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The Magic Formula of Business


The Magic Formula
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Business has a magic formula. It is crucial to understand it for almost any business. Understanding this little formula will make a profound difference to the way you understand how your business makes money, and could well make a profound difference to your future success. I am not exaggerating one little bit.

 

It's a very simple formula that can be understood by anyone but it has some subtle and powerful implications which you will benefit from understanding.

 

So what is this Formula? Well first let me state the obvious about business - money comes in and money goes out, and you hope that what comes in is just a little more than what goes out, and that's called net profit. So far so good - pretty straightforward.

 

Looking a little closer, we see that the money that goes out can actually be classified into two buckets. The first is the money that goes out buying the things you need to fulfil a sale you've made. So if you sell stock, then it's the cost of that stock. If you hire subcontractors for a specific job, then it's that cost. If you use fuel or consumables in serving the customer, then it's those costs. Obviously what I'm talking about is what the accountants call "cost of sales". COS for short, or cost of goods sold, COGS for short.

 

The second bucket is the money that goes out every month whether or not you sell a single thing. It would include your lease, wages and a myriad of other expenses just to keep the doors open. These are typically in the "Expenses" section of the profit and loss statement, and are also known as "overheads".

 

So the cost of sales costs are per sale, and the expenses are per month. For the vast majority of small to medium enterprises, I recommend that the costs and expenses be split this way. Sometimes I find wages in the cost of sales section however these wages need to be paid whether or not you sell something, at least in the medium term, so I think it appropriate that in small to medium businesses, wages are in the expense section of the profit and loss.

 

Now we come to the magic formula which is: income minus cost of sales equals gross profit gross profit minus expenses equals net profit. I will put a link in the show notes to my website with a PDF to download containing this magic formula writ large.

 

So why is this formula so magic? It's because it makes it abundantly clear that you need to make more gross profit then you have expenses in order to make net profit. More importantly it makes it abundantly clear how much gross profit you need to make per month (or week, or day).

 

It's not enough to have lots of sales, or low cost of sales, or large margins, if your gross profit per month is not greater than your expenses.

 

So how can you use this to better run your business? Well your expenses, your overheads, are largely predictable if you've been in business for a little while, just take a typical 12 months and that should tell you what it costs to keep your doors open for a year. Let's supposing that number is $300,000. Add on your desired profit. Let's make that $200,000 making a total of $500,000. Now you know exactly how much gross profit you need to make to leave you with the desired net profit. You can make more sales, could charge higher prices, could sell your materials for more and your services for less, or your services for more in your materials for less: but whatever you do, just make sure that you make $500,000 in gross profit each month and you will make your desired $200,000 net profit by end of the year.

 

Now here I am talking about a per month target, you could come up with a daily target. Most businesses are open for about 250 days per year. So you could take the annual target, the expenses plus desired profit, and divide by 250. That will give you a daily gross profit target. It will help you set your prices, schedule work so that you make enough gross profit per day, and then check back every week to make sure that you are averaging that required daily gross profit.

 

I have introduced this idea to a number of my clients and they have found it very useful. For one in particular it has been transformative and they have never made so much profit.

 

So there you have it, the P&L, the profit and loss, done properly and understood properly in terms of per sale, and per time, costs and expenses, you will have a firm grip on how your business makes money and how to make even more.

 

 

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