Entrepid

During a conversation with a business owner recently we were looking for ways to identify profit improvement opportunities.  That got me thinking about an old standby - the break-even formula.

The traditional formula is: Revenue * Gross Margin = Overhead.

It’s a simple concept, but in the daily bustle of running a business it can be easy to lose sight of its informative power.

Since this particular business, like a lot of businesses these days, sells services and not products, the idea of gross margin can be a little confusing.  Sure, a service business has a cost-of-goods-sold in the form of salaries and benefits for the employees providing services, but most smaller businesses don’t classify them as such on the P&L.  In that case, a variation on the break-even formula is more useful.

Revenue - Variable Costs = Fixed Costs…or

Revenue - Variable Costs - Fixed Costs = Net Profit or Loss

For most service businesses fixed costs are going to be relatively large and variable costs relatively minor.  The result is that within some range (unique to each business) revenue increases and decreases will have a dramatic impact on the bottom line.

Through the magic of algebra we can re-work the formula so that it can predict the impact to the bottom line of changes in revenue.  If we make Variable Costs a percentage of revenue we get and do a little reworking of the formula we get:

Revenue * (1 - Variable Cost %) - Fixed Costs = Profit

Now with numbers (in thousands or millions - whichever you like better):

$1,000 * (1.0 -.05) - $800 = $150

If we increase revenue by 5% we see a $47.5, or 31.67%, increase in net income.

$1,050 * (1.0 -.05) - $800 = $197.5

We would need to cut fixed costs by $47.5, or almost 6%, to get the same bottom line impact.  This isn’t a huge difference, but keep in mind that revenue growth compounds and cost cutting does not.

This is just one hypothetical example.  Your business will have different Variable Costs and Fixed Costs.  Plug in your numbers and see where the opportunities are to improve profits.  Perhaps it’s revenue.  Maybe it’s cost-of-goods-sold, or overhead - or a combination of the three.

As the owner and manager of your business you earn income from two sources: the salary you make as an employee of your business and the profit you make as the owner.  Conflating the two leads to inaccurate conclusions about the success of your business.

Payroll Is Not Reality

The smart business owner manipulates his or her salary to minimize taxes.  One of the most common methods is to keep salary low and profit high(er) and thereby lower FICA taxes.  A common opposite strategy is to keep salary high, thereby lowering the “real” profit, in order to maximize 401(k) contributions.

There is no absolute right or wrong approach to setting your salary.  Every situation is unique, with lots of moving parts, and you should work with you advisors to craft a strategy that works for you.  The mistake that occurs is assuming the salary you pay yourself accurately reflects the true value of your contribution as an employee.

Neither Is Your P&L Reality

If your salary is over or under the true value of your work, then your net income is overstated or understated by the same amount in the opposite direction.

If you want to know the real profit of your business you can do this simple calculation:  Actual Salary + Actual Net Income - True Salary = True Profit.  Where True Salary is the amount you would have to pay in the open market for someone else to do the job you do.

The True Profit is the number you use to evaluate the success of your business as if you were an outside investor.

An Example

John has owned and managed his distribution business for 10 years.  In the last year, the business had $3 million in revenue, a net income before taxes of $300,000, and John paid himself a salary of $75,000 for being the CEO of the company.

A net income before taxes of 10% for a company of this size, age, and industry is OK, but not stellar, and John is relatively pleased with how things are going.

However, John determines that the market value for a CEO of a company in his industry and of his size is $150,000 a year - $75,000 more than he pays himself.  His company’s True Profit is: $75,000 + $300,000 - $150,000 = $225,000.  Or 7.5% of revenue before taxes.  Not so great and John has some work to do.

What Does It Mean?

You can only evaluate the success of your business if you use accurate information.  The first step is to stop thinking of your salary and your profit as one pot of money.

Edit for clarification - By default, an LLC is treated for tax purposes as either a Sole Proprietorship (single owner LLC) or a Partnership (multiple owner LLC.)  You can, however, elect to be treated as a corporation and then elect that corporate status to be S Corp.  These are two separate elections and the IRS must approve your elections before they become effective.  There are rules and deadlines to satisfy, so consult your tax professional.

The vast majority of LLC’s I see have not done the elections for S Corp status, and are therefore paying more in payroll taxes than necessary.  Hence, the following article.

