An overall business plan should include a definite profit plan based on realistic numbers for revenue and expenses. Entrepreneurs generally are strong on vision but not as strong on numbers. In launching a new business venture, you should make sure your vision does not outrun your numbers. You shouldn’t shade your numbers to bolster an overly enthusiastic vision. On the contrary, you should temper your vision to fit the numbers. The driving force behind most business start-ups is a person with an impelling vision—a man or a woman who sees opportunities others do not and who is willing to take the risk of failure. But when the rubber meets the road, your profit numbers have to work. Every entrepreneur wants to build up sales as quickly as possible. But he or she shouldn’t simply assume that profit drags along behind sales, like a ball on a chain. It’s not as simple as this. Through this post, I would try to bring you to a closer look at a profit plan, and how it works. Enjoy!
The Profit Plan in Your Business Plan
When you start up a business, your profit plan should be specific and definite, as specific and definite as your marketing plan. Vague statements in your marketing plan about “moving a lot of product” or “taking advantage of competitor’s weaknesses” won’t cut the mustard. Product categories should be delineated, promotional strategies and pricing tactics should be spelled out, total market demand and the market shares of existing competitors should be quantified as best as possible, how you intend to position your products and your business name should be clearly explained, and the advertising media you intend to use should be identified. These are essential elements of a persuasive marketing plan for every start-up business, aint they?
Likewise, your profit plan needs a well-thought-out and convincing profit model: a blueprint that identifies the critical factors that drive profit. You’ve probably heard the business adage “Nothing happens until you sell it”. This is true enough, but once you sell your product: how much profit will you make? Answering this question is the purpose of the profit model. The profit model is the tool that transforms your sales number into a profit (or loss) number. A good profit model takes your sales number and predicts how much your profit or loss outcome will be.
Now, suppose that you have developed a rock-solid marketing plan for your new business venture. Suppose further that you have taken care of the many other things that have to be done to open the door and switch on the lights: hiring employees, leasing space, and so on. And suppose that you have enough money in the bank to get going and to stay going for awhile. You’re not certain what your sales will be for your first year of business. So you make forecasts for three sales scenarios: (1) pessimistic, (2) most likely, and (3) optimistic. Below table presents your sales revenue forecasts for each scenario:
You’re hoping for the best of, course, but only time will tell. In any case, you’re ready to take the plunge and move ahead. Just a minute here. Don’t you also need to forecast how much your profit or loss would be for each sales scenario? You’ve come up with numbers for the top line; you also need to forecast numbers for the bottom line: the profit or the loss from sales.
Two Opposite Cases [Variable and Fixed Expenses]
Between the top line and the bottom line are deductions for expenses, of course. The hard core of mapping a profit model is diagnosing how expenses behave. Some expenses are driven by and vary with the level of sales:
- When sales are higher, these variable expenses are higher; and when sales are lower, these costs are lower. The largest variable expense for businesses that sell products is their cost of products (goods) that are sold. Salespeople’s commissions that are based on sales revenue are another common type of variable expense. Packaging and delivery costs are variable expenses.
- In contrast, certain expenses of operating a business remain relatively fixed—they do not vary with the level of sales over the short run. Once commitments are made, a business cannot scale back fixed expenses—at least not in the short run. Examples of fixed expenses are rent paid under real estate leases, the fixed salaries of employees, property taxes, and insurance premiums.
To contrast the profit effects of each kind of expense, I’ll start by looking at two polar opposite scenarios for expenses: (1) the all-variable expenses case, and (2) the all-fixed expenses case. Almost all businesses have both types of expenses, which we will look closer at later.
. All-Variable Expenses Case
For the all-variable expenses case, suppose total expenses are 90% of sales revenue. Therefore, profit is 10% of sales revenue.
Below table shows your first-year profit for each forecast sales scenario:
. All-Fixed Expenses Case
In the all-fixed expenses case, suppose your total expenses for the year are $1,080,000. In other words, no matter what your actual sales turn out to be, your expenses are stuck at $1,080,000. Below table presents the profit or the loss result for each sales scenario:
What a difference compared with the all-variable expense case! Or, to be more precise, what a difference for the pessimistic and the optimistic sales scenarios.
