The traditional and popular way to evaluate businesses (large and small) is based on revenue. Your industry may have other specific metrics that it throws around, but revenue is typically the most popular metric. You might get asked, “What’s your revenue?” Or other people might throw out at parties that they “work for an $xx billion revenue company.” You might also hear people sharing in news stories or in networking groups that they “reached $xx revenue this year and expected to earn $xx revenue next year.”
Despite its popularity, it’s a very poor metric because it’s the worst indicator for how successful you will be. The most successful businesses I work with control their expenses, especially in the early years. If you can focus on costs above everything else, it doesn’t matter what your revenue is, you will have a profitable and successful business that is likely to stay in business no matter your revenue.
It’s better to focus on costs and profit margins than revenue.
Here’s an example. Which business would you rather have?
- A $500,000 in revenue business that spends $400,000 on employees, rent and equipment/inventory. Think about all the paperwork, the inventory the payroll and the management. The owner probably works two full time jobs. All for a profit of $100k. That’s a profit margin of 20%. Or,
- A business that makes $150k in revenue but spends less than $50k per year on base expenses. The profit is the same — $100k but the owner doesn’t have to work as hard. There’s less inventory, staff and things to manage. That’s a profit margin of 67%!
The second business is mindful of expenses. The second business likely involves less stress and less headspace than the first. If all you hear is the headline, I’m a $500,000 a year revenue business, you’re going to miss the real story on profitability.
Revenue, is the one surprising metric you should really stop focusing on.
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When you focus on controlling costs instead you set yourself up for business success which sets you up for successful business finances which then translates to personal financial success and growth. Being a business owner puts you in a unique position to choose how much you want to make by controlling your costs or seeking more clients and more profit.
When you’re an employee, you have very little recourse if you want to make more money. This is because as an employee, your ability to earn raises and bonuses only partially depends on your performance, it also depends on the company and your bosses supporting the increased compensation.
Profit Margins of Product- Versus Service-Based Businesses
What I find in my work is that product-based businesses that require product development and inventory have much lower profit margins (I.e. the first business example) they typically fall easily into the trap concept of “you have to spend money to make money”. Because the only way to grow is to spend more money first. You must buy the inventory, equipment, marketing dollars, and staff first before you can even sell one single product. Examples include stores/boutiques, food-based businesses, or beauty-based businesses.
Service-based businesses, on the other hand, rely on the knowledge economy and the insight/expertise of the owner. They can have wildly profitable businesses and much more control around how many hours are worked and in what capacity they work. They don’t have overhead and they don’t typically have to spend money to reach more clients. All you have to do is say you’re open for business. Finding clients costs time, not money. Profit margins are much higher. Examples are services that you can contract out for such as freelance designers, lawyers, PR professionals, therapists, and consultants.
I’m not saying that product-based businesses are a bad idea. What I’m saying is, it’s much more difficult to succeed with a product-based business. There are clear reasons to focus on a service-oriented business over a product-based business because of the cost structures. In either case, revenue shouldn’t be the main metric to focus on.
Setting Profitability Milestones
So how do you start focusing on profitability instead of top-line revenue? The first step is to consider, what’s your cost structure?
Each business is different, so you need to inventory your own costs. Once you have the costs down, you can begin to figure out and refine pricing that will get you to the profit you desire. You have to think about your individual capacity as well as your profit goals. Here are two approaches to arriving at your pricing.
Top Down Approach
With this approach you look at what you want your take-home profits to be and figure out on the back end what you have to charge to get there based on what you think you can sell or how many clients/customers you can get. You ask yourself:
- How much money do I want to make?
- How much do I need to sell to make that goal?
- And at what price?
Here’s a tip: When figuring out how much money you want to make, don’t forget to add tax!
Bottom Up Approach
With this approach we’re starting at the bottom with what we can realistically sell per month based on our pipeline, time, energy and resources for gaining customers. Then you figure out when you can break-even on costs and start making a profit. You ask yourself:
- How much can I sell per month?
- At the price I set, when will I break-even?
- When will I make a profit and how much?
It’s a good idea to try modeling both bottom up and top down to see if it reveals new information.
Then once you’re more established, you can look at things on a more macro-level to figure out where you are projected to go in the future:
- How do I define my market?
- What’s the size of the market?
- What market share can I reasonable capture?
- How long will it take me to capture that market share?
Here’s a tip: Set some stretch goals here!
It’s a good idea to work out what’s reasonable as you take a look at your cost and pricing structure and sales expectations. But after you do that, it’s a good idea to set a big goal for yourself. It’s often very helpful to see a potential range for how things could go.
Another helpful tip, I learned and employ from Mike Michalowicz’s book, Profit First is that you can figure out how to cap your expenses by using this formula:
Revenue – Target Profit = Expenses
As opposed to this formula
Revenue – Expenses = Profit
My goal is to help people shape businesses that will succeed so their personal finances can grow. It’s hard to make a business succeed without good financial planning. Here’s the bottom line: As long as you control expenses and focus on profit margin your chances of success increase.
When / if you find yourself in the position of considering starting a business think about which type of business you’re interested in and the different profit margins typically associated with each. It’s so rewarding to be in a position as a business owner to control your expenses and thus control your take home pay. This is definitely a luxury that employees in corporate America don’t have.
What kind of business have you thought about starting? Have you ever looked at typical profit margins in that industry?