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Profit Focused Basic Business Model

Profit Savvy is designed for business planning novices.  Its Profit Focused Business Model will show you how just 7 numbers will let you be fairly confident of achieving the Profit and personal Salary you desire.  In turn, this will help to reduce one of the major causes of stress in smaller businesses - “will I make a Profit and will I be able to pay my bills”?

Why a Business Model

You can spend a lot of time building a Business Plan.  We do encourage this for businesses that are looking for a longer-term growth path.  We suggest that you start with a Profit or growth goal in mind for several years into the future (your destination) and then build a Business Plan under that destination to show you what will be necessary to get there (see our Business Plan article).

However, your Business Plan is only what you hoped will work and a bit of a road map on how you are going to get to your destination.  It is not of any real use in making sure that your business operates in a financially sound way on a day to day basis.

People will argue that you can use a Budget for this purpose but a conventional Budget is also a fundamentally flawed document.

It predicts where you want to go but suffers from 2 often fatal flaws:

  1. You can pretty much bet that people will always spend what they have budgeted to spend.  This is often well before they can see that the necessary Income is flowing in, you can’t be sure how you are progressing with your target profitability.
  2. A Budget is another historical document that has the same problem as your annual Tax accounts from your Accountant as we discussed in Profit Autopilot - Introduction.

We argue that it is much better to build a “Model” of your business so that you can immediately see the impact of changing any of the Income and Expense data “variables” that drive your business.

It is called a “Business Model” because it is a replica of your business; just like a model plane is a replica of a real aircraft.

You can build a complete Business Model for your business with just 7 numbers.  This will show what Salary and Profit you want – in advance.  And show you what changes to your business are required for your business to live within its means.

The spreadsheet and PDF file are available at Profit Savvy Knowledgebase.

The spreadsheet has 2 tabs - one showing an example of the Model and the other tab for you to enter your data.

Let’s walk through the various components of the Profit Autopilot Business Model.

 

 NOTE:

We also have a program of written and video courses on Profit Autopilot that you can use for deeper study.  Visit:

https://www.profitsavvy.org/manager-training/my-courses/guruPrograms/8-profit-acceleration-courses/11-profit-autopilot-18

or you can watch the two videos before reading the balance of this written article.  See:

Video 1 - 8 mins

Video 2 - 15 mins

 Historical Data

We are going to begin this Business Model on an annual basis.  Later, we will do this on a quarterly basis so that you can keep track, very conveniently, of how the money is flowing through your Business Model.

Any of the spreadsheet ‘cells’ coloured tan in the document you downloaded are figures you can change.  Uncoloured cells contain formulas that will automatically change as you enter fresh data. Follow our examples which will show placement.

Column 1: “Historical” - contains the most recent information you have on Income, Profit, Salary, Tax, Cost of Goods Sold (COGS) and Operating Expenses.  Your accountant or bookkeeper will have this information.  Take a full year of data so that you capture ‘once a year’ financial events, for example, annual insurance payments.

Historical Data Web 660x320

We are using our Income - Profit - Salary = Expenses approach.

We can see that, historically, we had:

  • A pretty low salary, $25,000: surely you are worth more than that on the employment market.
  • A profit of about 5% of income: also lower than desirable.

Desired Financial Outcome

Column 2: "Desired" - create that “Desired” or "Ideal" world to see what the implications are. 

Income

Estimate your "Desired" annual Income and place it in cell C4.

Desired Income Web 660x130


Your estimate may come from last year’s actual Income if that was a "normal" year.  If you have already undertaken changes in your business operation that will have a consequent change on your income put your best guess.

At this stage DO NOT put in speculative Income that might come about from any growth that you wish to happen.  We only want to put in the actual Income that you can confidently expect during the year.

By taking a full year, you average out any seasonal impacts on your Income (for example weather, holiday times, less demand for your service).

Choosing a Profit Target

Because we are determined to make a Profit we need to decide what that level of Profit will be at the start of the financial year.  Initially, that is going to be determined largely by making changes to your Business Model so that the Residual Amount is zero or slightly positive.

We want to set ourselves a "guaranteed" Profit that we want to make during the year.  We may or may not make this Profit we are aiming for because we may make an informed decision to trade Profit for growth.  However, if we do not plan to make a Profit it is likely we will not make a Profit.  It is important that we estimate what Profit we want.

We are going to aim for a "Desired" Profit of 15% of Income, in this example it is in cell C19.  When 15% is entered, the formula calculates the Profit automatically based on your Income. In this example, the "Desired" Profit is $75,000 in cell C5.

