How much profit will you make this year?
If you are like many business owners, the answer is “We’ll see.” They consider profit to be the amount left over after all of the business expenses are paid. That’s an accounting definition, not a business definition. The accounting equation is R-E=P. While valid from an arithmetic perspective, that approach causes may businesses to look at profit as an incidental effect of cost control.
Intuitively, calculating profits as a remainder seems to make sense. It is how you approach your household budget. Your take-home income, less your living expenses, equals your savings. Household savings are available for unexpected expenses, lifestyle upgrades (a new car or home) and retirement.
Business profits are intended to be used. They aren’t a rainy day fund, nor are they a code word for owner distributions. Your distributions as an owner are part of your compensation. In the CPA licensed seminar “Making Your Business Really Fly” the Australian entrepreneur interviewee who is the subject of the video, Wally, says “If you are bearing the stress and pain of running a business, and all you are getting is a salary, then you don’t have a business, you have a job.”
From an accounting standpoint, profits fund owner distributions. That is a tax issue, not an operating methodology. Profits also allow the company to grow. They are spent to create more profits. They should be budgeted after appropriate distributions for ownership. Running your business with a philosophy that says “I pay the employees and other bills, and the rest is mine,” leads to two issues that hold back your company’s growth.
The first is starving the company of needed capital. Once you have done your tax calculations, it’s psychologically more difficult to let go of the money. I understand the tax advantages of reinvesting it as a loan to the business, but most of us don’t do that. We put it in our personal account, and withdrawing it from our “savings” to put it back into the company is painful. Most owners would rather cut expenses to the bone before reinvesting on a regular basis.
The second psychological issue revolves around the way in which many owners generate profits. They “squeeze” them out at the expense of good management practices. Employee performance reviews are delayed, because they are usually accompanied by raises. Technology upgrades are deferred or marketing is under funded. The resulting “savings” trickle down to the bottom line as “profits.”
Your budget should have two profit lines. The first is the planned distributions you deserve as an owner. That should be an amount that gives you a risk-adjusted return on your investment, an appropriate bonus above your executive salary for meeting management objectives, and a payment on the deferred compensation (or sweat equity) that most of us put in at the beginning. That can be considered your savings.
The second line is company profit. That is the money you need to invest in the business for growth, regardless of how you handle it for tax purposes.
Unless your business can fund both profit lines, you really just have a job.