Profits = Income – expenses
Profit margin is the percentage of profit over income. If you keep the ratio consistent, adding more revenue equals more profit. Relatively simple concept. (For simplicity let's keep income taxes out of the discussion.)
Yet it is interpreted very liberally and differently by small businesses.
The main reason is that most small business owners (practice owners) think of the business as an extension of their own personal accounts.
The formula becomes:
PersonalIncome = Profit = Everything left over is mine
Essentially, they exclude their own income from the business from the expenses and this inflates the profit margin.
I think this is a big mistake.
To determine if your business is really profitable, I think you need to include the reasonable costs of your time and effort in the formula.
All your time and effort.
The parts where:
- You are working in the business as a professional or providing services directly to a customer,
- All of the overhead work you do (bookkeeping, employee management, scheduling, etc.),
- All of the sales and marketing you do,
- All of the business planning you do.
What would it cost to replace you or from a different perspective, what could you make putting in all those hours for someone else.
You don't actually have to draw this income as salary. You make choose to take it out as dividends or keep it in the business.
Now the equation looks like:
RealProfit = Income - Expenses (including OwnerPay)
After you virtually or actually pay yourself, the real profit is what you have made by investing your time and money in the business. The value you have created above and beyond just the job. This can be income for you or you can reinvest it in the business if it makes sense.
If the number is less than zero you have a problem. You are subsidizing your business with your volunteer time. Hope you are getting some other benefits because you could make more working for someone else.
If you want to sell your business, an investor is looking at real profit to determine worth. Sure there are intangibles, intellectual property and other goodwill. But ultimately the buyer wants to make X dollars per year on their investment of Y dollars. And the investment return needs to be bigger than you would get on relatively safe investment vehicles.
Not liking the answer (and many business owners don't) is not a reason to ignore calculating real profit.