How Much Profit Should Your Business Make?

Introduction:

This week, Shawn Busse, Paul Downs, and Jay Goltz go right to the bottom line. Shawn points out how easy it is for businesses to fool themselves into thinking they’re more profitable than they really are. Paul talks about how margins can vary from year to year, especially if an owner decides to invest in improving the business—as Paul’s doing right now. Jay says he’s long sought a 10-percent profit margin, but so far, he hasn’t managed to get there. Plus: Shawn explains how he solved his accounts receivable problem. And have you looked at the 401(k) accounts of your employees lately? If not, there’s a good chance you’re going to find that they’re not saving a whole lot. Is that just the employee’s problem, or is it also the owner’s problem?

— Loren Feldman

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Key Takeaways:

Getting a clear idea of where your profit margins should be can be difficult. Use benchmarks in your industry to help set targets. Depending on your industry, 5, 10, or 20-percent bottom line could be normal.

Loren Feldman:
Jay, you said you’ve raised this question in multiple business group sessions and never really gotten a satisfactory answer. I’m wondering why you haven’t gotten an answer. I mean, obviously, profit margins are going to vary across industries. But can’t you get a pretty good guideline for where you should be in any given industry?

Jay Goltz:
I’d say no. I think there are a lot of factors. First of all, what’s the highest bottom line? I’ve got a friend who owns a business. He’s got like a 30-percent bottom line.

Loren Feldman:
It’s not a picture-framing business, right?

Jay Goltz:
No, it’s not. There are businesses that have a 3-percent bottom line. I would think that most people would say, if you had a 10-percent bottom line, that’s pretty good. There are books out there that you can buy with a bunch of industries in it—of course, picture framing isn’t one of them—that you can look up what is the average profit of a printing company or whatever. And I’d say, 10 percent is probably good. Retail? If you look at the big retailers in America, they’re usually at 5 or 6 percent.

Loren Feldman:
Shawn, Paul, is this something you guys think about?

Paul Downs:
I do. I’m in a CEO group, where we have a number of different kinds of businesses. And the guy who’s got the best margins is doing about the same gross revenue as I do, but he takes home four times as much money. He’s in a $4 million business taking home a million dollars a year.

Loren Feldman:
What kind of business?

Paul Downs:
He runs a company that does business valuations, SBA valuations for banks, and he’s an extremely smart guy who really has everything buttoned down. And it’s just like, he’s my hero in terms of running a tight business, but he’s also running a business where you don’t have to buy materials. You just have to pay people.

Jay Goltz:
Well, let me ask you this, because running a tight business certainly is part of it. But from my observation of being in five or six groups over the years, people that have really big bottom lines—I’m going to give you the checklist, and tell me if this is true in any of these—they’ve got some proprietary products, or they’ve got a patent. That would certainly do it. Or they’ve got some business that’s been around for years and years, and it’s got a brand name, and everybody wants to buy that. Or they’ve got one big, or only a few customers, and they don’t do any marketing, because they sell the buns to McDonald’s or whatever. So they’ve got that advantage. Or they have got some market advantage that most people don’t have. Does this guy have a market advantage? Why isn’t there competition going and doing the same thing he’s doing and undercutting his prices?

Paul Downs:
Well, there is. He’s just winning the battle. I think that what you brought up, that different businesses are just different, is really the gist of it. And then the other thing would be, how do you define profit? Because I’m an S corporation, and I’m the major shareholder, I tend to think we’re looking for something like 8 to 10 percent profit on an accrual basis. But then if you fold in my compensation and look at something called seller’s discretionary earnings, which is all this stuff I pay money for but I don’t have to through the business.

Business owners can influence profit by loading up on costs to make it appear that the business is less profitable than what it is, thus avoiding taxes. Owners can also cut costs and avoid making investments in the business to the point that the organization's profit looks better than what it really is – consequently stifling the company's growth. It's a good idea for a company to set a percentage of profit they'd like to hit that both ensures the company is performing well against industry benchmarks AND is able to work towards building a cash reserve to be able to handle unforeseen events like lawsuits, recessions, etc.

And I think that the big breakthrough I had was—and we’re touching on this a little bit—the artificial ways that business owners influence profit, either from the income side or the expense side.

So examples are: Some business owners load up the business with lots of costs to make the business look not profitable, because they don’t want to pay taxes. But then that creates some artificial views of the business, which can make it difficult when you want to get a loan or if you want to sell the business. I think it also just clouds your vision of what’s going on in the business.

