The most important number in business is your Net Profit, yet how many of us look at this number when it comes back from the accountant at the end of the financial year and wonder how we arrived at that figure. One of the keys to creating a successful business is to constantly focus on the profitability in your business, in particular understanding what the main profit drivers are.
Few businesses rarely analyze the net profitability they derive from each of the different products or services they sell (and let me be clear that I am referring to net profit and not gross product). The exercise can be very revealing. When I have done this exercise with my clients they have frequently been amazed and yes, sometimes horrified to find out where the profits are coming from or in some cases – not coming from. Inevitably, within their stable of products and services there are some that are much more profitable than others. This revelation often results in significant changes in their pricing, business strategy and marketing focus.
Most of us know the net profit we make in our business each year but how can we calculate the net profit we derive from each of the different products or services we provide. Well in order to do this we need to fairly proportion our production and overhead costs to each product or service. The way in which I do this with my clients varies depending upon the nature of their business, however I have outlined below a fairly simple method, which best suits most service businesses. You will need to go repeat this process for each product or service.
- Calculate The Gross Profit – From your sales price (excluding Taxes) subtract the Cost Of Goods and a charge for the time taken to produce or deliver the service. This will require an estimate of the number of hours it takes to produce or deliver the service multiplied by an average hourly production labor rate.
- Calculate Fixed Cost – We need to deduct an amount that represents your annual fixed costs. To do this, divide your Total Annual Fixed Costs by the Total Annual Production Hours. This will produce a figure, which represents the Fixed cost per production hour. Multiply this by the number of hours required to produce or deliver the service (see step 1) and then deduct from the Gross Profit (calculated in step 1). The result will be an estimate of your net profit derived from that product or service.
- Calculate The Net Profit Per Hour – So that you can compare each product or service, divide the Net Profit by the number of hours it takes to produce or deliver to calculate the Net Profit Per Production Hour. The products or services with the highest Net Profit Per Hour are the best.
There are alternative methods to coming up with this calculation and it may be necessary to use a slightly different approach depending upon the type of business.
The result of this calculation can yield some surprising results, which can horrify business owners. Business is a numbers game and there is no number more important than knowing your profits and where those profits are coming from.