The very basics business numbers

1. Creating Value – Profit

The first thing that you will do with your small business is to sell a thing to someone (customer) who wants it. The “thing” you sell can be a physical, manufactured product or a physical activity or service. The definition of product and service gets very blurry so can now if a customer interacts with the thing by themselves that’s a product, if they interact via a person that’s a service). Whatever the thing that you are selling you need to create a financial benefit or profit.

Basic Actual Profit

For many starting off in business, profit is not the primary goal. The goal is to generate something of value that is not directly linked to money. Whilst this is view is good to orientate the business and attract customers and workers if the business is operating under commercial law through the exchange of monetary value then profit must be understood and controlled.

The simplest expression of profit is this:

Profit = Sale Price – Cost of Sales

This expresses what a business needs to aim to be. For a business to generate a profit (more money after a Sale) the Sale Price has to be greater than the Cost of Sales.

This equation assumes that Sale Price is always higher than Cost of Sales. This isn’t always true as both the Sale Price and the Cost of Sales can change. To be clearer we need to define three outcomes of a sales transaction – Profit, Breakeven, and Loss.

Transaction Outcomes	Example
Profit = Sales Price > Cost of Sales	20 = 100 – 80
Breakeven = Sales Price = Cost of Sales	0 = 80 – 80
Loss = Sales Price < Cost of Sales	-20 = 80 -100

Simple example – a loaf of bread. Let’s assume you’re a baker and you want to know how much profit you make for every loaf of bread you make.

The Cost of Sales are all the ingredients, power etc needed to make the loaf. This doesn’t include your time or the cooking equipment. It’s only the cost to make the single loaf. To keep things simple there are no costs with selling the loaf – there is a customer that will buy it straight from the oven. The total cost of sale are 80p or £0.80.

The customer is willing to pay £1.00 so you set the Sales Price to £1.00.

In the above example, the 20p is made per purchase of a loaf of bread or per sales transaction. Not a lot of money but it’s a good start.

Profit and Profit Margin

20p may not seem like a great return for all the effort of baking a loaf of bread but it’s actually brilliant. The reason for the brilliance is due to another calculation that tells you more about the sale than the 20p and that is the Profit Margin – the percentage difference between the Cost of Sale and the Sale Price.

For our loaf of bread example

A 20% profit margin is very healthy. 1/5^th of Sale Price is Profit.

The profit margin is the percentage of the Sales Price that is profit (the money you get to keep) and the rest is Cost of Sale (the money you have to spend).

Markup Percentage or Markup

There is another important way of visualising how much profit you are making. Profit Margin looks at the percentage or fraction of the Sales Price that is profit. Another way is to look at the profit as a percentage or fraction of the Cost of Sales. This is the Markup percentage or simply Markup.

For the loaf of bread:

Profit Margin = 20% and Margin =25%.

In the figure below you can see the difference between profit margin – a fraction of additional money per sale and sale markup – a fraction recovered of costs per sale.

Setting Sale Price: Cost + Markup = Profit

What is the difference between sales markup and profit margin? Surely they are the same thing?

A brilliant question and one that took us a while to work out. The difference is in the timing.

The sales markup is what you will add to your costs to generate a sales price for your product.

Loaf of Bread (what you want to sell the product for)
Cost of Sale = £ 0.80
Markup = £ 0.20
Sale Price = £ 1.00
Markup Percentage of Cost = 25% (20/80)

The profit margin is what the customer actually pays for your product minus the cost of sale.

Loaf of Bread (what you actually sold the product for)

Sale Price = £ 1.00
Cost of Sale = £ 0.80
Profit = £ 0.20
Profit Margin Percentage of Sale = 20% (20/100)

In the example above you sold the product for the markup you wanted all as planned. However this may not always be the case. Perhaps there is surplus (excess supply) of bread and you have to got to drop your sale price as your key customer is on holiday and you have to sell to someone who will only pay 90p (£ 0.90). Or you find a customer willing to pay £ 1.10. In these situations you can to adjust your sales price as you wish to sell the product. The price you set is the markup with the price that is bought the profit margin. You may have no markup and sell at a loss to get some return greater than zero (no sale = all loss). This would be a markdown that is common in sales to quickly remove stock before it has to be thrown away.