And then other businesses are clouded in other ways, in terms of what y’all have been talking about, which is organizational debt. So they don’t invest in things over time, like software, people development, etc, etc. So they may have really good profits, but the business itself is suffering. And that impact happens over the long-term. So for us, I use a really simple idea, since we’re a service-based business, and we don’t have a lot of product coming through us. For us, we kind of treat 10 percent as a breakeven mark. If we get below that, red lights are going off.

Loren Feldman:
What do you mean 10 percent is the breakeven point?

Shawn Busse:
The way I came about this idea was somebody talked to me about how there will always be a mistake that you make. There will always be some unexpected event. Somebody files a lawsuit against you. An employee makes a claim. You really screw something up with a client, and you end up having to refund their money. There are just so many ways that a business is vulnerable. And what the 10 percent allows you to do is to have those events happen—the things that are out of your control, maybe an economic downturn—and you can live to fight another day. You’re essentially creating enough of a buffer to build resilience into the business. And if you fall below that—at least in my world, in my professional services world—you’re just very tenuous, and you’re often having to act reactively and emotionally, which is never very good for business.

Jay Goltz:
Okay, so the question is, you use the phrase “breakeven.” Correct me if I’m wrong, that’s really not breakeven. Wouldn’t it be more accurate, entrepreneur-to-entrepreneur, to say, “That’s our loser line. If I run the business, and I have a 2-percent bottom line, I’m a loser.” Like, that’s stupid. Whereas in your case, if you get to 10 percent, okay. You’re doing okay. Could do better, but you’re doing okay. It’s the okay line. It’s not really a breakeven line, it’s your doing-okay line. Is that not true?

Shawn Busse:
Yeah, yeah. No, you’re right. I mean, technically, zero is breakeven.

Jay Goltz:
Right.

Paul Downs:
But I think that Shawn just laid out pretty much the perfect example of what you need to have in reserve, and that when you take all the money out of the business, you’re starving it of any kind of durability or ability to swing with the punches.

Jay Goltz:
That’s a completely different thing, though. That’s cash flow. I mean, if you pulled all the money out as salary, okay, well, then it’s mostly profit. It’s not really a salary. That’s really a whole different subject of how much money you’re pulling out of the business. If you had it to pull out, that’s profit. You did well. You should have left some in there for cash flow purposes. But that’s really a different subject: it’s strangling the business.

Paul Downs:
I disagree. And I think that a lot of people are not in a position to make fine distinctions. They’re just trying to keep the doors open. And I’ve met so many people who are starting up a business who are not paying themselves. And so the first goal is: Pay yourself, and then look at profit beyond that. And because you’re working in the business, you cost the business something. The business doesn’t even really exist if the owner isn’t… no, that’s not a good way to put it. The business has no future if the owner isn’t paying themselves.

Jay Goltz:
Listen, we actually are on the same page. I certainly agree you need the 10 in case you need it, and all that. All I’m saying is, to really look at a business properly, you’ve got to pull out your salary as the market-rate salary. If you’re pulling out a million dollars a year, and you can replace yourself for $200,000, you really had an $800,000 profit.

Shawn Busse:
Correct. Yes.

Jay Goltz:
People should distinguish between those things.

Shawn Busse:
That’s super important. And I think a lot of accountants have given owners bad advice over the years to say, “Pay yourself as little as possible.” So you take your money in distributions, so you pay less taxes. And so it just starts to build an artificial version of the business, or the business owner just fundamentally doesn’t know what it costs to replace themselves. And so those are the problems you run into when you go to sell the business, when you go to get financing, etc. So I really advocate that folks build a true financial picture of the business.

Profit margins can change year-to-year based on when you decide to make investments in the business.

Paul Downs:
Yeah, there’s another guy who’s got some kind of insurance agency, and his margins are in that range, too. Now, one of the other things is your margins change year to year, depending on whether you invest. So a concept that we’ve seen play out over and over in our group is that you have a couple of years of profitability, and then you decide, “You know what? I want to get to the next level,” and you’ve got to splash out some money to do it. And in those years, when you’re implementing that, you have lower profits. I’m going through that. We’ll be going through that this year with all this new marketing I’m doing. And hopefully it works, and then you ride for a little while, and then you make a decision about whether to repeat that or not.

Profit and cash reserves are essential to survive recessions and weather storms. Businesses must refrain from tying their cash up and taking on investments they may not be able to handle. Having cash available during crisis is key.

