How to measure your profits
Measuring your profits isn’t just important for reporting or tax purposes. It’s also vital for good decision-making. Doing it right will give you insights about how to optimize prices, which product lines to focus on or drop and how to better run your company.
Unfortunately, many entrepreneurs have a poor handle on their company’s finances or a false sense of their profitability. They may rely on a bookkeeper or accountant to do their books without getting the information they need to understand how they’re generating profits.
“Business owners normally think the information is just for taxes or financial statements,” says Alka Sood, a business consultant at BDC. “Analyzing your profitability should be an integral part of decision-making.”
Here are four steps Sood says should be used to properly measure your profits.
1. Take ownership of your numbers
As an entrepreneur, you need to have a good handle on your finances. You can’t abdicate responsibility to a bookkeeper or accountant. They won’t understand your business as well as you do.
Their standard reporting usually won’t give a complete picture of how your business generates money. Don’t look for such details in your financial statements or tax documents. They won’t typically be there. It’s up to you to make sure you get these numbers for your business.
“You need to own your own numbers,” Sood says. “This is your company and your responsibility.”
2. Check your financial statements for mistakes
Take a close look at your income statements and balance sheet to make sure items are recorded in the right place. It’s common for financial statements to incorrectly categorize such things as costs and assets, even when prepared by a professional bookkeeper or accountant. This can result in expensive tax liability errors or an inaccurate view of your profitability.
For example, businesses often misclassify their material costs under “cost of sales,” whereas some of it may actually be an inventory asset that gets drawn down over time. The business then appears to be less profitable than it really is. “The company has a warehouse full of material, but it’s not reported correctly in their financials, and the company’s profitability gets understated,” Sood says.
The apparently poor profitability can cause headaches when the business seeks financing, for example. “Bankers want to see a good gross margin,” Sood says.
3. Break down your costs and revenues
Measuring your profits isn’t just about determining your overall business margins. You should also be aware of the profitability of various product lines, distribution channels and key customer segments.
To do this, you’ll need to have detailed breakdowns of your costs and revenues. That includes separating out variable costs for each product line (i.e., raw material, labour, production and shipping) and fixed costs for the business (i.e., rent, insurance and office supplies).
“Breaking it down is usually a real eye-opener for businesses,” Sood says. “Few entrepreneurs know these details. They know very little about which products or customers are making them money and more importantly which ones are losing money.”
Knowing the profitability of each product can help you focus on higher-margin areas or disengage from lower-margin ones. It can also show if your products are priced appropriately or if your overhead is reasonable.
“If you don’t know what net margin you need to pay for overhead, then you may price your products wrong,” Sood says. “Or if your overhead costs are too high, you can make a decision to become more efficient.”
4. Ask your team for detailed reporting
Work with your bookkeeper or accountant to get a detailed profit breakdown for your business on a regular basis—for example, weekly, monthly, quarterly or at least annually—whatever makes sense for your business.
Think about what details would be most useful for running your business. Then, ask your bookkeeper or accountant to prepare regular reports that clearly present this information. With today’s technology, you should be able to look at your financials with a simple press of a button, provided your bookkeeper or accountant is up to date with entering all of your financial transactions.
You may need to hire an outside financial expert to help you set up the reporting and determine how to optimally break down your numbers. “It can take a while to get the segments right,” Sood says. “It is a continual process, but as you go through this, you have a really good understanding of how profitable your business is.”