Profit Planning
Profit planning wasn’t a concept I was familiar with. I distinctly remember our first profit and not knowing what to do with it. I didn't have a plan. I didn't even know I needed one. That’s probably one of the best problems to have. I don’t remember what I decided to do, but I know that was the start of many efforts to come to grips with profit planning in case the miracle happened again. I can’t claim to be an expert on the topic of ’Profit Planning’, but here are my thoughts.
Profit is not a dirty word
Everyone loves what profits do. Profit provides bonuses, improvements of all types, and the ability to grow. Let me explain what I mean by profit. The simplest way to describe it is that profit is what is left after you pay all your expenses. In the normal course of things, you won’t find out if you had a profit until March when your accountant finishes your tax return. Profit Planning requires you to be more proactive than that.
For instance you might want to pay a bonus before Christmas – the traditional bonus-giving time. We did. We could never get used to giving bonuses any other time than mid-December. So before Profit Planning arrived, we paid (modest) bonuses at Christmas based on feel and available cash. An ’informed’ decision would have been a ’better’ decision about the size of the bonuses.
Our third (or fourth) accountant offered to review our books in early December so we could be more accurate and better informed about profit planning. That’s actually a good idea, but we only took advantage of the offer (and paid the cost) when we were pretty sure there was profit that needed planning. If we thought we we going to have a loss, it wasn’t because we were trying to have a loss. Besides no amount of planning would turn things around in 30 days.
Tactics
So the first tactic for Profit Planning is predicting your profit for the year by getting your accountant to review your books and tell you where you stand. Depending on your bookkeeping system, this might be pretty easy. In any event you will be able to make a better decision about bonuses and other year-end issues.
If you start this type of profit planning around Thanksgiving, you will have to estimate your income and expenses for the rest of the year. We always assumed that December would be a break-even (or worse) month because of time off around the holidays and clients getting distracted with the season’s festivities.
I recommend that you take your accountant’s advice with a pinch of salt. There is a difference between accounting advice and business advice. You may have to filter your accountant’s advice by your feel for internal and external ramifications. There were plenty of recommendations I wasn’t willing to follow to save $200. You decide. You need to KNOW the numbers, but you may not want to LIVE by the numbers.
We eventually had software that gave us a good feel for where our profit/loss stood. I never felt the need to get down to the decimal point with this type of projection – a few hundred dollars either way was good enough. So this is the second way to go if you have the in-house tool to make a decent year-end projection.
The main reason to go through all this is to determine bonuses and other uses of profit. Our situation, which I think is similar for most firms, was that we created a tax liability if money remained in the firm past year-end. Get your accountant to explain how you will be impacted so you have a guide for future years. Our goal was to use up all profit by year end so that there was very little tax due. An unfortunate consequence of using up all your profit is that you will very likely be short of cash for the first few months of the new year. We made every effort to avoid using our bank for working capital loans. Often times I loaned my bonus back to the firm to avoid a loan.
The key issue is that knowing the facts beforehand is much better than finding out the facts afterwards. Mark your calendar to start working on this in early November.
Uses Of Profit
So what is profit used for besides bonuses? This is the way that I think about it, and what we used profit for.
New capabilities or strategic projects – software, training, staff position, equipment, marketing initiatives
Furniture, Fixtures, Equipment – purchase and replacement
Growth of staff – equip, orient, train
Working capital
Donations (although we tried to do this by buying advertising, an expense)
Office space – buy, build, renovate
Profit Allocation
So if you have decided on bonuses, a new plotter, and a marketing initiative, you have probably just decided on how to allocate your profit. In fact my experience is that trying to allocate profit by some formula never seems to work out. Instead, if you give some thought to what you would do with a profit of $xx,xxx, this always seems to ‘allocate’ the profit. It also gives you a target to shoot for. Consider turning the process around, and decide what you would like to do, and how much profit that will take. Put numbers on each item, add them up, and you have your profit target – or at least your first stab at a target.
If you don’t go through this exercise, you don’t really have a way to determine what your hourly rates should be. If you aren’t charging enough to give bonuses, then you can’t give bonuses without going broke. (I described how to go about this in this post.) Profit gets factored into hourly rates, design budgets – make it conscious.
Markup In Profit Planning
To move beyond using an arbitrary percentage markup, plan how much profit you would like by budgeting amounts for your profit allocation. Here’s an example:
Lets say your breakeven budget is $400,000. To achieve your profit goal your total revenue has to be $450,000. What percent markup of your breakeven budget gives you the profit you want? See the example again. [BTW click here to download the spreadsheet.]
You need a markup of 112.5%. You will multiply the factor of 1.125 times your BE hourly rates to arrive at billing rates that generate the profit that you want. (Note that $50,000 is not 12.5% of your total income. It is 11.1%. 11.1% is your profit margin. The markup is always larger than the profit margin.)
There are so many things that can derail your profit planning that I think it is prudent to include a contingency markup on your markup. That’s why we invariably used a markup of 120%.
If you get comfortable with a certain percentage markup, you could use that assumption and work backwards in the table to see what that markup will allow you to accomplish. We often made a broad allocation of 75%/25%, for bonuses / other things, respectively.
Thinking about profit and what you would do with it seems to inevitably lead to thinking about how you would hit the target. What will it take? This kind of planning is always a good thing.
A lot of this profit discussion may not seem like it applies to one or two man firms, but I think it should. If you are going to take on the responsibility for running the firm in addition to doing the work, I think you ought to get more than a salary for your efforts. Otherwise you are “paying” for the privilege of calling the shots, rather than being rewarded for it.
I wouldn’t expect everyone to agree with my take on profit. After all, most architects have to make this stuff up as they go along. I certainly did.