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E-Myth – “Why most small businesses don’t work & what to do about it”

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Virtual CFO | Understanding Profit Margin

Intuit, the makers of QuickBooks did a survey of small business owners, testing them on their financial literacy says virtual CFO. They were asked questions about what balance sheets are, what are accruals and how to improve cash flow. Out of all of the respondents, 82% score less than 70% on the test. With such a high percentage of business owners who lack a basic understanding of financial literacy in business, many entrepreneurs struggle to understand how to calculate the profit margin in their business. As a result, many entrepreneurs do not price their products accordingly and end up failing to make enough money to cover all of their expenses.

One of the first things that entrepreneurs can do to help gain a deeper understanding not only of their profit margin but business financials in general, is understanding how many revenue accounts they should have in their business. Virtual CFO recommends that entrepreneurs have three or less. The reason why is because having more than three can create a lot of work as well as increase the opportunity for entrepreneurs to miss classify within the revenue accounts. Also, having three or less means that the income statement will fit on a single piece of paper. The reason why this is important is so that entrepreneurs can use the information to make informed financial decisions in their business.

When income statements are a single page, entrepreneurs can more easily review all of the information, and make important financial decisions. Entrepreneurs should be reviewing their income statement before they make any financial decision at all in their business, whether it is if they can hire more staff, if they need to lay staff off, if they have enough money to make an asset purchase, or even decisions like do they have enough money to run payroll. It is of paramount importance that the income statement stays one page so that business owners can quickly review the report, in order to read a lot of information quickly, so that they can make financial decisions.

Many entrepreneurs are not sure how to keep their revenue accounts down to only three, many entrepreneurs believe that their business is unique enough that they should have more accounts, and many other business owners believe that they are being extremely helpful in breaking down all the revenue streams. However, even the largest companies in the world only have three or fewer revenue accounts, and they all have a single page income statement. Virtual CFO says that entrepreneurs should ensure that they are calculating their revenue accounts properly so that they can ensure their income statement stays as one page.

When entrepreneurs learn how to read their income statement and classify the revenue accounts appropriately, they are creating a great tool in their income statement to be able to help them make great financial decisions very easily, and understand their profit margin so that they can ensure that their pricing their products in such a way that has them turning a profit in their business.

Virtual CFO | Understanding Profit Margin

With such a high amount of business failure among entrepreneurs in Canada says virtual CFO, business owners need to understand how to calculate their profit margin appropriately, so not only can they cover all of their expenses, but they can also learn how to turn a profit in their business. 50% of all business owners fail within five years of opening their business, and industry Canada say that 29% of those entrepreneurs fail because they run out of money in their business. By learning how to calculate their profit margin, so that they can set prices appropriately can significantly help many entrepreneurs avoid running out of money in their business, thereby increasing their chances of succeeding.

One of the most important things entrepreneurs can do in calculating their profit margin is understanding the difference between the cost of goods sold and overhead expenses. Not only do entrepreneurs need to price their products so that they are recouping their cost of goods sold, but they also need to be calculating their overhead expenses as well, so that they can price their products in such a way that allows them to get the cost of goods sold recovered and make enough profit to cover their overhead expenses as well. Virtual CFO says that when entrepreneurs are able to understand the difference between the two, they can ensure that they are creating prices that will allow them to cover all of their expenses so that they will not end up running out of money.

Cost of goods sold are the direct costs that are involved in making the product that they sell or the direct costs of the service that they provide. This includes raw materials and labor. These expenses only exist in the business if an entrepreneur makes a sale. Overhead expenses on the other hand, are the expenses that are going to exist whether or not an entrepreneur makes any sales or not. Examples of overhead expenses can include rent, utility bills, administrative staff, and office supplies. By figuring out what their monthly overhead expenses are, entrepreneurs can figure out how many products they need to sell at a markup in order to cover those overhead expenses. When they understand how many products they need to sell every single month in order to cover their cost of goods sold and overhead expenses, then entrepreneurs will know what their profit margins are, and they can ensure that their pricing their products in a way to avoid running out of money.

Entrepreneurs also understand that their cost of goods sold is going to fluctuate every single month depending on the sales of their businesses. Virtual CFO says that the reason why is the more products or services that an entrepreneur sells, the more they are going to have to by raw materials and pay labor to produce those products and services. As long as an entrepreneur ensures that the sales are going up by the same percentage that the direct costs are going up, then they can understand that their costs are not rising uncontrollably.

Entrepreneurs are better able to understand the expenses of their business, they can calculate their profit margin, and more easily avoid running out of money in their business.