Desired Profit Web 660x160

We will discuss the reason behind the 15% Profit later.

Salary

Working in your own business does not mean that you should forego the sort of Salary you might have received working for someone else.

In an ideal world, you should receive a real-world Salary, because that is what your time is worth, PLUS get a Profit for all the extra work and risk you take running your business.

You probably have a reasonably good idea of what Salary you would need to pay someone to do your job.  Keep in mind that you would be paying this person a Salary for doing the job - say Web Design - and a loading on top of that to compensate for the extra hours and risk that would be expected of a CEO (Chief Executive Officer).

We have assumed here that you would need to pay an outside person $50,000 to do your technical and CEO role, cell C6.

Desired Salary Web 660x200

Already, you will see, that our Profit and Salary in the “Desired” column are considerably higher than last year’s “Historical” figures.  We are already planning on a big improvement to these two numbers.

Cost of Goods Sold (COGS)

Whatever you sell will have various costs that are incurred for you to make your sales.

In a retail environment, you buy in tins of food and then sell it at a mark-up.  The purchase of the tins of food from the wholesaler is part of your COGS and your Income is the mark-up multiplied by COGS.

These are also known as "Variable Costs" because they vary directly with the amount of product that you sell.  The more you sell, the more your COGS move in the same proportion (being simple for the moment).

You can test whether something is a Variable Cost by asking yourself - "if I didn't sell a product would I still incur this cost"?  If the cost is not dependent on the product then it is an Operating Expense.

We can estimate your COGS% (cell B23) by dividing the Historical COGS by the Historical Income. In this case, it is $100,000/$500,000 = 20%

Desired COGS Web 560x240

As this ratio will remain the same (we are not worrying about quantity discount changes at this time, for example) we can see that the COGS in the “Desired” column has been automatically calculated in cell C8.  The figure, $100,000, remains the same due to the Income being the same.

Operating Expenses

Under this entry in the model we put all your other Expenses not already covered.  Typically, these will include:

  • Rent.
  • Staff wages (not yours).
  • Travel.
  • Advertising.
  • I.T.
  • and any other Expenses that your business incurs.

You can work these out by looking at previous year’s Accountant’s reports and bookkeeping files.

In this example, we have allowed the same amount of $332,500 for Operating Expenses as we do not expect any “Desired” changes, cell C9.

Desired Expenses Web 600x260

Sales and Income Taxes

In most Western countries, there are taxes relating to sales.  These might be referred to as sales tax, VAT (Value Added Tax in the UK), GST (Goods and Services Tax in Australia and NZ) for example.

This is money that you need to pay to the Tax Office - whether you make a Profit or not.  It is usually a percentage of your Income from Sales.

Sometimes you just pay this as a Tax on Sales.  Other times, you can claim back the same percentage on your Expenses.

In this case, we are assuming you pay 10% GST on sales and claim back 10% of expenses.

Tax is also paid on your Profit.  As we know the Profit we "Desire" is $75,000 we can estimate the Tax.  In this example, the Income Tax rate is 30%.

Desired Tax Web 600x260

The total Tax is worked out with a formula in cell C7, this is how it works:

  • 10% of sales = $50,000.
  • Less 10% of total Expenses (Cost of Goods Sold + Operating Expenses) = $43,250.
  • Plus 30% of Profit = $22,500.
  • Equals Tax payable of $29,250.

We know that we will have to pay this Tax no matter how well the business is going and how much cash you have on hand when it falls due. 

Profit Autopilot is designed to make sure that you always have sufficient money to pay this figure.

Reality Check

Automatically, your Business Model has calculated a Residual Amount and displayed it, cell C10.

Desired Residual Web 600x280

In our example, it is a negative amount of -$86,750.

What the model is telling us is that with the Profit and Salary that we "Desire" and the realities of our present Income, Tax, COGS and Operating Expenses we would have lost $86,750 this year.

That means our business is not sustainable in its present format.

We now come to the interesting part.  How do we play around with our model to get the Residual Amount to at least zero and preferably a positive number?

Until you can get it to zero or positive, you do not have a viable business

that will automatically pay you both a Salary and Profit.

Your Profit Autopilot is not yet engaged because it cannot automatically ensure your business remains viable.

Decided Financial Outcome

Column 3 “Decided”: contains numbers modified from those in the “Desired” column so that we get to a positive Residual Amount – we can then engage the Profit Autopilot.

Getting a Positive Residual Amount

In our example we have -$86,750 as the Residual Amount, we know that we must make changes to our Business Model to get that to zero or positive.