The profit margin is whatever the product actual sold for be that a positive profit margin (markup) or, if things don’t work out, a negative one. A negative profit margin sounds really bad – why would you run a business with a negative profit margin? Losing money doesn’t make any sense.

In order to understand how a business can run at a loss we need to make things a little more complicated but realistic.

The Three Profits: Gross, Operating, and Net Profit

So far we have kept things very simple to explain profit as the difference between Sale Price and Cost of Sale for a single loaf of bread. In reality a business is more complicated as even to make a loaf of bread then there are tools/ equipment and premises plus administration costs to operate.

These other activities introduce more costs that take money away from the profit generate through a sale. If we extend our baking business to 100 loaves of bread a day then we can introduce some new terms.

Revenue – all the money collected through sales transactions. Revenue is part of a business’s income. Revenue is also called Sales depending on the industry.

Income – Another word for profit. Income is all the money coming into the business. Income is revenue and then any other monies coming in like a tax rebate or interest gained on something.

Expenses – another term for Costs associated with professional services like accounting, consulting, marketing – anything where you are paying directly for someone’s time and things they have to buy as part of that time. Businesses can also use Expenditure.

Direct Costs – all the costs associated with a sales transaction e.g. materials, ingredients, packaging etc. Can be associated with a single sale.

Indirect Costs – all the costs associated with running operations that are not directly associated with a sale e.g. machinery, operations, buildings, marketing etc.

Loss – activities that have cost the business money. Can be an investment or stock that no longer has any value and is said to be have be written-off.

Earnings – another word for profit

With these new definitions we can look at profit through three different levels of business operation.

Level 1 – Gross Profit: Revenue – Expenses

Gross profit (or income) is the money generated from sale transactions with customers minus the money needed to generate the revenue. Gross profit is the maximum amount of profit a business can record. Gross profit will feed into the cash the business has once all other costs have been removed. If a c

Gross profit = (Total Revenue – Total Expense)

Total Revenue = 100 x 1 = £ 100
Total Expenses = 100 x 0.80 = £ 80
Gross Profit = 100 – 80 = £ 20

Gross profit margin = ( Gross Profit / Total Revenue ) x 100

Gross Profit = £ 20
Total Revenue = £ 100
Gross Profit Margin = ( 20 / 100 ) x 100 = 0.2 x 100 = 20%

This is the maximum profit a business can state. This number will go down as we go through the next two levels.

Level 2 – Operating Profit: Gross profit – operating costs

Operating profit (or income) take the gross profit (Gross revenue – Gross expenses) and subtracts all the internal activities of the business that incur costs. These costs are indirect costs or internal expenses and will be incurred regardless of the number of sales for a period. Common examples of operating expenses and rents for buildings, cost of machinery, administration costs and salaries/pay roll.

For our bakery example let’s say the cost of the electricity is £ 3 and rent for the kitchen £ 7.

Operating Income = Gross Profit – Operating Expenses (simple version)

Gross Profit = £ 20
Operating Expenses = 3 + 7 = £ 10
Operating Profit = £ 10

The reason this is the simple version is that the true calculation of operating profit has to take into account depreciation and amortisation. Depreciation is a cost incurred for using assets (things the business own that have a positive value) as the value to the asset drops through use and through just being older. For example the oven will be worth less after a year of baking than it did at the start. Amortisation is a little more complicated as it refers to intangible assets like patents or brands, or paying of loans. For this simple case we can ignore both depreciation and amortisation. For completeness (as there are already a lot of terms being introduced) we need to introduce a very accounting term.

EBITDA (Ee-Bit-Dar) – Earnings Before Interest, Taxes, Depreciation, and Amortisation

EBITDA is the profit or income a business makes before all the non-operating costs are taken off. It indicates how efficient a business is running with the assets it has before costs it simply has to incur. Forget the term for now as we are keeping things nice and simple to get the hang of the simple aspects of price, cost (expenses) and profit (income).

Operating Profit Margin compares the total revenue generated (Revenue or Sales) minus all operating costs against total revenue.

