The Important Difference between Profits and Profitability
Every business owner wants to increase profits. And no matter what type of business you’re in, there are only two ways to do that. You can either a) generate more revenue through sales, or b) reduce expenses. Ideally, you want to implement strategies that will accomplish both goals. But far too often, companies focus on increasing revenue but don’t put the same emphasis on reducing expenses. That may result in more profits, but not necessarily increased profitability.
As Certified Public Accountants, we wanted to explain the difference between profits and profitability, and how to get a true picture of the health for your business.
Profits Are Just One Part of the Picture
Calculating profits is simple. You subtract total revenue from total expenses, and whatever is left is your profit. But relying solely on profits as an indicator of the health of your business is a mistake. Let’s look at an example.
Assume that Alpha Company has spent $900,000 to generate $1 million in sales. Meanwhile, Beta Company has spent $400,000, to generate $500,000 in sales. Both companies have made $100,000 in profits, but are they equally profitable?
The short answer is no, and here’s why. Companies who spend more money to generate profits are more vulnerable to minor shifts in costs or expenses. So let’s say Alpha Company spends $200,000 in shipping costs and those costs increase by 10%, or $20,000. Alpha Company’s profits have just been reduced to $80,000. Beta Company, on the other hand, spends $100,000 in shipping costs. That same 10% increase will only reduce their profits by $10,000.
The bottom line? Alpha Company has made $80,000 in profits and Beta Company has made $90,000 in profits. In this example, Beta Company is clearly the more profitable business.
Profit Margins Provide a More Nuanced Perspective
Another number to consider is your profit margin, which is expressed as a percentage of the ratio between profit and total sales.
Let’s go back to Alpha Company. We can determine their profit margin by dividing $100,000 (profits) by $1,000,000 (sales) to get 10%. We get Company Beta’s profit margin by dividing $100,000 (profits) by $500,000 (sales) to get 20%. While the two companies have made the same profit, Beta Company is twice as profitable as Alpha Company. So how can Alpha Company increase their profit margin?
Cutting Costs to Increase Profit Margins
There are two ways Alpha Company can increase their profit margin. First, they can increase the price of their products and services, but that carries the risk of driving customers away and hurting sales. The other option is to reduce expenses, which is the route most companies take.
Not only does cutting costs carry less risk of hurting sales, but it’s been shown that even a minor decrease in expenses will improve your profit margin more than a comparable increase in sales.
We’ve already determined that Alpha Company has a 10% profit margin. If they increase their sales by $50,000, but don’t decrease costs, then their profits increase to $150,000. In turn, their profit margin also increases to $150,000 divided by $950,000, or 15.8%.
However, if Company Alpha keeps sales constant, but reduces costs by $50,000, then profits will once again be $150,000 but the profit margin now increases to $150,000 divided by $900,000, or 16.7%. In this example, cutting costs is the clear path to increased profitability.
In the real world, the most successful companies track profitability closely and use a combination of cost-cutting and pricing strategies to reach their goals.
If you need help determining your company’s profits and profitability, contact the tax experts at Tobin & Collins. We provide financial and tax reporting services, and go a step further than most other firms to provide strategies and recommendations for improving business operations.
For over 50 years, Tobin & Collins has provided accounting, tax, and business support services to clients in the New Jersey and New York metropolitan area. Our exceptional team of professionals provides personal service to ensure we resolve each client’s financial challenges and provide sound financial strategies that puts clients on the path to future success. Contact Tobin & Collins today.