At this early stage, we do not want to reduce the Profit or the Salary because that is the money we take home.  If we cannot get reasonable figures for Salary and Profit in our model, we have to ask ourselves if it is really worth running the business?

We cannot reduce the Tax - that is a direct result of the Income and Tax rates - out of our control.

The Cost of Goods Sold is also closely related to Income and is not easily changed although you may pick up some tips from our Reducing Variable Costs article.

That leaves the Operating Expenses as the main line for us to work with.  Fortunately, there is usually a fair bit of fat in Operating Expenses, unless you have recently done our Double Your Profit in 100 Days (DP100) Profit SavvyProject.

Let's work on our Operating Expenses.

Find a listing of your Operating Expenses in your Profit & Loss Statement over the last 12 months.  We described what Operating Expenses are above now go looking for them.  At worst, this will be in your accountant’s reports but usually not in much detail.  It is better if you have it in an accounting program where you manage your own books.  Print out the expenses that fall within the Operating Expense categoryAs a note to yourself, you could change your bookkeeping system so that these expenses are grouped together under the one sub-heading as Operating Expenses in your P&L Statement for future convenience.  In later periods, this will make it easier for you to see the trends with your Operating Expenses and print them.

Now either use multi coloured highlighters or simply make a note next to each of your major expenses grouping them into 3 categories:

  • (N) Necessary - these are expenses that you absolutely must pay.  There will probably be surprising few of these.  As you will see below, it does not include things like Labour, Rent and Vehicles.
  • (R) Reducible - these are expenses that you may be able to reduce without adversely affecting your Profit.  Typically, this might include such things as renting cheaper premises, down-sizing to a cheaper vehicle, using less out-sourced accountant’s labour.
  • (U) Unnecessary - these are expenses that you could definitely do without.

Removing Unnecessary Expenses 

The Unnecessary Expenses are simply expenses that you do not need to incur.

Sometimes these will be your personal and domestic expenses that have crept into your business.  You might find yourself paying your Netflix subscription, gym subscription and "entertainment expenses" for the beer that you buy on the way home on Friday evening.  Many of these are not even legitimate expenses so you leave yourself open to trouble with the Tax Office if you get audited.  Certainly, many of them should be in the personal expenses paid from the Salary that you are now planning to pay yourself.

By and large, you should aim to remove all Unnecessary Expenses because (surprise) they are unnecessary.

Reducible Expenses

Reducible Expenses are ones where, over time, you perhaps indulged yourself more than you needed to.

Reducible Expenses will be dependent on you and your business but they typically include such things as:

  • Rent for a premises that is better, larger and generally more expensive than you really need.  Perhaps at some time you planned to "grow" and you obtained premises that enabled that.
  • Cars - you may have purchased a vehicle that is more expensive than you need to get the job done.  Perhaps you can down-size that vehicle to something cheaper.
  • Travel - if you do not need to travel for work then this is an Unnecessary Expense.  If you do need to travel for work you may be able to stay in cheaper locations or travel on a cheaper grade of flight.
  • Subscriptions of various types - you may be subscribing to magazines, business organisations, various types of subscription software and other similar membership type expenses.  Some of these may be necessary to conduct your business but you could either go to cheaper versions of them or remove the ones that you do not really need.

You may find it depressing working on your Reducible Expenses because it seems to be taking all the joy out of your business and perhaps your life style. However, this really is a short-term issue.  The price you are paying for having reducible costs that are higher than you can afford is continuous angst as to whether you will be able to pay your Tax bills, Salaries/Wages and other expenses on time.  By reducing these costs, you buy yourself peace of mind and some breathing space in preparation for your growth under more controlled circumstances.

A handy tip on getting this done as fast as possible is to always focus on your biggest expenses first.  A 10% reduction in a $100,000 expense will have a far bigger impact than a 10% reduction in a $1,000 expense.  Read more about this in our The Amazing 80/20 Rule Tool article.

Getting a Positive Residual

Our goal is to get the Residual Amount to either zero or a positive number.

This will mean that, after calculating and allowing for a Profit and realistic Salary, you can be reasonably sure you will achieve that target Profit and Salary.

As long as the residual remains negative, you can be sure you will not achieve this desired Profit and Salary combo.

What do we do in that situation?

In our example Business Model, you will see that after removing the Unnecessary Expenses and reducing the Reducible Expenses, the Operating Expenses have reduced by $82,500 to now be $250,000 (cell D9 - Decided Column).  Prior to any other changes the negative Residual Amount will have fallen to -$12,500.

