BARRIERS TO BUSINESS GROWTH 3 – The Wrong Objectives

The essential guide to Starting Up & Growing your Business

Barrier 3 – The Wrong Objectives

When you’re reviewing your business figures at the end of each month, do you focus on how much turnover you’ve generated, or are you more interested in the profit margin you’ve achieved?  What is your key focus?  Not all business owners have clear objectives, and those that do often focus on the wrong ones.  Invariably, turnover, or sales, is the only number that interests the entrepreneur, with no regard for other more critical objectives such as gross margin, net profit and cash generation.  Growing turnover is often at the expense of profitability but hopefully, for most of us, greater profit, less work and fewer problems should be preferable to rapid sales growth at low margins.

During my consultations I’ve occasionally (not often thankfully) been asked what is the difference between operating margin, gross profit, net profit etc.  You also, may have squirmed in embarrassment during the Dragon’s Den whilst some poor entrepreneur is chewed up and spat out by Peter Jones and Duncan Bannatyne because they can’t explain how they calculated their forecast profit margins.  It is, however, extremely concerning that people are running a business without understanding what their financial situation is, or how to monitor their viability and success.

If you don’t know whether your business is making a profit or not, you stand little chance of wisely investing cash back into the business.  Last weeks’ blog highlighted how important planning is in any business – especially start-ups.  Your business plans must focus on profit margin expectations otherwise you’ll be stumbling around in the proverbial dark.  Having the wrong objectives is a major barrier to business growth.

Here’s a brief and simplified explanation to help you focus on the key points, but remember to consult with your expert and qualified Accountant to apply the specifics to your own business.

Turnover (Sales)

is the income into the business, through the sum of money your clients pay you for the goods or services you’ve provided to them.  There are other forms of income such as interest on the business current or savings account, but let’s keep it basic.

If you charge VAT, then account for that separately.  It’s not part of your turnover, and you shouldn’t rely on it for your cash flow either.  Easier said than done when cash is tight, but keep on the right side of HMRC with your VAT returns.

Direct Costs (sometimes referred to as Cost of Sales)

are expenses you can easily connect to the specific item you’re producing, like the raw materials you buy in, packaging, direct (hands on) labour directly associated with making the product.  Think of it like this – if you didn’t produce ANY product, or provide ANY service whatsoever, which costs would you not be generating.  You would lay off your work force, not buy any stocks or raw materials, and wouldn’t need any packaging.

Gross Profit

is your turnover minus directs costs.  So if you’re selling 100 mugs for £10 each, and your direct cost is £4 on each mug, then

Turnover (Sales)       100 mugs @ £10 each        = £1,000

Direct costs               100 mugs x £4 each            =    £400

Gross Profit               100 mugs x £6 (£10 – £4)    =    £600 or 60% of sales

Looking good isn’t it!  Except …………

Indirect costs or Overheads

You’re also paying for rent on your small workshop, or premises, telephone, internet, heating and lighting, marketing, your admin staff’s and your own salary, employer NI and the other expenses, defined as the indirect costs or overheads.  These are the expenses you have to continue paying even if you don’t sell or produce anything.  Lets assume over a year these add up to £200 (simple I know)

Operating Profit

is the gross profit less the indirect costs or overhead.  So in our example, £600 gross profit less our £200 overhead = £400.  This brings our operating profit to 40% of our original £1000 turnover.

Net Profit (before Tax)

can add back into the operating profit any other income streams not directly related to sales, such as the interest on our business bank accounts, or deducting costs of eg. interest paid out on business loans.  We’re going to assume our mug business doesn’t have any other income of this type.

Net Profit (after  Coporation Tax)

Remember HMRC will have to be paid Corporation Tax (I’ll use 20% to keep the numbers simple) from your Net Profit.  So from our £400 operating profit, 20% or £80 is payable in corporation tax, leaving you with £320 (or 32% of your sales turnover) in real cash terms.

Retained Profit or Dividends

You can then choose whether to re-invest your £320 net profits back into the business, known as Retained Profit, or pay it out as Dividends to the shareholders or business owners.  Remember, if you decide to pay yourself and other shareholders or Directors, profit share in dividends that money counts towards your own personal income and you will be taxed on it accordingly.  Tax payable on dividends varies, but there is normally a tax free dividend allowance.  Check the latest HMRC tax on dividends.

In summary, from the original figure of £1000 in sales turnover, that some business owner/managers would get excited about; after deducting all costs, expenses and taxation we’re left with £320.  You can now appreciate why profit, rather than your turnover, should influence how you manage your business growth.

And remember last week’s blog extolling the virtues of good planning – now you can see the difference it will make in how you run your business and take decisions.  Ideally for micro and small businesses, a simple spreadsheet showing these calculations at least monthly, together with monitoring your bank account closely, will keep your finger on the pulse of your business status.  In essence Turnover is Vanity, Profit is Sanity, and Cash is Reality!!

Special thanks to Martin G. Pullen of MMP2018 Accountants, for his specialist knowledge and input provided in this blog. Martin can be contacted on 01233 633336 or MGP@mmp2018.co.uk.

Next Week

Barrier 4 – Muddled Marketing  – are you confusing your prospective clients and potentially losing business through mixed messages to your target audience?