What Companies Should Do for Profits and Valuation
Joe J. Wallace, Managing Partner, Hadannah Business Solutions

Preamble: Profitability is what is called the amount of money that a business has remaining after the expenses incurred to produce, sell, market, secure the future, and operate the office functions, and depreciate long life items.

Alert: There is a difference between working in a business and working on a business. Working in a business is when the owner/manager spends time on tasks that could be and often should be done by someone else. Working on a business is that time that an owner/manager spends on strategic thinking and implementing plans that have the sole purpose of increasing the value of the business. Owner/managers of small to medium sized business often are caught up in the day to day tasks and neglect to work on their business. This is a fatal mistake.

Key Metrics:

Revenue: Revenue is simply how much money has been brought into a business from carrying out the efforts that the business is doing. This is most often known as the TOP LINE.

Direct Costs: The amount of money that it costs to directly produce the product or service being sold. Raw materials, purchased subassemblies, direct labor, and the overhead associated with direct labor such as workers compensation and FICA taxes typically make up these costs.

Gross Profit: Revenue minus Direct Costs equals gross profit. A good general metric for targeting gross profit is that it should be equal to or greater than 50% for a growing and thriving business.

Operating Costs: Operating costs are the costs of operating a business that are not classified as direct costs. These costs include, facilities, maintenance, marketing, sales, product development, warranty costs, interest, insurance, general administration, insurance, licensing, permits, training, and utilities are items that most companies incur in day to day operation. The total for operating costs should not exceed 30% unless direct costs are below 50%.

Profit Before Taxes: Gross profit minus operating costs equals profit before taxes. Companies should be priced and sized so that this metric is at least 20%.

Net Profit: The amount of profits earned by a business after all costs including local, state, and federal income taxes. This number depending on the business location should be in the 12% – 15% range.

EBITDA: Earnings before interest, taxes, depreciation, and amortization. This is a term that is the basis of valuation for a non-public company. A healthy small or medium business should have an EBITDA that is at least 20% of revenue.

Some Tips for Profitability:

1. Always assure that the gross profit is adequate and above 50%. If it is below that there are only three things to do to correct it. First is to increase the top line without hiring more people. That can be done by raising your price or by selling more products or services. Second one can renegotiate the prices paid for the raw materials purchased. Third, if the first two actions do not work, you to reduce the cost of labor. That means either pay cuts or layoffs. Caution: In most companies when the gross profit is too low it is either a pricing problem or a cost of labor problem. This is an opportunity to innovate for the business owner. Innovation can find ways to ad value to justify a price increase or to increase the efficiency of the labor force.

2. Match the size of the overhead (operational costs) to the size of the company. A minimum number of functions just have to happen. The number of employees can be minimized by cross training. Some functions such as payroll and janitorial services are much less expensive when an outside service firm is hired to do the work. Health insurance is an important benefit in attracting good people to a business. It is also one of the most expensive line items in a company’s budget. By cost comparison, promoting and rewarding healthy lifestyles, doing background checks, drugs screens, and hiring people who have a healthy lifestyle this cost while still high can be minimized. Make sure that your marketing is well invested and portrays your business in the more favorable terms possible.

3. Awareness of the industry trends is of the highest importance for an owner/manager. Knowing where pricing is on a global basis and adjusting as appropriate is paramount to having a good business model. Make the effort to know everything that your competitors are doing like hiring, firing, pricing, changing locations, and adjusting benefit plans. Never stop learning what your competitors are doing and always have a way to differentiate your business from the pack.

4. Have a compensation policy that puts your business at the absolute top of your industry. Pay professional talent at least 20% above the averages and enjoy the premium output that those employees will generate. Never ever hire less than excellent people to save money. If you pay critical thinkers average or below average salaries you will eventually have a mediocre business.

5. Take advantage of upgrades and accessories. Selling ad-on items or services is nearly always the highest profit margin enhancers that a business can use to grow earnings. As an example if a business has $1M per year in revenue and a net profit of 10% ($100,000), and grows its revenue by 10% with accessories that have a net margin of 50%, the newly sized company will be a $1.1M business with 15% profits. By growing 10% in the right way the company’s profits can increase by 50%.

6. Concentrate on valuation. An additional dollar of profit increases the value of a business by up to $10. Remember that when making spending decisions.