The title question says it all. Should profit be planned or treated as residual?
Many small business owners treat profit as a residual. Yet we know what “residual” means -whatever’s leftover. It’s the guy who is chosen last for an after school baseball game. It’s the un-popped kernels in the popcorn popper; the uneaten leftovers from dinner two nights ago; the last seat left in the stadium. If an actor with a successful TV series to his credit treats profits as residual, it’s understandable. He knows that he can probably retire and live off of his residual income. However, a small or medium size business that does not plan its return on investment (ROI) and simply hopes it might be lucky enough to have leftovers may be setting itself up to fail.
The owner who treats profit as “residual” is probably thinking something like this, “If I work really hard and catch a few lucky breaks, at the end of the year there should be some cash in the bank left over after paying all the bills! That will be my profit…and I sure hope it will be more than last year...” Hope does not make profits fall from the skies. Profit has to be planned.
Treating profit as a residual is a common mistake which leads many businesses to fail. Making an investment without knowing what the outcome will be is like playing the lottery. It is inconceivable to plan buying a house as soon as one buys a lottery ticket, because of course the possibility of winning is approximately one in almost 14 million according to statistics experts.
A more responsible way to manage a business is to treat profit as the first item of expense. In other words, the focus is to get paid first. Just like when any project is in the “planning" phase, the first questions that the Project Manager and the Business Analyst should ask themselves are:
• What will be the benefits of initiating such a project?
• How and when will it be achieved?
• What is the expected return?
• What are the risks of failure?
• Can the company afford those risks, should they occur?
• Will it be a waste of the company’s resources and time?
• Will the stakeholders’ expectations be met?
Efficient business planning ought to treat every other item of expense as secondary to the company’s profitability because companies are in the business to gain some sort of profit out of their investments. To do so, many business owners use tools like costing calculators. A costing calculator can be as simple as an Excel spreadsheet, but its use helps to point the mental organization toward profits in a business. From a technical perspective, it would not matter whether “Overhead” is the first variable, or whether it is Labor or Material Costs. The formulas in the calculator would still give the correct cost. At the end of the year, profit is still what is left over after paying Direct Costs, Overhead Expenses, and before paying taxes.
The difference is found in the word “planned.” A business that is set up on the basis of planned profit is a business that is focused and transparent. Setting a profit target and then tracking how closely the business comes to the goal is a major step toward truly running a company like a successful business should be run.
When a business is set up on the basis of planned profit, it has a higher chance of success. A business owner who sets profit targets and tracks how closely he or she is able to meet or surpass that goal takes a major step toward fully assuming the responsibility of being a business owner. If a business is struggling just to have “leftovers” and the bank account is constantly in the red, it’s clearly time to get help in order to plan strategically and to set clear expectations.
In a nutshell, having a plan in order to achieve your desired goal is the key to achieving success and to experiencing continuous growth.
“In preparing for battle I have always found that plans are useless, but planning is indispensable.” ― Dwight D. Eisenhower
Photo credit: geralt via Pixabay, CC0 Public Domain License
I like this article. One could say that the "residual profit" approach is a trap that some business owners and managers step into. However, some people find it daunting to make a realistic business plan.
I believe that having a vision and carefully analysing the market environment are necessary steps to define where the business should be in a few years time. That helps to formulate a strategy and then to define more detailed goals that actually form a business plan.
This indeed can be daunting as it requires a lot discipline and dedication. However, as the article states, it is indispensable to be able to measure progress.
I would like to add that the implementation of a plan has also lots of pitfalls and misconceptions.
It is important to regard the implementation as a dynamic process that provides important feedback to the definition of a business plan.
I interpret Eisenhower's saying in a way where planning is a decision making process based on a vision and the lessons learned during its implementation.
An interesting and seemingly essential way to look at how to approach both setting up and running a business - in other words, the professionalism which people use to come up with their original ideas should extend to how they're going to earn enough to pay themselves and ultimately create a sustainable business.
How then to demonstrate to business owners that it is worth the 'discipline and determination' which Eduard talks about? Setting and using micro-goals which are SMART (specific, measurable, attainable, realistic and timely)?