Operating Profit Margin = ( Operating Income / Revenue ) x 100

Operating Profit = £ 10
Total Revenue = £ 100
Operating Profit Margin = ( 10 / 100 ) x 100 = 10% (10% less than Gross PM)

Whilst the operating costs may not be realistic a drop of 10% from Gross to Operating profit is not uncommon or bad. It all depends on what your competitors are doing as if they have a higher Operating profit then then will have more cash and can offer better deals taking away your customers.

An important point to highlight at this point is that you have to declare what your operations are if you are going to be a registered or, more formally, an incorporated business. An incorporated business needs to state it’s main operations to be able to tell what is operational income (the main activities of the business) against other incomes not associated with business operations.

For example imagine our bakery business had 10 bakeries producing loaves of bread. Let’s say each bakery is worth £ 10,000. If we sold 2 bakeries for a total sale of £ 20,000 this would be cash that would be in the business accounts. However, this is NOT operating income as selling any real estate is not part of our business operations. If an investor saw our business make £ 20,000 extra that would be very tempting as it looks like our business makes a lot of money. But this is not true – in fact we have reduced the amount of money we will make in the future by selling the buildings needed to make bread.

If you are not going to be an incorporated company you are likely to be a sole trader. The UK Government strongly advise registration as a sole trader for tax and benefit purposes but you don’t strictly have to. However you will have to account for your income if the Government asks.

Level 3 – Net Profit: operating profit – all expenses (taxes, interest)

Once we have worked out the operating profit the final deduction are any additional costs/expenses the business has to pay over a reporting period (normally a year). The additional costs are those associated with charges on the business namely business or corporation taxes. Taxes are calculated against the operating profits as this does not affect the operations of the business but does affect the return for the business owners (the taxman always gets in before investors). The good news is that after these expenses have been removed then all that remains is owned by the business and in turn the business owner(s) who may spend it how they wish.

For example we’ll assume that for our bakery they have no interest to pay on loans so we will only need to pay corporation tax. Corporation tax is complicated, taxing even. To keep things simple will just apply 20% tax on the operating profit.

Operating Profit = 10
Corporation Tax at 20% = 10 x 0.2 = 2

Net Profit = Operating Profit – Interest and Tax costs
Net Profit = 10 – 2 = £ 8 (this is the money the business made and the owners get to keep)

Net Profit Margin = ( Net Profit / Total Revenue ) x 100
Net Profit = ( 8 / 100 ) x 100 = 8%

Let’s see how we got to £ 8 and 8%

Quick Summary
Total Revenue = £ 100 (100 loaves sold for £ 1)
Total Costs = £ 80 (100 loaves made with £ 0.80 ingredients
Gross Profit = 100 – 80 = £ 20
Gross Profit Margin = ( 100 – 80 ) / 100 = 20%

Operating Expenses = £ 10 (£ 3 for electricity + £ 7 for rent)
Operating Profit = Gross Profit – Operating Expenses
Operating Profit = 20 – 10 = £ 10
Operating Profit Margin = ( Operating Profit / Total Revenue ) x 100
Operating Profit Margin = ( 10 / 100 ) x 100 = 10%

Profit expenses = 20% corporation tax
Profit Expenses = 10 x 0.2 = £ 2
Net Profit = Operating Profit – Profit Expenses
Net Profit = 10 – 2 = £ 8
Net Profit Margin = ( Net Profit / Total Revenue ) x 100
Net Profit Margin = ( 8 / 100 ) x 100 = 8%

Profit Type	Amount (£)	Margin
Gross	20	20%
Operating	10	10%
Net	8	8%

These profit levels are just examples and not to be taken as good or bad levels. The key lesson is that level of your Gross Profit will drive everything. And the key to driving this profit is to know how to set price and then how to control costs/expenses.

It’s not just about keeping costs down

After reading this one conclusion you could have is that to be successful in business you have to be merciless in keeping costs down. Whilst you do need to control costs you have a choice on how to you manage your costs. You may decide to pay staff, suppliers and others more than the minimum. This will affect your profits but it will also create a better workforce and better supplier relationship. Business is about partnership not conflict.

The next thing to learn is how you can and can not set the market price.

Setting your Price – Economics – Price (Supply) and Purchase (Demand)