Understanding Profit and Loss
“My consulting service is a nonprofit business. It wasn't designed that way, but that's how it's working out!”
Too many businesses get so busy that they forget to make a profit. They don't quite understand what “profitability” really means or how to seek and maintain it. Profit is simply the amount of money you have left over once you've paid all of your expenses. If you have more expenses than income, you have a loss. It seems pretty simple.
Of course, there's much more to profit and loss than numbers on paper. Your business can actually show a profit on paper, yet not have any cash. In fact, many profitable businesses go out of business each year because of negative cash flow.
How can you keep your consulting business profitable and the cash flowing? By clearly understanding profitability — especially gross and net profit — how to reduce expenses and how to increase income. Later in this chapter, you'll learn how to manage cash flow.
Profit is income less expenses. It's what's left over after you've paid the bills. Because you have some options as to how you price your services, earn income, and pay expenses, you also have choices in profitability. Certainly, you want the highest profits your business can consistently earn. The problem is that if your profits — based on your prices — are too high, they will develop market opportunities for competitors. If you sell a service at $120 an hour that a competitor profitably offers for $80 an hour, you will lose some business to that competitor.
As you develop your consulting business, you should study competitors to determine what their profitability is. This will help you see how your business can be at least as profitable in the long run. You may decide to offer some services at prices lower than the competition — called loss leaders — to draw clients who may also purchase more profitable services. You may learn that a competitor works on an average profit of twelve percent. You may then decide that you can beat the competition with a profitability of 10 percent. In addition, you will offer some loss leaders at no profit and others at 20 percent profitability. You don't have to get into the specifics just yet, but you should develop a profitability goal for your business early on. Otherwise, when you finally do come to the question of profits, you may find that the business model you developed won't support sufficient profits.
If you can, purchase stock in your competitor's business to find out what their profits are. If the business is a franchise, become a candidate for the franchise and learn what level of profitability is required to maintain the franchise opportunity. Alternately, ask a business consultant who can do the research for you and offer a fairly accurate estimate of the competitor's profitability.
Profitability is the bottom line. It is why you spent time determining the appropriate pricing for what you sell. If your business isn't profitable, you won't be able to serve your clients for very long.
Profitability is the ability to make a profit. Profit is income less expenses. Sell $200,000 worth of services with expenses of $150,000 and your profit is $50,000. The primary purpose of your business — any business — is to make a profit for its owner(s) and investor(s).
Of course, calculating a profit isn't quite that easy. Gross profit or net profit? Before taxes or after? Which taxes? Are there tax credits available? Is the profit retained by the business or passed on to the investors? The following topics will analyze profitability.
Gross profit is the difference between revenue and the cost of providing a service before deducting overhead expenses and taxes. If your consulting service takes in $5,000 for a project and must pay $1,000 in direct expenses, the gross profit is $4,000. Those direct expenses can include research, unreimbursed travel, and any expenses that are tied directly to that project. Depending on the business, gross profit is also called sales profit or gross operating profit. It typically doesn't include expenses of operating the business, called indirect or overhead expenses.
Net profit deducts overhead from gross profit. Overhead includes the costs of your office operation, staffing, and any other expenses that are required to keep your business open, such as telephone service. Net profit is the amount of money left over after all fixed and variable expenses are paid except one: taxes. Net profit is also known as pre-tax profit; once taxes are paid, the amount becomes profit after taxes. If no profit was made, it is loss after taxes.