Decided residual web 660x320

We are still $12,500 short on getting our Residual Amount to zero or positive.

There are only 2 places that we can further cut and they are either Profit or Salary in the Model.

We do not want to fool around with Salary to start with. Salary is a figure that you are worth in the marketplace.  To reduce that means that you are working for less than you could get working somewhere else.  This really is not a good idea.  Until your Salary is a decent amount, you are condemning yourself to substandard wages.  Something you would never do to your staff so why do it to yourself?  Especially when you are not making much Profit.

The number that we want to work on to get the Residual Amount down to zero is a reduction in Profit.  This is only a short-term reduction until the Income increases leading to more available Profit, providing the Operating Expenses do not start creeping up again.

In the example, we have reduced the Profit from $75,000 to $64,000 (cell D5). The Residual Amount is now +$1,800 (cell D10).

Decided Residual Pos Web 600x280

We now know what Salary and what Profit we expect to make this year.  We have achieved this largely by reducing costs rather than sacrificing Salary and Profit.

We have added another calculation in the Model which is the “Decided Profit %” (cell C13).  This shows us what percentage of the Income will be Profit.  In this example, it is 13% which is a little down on our target of 15%.

Importantly, we are now planning to make this money in advance and providing we monitor the figures in our Model monthly or quarterly, we are going to get to the end of the year having made that Profit and Salary.

Quarterly Updates to Model

Without doubt your Income and Expenses will vary from month to month.

As these variations start to get some sort of trend - hopefully up but possibly down - we need to tune the Business Model accordingly.

You could do this each month but experience shows that there is too much variation monthly to be of very much guidance in the direction the business has taken.

For example, one substantial Income payment that comes in at the end of the previous month or the start of the next month can dramatically impact a month’s Profit.

Sometimes there will be an extra pay day in a month and then one less in the following month.

Collect the information on a monthly basis but consider the results to be indicative only.  If each of the 3 months in the quarter worsens, you almost certainly have a problem.  If results are up and down, you may only be seeing the normal variation in short term results, for example, months with more or less pay days in the month.

As you receive your accounting results each quarter, which ideally should be very soon after the end of the quarter, put them into the relevant quarter column in the Business Model

Column F - Quarter 1 - the Model automatically takes its values from your "Decided" figures (Column D).  The following quarters are set to equal the preceding quarter.  Initially, the "Annual" column (Column J) will be equal to the "Decided" column.

Decided Annual Web 600x210

As you enter real data to overwrite the calculated data in the "Quarters" columns, you will see how your trend for the year is progressing.

The "Annual" column will change and you can compare it with the "Decided" column to see whether things are improving as you would wish.

If things are improving, and if you had reduced your "Desired" Profit and/or Salary to get your Residual Amount positive in the "Decided" column do the following:

  • The first changes you should do, before increasing your Expenses to fund growth, is to gradually increase:
    1. The Salary and then
    2. The Profit figures in your "Decided" column (Column D).

As you move these up slowly, the remaining "Quarters" and the "Annual" amount will automatically change.

You can afford to increase them until the "Residual Amount” turns negative. Adjust these figures until the Residual Amount returns to zero or positive.

Once the Profit and Salary figures are at your "Desired" values, you will then find that any money that accumulates in the "Residual Amount” is available to you for funding your growth.

Providing the money you use to fund your growth never grows to a figure that causes the Residual Amount to turn negative, you know you are able to:

  • Grow the business.
  • Maintain your "Desired" Profit and Salary.
  • Remain in positive Financial Operating territory.

When you are in the fortunate position of being able to increase your Profit or Salary levels, do not do this in one very large jump or there is a risk that your following Quarter will not be as successful and you will go back into negative Residual territory again.

One simple rule of thumb to apply is to take half of the Residual Amount in the Quarter and allocate that to either Salary or Profit.  Start with Salary until it is where you want it.  This will mean that your Residual Amount should remain safely in positive territory.  Even if there is a down-turn in your business Income, you have your Profit Buffer available to you to take up some of that slack and to give you several weeks of protection, in even the worst instance of zero Income.

You should also consider the increases in Profit or Salary to be "a one-way street".

If you find yourself having to reduce your Salary or Profit then your Business Model is not stable.  Our goal is to get you onto a sustainable business trajectory where you can be confident of banking your Salary and Profit. 

Being forced to reduce them after an increase means that your Business Model is still not stable.

Profit Insurance Policy

When an emergency patient is admitted to hospital, they are first stabilised (in medical terms this is called Triage) so that their health can be worked on and restored.  While they are in an emergency condition, the only sensible thing to do is to stabilise them, not to start to improve their health and well-being.

