What are the different kinds of profit?

How much profit do your staff think you are making? This is a question put to staff when I’m teaching financial control skills, and the answers I get are often quite bizarre. The majority of staff default to assuming that the owner of their business is making fifty cents in the dollar. The attitude, ‘I’m working for an uncaring capitalist bastard who’s exploiting the working masses’ is disturbingly prevalent. They are often quite shocked when I explain the reality of the situation — most of the business owners I deal with would be better off financially and personally if they sold up and put their money in blue chip shares on the stock exchange.

Busy does not mean profitable

Busy does not mean profitable

I was taught many years ago, when times were much better, that the target for profitability of a low volume hospitality business (i.e. 90% of the industry) is 25% per year. That means, for every four dollars you have invested in time and money in your business, you should get one dollar return each year. In a high volume business, like a large fast food operation, I would expect a lower profit, typically between 15-20%. Unfortunately, very few hospitality businesses are now meeting these obsolete targets. A depressingly large proportion of the industry is struggling along, just making ends meet.

Operating profit

The financial return I’m talking about is what we call ‘operating profit’ — the gain we make on the turnover of money through our businesses. It’s a result of doing two things simultaneously: maximising income and minimising expenses. Interestingly, it has little to do with customer numbers — I see plenty of restaurants that are doing good trade but are not profitable.

Economic circumstance can change very fast. I find that businesses that do not keep tight financial control and establish their profit or loss on at least a monthly basis seldom make much money. The best businesses do the full bit — accurate sales forecasts, costed staff rosters, weekly beverage stocktakes, monthly food stocktakes, full stock reconciliation, etc. Typically, we can add 6 – 10% to the profitability of a business by installing these controls and teaching the staff to use them.

Don’t be paranoid about sharing financial information

They perform much better when they understand where the money goes

They perform much better when they understand where the money goes

If you want to realise these potential gains you have to be prepared to alter your business philosophy and adopt a policy of ‘open books’. This means you have to share your financial information with your staff. The reasoning behind this is simple — your profit is the end result of a large number of individual actions by both you and your staff. The majority of the activity that yields profits comes from the bottom layer of your staff — the cooks, kitchen hands and waiters.

If they are not trained to appreciate the reality of your financial performance, they will default to the mistaken belief that you are making a fortune, and will not look after the cents.

I’ve come to this conclusion after structuring and working with many businesses. Some of my biggest arguments with business owners involve this very issue. Sometimes their secretive nature fuels their reluctance to divulge financial information, and sometimes their ‘black money’ shenanigans render it difficult or impossible. One way or another they are dipping out on 10% extra profit, which will devalue their business when they come to sell it.

It could be worth a lot, or a little -- depending on how it was run.

It could be worth a lot, or a little — depending on how it was run.

Capital gain

Operating profit is not the only kind of profit, I also have to consider what we call ‘capital gain’ in the financial equation when I look at the success of a business. This is a longer term form of profit. It is the difference between what a business has cost to buy or set-up and develop, and what we would get for it if we sold it. To understand this properly, you have to understand what makes a business valuable.

Three things contribute to the value of a business: operating profit, manageability and potential. I have already discussed the first, so I will concentrate on the others. The manageability of a business is a direct result of its structure and how it is run. If it has no supervisory or management structure and it is run as a dictatorship, we have to find another dictator with similar skills to sell it to. Hypothetically, there may only be a couple of hundred dictators in the market for a business at any one time. The laws of supply and demand dictate a very low value for this business.

What is the ‘holy grail’ of management?

If the business is properly structured and can run itself without the owner having to be there (the holy grail of management), it can be sold to any investor with a pocket full of money and all they have to do is maintain the management structure (or not, if they want to go broke quickly). At any one time there may be tens of thousands of these potential purchasers, and the business becomes much more valuable due to increased demand. A properly structured business can be worth up to four times the value of an unstructured one.

Does it have the potential to grow further, or has it passed it's use-by date?

Does it have the potential to grow further, or has it passed it’s use-by date?

Potential for growth

The third factor — potential — relates to the opportunity to grow the business in the future. Some businesses look good on paper but when you consider the big picture they have very little scope to develop. They may be located in a dying suburb, or they may have a concept that is becoming unfashionable, or they may be in a market that is poised to be overtaken by the big multi-national operators, or some other factor may prevent growth.

So the issue of profitability is a complex one, and one that a lot of operators are wrestling with at the moment. For me to consider your business to be successful it must satisfy three criteria: it must produce a consistent suitable operating profit; it must be potentially saleable and valuable; and it must deliver a suitable lifestyle to its owners. If you can give a tick to all three, you’re doing very well.