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Wednesday, June 22, 2011

The ABCs of Profitability

By Jennifer Shelton with the Bellingham SBDC.

As a business owner or future entrepreneur, I believe it’s never too early to start thinking about how to make and keep your business profitable. In simple terms, profitability is the amount of sales revenue left over after business costs. Learning to measure profits helps to answer the question, “Are we making enough or going to make enough money for our efforts?”

You, as a business owner, have control over four major areas that affect profitability:

1 Price you charge for your products and/or services.

2 Quantity (or volume) of products and/or services you sell (marketing or operations issue).

3 Variable costs you directly acquire by producing or buying the products and services you sell (These are called variable costs because they increase or decrease as your sales increase or decrease).

4 Fixed costs you incur whether you make any sales or not.

The strategy you come up with involves taking action to increase or decrease any of the four factors in consideration of its impact on, or the impact from, each of the other factors.

Here is an example of learning to measure profitability and make changes. A few years ago I met with owners of a service business that had not been profitable since it started two years prior. I prepared a break-even summary for them, which is a simple equation that says how many sales dollars or units sold are necessary to cover fixed and variable costs.

The conclusion was they needed eight sales a day to break even. Their gasp of horror was the only thing I heard. “But we can only process three sales a day,” they said. “Ah ha,” I responded. “There are two things you need to do to improve profitability in your business.”

1 Streamline your system, (operations), so you can handle more quantity of sales.
2 Raise prices. In this case the paperwork around each sale is what was providing their value to the customers.

The reason it took them a few years to recognize they weren’t profitable was because they were not keeping on top of their bookkeeping. Bookkeeping errors is my fifth addition to the four factors of profitability. SBDC advisors around the state will agree that nearly all of the businesses they advise have errors in their books.

One of the best things a business owner can do is to learn what each report means, how to read it and how to set it up to accurately reflect the true activities of the business. Questions I often hear are: “What is the difference between a balance sheet and income statement? Why does the business show a profit on the income statement yet has no cash in the bank?”

As the leader of the business, learning the answers can be one of the most empowering things an entrepreneur can do. When set up correctly, the information in these financial reports can be used to make accurate decisions toward being and staying a profitable business. As the saying goes, “All roads lead to the numbers.”

This article was written by Jennifer Shelton with the Bellingham Small Business Development Center, which is part of the 24 statewide offices of the Washington Small Business Development Center (WSBDC).  Initially seen in The Bellingham Business Journal and at http://bbjtoday.com/

The WSBDC offers in-depth, confidential, and no-cost management advice to businesses within Washington State. To locate your local SBDC advisor please visit the SBDC web site www.wsbdc.org/map.

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