If your business is organized as an LLC, you have a choice of being taxed as a Corporation or as a Partnership.  Most LLC’s choose the latter through inaction.

If this is you, you’re wasting money on FICA taxes.  All of the Guaranteed Member Payments and the net income for those actively engaged in managing the business are subject to FICA (Social Security and Medicare taxes.)

The profits of an S Corporation are NOT subject to FICA.  Here’s how the two compare:

For simplicity, let’s assume you are the sole owner of your LLC and you actively manage the business.  The income to you (Guaranteed Payments and/or net income in any ratio) is $80,000.  The entire $80,000 will be subject to the FICA self employment tax of 15.3% for a total of $12,240.  Half of this will be deductible from your income tax - worth approximately $1,836 in the 30% tax bracket, for a net cost of $10,404.

An S Corp is Treated Differently

Salaries paid to an owner of an S Corporation are subject to FICA - the company pays half and the employee (owner) pays half.  The total is still 15.3%.

Here’s where it gets interesting.  The profits of the S Corp are NOT subject to FICA.  Let’s see how our example changes.

Let’s assume the same $80,000 in income, but this time half ($40,000) is paid as salary and half is allowed to flow through to the owner as profit.  Both halves of the FICA total $6,120 - half of the total for the LLC.  The half paid by the corporation ends up being a tax deductible expense, so at the same 30% income tax bracket, this is worth $918.  The resulting total is $5,202 - a savings of over $5,000.

Don’t Get Greedy

You are probably thinking that if splitting your income 50/50 between salary and profits is good, splitting 80/20 or 90/10 must be even better.

All things being equal that would be the case, but the IRS knows this too.  There are rules in place that require your salary to be "reasonable."  What’s reasonable is subject to interpretation, so you should consult your tax advisor.

You May Still Want an LLC

There could be some other reasons why you want an LLC, even though it costs extra FICA taxes.  You should consult your attorney or CPA.  However, for most business owners I believe an S Corporation is the way to go.

The folks over at FreelanceSwitch have a slick Freelance Hourly Rate Calculator. I say slick, because it’s a nice piece of software, but I think it gets the order of things backwards.

It’s actually pretty common for small businesses (and consultants and freelancers) to attempt a cost-plus approach to setting prices. It’s easy to add up all your costs, put in a profit percentage, and voila!, you have the price you want to charge. Unfortunately, the real world doesn’t always co-operate.

The price you can charge your customers is limited on the upside by “value” and competition.

Value is a slippery concept, but even if your customer doesn’t have a firm number in mind, they do have some notion of what your product, service or time is worth. Whether or not this is enough to cover your costs is of no concern to them.

Think of it this way: if a prospective client approached me to do several months’ worth of backlogged bank reconciliations and I quoted them a rate of $175 an hour, I doubt very much they’d engage me. Bank reconciliations don’t have a “value” of $175 an hour.

Which brings up the second price limitation: competition. The prospective client could certainly find someone else to do bank reconciliations at a much lower hourly rate – maybe $20 or $25 an hour. Even if they’re not as efficient at bank recs as I am, their total cost will still be much lower.

So, your price is limited by both the value of the product or service AND by your competition – you get the lower of the two.

But, maybe your value is very high and you either don’t have much competition or they charge high prices. Why would you want to limit your income to some cost + profit level when you could possibly charge more?

I can see two bad results from using the cost-plus approach. Either you price yourself out of the market and don’t get enough business, or you underprice yourself and leave money on the table. Neither one is a good result.

That doesn’t mean I think the calculator is a bad thing. It’s a useful tool to see if the prices you plan on charging are enough to cover your expenses. If not, you need to rethink your business.

Hat Tip: Lifehack.org

Lagging Indicators are those pieces of data that tell us what happened. They’re history.

The most common collection of lagging indicators that business owners are familiar with are the financial statements – Balance Sheet, Income Statement and Cash Flow Statement – along with the other management and financial reports pouring forth from the accounting department.

If you’re like a lot of companies I come across that are transitioning from small business to small enterprise, you get your financial statements for the previous year in April July. So not only are your indicators history, they’re ancient history. That’s a tough way to manage a business. Read the rest of this entry »