Category Archives for "Growing a Business"
Many people want to know how much money does a business owner make. Surprisingly, most business owners don’t know either. This is a byproduct of our accounting rules and tax laws. While accounting may be the language of business, it’s a foreign language to most business owners. Standard accounting statements and tax returns do not provide the answer. Accounting follows the money. Consequently, it doesn’t tell you how much money the business is making. At least, not without some digging around the numbers, asking the right questions, and making proper adjustments.
So, why is this important? If you don’t know the profit, you can’t know value.
1) Market value rests on the buyer’s estimate of future profits.
2) Estimated future profits rely on past profits (amount and trend).
3) Thus, past profits drive market value.
So, how can profitability be calculated?
While “profitability” can be defined in many ways, the most common measure of profitability is discretionary earnings. These are the earnings of the business available to one owner/operator before interest on debt, income taxes, non-cash expenses, owner compensation & benefits, and normalized for non-operating and non-recurring items.
The simplest way to calculate discretionary earnings is to start with pre-tax earnings (EBT). On the typical Quickbooks Profit & Loss statement, this is called “Net Ordinary Income” usually found just above the very bottom. Then, make the appropriate adjustments, as shown below:
Simplified Calculation of Discretionary Earnings
“Net Ordinary Income” (a.k.a. pre-tax earnings, earnings before tax, EBT)
+ Interest (on debt)
+ Owner Compensation & Benefits (for one full-time owner/operator)
= Discretionary Earnings
As this is a simplified example, not every potential adjustment is listed. For example, any non-operating or non-recurring revenue and/or expenses would require additional adjustments. Furthermore, multiple owners or a non-full-time single owner would also require additional adjustments.
By calculating discretionary earnings, the question of how much money does a business owner make can finally be answered.
When small business owners get busy, the default response is usually to add capacity. More employees, more equipment and/or more space. Yet, there is an alternative. Raise prices. It is a simple, yet often overlooked option. If you are a business owner, did you raise prices in the last 12 months?
In short, raising prices has become a forgotten choice. Trades, professions, and even entire industries can also be forgotten. Throughout the Iron Age and Middle Ages, blacksmithing was an important craft. Tools, weapons and other iron wares were produced…one by one…by the strong arm of the blacksmith.
Upon the advent of the Industrial Revolution, machines replaced strong arms. They could turn out the same item, but faster and more uniform. And most important…cheaper. In short order, the machinist replaced the blacksmith.
There are still a few blacksmiths around today. Instead of making weapons and tools, they make architectural and ornamental iron works. Gates. Railings. Hooks. Even decorative leaves. Some are for new construction. Some are replacement pieces. All are expensive. The custom work of a skilled craftsman comes at a price.
If you have been to a state fair or a historical re-enactment attraction, you have likely seen a blacksmith in action. Heating the iron. Hammering it. Bending it to his will.
At our state fair, we had the pleasure of meeting a blacksmith. He was demonstrating his craft to anyone who stopped by his stall. It’s hard not to stop. The hot coals. The rhythmic clang of the hammer. The orange glow of the searing hot iron. And the beauty of turning an ugly iron bar into a work of art. Not something you see every day.
With a few questions, we discovered some interesting things about this man. This was no weekend warrior or part-time blacksmith. He was (and is) a full-time commercial blacksmith. With employees and paying customers. In other words, a real business.
He explained in some detail how his business works. He classifies projects by the time they take to complete. There are only two types. Small jobs and big jobs. Small jobs take 3 weeks or less to complete. Big jobs take longer than 3 weeks.
At that point, he mentioned how he was looking for new apprentices on account of how busy he was. And how hard it was to get young people interested in such an old profession. Young folks are interested in new technology. And the technology of the blacksmith is about as old as it gets.
“Well how busy are you?”, we asked, expecting the usual answers that come from small business owners. I’m working 60 hours a week. I’m months behind schedule. Typical responses. But what he said truly shocked us.
He said, “On the small jobs, the waiting list is 8 to 12 months. On the big jobs, the waiting list is 9 years.” 9 years! Needless to say, we were blown away. Apparently, he and his employees are so good at what they do, customers are willing to wait that long. It reminded us of the restaurant in upstate New York where one has to book their table 5 years in advance.
To us, this is a clear example of a time to raise prices. Most owners default to increasing capacity. Hiring another employee. Buying equipment. Leasing more space. Of course, these “solutions” often add significant upfront costs. And, in the short term, it can actually decrease your capacity. New employees need to be trained. New equipment needs to be procured and installed. Adding space is always disruptive…especially if it involves moving…which it typically does.
The simplest (and usually best) solution is to raise prices. Yet few owners seem to consider this as a viable option. If the blacksmith raised his price enough to lower his waiting list to one or two years, he would still be just as busy. But he would be making a lot more money with no additional risk.
Don’t get me wrong. We are not saying that small business owners should never grow their customer base. Or add capacity. But understand this…when you add capacity, you add costs. Some you count on. Others you don’t see coming. These costs can outweigh the additional sales you add. When this happens, you can actually make less bottom line profit.
So the next time you think about “growing” the business, give equal consideration to raising prices. It just might be the better option.
photo credit: <a href=”https://www.flickr.com/photos/opedal/6038590979/”>Dag Endre Opedal</a> via <a href=”http://photopin.com”>photopin</a> <a href=”http://creativecommons.org/licenses/by-nc-nd/2.0/”>cc</a>