However, once the patient is stable, and in the case of our Profit Savvy Business Model - as soon as your Residual Amount gets to zero - we can begin to think about how to improve the Business Model and our Profit.

Earlier, we suggested to set your Desired Profit to be 15% of your Income.  Now we come back to that with a little science to explain how we arrive at the calculation.

One of the reasons that it is very important to have a reasonable Profit margin set up in your Business Model is that Income is very likely to be unpredictable

At best, if we use average Income as we are doing here, we can be sure that the actual monthly Income will be either greater or less than the average and very unlikely to be the actual average figure.

If your business experiences a fair degree of seasonality (summer holidays are better than winter for example), it can mean considerably more or considerably less Income in the period.  Many of your fixed expenses like Rent, Interest and Wages will continue to demand payment even while Income slows down.

It is entirely possible that you may go through a soft patch of Income for some reason; such as you lose a major client.

For this reason, we need a "Buffer" that tides us over while we find replacement Income

Specialists suggest that you can tie the number of weeks in your Income Protection Buffer to a percentage Profit.

Depending on your expectations of how long you might suffer an "Income Drought" you can use one of the following rules of thumb offered by experts:

  • 5% Profit allocation = 3 weeks of Income Insurance before you run low on money.
  • 12% Profit allocation = 8 weeks of Income Insurance.
  • 24% Profit allocation = 5 months of Income Insurance.

These numbers may seem a bit odd, but remember, if you are not earning an Income, you are not paying Expenses like Tax and Profit distribution to Owners.

Also remember these numbers are guesses.  The real period you can exist with much lower Income will depend on your particular circumstances at the time.

Presumably, you will also be taking action to reduce the impact of an Income Drought.  Your Residual Amount will likely have turned negative again and we know that is a sign to reduce expenses so that you once again start to live within your financial means.

Experts suggest that aiming for 15% Profit gives a comfortable Buffer against the almost inevitable variations in Income you should expect.

The fluctuations in your Income will also be influenced by the industry you are in.  If the industry has a history of large swings, go for more Profit Insurance by setting a higher rate. 

Managing Growth

Now that we have agreed on the target Profit figure range, we can decide when to start to grow the business and how quickly.

Let’s say our minimum Profit target is 10%.

Over time, we improve our management and the Profit margin creeps up to 17%.  At this point we have 7% x $500,000 = $35,000 (7% x Income).

$35,000 ‘Buffer’ above the minimum 10% Profit we want to exceed.

We can spend this $35,000 on something that will improve Income.  Maybe a new staff member (Sales Person, not an Accountant) or a piece of machinery.  Then we repeat the process.  If we do not spend on productive assets, the Profit will not go up; our growth is stalled.

In this simple way, we should not grow faster than a rate that permits us to continue making our target Profit.  If Profit drops due to tough circumstances, we automatically stop growing until we recover.

Reflection

A lot of ground has been covered in this article.

We have shown how turning conventional accounting on its head, by building a “Model” that puts Profit and Salary before Expenses, quickly shows you how much you have to reduce Expenses to get your desired Salary and Profit outcomes.

Decided Profit Salary Web 600x280

Once on that path, you can update the calculation each quarter to be sure you are improving.

When you hit an inevitable downturn in your Income, your Profit acts as a “Buffer” to help you ride out the downturn in Income.

What Next

This has been Part Two of the Four Part Profit Autopilot series.

The four parts are:

  1. We begin with an introduction to Profit Autopilot.
  2. Then we look at building a Profit Focused Business Model designed to give you confidence that you will earn enough to pay you a Profit and a Salary (this article).
  3. From there, we discuss how to set up a system of “Piggy Banks” to be confident of having cash for expenses when you need them.
  4. Finally, we review what you have covered and introduce the next Profit Savvy projects which continue you on the path of building your profit.

Move forward if you are confident that you have grasped the story to date or go back over the same ground until you are.

NOTE: We also have a written and video course on Profit Autopilot that you can use for deeper study.  Visit;

https://www.profitsavvy.org/manager-training/my-courses/guruPrograms/8-profit-acceleration-courses/11-profit-autopilot-18

A Disclaimer

We do not know your business and its environment so we can only offer general advice on what might assist you to grow the Profit for the business you presently have. You should always seek professional advice on specific matters only discussed in general terms here.

As discussed above, we cannot guarantee results in any particular period of time or amounts, we do not know your particular circumstances.

 

 

 

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