Most people think businesses make enormous profits; some surveys show that the average person believes between 25-50% of business revenues go into the owners’ pockets. That is wildly exaggerated. Very few businesses are that profitable.
Net profit margins vary from industry to industry, but most people would be stunned to learn that most businesses work hard to scratch out a bottom line measuring 10% or even 5%. Those that reach double-digit profit levels usually are in capital-intensive businesses that require a constant infusion of investment funds. Within our plumbing company, for instance, much of our profits go to the purchase of new vehicles and upkeep on those still in use. Our service vehicles consume a lot of mileage on Southern California roadways and need to be replaced every few years. Similarly, the tools and equipment of our trade do not come cheap. To support it all we need to make a profit, which is probably more modest than you think.
One reason so many people think business profits are enormous is that most non-business people fail to distinguish between gross and net profit, or they equate markup with profit. Markup is the difference in what a business pays for a service or merchandise versus what it sells it for. For instance, if a widget is $75 and sells for $100, it has been marked up by $25, or 33% more than it was bought for. The gross profit on that sale would be $100 minus $75 = $25, or 25% of the selling price.
However, gross profit is not the same as net profit. Net profit is the amount left over after all overhead expenses are covered. Overhead varies greatly among businesses. Some can get by with relatively little overhead by operating out of a home basement or garage, for instance. A one-person shop can do that, but most businesses, including our company, would find that impossible. Anyone who has seen our facilities knows we don’t operate out of the Taj Mahal, but we do require space for our trucks, tools, equipment, offices, and inventory. Operating such a facility does not come cheap.
Here are some of the components of overhead for the typical plumbing company and many other small businesses:
- Salaries and wages for owner(s), supervisors/managers, office staff, & field workers
- Payroll taxes for all of the above
- Retirement fund/401k for all employees
- Natural gas or propane for heating
- Vehicle & equipment leases/payments
- Maintenance/repair — vehicles & equipment
- Gas/oil for vehicles
- Maintenance/repair — office equipment
- Interest expense
- Property tax
- Federal, state, & local taxes
- Insurance — liability
- Insurance — vehicles & other mechanical equipment
- Insurance — umbrella
- Insurance — medical/dental
- Insurance — life
- Bad debts/collections expense
- Credit reports
- Legal expense
- Accounting expense
- Consultant expense
- Small tools
- Consumables (nails, screws, oil, grease, etc.)
- Business travel
- Office supplies
- Printing & copying
- Depreciation — building
- Depreciation — vehicles
- Depreciation — equipment
- Depreciation —tools
- Depreciation — office equipment
- Bank charges
- Returned checks
- Credit card fees
- Dues & subscriptions
- Charitable donations
- Coffee/soft drinks/snacks for employees
- Discounted sales
- Customer gifts
Some of these expenses amount to a lot of money, some very little, but you can see that the list of expenses to cover is quite long before reaching net profit, also known as the bottom line. Net profit is used to pay for a business expansion, with some perhaps paid out in employee bonuses in a good year.
Running a business is not essentially different than managing your household budget. Family members bring in income (revenues) and from that, you must cover various expenses that could be detailed along the lines of…
- Home maintenance/repairs
What you have left after paying for everything is your net profit, which goes into savings, to pay down debt, or perhaps as a bonus to splurge on a dream vacation or whatever else your heart desires. If you have negative net profit, i.e., you spend more money than you make, you have to cover it out of savings or borrow money to pay bills.
Whether you are running a household, a business, or a government, one rule stands out above all. While borrowing can cover short-term deficits, you cannot forever run a negative net profit by continuously spending more than your income. At some point, debt becomes unsustainable.
That’s why profit is essential to running a business, just as it is to your household.