Managing costs

Profit: don't be fooled, not all profit is good

There are two types of profit – good and bad.

One type can result in business longevity and success, the other bankruptcy. This is best explained by this true story from Travel Stars (business name changed).

Travel Stars was a company that created itineraries for people looking for customised tours around the world. They made $500 profit on each sale (average sale was $1,000) and needed more money to ramp up their marketing and sales efforts.

Their customers were happy and were writing great reviews about the service. Travel Stars went to Business Angels and Venture Capitalists and raised $500,000 for more marketing, and at first, the funding was considered a great success.

Business Angels chased Travel Stars for a full set of accounts but found it difficult to get them. The bank account decreased rapidly and the creditors demanded more collateral to cover potential risks. Travel Stars was unable to meet the obligation, the creditors called in their loan and the company folded.

In the aftermath it became clear the managing director of Travel Stars had misunderstood the type of profit they were making. They were making a gross profit of $500 while everyone assumed they had meant net profit. 

Gross profit is the amount that remains after deducting the cost of goods sold, while net profit is what is left after all expenses, interest and taxes are deducted.

When you take the cost of running the company and divided it by the number of sales, there is a cost of $1,300 per sale. So each sale cost Travel Stars the variable cost ($1,000) plus a share of the fixed cost ($1,300) for a total cost of $2,300. Customers were paying $1,500 and getting $2,300 worth of value – and Travel Stars ended up with a negative profit margin, not even getting close to making a break-even point.

Every sale Travel Stars made caused the company to go into debt a further $800. The investment only sped up the demise of the company because sales increased and the net profit margin sunk the company further.

How to ensure your profit is good profit

The goal is to determine which products are providing net profit and abandon any that aren’t. Here’s how to check which products you need to review:

  1. Create a list of your products and services.

  2. Write down what you have to pay someone to provide the service or product (this is the cost of goods sold).

  3. Write down the sales price (if you have given discounts, use a weighted average).

  4. Calculate the gross profit (sales price less cost of goods sold).

  5. If the gross profit is negative for any entry, urgently investigate removing that product from your portfolio.

  6. Calculate the total expenditure made by your business and subtract the sum of the cost of goods sold (from step two).

  7. Divide the remainder (from step six) by the number of entries in the list of products (from step two) – this is the allocated fixed costs.

  8. For any entry in the list where the gross profit (from step four) is lower than the allocated fixed costs, investigate removing that product from the portfolio.

Products that make it through this process should add profit to your company. Remember that your gross profit and gross profit margin are not as good indicators as net profits. Spend more time marketing and selling those with the highest net profit.

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