“The way to get started is to quit talking & begin doing”  Walt Disney

Profit, all you ever wanted to know – part 1

Written by Doug

Part 1: Profit and Time

In the post “Business or Hobby” I set out my stall for my articles on those administrative tasks essential to ensuring the health of your business.

I put forward the argument that at the heart of any serious business is the absolute goal of generating a profit.

Profit is the excess of sales over costs (and loss is when costs exceed sales). But there’s more to it than that!

For the next 2 instalments, let’s take a closer look at this thing called “profit”.

In this instalment we will consider the relationship between profit and time.

A profit always goes hand-in-hand with a specific period of time. There’s no set rule – the period could be a day, week, month or year. Or indeed, a number of years.

The time period you choose in order to measure your profit will depend on your needs. If you’re trading huge sums of money on volatile stocks or commodities you might even need to monitor profit in seconds or minutes!

Most businesses work in larger periods – most commonly in months. If time is not too critical, the yearly profit might be the most suitable. If you want to provide investors with a business plan, then 3 or 5 years is quite normal.

So, the time period is fundamental to understanding the context of profit. If someone at a dinner party told you that their guesthouse had made a profit of R100,000 you might be impressed. If they told you they did this in one month you would be super impressed – if it was in fact over 5 years you might be less in awe!

In this example let’s keep using our previous business as a guest house. As you know these types of businesses are subject to seasonality. You know all too well that some months of the year are great for business and others are pretty dire. If you select just one part of the year in isolation to measure the profit of the business (and therefore its health) you could get entirely the wrong impression, whereas measuring your profit over a 12 month period would take both the good and bad times into account. This is possibly why an annual profit is so popular and useful.

There is a second aspect in which time influences profit. In this sense, the individual sales and costs that go together to make up the profit number each have a moment or period of time attached to them.

One of the fundamental rules that accountants follow is to always make sure that the time elements of sales and costs are matched.

This is critical because to ignore this rule could result in a greatly distorted profit calculation. This in turn could give the wrong impression of the health of the business, which could lead to bad decision-making.

The smaller the time period for profit measurement, the more critical the need to ensure exact matching. Monthly profits need more matching than annual.

To illustrate this point, say you pay your annual municipal rates in one lump sum. Without time matching, the profit for the month of payment would appear much lower than it really is (equally, the profit for the following 11 months would appear higher than they should be). To avoid this problem, the cost of the rates is spread across each month.

Other areas where the need to time-match commonly arises are advertising subscriptions, customers billed in advance, standard tour operator rates charged ahead or after the date of stay – indeed any item where the timing/period is out of synch with the date of the (related sales) transaction.

This concept is very important because the profitability (or lack of) of your business should be a major factor in how decisions are made in order to run the business. If your measure of profit is not accurate, how accurate are your decisions?

In part 2 I will continue the “What is Profit” theme and look at how different types of profit can be measured and how these can give insight into your business.

See you in Part 2.

Doug

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