taxes: A percentage of your profit is taxable in Australia and many other countries.
As a sole trader in Australia, you pay the same tax as an individual. The rate varies from 19% to 45%, depending on your income. In addition, you're required to pay a 2% Medicare levy.
If you're operating as a company, as I do, the corporate tax rate is a flat 25% for revenue under $50m.
That means if your revenue is $100 000 and your net profit is $20 000, your tax payable would be $20 000 x 25% or $5000. Interestingly, many huge companies pay little or no tax, possibly the same for many smaller companies, depending on your profitability. Your accountant can advise you on this issue.
Practical Implementation to Optimize Your Business
Though the five lines may seem straightforward, mastery over them holds the secret to running a thriving business. Rather than delving into the mundane aspects of accounting, let's explore how these five lines can assist you in making crucial business decisions. In upcoming articles, we will focus on the practical implementation of these principles, providing valuable insights on optimizing your product mix, pricing strategies, time allocation, and marketing efforts.
Cheers
Nigel Rawlins
https://wisepreneurs.com.au/
PS. This article will appear in my LinkedIn Friday newsletter and my website in about three weeks. I will have rewritten parts of it by then. If you have any feedback that you would like to add, reply to this email.
Don't forget to check out the Wisepreneurs Podcast and other articles on my website.