The next table compares profit performances between the two extremes of the expense cases. In the optimistic sales scenario, the large profit is the result of spreading your fixed expenses over the maximum amount of sales. You squeeze every last ounce of sales out of your fixed expenses. In the pessimistic sales scenario, the large loss is the result of too few sales over which to spread too much fixed expenses.
Put another way, in the optimistic sales scenario, you get maximum leverage from your fixed expenses. The profit acceleration effect from fixed expenses as sales increase is called operating leverage. Operating leverage is a close cousin of financial leverage, which refers to using debt in addition to equity (ownership) capital. Interest on debt is a fixed expense for the period and, therefore, has the same effects on profit performance as other fixed expenses.
The all-variable expenses case is like investing in a savings account (or other fixed income investment). You make a steady 10 cents of profit from every dollar of sales. Profit moves in lock step with sales. The all-fixed expenses case is more like investing in stocks that can fluctuate wildly in value: It has a much higher payoff for the optimistic sales outcome, but it carries the risk of a large loss for the pessimistic sales outcome.
If you had your choice between the two expenses cases, which would you prefer?Most entrepreneurs would probably favor the all-fixed expenses case. Anyone willing to start up a new business venture is a risk taker and an optimist.
Basic Profit Model
Virtually all businesses have both variable and fixed expenses. So, our profit model should include both variable and fixed expenses. Notice that for the most likely sales scenario, profit is the same for both the all-variable expenses case and the all-fixed expenses case. In both cases, sales revenue is $1,200,000; total expenses are $1,080,000; and profit is $120,000. Suppose total variable expenses equal 60% of sales revenue, or $720,000. Therefore, total fixed expenses are $360,000: ($1,080,000 total expenses – $720,000 variable expenses = $360,000 fixed expenses). Fixed expenses, being fixed, would be the same for both the lower and the higher sales scenarios. In contrast, variable expenses, being variable, would be 60% of sales revenue for both the lower and the higher sales scenarios.
Please Note: I don’t mean to suggest that the breakdown between variable and fixed expenses for this example is typical across a broad range of businesses. In fact, the mix of variable and fixed expenses is quite different from industry to industry. The example’s 60% ratio of variable expenses to sales revenue is in the ballpark for many businesses, although I would quickly point out that this ratio is generally higher for companies that sell products. (The product costs of many high-turnover retailers, without considering their other variable expenses, are 70% or more of sales revenue).
The profit model for our business example is now a little more complex. Below table presents the profit model of the business based on its mix of variable and fixed expenses:
The operating leverage effect on profit performance is still rather pronounced, although it is dampened down quite a bit. Compare it with the third table above: Notice that profit in the optimistic sales scenario in below table is only $360,000, as compared with the $720,000 profit in the third table. The counterbalance is that the loss in the pessimistic sales scenario in below table is only $120,000, as compared with the $480,000 loss in the third table above.
Turning the Profit Model into the P&L Report
Shortly following the close of each period (month, quarter, year), business managers receive a profit-and-loss (P&L) report, which summarizes sales revenue and expenses for the period. As you probably know, a company’s accountant prepares these profit performance reports, which more formally are called income statements, earnings reports, or some other title (terminology is not uniform).
In my view, P&L reports to managers should be tailor-made for the decision-making and planning purposes of the managers. However, in most cases, accountants simply copy the format of the income statement that is presented in the external financial reports of the business and use this format for P&L reports to managers, even though the external income statement format is not entirely satisfactory for managers regarding how expenses are reported.
I don’t mean to sound critical here, but let’s face it: Accountants are not business managers. Accountants are financial scorekeepers, which is an essential function, to be sure. Accountants prepare the income tax returns and the external financial statements of the business. They, quite logically, look to the particular categories of expenses that are required in income tax returns and also consider how expenses are disclosed in external income statements. Expense accounts are set up with these two major demands for information in mind. For example, if the income tax return requires that repairs and maintenance expenses be reported (which it does), then an account for this particular expense is established. In short, expense accounts are established to be a good source of information for preparing income tax returns and external income statements.
