The Types of Profit, And the One You Must Earn
- Published: 08/07/2012
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In our last article, “Develop a Profit Paradigm” we discussed the importance of acknowledging two important facts about your business:
- That profit is the only objective measure of its performance. And,
- Without profit your business cannot survive, let alone grow.
Soon after this acknowledgement, most owners struggle to find a useful “profit” measure. Eventually, most throw up their hands and ask: “Exactly what is profit and how does it relate to MY business!?” Answering this question will be the focus of today’s article.
What is Profit? A basic definition of Profit is this: Money generated by selling a product or service that exceeds the cost of providing that product or service. Simple enough, right? Unfortunately, it is not. Measurements used to calculate “profit” can vary greatly. For example, your accountant will probably say that profit is your company’s “Net Income” on its Profit and Loss Statement – a number he wants you to maximize. Your tax professional, on the other hand, will point toward “Taxable Income” as a measure of your company’s profit – a “profit” you hired him to minimize.
In addition to often giving extremely different “profits,” both Net Income and Taxable Income are extremely limiting measures of business performance for two more reasons:
- Neither considers the amount of “profit” a small business must earn to pay the owner’s living expenses. What good is a $50,000 “profit” when the owner needs $75,000 to pay their personal bills? And,
- Neither measures the life-blood of business: Cash. How will an owner pay tax on a $50,000 Taxable Income when $30,000 of it was spent making non-expendable loan payments?
To compensate for these limitations, let’s consider a third type of profit: Economic Profit.
Economic Profit: Economists use Economic Profit to measure the earnings potential of business resources. In the small business world these resources include Labor, Time, & Talent. Economic Profit differs from net income and taxable income because it includes an activity’s “Opportunity Cost” (money that could have made by doing something else with your resources - labor, time, and talent) as an expense.
Here’s an example of how Opportunity Cost works: Say you left a job earning $75,000 per year to start your own business – $75,000 is the Opportunity Cost of starting your business. If your business earned an annual “profit” of $50,000 your business did not earn an Economic Profit. It actually incurred an Economic Loss of $25,000 (the $50,000 it earned minus the $75,000 you gave up). You lost $25,000 because you started your business – a very real loss if you need that $25,000 to pay your bills!
Opportunity Cost also enables owners to compare the effectiveness of their business decisions to those of other business owners. If your business earns substantially less than similar-sized businesses in the same industry, it’s incurring the opportunity cost of ineffective business decisions. It may be time to review and redeploy your business resources.
Unfortunately, Economic Profit also fails to incorporate cash flow into its analysis. As with accounting and taxable “profit,” a business can actually earn an Economic Profit while lacking the cash to pay its bills. This limitation brings us to the measure we use to gauge small business performance: Entrepreneurial Profit.
Entrepreneurial Profit: Entrepreneurial Profit blends Accounting Profit, Economic Profit and Cash Flow into a single measure gauging a business’s ability to pay its bills, the owner’s bills, and generate growth.
How is Entrepreneurial Profit Calculated? Here’s a basic example: You leave a job making $6,250 per month – money you need to pay your living expenses - to start your own business. Your business has a truck and other debt payments totaling $1,200 per month. If your business’s monthly accounting profit is $5,000 what is its Entrepreneurial Profit? Unfortunately, your business didn’t have one. It actually incurred an Entrepreneurial Loss of $2,450 ($5,000 – ($6,250 + $1,200) because it was not able to pay both its costs and your bills. This is very important because, if you’re like most small business owners, you ARE your business. Your Entrepreneurial Profit lays out the cold, hard truth: To remain open and avoid severe financial hardship, your business must generate $2,450 more in monthly cash flow.
A small business must survive before it can grow. To survive it must cover its costs and pay its owner enough to make a living. To grow it must generate excess cash to reinvest - it must generate an Entrepreneurial Profit.