The playwright Arthur Miller once said:
“Don’t be seduced into thinking that that which does not make a profit is without value.”
That’s a lovely luxury for people in the arts, but not an attitude that is sustainable for most of us. For normal businesses, profit is essential, and there doesn’t have to be a tension between making money and offering value. Surely the best businesses make a profit precisely because they deliver something that people value enough to pay for.
It is not enough to sell your goods or services and get paid for them. Unless you make a profit after paying for your costs, the company will not last long.
Why not measure net profit?
Your formal accounts will include net profit before and after tax, but unless you’re selling your business or your shares are trading publicly, that one doesn’t actually matter as much as you’d think.
Net profit is the measure that analysts typically use to compare companies. But net profit includes some costs that are within your control and some that are not, so it is not entirely consistent. And it is not the very bottom line, so it does not reflect what is kept in the company for next year.
Instead, there are two really key profit measures to keep an eye on:
Profit you can influence
Operating profit is a vitally important profit measure. All the numbers within it relate to aspects of your business that are within your control (or at least influence). It is a good plan to make your management team accountable for the result, so that they work together to drive profitable behaviours throughout the organisation.
Typically, the CEO will hold the sales team accountable for Revenue or Sales income and set them a target to achieve. This drives performance, but is dangerous without any counter-balances. If their only target is to sell things, the sales team will sell at any discount to close a deal and undercut the competition. They will not care whether the company makes a profit or not, and often will not even know the break-even point for what they are selling.
If sales are accountable for revenue, who is accountable for costs?
I’ve worked with one company where the finance manager only presented the revenue figures to the management team. Profit was never discussed and nor were costs. Sadly, this is not rare.
In many companies, the management team never discuss the finances. Or the finance person will present complicated spreadsheets while everyone else nods wisely and wonders what’s for dinner.
Yet the sales team can influence the profit by reviewing the pricing and discounting strategies, and by knowing the break-even point on the goods or services they are selling. Try setting their bonus against profits instead of revenue, and they will soon start paying more attention.
The management team as a whole also control or influence the costs in a business. It’s easy to ask for another person for your team when there is always too much to get done. But if you knew the impact on profit of adding another head to the payroll, would you find you could cope without?
It’s well worth having strategic discussions about major costs and deciding what level of quality you want and can afford to have. Where can you cut costs without affecting quality significantly? How can you do things differently to improve productivity? If you know your operating profit, you can measure the impact and set new targets for growth. Keep looking for those 1% improvements and the marginal gains will soon add up.
The directors’ cut
This is the second profit measure that matters. Once you have your operating profit, you deduct interest payments and tax to find the net profit. Then dividends are taken out by the shareholders, or drawings made if you are a sole trader. All of these items are completely outside the control of the management team, so it would be unfair to measure their performance against net or retained profits.
However, it is an important measure for the directors to manage as the ultimate bottom line. This is the amount of profit left in the business to be carried forward into next year and used for long term growth. If a business makes a good operating profit, but the directors take all of it out as dividends, the company will struggle to grow.
Money needs to be retained to invest into new ideas for growth. Without retained profit, the company has no long term future. And without a long term future for companies, there will be little long term future for our economies, or people with enough money to go to the theatre and watch Arthur Miller’s plays.
Michael Porter is a renowned American economist. He sums it up best:
You can’t have a healthy society unless you have healthy companies that are making a profit, that are employing people and that are growing.
Are you measuring a profit? Or are you at a loss?
What profit measures do you look at? Do you wait for your annual accounts to tell you whether you’ve made a profit this year? Or perhaps you’re more in control and you look at your management accounts every quarter or every month. But you are still looking backwards and not forwards.
If this is you, it’s time to get ahead of the game and start forecasting profit measures into the future. Don’t just wait and see what happens. Schedule an appointment for a no-obligation chat, to see how we can help you take more control of your finances and see what’s coming. We can help you get a handle on the two profit measures that really matter.