Following the path of least resistance, accountants generally do not reclassify or regroup expenses for internal P&L reports to managers. In particular, variable expenses are not segregated from fixed expenses in P&L reports to managers. I should mention that much more detail is included in internal profit performance reports to managers. Managers may see more than a hundred separate expense accounts in their P&L reports, and some of these expense accounts are backed up with even more detailed data. But whether an expense varies with sales or is fixed for the period is not made clear in a typical P&L report. The manager may or may not know how a particular expense behaves relative to sales. The standard P&L report does not make this distinction clear, except for one particular variable expense.
For a business that sells products, its “cost of goods (products) sold” expense is reported on a separate line, both in its external income statements and in its internal P&L reports to managers.
Cost of goods sold is usually the largest variable expense of a business that sells products. There’s no argument about reporting cost of goods sold as a separate expense. It definitely should be the first expense deduction from sales revenue in both the external and the internal profit reports. Managers seem to understand that cost of goods sold is a variable expense. Most businesses have additional variable expenses that collectively are a significant percent of their sales revenue. These additional variable expenses should be reported in a pool separate from the fixed expenses of the business.
In this respect, the typical P&L report to managers falls short of what is needed for their decision-making analysis and for planning for changes in the future. Managers should not be in doubt regarding whether an expense is variable or fixed in nature. A manager should not have to interpret whether an expense is variable (driven by the level of sales) or fixed (not dependent on the level of sales for the period). As I’ve said before, expenses should be sorted between variable and fixed in internal P&L reports to managers.
I’ll keep the P&L report as short as possible at this point, to highlight its essential features. All variable expenses are collected into one pool, and all fixed expenses are assembled in a separate pool. (The variable expense pool includes the cost of goods sold expense, of course). Below table presents an abbreviated P&L report for our business example:
Essentially this P&L report is a vertical version of the company’s profit model. The P&L report shown in the above table introduces one very important line of information—margin.
Margin = Sales Revenue – All Variable Expenses
In our business example the margin ratio is 40% of sales revenue because variable expenses are 60% of sales revenue. I don’t include these percents in the brief P&L report, but it’s a good idea to include these ratios in P&L reports to managers. Margin ratios vary a great deal from industry to industry, as mentioned earlier. A margin ratio less than 20% of sales revenue is rather rare, except for businesses in desperate circumstances.
Margin ratios have to be adequate for a business to survive and to earn a sustainable profit. Whatever type of business you’re in—whether you’re a retailer, wholesaler, manufacturer, or service business—you have to maintain margins to make enough total margin on sales in order to overcome your fixed expenses and yield a profit. Therefore, the first focus of P&L reports to managers should be on margin—not that fixed expenses are unimportant, of course. Earning an adequate margin is the absolute, essential first step for making profit.
Deciding on the level of fixed expenses for your business, broadly speaking, is the essential second step toward making profit. Your total margin could be adequate. But your fixed expenses may be out of control. Ideally, fixed expenses should not be any higher than they need to be in order to support the level of sales for the period. It’s easy to lose sight of this key point.
Look at the fixed expenses line again. Notice that “fixed expenses” is the same total amount for all three sales scenarios. This means that the business took on fixed expenses high enough to support its optimistic sales forecast. Its fixed expenses are higher than would be needed for the most likely sales scenario and are much higher than would be needed for the pessimistic sales level.
A Closer Look at Fixed Expenses
Fixed expenses are a mixed bag of diverse costs, but they all share one key characteristic: Once you make the commitments to incur these operating costs, it is very difficult to ratchet down any of these expenses over the short run. Fixed expenses are like the old joke about hell: It’s easy to get into, but very hard to get out of. It takes a relatively long time to get out from under fixed-expense commitments; these expenses continue whether your actual sales level is good, average, or poor. In short, you’re stuck with fixed expenses over the short run. Once you’ve made these commitments, you can only hope that your actual sales will be high enough to justify your fixed-expense decisions.
Suppose you sign a one-year lease for warehouse space. Every month, you have to pay the rent whether you need all the space or not. Suppose you purchase an insurance policy; the insurance premium for the period is the same whether sales are high or low. Many employees are paid fixed salaries that don’t depend on the actual sales level. Depreciation expense is recorded each period to spread the cost of buildings, machines, tools, and equipment over their useful lives. You guessed it: Depreciation expense is a fixed amount per period, regardless of your actual sales level for the period. Real estate property taxes are another example of a fixed expense.
