Your Operating Profit
So you’ve launched your business. You’ve tracked your sales, kept record of all your media buy or inventory, and have glowing reviews from your early customers, many of whom were friends and family.
You’ve followed the best practices and absorbed the content. You read the blogs, watched the YouTube videos, and maybe even signed up for an online course. Great. You’re Mr. Hustler, Ms. I Get Sh** Done.
But here’s a question, How much are you really going to keep?
That is, what’s your operating profit? To answer that question, it takes simple number crunching. In short, it’s an accounting question with an accounting answer. And while that isn’t as sexy as your new marketing campaign or the “I-Made-$60K-In-One-Day” Instagram story, the TRUTH is that accounting and tax is more important than all of that noise.
If you’re doing this for the fun of spending money and not getting a return on investment (ROI) for yourself or investors, stop reading. But if you’re here to win, to cash in on that hard work, then hear me out.
Because I’ve worked with CEO’s of 8-figure companies and with guys that had scraped together $20,000 from Uber for their first inventory order (who by the way, became the CEO of a 7-figure e-commerce brand). I’ve seen big companies fail and first-time entrepreneurs exit. And good or bad, creative or quant, you don’t have a business if you can’t explain your numbers.
Accounting for Noobs: The Early Days
Can you calculate your operating margin?
And while this is an incredibly important question, only a handful of business owners can accurately calculate their business’ true profit in the earliest stages. And those months are critical because where you place your focus (or don’t place your focus) in those early days, if left unattended, can be disastrous for your business.
You have a narrow sales focus without cash projections? You’re going to make sales but run out of cash. Unable to purchase enough inventory to keep with demand, most sellers have to take out an expensive line of credit or fail.
Maybe you’re a marketing wiz constantly testing social media and click-bait tactics, but haven’t touched bookkeeping for over a year? Taxes will kill you and if they don’t you’re going to have a lot of explaining to do when you need a bank loan.
Selling product like crazy without tracking inventory? You’ll be out of business sitting on unfulfilled orders, processing refund requests.
These are real-life examples. And here’s the punch line: how about you work your tail off, create a client list, hire contractors and then realize that your margins are way worse than your competitions and don’t work at scale? I’ve seen entrepreneurs leave investor meetings baffled why the investors didn’t “get” their business that has sales – short answer: lack-o-profits (not an official accounting term).
In truth, there are a handful of numbers that matter in business and we’ve identified our top list that if you track, will give you a thermostat for your short-term, medium-term and long-term success.
- Gross Profits = Sales – Cost of Goods Sold or Cost of Service. I like looking at this number on a rolling basis over a multiple-year period, but should be tracked at least monthly. GP also needs to be evaluated anytime manufacturing or services costs are expected to change, for example, changing manufacturers or when tariffs on your products are imposed. A corollary is Gross Margin, or Gross Profits divided by Sales. In retail, this is a critical number. If you watch Shark Tank, this is what they mean when they ask about “Margin” or what the multiple is – it’s a question you should expect from any investor. You should be selling at 4X-5X costs (that’s the multiple), which would give you 80 cents in Gross Profits for 20 cents in costs, or an 80% Gross Margin (100 sales – 20 costs = 80 gross profit, divided by 100 is 80%).
- Operating Profits = Gross Profits – Operating Expenses. Tracked monthly and projected for at least the next month and quarter. There are two Operating Profit numbers to track: (1) Actual Operating Profits and (2) Projected Operating Profits. For actuals, this is something that should be done at minimum on a monthly basis.
- Cash Projections (1-Month, 3-Month, and 6-Month Rolling): Cash on hand after projected sales, taxes, inventory purchases, and other operating expenses. Note: This number can be different than operating profits, hence why businesses will refer to a “paper loss” but will still have a healthy balance sheet with cash.
The table below shows a sample of a simple profit and loss (“P&L”) statement, showing both Gross Profit and Operating Profits, as well as their respective margins.
If you want to operate like a pro, a comprehensive set of financials projections that are reconciled to actuals, can cover each of the above metrics while also highlighting how your business is falling short or exceeding your expectations. And knowing that will tell you whether you’re truly ahead or behind.
What to Track When The Excitement Fades: Look Beyond Sales
When do business owners get real about their business’ accounting and metrics? Unfortunately, for many businesses between the $500,000 and $5.0 million mark (our businesses’ sweet spot), only during tax time or when the company is seeking equity or debt financing.
But let me suggest that there is a reason beyond compliance and banking. And that’s to answer the question that should be answered by all businesses, Do I really have a business worth growing?
I won’t delve into the non-profit-motivated benefits of business (even though I’m a huge proponent of conscious capitalism) because the point applies to all business, irrespective of non-profit-motivated goals. I can get behind the good you’re doing in the world, but if you’re not turning a profit that scales, then your impact is limited.
And that’s the point: what works at $20,000 in sales won’t work at $200,000 in sales. I’ve seen high-margin $500,000 (in sales) businesses turn into $2.0 million-dollar failures because of margin. As you can see in the table below, there is naturally a diminishing return of profit as sales increase. The reason why is that absent of technological innovation, the cost of sales in any business decreases with a constant rate of sales growth.
If your profit is moving like the figure above, you need to stop and evaluate your growth strategy because you’re working harder but keeping less. But without a focus on margin over time, you’d think you were successful without knowing why you’re not feeling the fruits of your labor.
Alternatively, if you have run the numbers and you’re projected margin works at scale, then you have an obligation to grow the business. Because if you’re doing something better than everyone else, trust me, there are investors (myself included), who would be happy to beat their returns from the stock market by helping you grow what you’re doing.
First and foremost, know your numbers.
Second, track and project your profits over time. You may not be keeping as much as you used to and that can be okay, but the key is to understand how profits are changing and be able to speak to those changes.
Finally, reconcile your profit expectations with actual results. Knowing how you’re measuring up to your vision will help you make adjustments to your business in real time.