Making a Profit
If profits are the retained earnings of businesses after expenses are paid, the question is, how do entrepreneurs make a profit? The simple answer is that they spend less than they receive in revenues. The more difficult question is, how does this occur? How does a business spend less than it takes in?
One way to spend is to begin with a plan called a budget. A budget is a prediction of how much money an entity will receive and how much it will spend over a given period of time. Typically, budgets are written each year, the beginning of which may or may not be January 1. Sometimes a budget year, commonly called a fiscal year, begins at a time when the business cycle for the entity logically begins or ends.
For the Walt Disney Company, the fiscal year begins on October 1 each year and ends on September 30. Many other leisure services corporations choose the same dates for the fiscal year because their busiest season is the summer, and by the end of September most of their revenues should be received and their bills paid. Using an October-to-September fiscal year allows the accounting system to match revenues and expenses, minimizing accruals.
Within a business budget, the first issue is the cost of goods sold, which is the cost of producing the product or service considering its direct costs. For instance, suppose a person started a coffee shop called Coffee Café. If the average cost of a Coffee Café cup of coffee includes the cost of the cup, coffee, and condiments, the direct cost might be $1.00. If Coffee Café predicts it will sell 50,000 cups of coffee in a year, the predicted cost of goods sold is $50,000.
The next budget consideration is the gross profit, the difference between the total revenues of the product or service and the cost of goods sold. If the Coffee Café sold 50,000 cups of coffee at an average cost of $6.00 each, its total revenue would be $300,000, and its gross profits would be $250,000. Dividing gross profit ($250,000) by total revenue ($300,000) generates a percentage (84 percent) called the gross profit margin, which is pretty good since coffee stores usually sell more than coffee and have other gross profits in the mix. But let’s assume that coffee is all the Coffee Café sells. If that awakens your sense of greed and makes you want to start a coffee shop of your own so you can keep 84 percent of the revenue that comes into the store, hold on a second. There are other costs to consider in a budget.
There is the labor to staff Coffee Café, rent or a mortgage to pay, utilities, cleaning supplies, the cost of furniture and equipment, and advertising. These are the indirect costs of doing business and must be subtracted from gross profits. Let’s say these indirect costs of operating Coffee Café total an additional $200,000. Then the gross profit ($250,000) minus indirect costs ($200,000) would be a net income of $50,000. Dividing net income ($50,000) by total revenue ($300,000) generates a net profit margin of about 17 percent from the coffee product line.
If the owner of the fictitious Coffee Café sold only coffee, he would not have $50,000 at the end of the year, however. He would have to pay taxes on the profits. For the sake of argument, let’s say that the owner is in a 35 percent tax bracket. His taxes on the net profits from the store would be $17,500, leaving $32,500 as the profit. Table 4.1 reflects the budget for the coffee shop.
Included in the budget is a column for the actual revenues and expenses. Assuming that only 80 percent of the total revenues are received, and considering that the direct expenses of coffee, cups, napkins, and condiments decrease accordingly, the Coffee Café is no longer profitable. Because the business is heavy on fixed and indirect costs of labor, rent, utilities, and other expenses, a 20 percent decline in predicted revenues changes everything.
That is why it is so important to accurately predict revenues for a business venture. Unfortunately, revenue prediction is not an easy task. Market research helps, but the basic product idea is the foundation. Without an idea that costs less to provide than the market will bear in price, there is no real opportunity to make a profit.
The points to remember are as follows: Profit margin is the difference between revenues received for the products or services and the cost of goods sold. Gross profits are a function of the total number of products or services sold as well. But net profits need to consider the indirect overhead costs that are part of running a business. This is a somewhat simplistic view of profitability, but a more detailed view will be presented as we continue.