The total fixed expenses of a business for a period sometimes is called its nut. Once the managers of a business commit to a certain amount of fixed expenses for the coming period (hiring fixed-salary employees, renting warehouse space, and so on), the business has to make enough sales and earn enough total margin to cover its nut for the period and still have some residual margin left over for profit. In the “pessimistic” scenario (see the last table above), the business earns $240,000 margin, which is $120,000 less than its $360,000 fixed expenses. So, the business suffers a $120,000 loss. (By the way, this loss does not mean that the company’s cash balance decreased $120,000 during the
Now, let’s pose a key question here. For the sake of argument, suppose the pessimistic forecast turns out to be your actual sales for the first year, and assume your variable and fixed expenses are as shown in the last table for this sales level. So you suffer a $120,000 loss in your first year.
My question is: Why did you incur this loss?
We’d bet that you’d be quick to blame your poor sales for the year. Well, not so fast. I could lay the blame for the loss on your fixed expenses instead. You made decisions that committed the business to a $360,000 level of fixed expenses for the year. This amount of fixed expenses would have supported $1,800,000 sales, the maximum sales level forecast. But actual sales turned out to be at the minimum end of your sales forecast. In short, your loss is caused by excess fixed expenses.
A manager should translate the level of fixed expenses into a measure of how much sales capacity these costs provide for the year.
In our business example, the $360,000 fixed expenses provide support for a maximum $1,800,000 sales activity, which is three times actual sales for the first year (at the pessimistic level). If you had known for sure that your first year’s sales were going to be only $600,000, you would have committed to a much lower level of fixed expenses, although it’s difficult to say how much lower your fixed expenses could have been.
To illustrate this important point, suppose that you had played it safe and committed to only $240,000 fixed expenses for the start-up year (smaller warehouse space, fewer fixed-salary employees, and so on). This amount of fixed expenses would have been adequate to support your $600,000 sales for the year. Sales generated $240,000 total margin, which would exactly cover your fixed expenses for the year. Your profit/loss for the year would be exactly zero, which is called the breakeven point. Given the $360,000 fixed expenses, your sales had to be $900,000 just to break even. Your margin would have been $360,000 (40% margin ratio × $900,000 sales revenue), which would have equaled your fixed expenses for the year. In the most likely sales scenario, sales revenue is $1,200,000, which is above the breakeven point, and profit is $120,000 (see again the last table on the last section).
But bear in mind that the $120,000 profit figure would have been higher if your fixed expenses had been better matched with sales for the year. In other words, a level of fixed expenses somewhat lower than $360,000 would have been adequate to support $1,200,000 sales revenue. In our business example, fixed expenses could have supported an additional $600,000 of sales (over the $1,200,000 sales revenue for the most likely scenario). I could argue that you should have kept fixed expenses geared for the most likely level sales scenario instead of going all out and providing for the high end of your sales forecast.
Managers should be equally vigilant and just as hard-nosed about their fixed expenses as they are about their margins. Profit depends on both factors. Managers should take a hard look at their fixed expenses even when sales are good. All too often it takes a steep nosedive in sales to get managers to seriously consider scaling down or cutting back on their fixed expenses. Of course, these are tough decisions, usually involving laying off employees, selling off surplus assets, renting smaller quarters, and so on.
The relative neglect of fixed expenses, compared with the close attention to margins, is due in part to the fact that fixed expenses are not separated from variable expenses in P&L reports to managers. Compounding the problem is the fact that managers do not gauge the sales capacity provided by the level of their fixed expenses. To repeat the key points explained above: Fixed expenses should be clearly identified in P&L reports. And managers should quantify the sales capacity provided by their fixed expenses, which should be compared against actual sales for the period.
A business plan is no better than the quality of its profit plan. A profit plan depends on developing a profit model that quantifies how expenses behave relative to sales activity. Some expenses vary with sales activity, and other expenses remain virtually fixed and do not depend on the sales level over the short run. These two types of expenses should be clearly segregated in internal P&L reports to managers. Sales revenue minus variable expenses equals margin. Enough margin has to be earned to overcome fixed expenses for the period and yield a profit. Making sales and maintaining margins is essential. Equally important, fixed expenses have to be controlled and kept in line with the level of sales. Excess fixed expenses can put a dent in profit as big as that caused by weak sales or inadequate margins.