Are you making the profit you think you are?
In this post I’ll show you a common mistake that many business owners and managers make when applying profit to the cost of their products and services.
I’ll also show how, if you’re making this mistake, you could be losing thousands of pounds a year.
If you calculate your price based on making a specific profit percentage (profit margin) over your costs, then please read this post and make sure you are getting this right.
I have had many conversations with business owners about this over the years and recall one in particular a couple of years ago. It was the look on his face – the initial shock followed by drop of his features as it dawned on him how much money he would have lost because he had been getting this wrong for the last 20-odd years.
When I asked these business owners how they calculated their prices based on making a specific profit margin, they said they worked out their costs and added that percentage. Do this and then you’re actually charging less than you should be.
What you’ve done here is calculated a percentage add-on based on the cost. But profit and profit margin, is based on the sell price.
Profit is the actual amount your business earns after expenses are taken from your revenue. Profit margin is the equivalent in terms of a percentage. For clarity, your gross profit is what you make minus the cost of the product or service. Your net profit is what you’re left with after all your business’ expenses and tax have been taken off.
When I spoke to these business owners, they stated they took their costs and added 30%. In this case they would take their £70 cost and add 30%. But £70+30% = £91 not £100. They had calculated 30% of the cost £70, which is £21.
This is not 30% of the sale price and hence 30% profit margin. They actually only made a profit of 23%. 70/91 = 0.77. Take that number from 1 and you have 0.23 or 23%. 23% of £91 is £21)
Profit is based on the sell price so you can’t take your cost and simply add a percentage profit margin.
So, how do you calculate that 30% profit margin for your, as yet unknown, sell price but instead from your costs?
Let’s pick another simple example. Say you want to make 30% profit margin and your costs are £100. Many people will simply take 30% of 100 and add that to give them a sell price of £130.
30% of £130 is £39, which means for a sell price of £130 and a 30% profit margin, your cost would actually need to be £91. The profit margin you actually made was 23%.
30% profit on £100 cost is actually £142.85. (30% of £142.85 equals £42.85. Take that off £142.85 and you have £100.)
To calculate the sell price from your costs, divide your cost figure by 1 minus the decimal equivalent of the percentage. The decimal equivalent of 30% is 0.3 (30/100). So, in this case divide 100 by (1-0.3) = 100/0.7 = 142.85.
This is really important because over a year this common miscalculation can make a huge difference in potential lost profit.
If your overall cost of care, your breakeven point, comes to say £600 and you wanted to make 30% profit, then calculating it the wrong way would give you a fee of £780. The correct way would give you a fee of £857.14, a difference of £77.14 a week. This equates to £4,011.28 a year.
Get this wrong for 30 clients on the same package of care you’re looking at a loss of profit of £120,338 a year. Not a trivial amount.
You can easily double-check this: £857.14x30% is £257.14. Take that from £857.14 and you have of course, £600.
If you want to make 35% profit margin on top of your costs, then divide by 0.65 (1-0.35). If you want to make a profit of:
- 40% then divide by 0.6;
- 50% then divide by 0.5;
- 60% then divide by 0.4 and so on.
Your business needs to make at least 30% gross profit if it is to be financially healthy so please make sure that if you calculate your sale price from your costs that you’re not inadvertently reducing your profit and weakening the financial strength of your care home.