Just WHAT is PROFIT?

Understanding profit is essential to anyone interested in starting their own business. It is also important for anyone who works in a business that seeks to make a profit. Much of the misunderstanding about profit is related to a lack of understanding of the terms used in business that explain financial decisions.

For example, return on investment means the percentage you make each year on the money you invest. If you put $10,000 in a savings account at the bank you will earn interest...probably around 5-6% per year. If you put that same $10,000 in stocks you will hope to earn dividends as well as have the value of the stock go up to give you a return on your investment. Now, if you invest that $10,000 in your business you will hope to be able to make even more as a return on your investment than just putting it in the bank. In that case you would expect to make an annual profit that is greater than about $500 (5% of $10,000). After all, the higher the risk the greater return the entrepreneur would expect for the investment.

Next we need to define profit...or better yet what profit is not.

Profit is not included in the amount of money a business owner pays himself/herself. Many new entrepreneurs forget to count the costs of their time and take out a regular salary. Or when times are tough the salary is the first thing they forget.

Profit is not the difference between the costs of the product or service and the price being charged for it. In addition to the costs of the product sold you must account for thefixed costs that are paid regularly each month no matter what. These include such items as rent or mortgage payments, utilities, regular salaries, insurance, etc.

Next you must remember to plan for the variable costs of running the business that fluctuate with the success of the business and resulting needs for advertising, staffing, supplies, etc. The fixed costs and the variable costs together are known as overhead. Overhead, as well as the costs of the products sold, is subtracted from the income from sales before profit can be made.

Finally you must pay taxes out of the income before actually determining your profit from your business. These include federal, state, and local taxes which are based on a percentage of your income minus expenses. After all these costs, the owners' profit is what is left.

What are the decisions that affect profit?

For any small business there are many day-to-day decisions that change the possible profit the business might make. For example consider what each of the following choices might do to your profit:

* Pay employees more

* Hire more employees

* Buy new furniture

* Buy a new truck

* Find a cheaper source of products

* Increase the advertising budget

* Give your daughter money to buy a new dress

* Select a cheaper long distance phone service

* Remodel your building

All of these decisions increase, or decrease your cost of operations affecting what is left as profit.

When deciding how to price the goods or services to be sold, the owner must take into consideration the costs of all decisions made. Some decisions will result in higher sales which will more than make up for increased costs. It is thought that appropriate advertising will do this. Or if you pay your employees more they may be willing to work harder and increase sales. However, nothing is really sure about these decisions and their effect on profits.

So business owners often decide to use a percentage of the product costs in determining their selling prices. The percentage is based on distributing the costs of running the business (overhead) and profits in an equal manner to all items sold, based on the product costs. This is called markup. Think of markup as the share of the consumer's price that is necessary to run the business, plus what is left over as return on the owner's investment. The markup on all the products sold, added together, is designed to cover the costs of running the business and making a profit.

Business owners use past experience and experience of similar businesses to determine the expected overhead costs and profit they hope to make. This is called their margin...the amount of money available after the costs of products sold are deducted from the income from sales. If your sales equal $1 million and your product costs are $200,000, your margin is $800,000. Remember, this is not your profit. We hope by now you can explain why this is so. If not, please read this article again.

LET'S PRACTICE MAKING A PROFIT

This is the story of Goodies Gift Shop in its third year of operation in Small Town USA. Amelia Goodies, the owner, runs the shop with 4 full time employees, 2 part timers and herself. Her sales last year were $500,000 and her profit was $20,000 after taxes. If her balance sheet shows a net worth of $100,000 can you tell us what her return on investment was last year?

Balance Sheet ( Year 2)

Current Assets: Cash Accounts Receivable	$ 10,000 $ 15,000
Inventory	$200,000
Property and Equipment	$100,000
Total Assets	$325,000
Liabilities: Accounts Payable Loan Balance	$ 80,000 $145,000
Owners Equity	$ 100,000
Total Liabilities and Equity	$325,000

This year Amelia has projected sales of $600,000 with a margin of $250,000. She has budgeted the following overhead:

Owner Salary	$35,000
Employee Wages	100,000
Rent	10,000
Advertising	4,200
Supplies	1,000
Telephone	1,000
Other utilities	600
Insurance	2,000
Payroll taxes	30,000
Maintenance	3,700
Legal and other professional fees	500
Miscellaneous	2,000
Interest on Loan	10,000
Total Overhead Expenses	$200,000

If taxes are 20% of Net Income, what is the planned profit for the year?

EFFECTS ON PROFIT

The day-to-day decisions for the gift shop and the level of business Amelia is able to maintain will affect this budget, resulting in many variations of the plan. Discuss with other students the effects the following issues would have on profit.

1. The employees demand a 10% raise

2. The lease is up on the building and the owner would like to sell her the building for $150,000 or increase the rent to $15,000.

3. Amelia is considering adding another full time employee for an annual cost of $20,000

4. Insurance coverage is too low and she needs to double it

5. There are new opportunities to advertise in connection with community events that would expand her advertising budget.

6. She needs to buy a computer to improve her record keeping systems

7. Shoplifting losses force her to increase her markup an extra 5%.

8. Sales in the first six months have been 10% below expectations.

9. Her daughter "borrows" money from the register and does not repay it.

10. She is considering buying a used van for $10,000 and offering free delivery services to her customers.

What advice would you give Amelia about running her business after considering the information you have been given? What additional information would you like to have in order to discuss this case?

Do you now have a better understanding of PROFIT?

(For more help in answering these questions please refer to the PACE curriculum units on Pricing, Analyzing Finances, and The Business Plan. Available from The Center on Education and Training for Employment, The Ohio State University, Columbus, OH (800-848-4815) (This activity was published in EntrepreNews & Views and is free to copy for use in the classroom. EntrepreNews & Views is published by the Consortium for Entrepreneurship Education, Columbus, OH.)

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