Small business: how to calculate your net profit

In previous posts, I have discussed Financial Business Management 101:

• We started with an easy way to do record keeping
• Followed by how to create your sales forecast for the coming year
• Then, we looked at how to determine if you have the full overview of all your costs and expenses
• And finally, we calculated your gross profit by using the actual cost of what you are selling. Also known as Cost of Goods Sold (COGS). I explained how to calculate the COGS for both products (like manufacturing or retail) and services (like consulting or graphic design). We also discussed what actions to take if you are making a loss at this stage.

We can now use this information – our business data – to find out if our business is making a profit or a loss.

So, how to calculate it?

Calculate your operating expenses

Your operating expenses (OPEX) are the expenses that are needed to keep the business running. It includes:

• Rent of office space
• Office supplies
• Phone cards or phone subscription
• Business cards
• Marketing expenses
• Office staff salaries, including your janitor
• Insurance
• Bank account charges
• Any accounting or legal fees
• Transportation & travel

Two weeks ago, I explained the difference between your direct costs and your indirect costs.

To refresh your memory:

• Direct costs: any cost that is incurred to produce a product or service. There is no way to produce your product or service if you do not have these costs. Here are some examples:
  • Furniture business: the cost of wood, other materials to produce the furniture, and tools
  • Manufacturing: the cost of production workers, raw materials, equipment, and rent & utilities (electricity and water) of the production facility, not your office building
  • Transportation company or tour operator: the salary of the driver and fuel
  • Consulting firm: the billable hours of your consultant(s), staff training to carry out a particular project
  • Construction company: the daily wage of workers, building materials
  • Retail company: the price of buying the products for resale
    
    
• Indirect costs: any cost that is not directly related to manufacturing a product or creating a service. These are the expenses you have for any activity that supports your core business. Here are some examples that many businesses will recognise:
  • Cost of transportation or distribution
  • Marketing expenses
  • Packaging expenses
  • Salaries of IT support, security and administrative staff
  • Office supplies
  • Insurance premiums
  • Phone cards or phone subscription
  • Purchase of business cards
  • Rent of your office building (not your production facility) and utilities (water and electricity) at your office building

If you look at your indirect costs, you will see that they are the same as your operating expenses.

Calculate your net profit or loss

Take your gross profit and subtract the total of your operating expenses. If you pay taxes, make sure to also subtract the amount you will have to pay in tax. The result is your net profit or loss. It will tell you how your business is doing financially. Note: your net profit is also called net income.

Here is an example of a first quarter (= 3 months) profit and loss statement for a consulting company. I designed this for use by small businesses in Africa. (Click on the picture to enlarge it.)

As you can see, this consulting firm is doing well, but they incurred a loss when they needed to purchase computers. My recommendation to them will be to start saving money to create financial reserves for these kinds or purchases. If they do so, they will be able to use their reserves to do payment without incurring a loss.

How is your small business doing?

I’m curious to know, did you follow the steps outlined in this series about Financial Business Management 101? What is the result for your business?

Is your small business making a profit?

Congratulations! That is great. 😊 Your next step will be to determine how to increase your profit and grow your business. You may be interested in the following advice:

• How to attract new customers
• Basics of business growth
• World class sales strategies for small business
• How to market your business for free on Facebook

Is your small business making a loss?

Okay, that is bad. But you can still turn a loss into a profit. The first step is to analyse why you are making a loss.

First of all, you need to find out where the loss is happening.

Is your small business seeing a loss at the gross profit level?

From last week, we know that if your gross profit is actually a loss, it means that your business is not making profits on what you are selling. This may be happening because:

• Your selling price is too low

This may be because you did not take into account all your direct expenses when you were calculating your price. If so, I recommend you adjust your price now that you know your expenses. Another reason may be that the Cost of Goods Sold (or the Cost of Services) has increased, but you did not increase the price for your customers. Maybe because you fear your customers will look for another supplier. If so, you are trying to compete on lowest price. Unless you have huge financial reserves, this is not sustainable for your small business. I recommend you find ways to compete on other things.

• The discounts you are giving are too high.

Discounts can be a good way to attract customers. However, you need to make sure that the discount you are offering is less than the profit you are making on that same product. This is why you should always know the true Cost of Goods Sold. Because if you forget to include some costs and expenses, you may think that you are doing well and still see your business continuously making a loss.

Is your small business seeing a loss at the net profit level?

This may be happening because:

• Your operating expenses are too high

If you followed the series, you will already have reviewed your costs and expenses to determine where to cut costs. Now that you see your business results, review them again. Try to cut costs as much as possible without reducing quality. Consider if there are ways to postpone expenses, for example, by spreading payment over a longer time. Or if you can rent certain things instead of buying them.

• You are taking too much money from the business

For most business owners, the business has to support themselves and their families. But is the business able to sustain the amount you are taking from it? Here too, see if it is possible to reduce expenses. Or maybe even if your family members can find ways to generate some additional income so that the expense will not fully be on your business.

• Your gross profits are too low

This is caused by your selling price being too low or your Cost of Goods Sold being too high. Look for ways to increase your selling price, either by adding products that have a higher price or by finding ways to increase your current prices. If increasing the price is not possible, try to see where you can reduce the Cost of Goods Sold, for example by buying in bulk or by using materials (or staff) that are cheaper.

FAQ’s

How often should I calculate my profit or loss?

You should try to do this at least 1x per month. Why? Because the profit and loss statement tells you how your business is doing. If your business is not doing well, taking action after 1 month will give you a better chance to improve your business instead of waiting 1 year (or longer).

I know my business is profitable, but at the end of the day, I still make a loss. How is this possible?

There are various reasons why this may be happening. One: there may be some costs or expenses that you are not including in your calculations. I recommend that you keep track of your expenses and costs for at least 1 month (1 year is best!) to find out if you have any hidden costs. Two: you may be taking too money from the business for personal or family use. The total amount you take from the business for personal use should always be less than your total net profit. If you are taking more money out than your net profit, your business cannot survive. If that is the case, find a way to reduce your personal or family expenses, or look for ways to increase your sales & profit. Three: somebody is stealing from you. The best way to check this is to keep good records, assign separate responsibilities  to staff, and carry out regular checks.

I already know how my business is doing. Why should I calculate my profit or loss?

Well, the profit and loss statement tells you how much money is actually leaving your business and how much is actually coming in. This means that it can show you where you need to take action to cut costs and increase profit. Instead of just relying on your feelings about the business, you will have business data to guide your decisions. This will help you run your business in a more professional way.