Welcome once again, and let’s consider the aspect of business profitability and loss making today. Often times we hear people talk about business profits and losses, and we assume that everybody understands this fully, yet in reality this is not always the case. As I mentioned in my recent blog, business profit arises where the expenses (note the word expense and not expenditure) are less than the revenues or income (note the word income and not inflows) for a given period of time. In practice many enterprises do their statutory financial reporting on a yearly basis, though obviously financial reports that indicate profitability and financial position can be done on a monthly basis. As an entrepreneur you can decide how often you would like to measure your profitability, whether monthly, quarterly, half yearly or yearly. It’s up to you, isn’t it? It’s important to note though that very short-term measurements tend to be less accurate than longer term measurement – but minimum is a year.
Just to clarify a bit regarding the above section, let me say this. Expenditure usually denotes all outflows of cash whether they are expenses chargeable or deductible in arriving at profit or loss for a given year, or not. Even disbursements of funds for fixed assets that generate revenue for an enterprise for many years to come, are called expenditures. So it implies that the word expense is more appropriate to use, as these can be easily measured and related to a specific accounting period, hence better for assessing profitability. Again revenues or income need to be identified separately from inflows of cash, as some inflows are not income. Inflows arising from loans or borrowed resources for example, is not income. Similarly, receipt of receivables – or amounts already earned and expected to be collected – can no longer be treated as income. Do you get what I mean here? I hope so.
Yes – these terms need to be properly explained. Don’t you think so? I know there can arise many questions from the above – and I’m ready to address any concerns that may arise. Again, when recognizing income and expenses for a given accounting or financial period, it’s advisable to use what is called the accrual principle. Now, we are entering a bit into some accounting terminology, but nothing to worry about as these are oftentimes easy to understand when put in a simply way. The accruals principle basically requires that you recognize or account for incomes earned in a period though not yet received, and expenses incurred in that same period, whether paid for or not. The incomes earned have to be matched with the expenses incurred. Back to the point; let me say the following regarding profitability, before I go very deep into definitions and clarifications.
- Revenue generation is one of the key determinants of profitable or loss making operations of an enterprise. Revenue is an aspect of volume or quantity and rate or price – for example, 10,000 units of an item sold at say 500 dollars each (whatever currency you would like to use – no offence intended), or say 350 contracts of services delivered at say 500,000 dollars each. I guess at this stage you can realise that the aspect of volume is critical, as the higher the volume the more the income, as price many times do not vary much over a reasonable time period. Moreover, you can’t be adjusting your price every other day, can you? You should know the answer. So, back to the equation we have – income (revenue) less expenses equals profits (if positive) or loss (if negative. The revenue part of this equation becomes vivid as quantity times prices gives you the income or revenue. I believe we are in the right direction.
- Expenses – variable and fixed (overheads). Variable costs are those costs that vary in direct proportion to changes in out-put levels, for example raw material consumption normally varies in direct proportion to output level. Even power consumption for production entities tends to follow this trend. Fixed costs sometimes referred to as overheads; however tend to remain constant despite changes in output levels in the short and medium term. In the long term they also change though they move in steps unlike variable costs. Costs such as rent of premise, salaries of permanent staffs, etc normally fall under overheads. Now, the way that you manage your costs as an entrepreneur, has a very important impact on your profitability. Do you get what I mean? Simply because income less expenses (costs) equals your profit or loss, it is very obvious that expenses are critical to control. Whatever approach you use to do this, is basically up to you and I’m not going to get into it.
- Level of business – breakeven point. Again, the level at which you operate as an enterprise determines your profitability. At the break-even point total revenue equals total costs hence neither a profit nor loss situation. This means that your enterprise must operate above the break-even point to generate profit. By the way, I assume that you have heard about or used in practice this principle. If not, simply go ahead and read more about this principle because it could determine the future of your business. I hope you agree with me.
- Management of the inter-relationship of the above factors. The management of the interrelationship between the above determines your profitability. They all have to be looked at together. Poor pricing could give you low margin which will be fully absorbed by overheads hence no profits. Low revenue generation with huge fixed costs means losses.
I candidly think we have had a very long one this time. We will catch up another time.
The Wise Entrepreneur