You offer multiple services, but are they as profitable as you think? Often, owners don't include all the costs in calculating profitability. The danger is if the services that you think are most profitable and you focus your efforts on growing it, only to realize later that the profitability is actually much lower than what you thought...this means you lost time and effort on growing something that gives you lower ROI. And you could've accelerated your profits growth if you focused on other more profitable services that you already offer. To avoid this danger, here's how you can ensure you're calculating your profitability of each service offering correctly in 5 steps...
We'll start with the service that you think is most profitable. You'll take all the sales and costs on an annual basis from last year's actual financials so there won't be seasonality impact.
Step 1: Capture All the Direct Costs
Start adding up all the annual costs that are directly associated with providing this specific service. This would include:
A. Contractors and Consultants' costs that work on this service. Let's say for this example, it's $20,000.
B. Employees' cost from the time that they worked on this service. If your employees currently don't track their time associated with it, then you can make an estimate for the purpose of this calculation right now. You'll need to include any sales commissions that you pay out to your employees too. Let's say you pay one of your employees $50,000 a year, including benefits and sales commissions. And they spend 25% of their time on this service, then it's $12,500 of their time to this service.
C. Marketing costs that you used in an effort to drive sales. Let's say it's $3,000
D. IT - if there's any software that you use specifically to provide these services. If you're using the software across multiple services, then just count up how many services and take the software costs to divide it by this. For example, you're paying $20,000 for a software and you have 5 services, then it's $20,000 divided by 5 services = $4,000
E. Equipment - if you purchased equipment that can be capitalized, meaning it doesn't hit your expenses all in 1 year, and can be allocated across a few years. For example, if a piece of equipment you use can be for 4 years, then you would take the equipment that you purchased for e.g. $40,000, and each year would have $40,000 divided by 4 years = $10,000 of costs associated with this.
F. Supplies, if applicable that directly relate to providing for this service
G. Other costs - such as rental of space for the service, travel, meals and entertainment, and anything else that you can think of specifically relate to performing this service. Similarly, if you have any costs that you use for multiple services, such as rental of space/travel/meals/entertainment, then just take it and multiply it by an estimate of how much that service used up.
For example, you rented space, and it's used 70% of the time/space for this service, then you would take the cost (e.g. $5,000) and multiply it by 70% to get to $3,500 for this service. Similarly for travel/meals/entertainment, if this related to multiple services, then figure out how much % of the time was used for this service. For example, the travel was 5 days, where 2 days of the trip was for this service, then it's 2 days divided by 5 days total, or 40% of the travel cost to allocate to this.
Step 2: Capture All the Indirect/General Costs
Next, you have all your indirect/general cost, such as: rent, insurance, IT, general marketing, general office costs, repairs and maintenance, general equipment, and your supporting employees such as your operations manager, office manager, HR, IT, and finance. Add up all these costs and divide by the number of services you offer. For example, if you have $200,000 of these costs with 5 services, then you have $200,000 divided by 5 = $40,000 for indirect/general costs.
Step 3: Capture the Cost for the Time You Put Into It
Your time as an owner is what a lot of owners forget about when calculating profitability. Do a quick estimate of the % of your time for what you spend on this service, including sales/marketing/delivering the service. For example, 10%. Then, figure out what % of your time is dedicated to general business running, let's say 40%. So you would take 40% and divide it by the number of services you have, e.g. 30% divided by 5 services = 8%. So in total, about 10% + 8% = 18% of your time is for this service.
Then take how much you should pay yourself in salary, or an estimate of how much it would cost you to pay someone else to do your job for a correct market estimate, and then multiply it by the % of time. For example, you pay yourself $100,000, and 18% of your time is for this service, so $100,000 x 18% = $18,000.
You'll need to include the cost for all the owners if you have other partners in the business.
Both the indirect/general costs and your time are important to consider in profitability since these costs are required so that the services can run. And if you want to eventually do something else, and hire someone else to do the work that you do now, then this is a market cost you need to factor in.
Step 4: Calculate the Profitability as % of Sales
Add up all the costs, with this example, it's:
+ Contractors/Consultants $20,000
+ Employees $12,500
+ Marketing $3,000
+ IT $4,000
+ Equipment $10,000
+ Other direct costs $3,500
+ Indirect/general costs $40,000
+ Your Cost $18,000
TOTAL COST = $111,000
For this example, let's say annual sales last year for this service was $120,000.
Profit = Sales - Total Cost = $120,000 - $111,000 = $9,000
Profitability as % of Sales = $9,000 divided by $120,000 = 8%
This is often different from what a lot of people calculate the profitability to be, as they often forget to include the IT, equipment, other direct costs, indirect/general costs/your costs when calculating profitability. So they get profit = $120,000 - $20,000 contractors/consultants - $12,500 direct employees costs - $3,000 marketing costs = $84,500. The $84,500 divided by $120,000 = 70% profitability. Even if people accounted for all the direct costs, which would result in profit of $67,000 and a 56% profitability.
You can see the big difference in profitability, profit as % of sales of 70% or 56% for how most people calculate vs. 8% actual profit as % of sales...What you thought was a very profitable service, is actually not as profitable as you may have thought.
Step 5: Where to Focus Your Time to Accelerate Profits and Stop Offering Services
Now do this calculation for all your services, and then compare the profitability as % of real sales:
- For the ones that have high profitability as % of real sales, this is where you should focus on
- For the ones that have low profitability as % of real sales, I'm talking about below 5%, you should work on either increasing pricing, cutting costs by figuring out how to make delivery of these services more efficient. Or if you can't figure out how to increase pricing/cut costs , then just stop offering these service and focus you and your teams' time on the higher profitability service.
- For the ones that have negative profits, you should definitely focus on stopping to offer these services for now. Your ROI will be much higher on your time if you focus on the higher profitability services.
I worked with a client on a profitability analysis, originally, they were going to focus most of their efforts on growing Service A, that they thought was most profitable. After the analysis, the result was that a service that they thought was one of the top 2 profitable services, was actually in the bottom of the profitability (about 5%). This allowed them to save time and also grow their profits faster by focusing on the ones that are actually more profitable of 15% to 20%.
Next Steps:
If you're wanting to make it easy for tracking and correctly allocating your costs to specific services, so you can truly know your profitability for your services or clients, contact me for my profitability analysis system via angela@askangelalin.com
What are your biggest problems with your accounting/financial processes for growing your profits? Comment below so that I can help you!
