Those who have just started a business are apt to make a few mistakes which can immediately put at risk all the hard work and inspiration that has got them to this point. Learning to avoid these mistakes and grasping a few basic accounting fundamentals can be the difference, at least in the early days of your business, between failure and longer-term survival.
- Sales are not profit.
It is easy to confuse sales with profit and to assume that because your sales are strong, that your business is profitable. This is simply not true. Sales are what you get from selling your goods or services, profit is what is left over after all your costs have been deducted from those sales. The bottom-line is this: if your costs are greater than your sales your business is operating at a loss.
There are two types of business costs, variable and fixed. As their name suggests, variable costs vary with sales levels. They include the cost of raw materials or stock, and the direct labour cost of producing a good or providing a service. The more you sell, the higher these costs, and vice versa. Fixed costs, on the other hand, also known as overheads, are there regardless of how much or how little you sell each month. Such costs include office rent, utility bills, office expenses, and, to a large extent, staff costs.
Variable costs can be reduced in the short-term, fixed costs much less so. The mistake many small business owners make is not to include all their costs when setting a price for their goods or services. Therefore, they will determine a price which appears to cover all their variable costs, without taking into account all their business overheads. This means that they leave either not enough profit to cover those overheads, or end up with a very thin margin overall. It is important, therefore, to make sure you include these business overheads, or at least part of them, in your pricing calculations.
Ask your financial adviser or accountant to check your pricing before you start selling, so that they can check for you that all relevant costs have been included. This will give you the confidence to start off knowing your prices are profitable.
- Profit margin is not the same as mark-up.
Another common confusion is between profit margin and mark-up. Your mark-up is the amount added to the cost price of goods or services to cover overheads and profit, while profit margin is the amount by which sales exceed the costs in a business. The two are not the same as the following example shows.
Assume a business owner wants to make a 25% profit on the cost price of a good or service, the unit cost of which is €100. The easy assumption to make would be that you need to add €25 to the cost price to achieve the desired profit margin of 25%.
However, using the following formula: Price-Cost/Price, it can be seen that the actual profit margin in this case is only 20%. To achieve the desired profit margin of 25%, the selling price would need to be increased to €133.33, some €8.33 higher than might initially have been assumed. By using mark-up instead of profit margin, a business can effectively give away part of that desired profit margin by setting incorrect prices from the off.
Determine in advance what your profit margin should be, and then work back to determine how much you need to mark-up your services or goods to achieve that margin. Again check with your accountant or financial adviser that you have got your sums right and your prices deliver the required margin.
- Profit is not the same as salary for business owners
Many new business owners assume that any money left over as surplus profits can be taken out of the business as their salary. But profits are needed to sustain and grow your business. Taking all these surplus funds out of the business leaves nothing for growth or to provide a buffer in case the business hits a rough patch. Therefore, their “salary” should be included as part of the business costs; the true profit of the business is calculated after deducting all costs, including taxes, plus an amount for their salary. Of course, in the early days of starting a business, many owners might not be able to draw much money from the company, so that initial salary might be quite small. However, as the business grows and becomes more profitable, that salary should be increased to a level at least in line with what they could earn as an employee, and probably more. After all, what is the point of all the risk and hard work involved in starting a business if there is no reward?
Aim to make enough profit to pay your salary and to have enough left to continue sustaining and growing your business. Again this should be reflected in your pricing.
Starting a new business is challenging enough without giving your self additional handicaps by misunderstanding some of the business fundamentals. Don’t confuse sales with profits, mark-up with profit margin, or equate your salary with surplus profits. Get your pricing right, consulting with your accountant or financial adviser where applicable, and you can avoid these common mistakes.