Back to basics: profits, mark-ups and margins
Are you mystified by money matters? Here’s a back-to-basics lesson on small business finance terminology and concepts to help you manage your business finances.
Small business owners wear many hats, one of which is usually ‘finance manager’. Though in my experience, many soloists have very limited understanding of small business finance basics. (Note: Checking your bank balance as an indicator of how your business is going does not equate to managing your finances!)
Even if you outsource much of this role to an accountant, it’s important to know the essentials to keep you on track to profitability.
Mark-ups are used when calculating your prices. Once you have worked out how much it cost you to create your offering, the mark-up is the amount you add on top to reach your sale price. Often it is a percentage or multiple of your cost, such as a restaurant that marks up 4 x food costs.
Profits and costs
The costs to run your business are categorised to make it easier to read your financial results and make more effective decisions about your business. The basic ones are:
"Tracking changes in Gross Profit each month makes it easy to pick trends before they get out of control."
- Cost of Sales: any cost that you directly incurred to create your product or service, including materials, parts or wages.
- Cost of Goods Sold: the cost of materials to create your offering, including ingredients, materials or parts (no wages in here).
- Gross Profit (GP): the amount left over from your revenue when you take out total cost of production (Cost of Sales). This is expressed as the total number or as a percentage of revenue. E.g. GP $30K from total revenue of $60K is 50 per cent.
- Overheads: expenses incurred that aren’t related directly to production. These are usually fixed and are more consistent, such as insurance, rent, marketing, fees and wages for non-production activities such as marketing, administration or accounts.
- Net profit (NP): the amount left over from your revenue when you take out Cost of Sales and Overheads. This is your profit before tax. E.g. NP $12K from total revenue of $60K is 20 per cent.
Margins are used when analysing your finances, often as percentages (as used above). The mistake that many business owners make is they confuse mark-up and margin. Mark-up is not Net Profit because it still includes some costs.
Want more articles like this? Check out the financial management section.
How to use these numbers
With these figures you can very easily and quickly check the vitality of your business or individual product lines. When looking at reports, the Net Profit will obviously be of interest – because that money is yours, but Gross Profit will tell you a lot about your business. GP quickly tells you if you need to take action with pricing, costs or efficiency, and tracking changes in GP each month makes it easy to pick trends before they get out of control.
Case study 1: Service Business
A service-based business that I worked with had monthly revenue of $100,000 with the main Cost of Sales being salaries. Over time, profit had slipped with GP dropping from 45 per cent to 43 per cent. After investigating changes to wage costs we found that superannuation increases, annual pay rises and increased travel costs had all contributed. Action was needed to increase prices, accept the decreased profit or reduce costs.
Case study 2: Manufacturing business
One of my old clients manufactured packaging products. When I first met them they said their Margin was 20 per cent. After I looked more closely at their accounts I soon realised that it was, in fact, their Mark-up that was 20 per cent. So for an average monthly material cost of $50,000 their sales were $60,000 with GP of 16.7 per cent. Considering overheads were $15,000 (25 per cent) they were losing 8.3 per cent per month. Prices went up promptly.
Do you have a solid understanding of small business finance basics, or do finances mystify you?