If you want to be a successful small business owner, be an important part of someone else’s business or just want to run a tighter ship at home, it’s critical that you understand the difference between profit and revenue. Many people, even sophisticated entrepreneurs, forget the distinction and as a result end up bankrupt. If you want to be in business for yourself and stay that way, this topic is something you simply can’t ignore.
What is profit?
Profit is simply what your business has left over after all expenses. Or if you are looking at your household as the “business entity” profit would be what you have left over after you pay all your bills.
As fundamental as this sounds, many people fail to grasp the real meaning of this. They get tripped up because they don’t consider “all” their expenses but rather only a few.
There are actually 3 kinds of expenses that businesses and households incur:
1. Recurring Expenses
These are the expenses that come up every month. Examples are rent, utilities, employees, supplies and inventory. Since we have to pay these bills every month, people generally don’t overlook these expenses. The problem is that people often stop there. They think that as long as they have funds left over after they pay their recurring expenses, they have a profit. As you’ll see, this is extremely short-sighted and dangerous.
2. Non-recurring Expenses.
These are bills that don’t come every month. Examples are taxes, insurance, legal fees etc. The smart thing to do with these bills is to:
- Be aware of them,anticipate them and budget for them.
- Spread out the cost over the course of the year. This is known as amortization. For example, if you have a $1200 insurance bill that comes up twice a year, the smart thing to do is amortize the cost over 12 months – or $200 a month. By doing so you get a better picture of your real monthly profit. This is super important – especially if you have a seasonal business.
3. Invisible Expenses.
These are expenses you incur but don’t see like depreciation. For example, if you are a homeowner, the wear and tear on your roof is a real expense – but you don’t notice it until the day when you have to replace the entire roof. In reality, the wear and tear was something you incurred every single month – not just the month in which you had to replace the roof.
If your business has equipment, sooner or later you’re going to have to replace that equipment. This is also called depreciation and it’s much more than simply a tax term. By setting aside money for “invisible expenses” every month, you’ll have the cash to replace your roof or equipment when reckoning day arrives.
You should deal with “invisible expenses” just like you do with non-recurring expenses by amortizing them over the life of the asset in question. This gives you an honest look at how profitable your business is. You can’t neglect this step if you want to make your business more successful.
By being aware and tracking all 3 kinds of expenses you will have a more reliable monthly profit and loss picture. You’ll know where you are making money and where you aren’t. This will also put your statement of cash flows into perspective. It will simply help you make smarter business decisions. And to be completely frank, without doing this, you really can’t make good decisions about your business or household.
What is revenue?
Revenue is a much simpler number. It’s just your gross receipts or income. If you sell a Bentley in January for $200,000 your revenue is $200,000 for the month. Very simple. But as you can see, that $200,000 isn’t your profit.
Which is more important?
If you want a successful small business you need both revenue and profit but you have to understand the distinction between the two. Having said that, profit is clearly the more important between the two. Without profit you’ll have no business. If you sell lots of Bentleys at $200,000 you might have a ton of revenue. But if you pay $250,000 for each one, you’re losing money on every sale and it won’t be long before you’ll be working at the car wash.
That’s why it is most important to understand how profitable your business is on a monthly basis – after all 3 types of expenses are concerned. The best way to get that understanding is to use a software package that tracks your budgets and you’re spending. A very popular business application is QuickBooks. I’ve been using it for years for my business and I love it. But if you have a very small business and/or you want something for home use, I recommend YNAB (You Need A Budget) hands down. It is much better in helping set up budgets and comparing your actual figures to your budgeted numbers.
How does revenue impact profit?
Normally, your profits increase as your revenue goes up. But you can’t assume that’s the case. Here is a great approach if you want to maximize both profit and revenue:
1. Get clear on how profitable your business really is. (In the example above, more Bentley sales equal lower profits. In that case, simply increasing sales would be the worst thing to do. First find out what is really going on in your business. Understand which activities are profitable and which are not.
2. Do all you can to slash your operating costs. Once you understand how you are really making your profits, do all you can to enhance the most profitable activities. If there is a part of your business that is simply eating up resources, time and energy, shut it down and focus on the profitable elements of your business instead.
3. Increase sales. Once you’ve done the previous two steps, focus on increasing sales and revenue.
As you can see, it’s important to understand the difference and importance of revenue and profits. Most business people have knee-jerk reaction and think that greater revenue is always better. You can see that revenue should not be your focus. Understanding should be your focus. Once you are clear on what is really happening in your business or household, it makes sense to focus on increasing revenue. And even though it’s the first thing many business people focus on, it actually should be one of the last items on your “to do” list.
Have you always been clear on the distinction between profit and revenue? If not, how do you learn this lesson?