Examining Profit

Are you making the wrong sort of profit?

A while ago I was told a sad story of a company that went bankrupt because they made the wrong sort of profit… did you know there was more than one? In fact there are two key types of profit. This is what happened...

This is a salutary story related to me by a Business Angel about a company he invested in. I’ve changed the name and amounts to simplify the story but I have retained the key issue that caused the investment to fail.

Travel Stars was a company that put together personal itineraries for people looking for customised tours around the world.  They made $500 profit on every sale (average sale was $1,000) and simply needed more money to ramp up the marketing and sales effort. They had created a “sausage machine” – capital in, profit out. Customers were happy and writing great reviews about the service. They went to Business Angels and Venture Capitalists and, after a lot of effort, raised $500,000. Success.

Or was it?

The BA chased Travel Stars for a full set of accounts but it was difficult to get them. The bank account started to go down rapidly and it began to look like Travel Stars would need more money. Eventually the creditors demanded more collateral to cover potential risks and Travel Stars were unable to meet the obligation. The creditors called in the loan and the company folded – the creditors got all the blame.

In the aftermath it became clear that the Managing Director of Travel Stars had misunderstood the sort of profit he was making. He was making a Gross Profit of $500 while everyone assumed he had meant Net Profit. Gross Profit is the amount that remains after deducting cost of goods sold while Net Profit is that is left after all expenses, interest and tax deducted.

In other words, they bought in product at $1,000 (cost of goods sold) and sold it for $1,500. So the Gross Profit was $500 ($1,500 - $1,000). Gross profit has to cover all the costs of running the company – the staff, business systems, rent, interest, tax, insurance, etc. and leave some over which is called the Net Profit. The trouble was when you took the cost of running the company and divided by the number of sales, you got a cost of $1,300 per sale. Put another way, each sale cost the Travel Stars the variable cost (of $1,000) plus a share of the fixed cost ($1,300) for a total cost of $2,300. Each sale brought in just $1,500. So every time Travel Stars sold something it cost the company $800.

No wonder there were great reviews of the company. Customers were paying $1,500 and getting $2,300 of value. Who would not be happy?

The investors – they are not happy!

Every sale that Travel Stars made caused the company to go into debt a further $800. In fact, the investment sped up the demise of the company because they ramped up their sales! And the creditors did the company a favour, they stopped the company continuing to lose money.

If you are not sure about your Gross or Net Profit, then now is the time to work it out and make sure you know that you are building profit for the future. If you need any help or have any comments please leave a note below or drop me a line.

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