How then to demonstrate to business owners that it is worth the ‘discipline and determination’ which Eduard talks about? Setting and using micro-goals which are SMART (specific, measurable, attainable, realistic and timely)?
Thank you for your feedbacks Paul and Eduard.
You have raised an interesting question! As Ironic as it may seem a lot of small and medium size business owners do not like to invest the time to plan, nor to investigate what the ROI (return on investment) of their investments will look like, before taking a dive into a business’ river! One would think that is the first logical step to make, which is to see if the benefits will be achievable? If so by when? How? And where should the product or service be sold? What about the location? Has the location been chosen strategically in an area where there is a demand for that product or service?
So do business owners skip that critical step?
Below is what I found as possible reason:
1. It requires a lot of work. Performing market analysis and benchmarking is time consuming. But is it worth it? Is it better to have that information ahead of than not?
Here are some tips for you:
• Is there a demand for your business in the market segment in which you are operating?
• Know your competitors! Check out their prices compare to yours
• Are you going to be able to beat that competition, or just be a comparable cheaper alternative? How is the quality of their products or services compared to yours?
• How much of an investment risk are you willing to take? If you do take that risk, how will measure the expected profit? By when will this planned profit be realizable?
• How about your expenses, fixed and variable costs? Will the business be able to pay its own bills? Or does it looks like, your account will be in the red every month? Or do you need to take out a loan just to pay your employees? Do you see where I am going with this analysis?
• Unless a business is able to determine these factors, prior to embarking into any business endeavor, I am almost positive that there will be some surprises and they will not be called “Profit”
• All the above elements need to be taken into consideration, using “Profit and Expense Control tools” which help an investor or business owner to predict way ahead of time what the ROI will look like in a year, up to even 5 years from now. These steps are logical steps to take. Or if it is a lack of “know how” call up a consultant to do the work for you. One might say; well it will be too expensive, to do so! It might seem that way for the moment, but it does not matter as things will balance themselves out at the end. That is exactly why you should plan ahead. If one gets into a car without knowing how to operate it, the risk of getting into an accident is 90% greater, and that shouldn’t be a surprise if it happened. Well, the same theory applies to “profit planning”
Since I am in business, I cannot treat profit either as a residual OR as an expense. First, I am in business to make a substantial profit as well as return on my investment. My eventual goal, when all units of my ten-plex are occupied is to make a profit of about $2200 per month. Certain rehab issues, however, make that goal impossible at the moment. So long-term profitability is the goal, and it must be specific. Since I have no need to pay myself a salary at this point out of the business, I can allow reserves to accumulate and then I can spend these on upgrades and rehab, and that way they are not profits and are not taxable (I am already in a pretty high bracket). However, by the end of the first year, I should have 8 of 10 units rehabbed and ten occupied, so I should begin at that point to accumulate taxable profits at about the level described. So, while I agree that profit should not be treated as a residual (it is, after all, the reason one is in business in the first place), I disagree that it should be treated as an expense--up to that point where one can draw a regular salary from one's profits, and at that point it becomes a planned expense.
Dr. Don,
Thank you for this substantial comment. Your are partially right when considering your analogy. I admire your ability in justifying your disagreement as it relate to your personal point of view and experience about the way you manage your own business. Maybe the next few lines might change your point of you:
For example when one considers the theorem that " Profit = COGS - Expenses" it is logical that in an income statement revenues should be listed as the first items. All related costs such as operating expenses, salaries,benefits, commissions. Expenses for Cost of goods sold items (such as direct manufacturing labor, or manufacturing overhead) impact are subtracted from sales revenues to produce gross profit and gross margin. The above-referenced principle of accounting substantiate the reason why profit should be planned.
I hope that helps understanding why expenses and profit are inter-connected, and because profit is what ever is left after all expenses are paid, they must be subtracted from the revenues in order to capture the true net profit. In other-words what ever the amount of expenses a company plans must be based on the expected revenue from COGS and COSD. Some companies for example have a line of credit to pay their employees just to make in case they do not reach their expected profit or revenues. That is an example of bad management, lack of planning and inefficient accounting practices.