Use these cash tools to improve your company's cash position.

Shawn Busse:
So what profit allows you to do is to survive to fight another day. What the 2008 recession showed us was how many businesses were out over their skis. And the truth is, that recession, while it was severe, it didn’t last that long. Maybe a year, six months for some. It hit me really hard in early 2010. And it was dramatic, but by the end of the year, I was moving again. But if you don’t have any profits to survive off of, you’re screwed.

Paul Downs:
Well, that’s always true. You need to have resources to survive in small business. You just need to be able to get them, somehow.

Cutting expenses can improve profit margins; however cutting too much can start to impact the health of your business. It's a good idea to manage your expenses; however make sure you're investing in the services your business needs to function properly AND grow.

Shawn Busse:
You’re talking about such an important idea, which is: Do you cut your way to success or do you build something? And what Paul’s doing with going into the B2B space, after having gone kind of direct to the buyer for a long time, he’s creating something new, and he’s investing in that. It’s so rare you can kind of cut your way into winning.

Paul Downs:
It’s a bad model. It’s a model for a mature second- or third-generation business. But if you’re trying to grow something, you start at zero. What do you cut, right? There’s nothing to cut.

Jay Goltz:
There are a lot of businesses out there—I just deal with them—they’ve knee-jerked, and they cut their service back so bad. Like, I’m done. I call them. They don’t call you back. So there are companies where you can’t even find a phone number on their website. They decided they’re going to save some money and not have anyone answering the phone.

There are some companies making some really bad decisions now. They’ve gone past cutting fat. Now they’re cutting into the bone. And one day, someone’s going to find out, they put themselves out of business—though they’re not going to blame it on the service that they’re giving or not giving. They’re gonna blame it on the economy. They’re gonna blame it on their bank. There are a lot of companies giving horrible service now that rationalize it because, “Oh, I can’t find people,” which, give me a break. I mean, from my experience of being the customer, I would say 75 percent of my experiences now dealing with anyone are disappointing. And it’s gonna catch up to them. Am I wrong?

Shawn Busse:
No. I mean. Well, sort of. [Laughter]

Paul Downs:
Well, Jay, I’m staying the hell away from your lawn. I’ll tell you that. [Laughter]

Shawn Busse:
I think you’re putting your finger on something that’s been going on for a while now, which is market consolidation and monopolization. So it’s like, have you ever tried to call Google to get something done? You’re never gonna get a hold of anybody there, but they don’t care because they’re the game. They’re it. You don’t have a choice.

Financial literacy training can help employees understand the importance of investing in their 401(k) and give people financial  skills they can take back home to improve their current situation.

Shawn Busse:
I mean, I always try to remember that I’m in a different position than business owners who have roles in their business that pay, I don’t know, $40,000, $50,000 a year. We’re just in a different market space. The cost to employ the type of folks who work in our business is just much, much higher. So as a consequence, you just have a different cohort. But something I think does bridge the gap between this conversation is, I’ve been thinking a lot about financial education, and where do we learn how to think about money? And most of us don’t get that training.

I grew up in a household where the lessons I took were terrible, if I had just followed those lessons my whole life—you know, living off of credit, living beyond our means. I don’t blame my family for it, but we just don’t do financial education in this country at all. And so some of us get lucky, and along the way, we meet the right people, or we self-educate, or we’re motivated. Some of us are just blessed to have good fortune from the beginning, and then we fritter it away, like some wealthy people do.

But I think there’s an opportunity for business owners to help, not only on a financial front—which I really admire how Jay thinks about this—but I think also on an education perspective, of helping people understand the value of an emergency account, helping people understand the value of compounding interest. And I’m trying to work on that in our company, because even though I have, like I said, highly educated, very smart people who make good money, it’s all over the map. Some of them are contributing to their 401(k), and some are not. And they totally should be and could be, but they aren’t. So I think about that a lot.

Loren Feldman:
Do you talk to them about it?

Shawn Busse:
We do. Yeah, constantly. But I also think there’s something to be said for outside expertise, and you know, not their boss. I think a financial coach to help folks, that’s a goal of mine in the company—to create resources for that so folks can do some lightweight financial planning, thinking about kids, and do I contribute to a college fund?

The problem is that the industry is very predatory. So there are a lot of folks out there who are trying to sell financial products, and they’re incentivized by the commission they make on those products. And so to help an employee to have access to an RIA, a registered investment advisor—that’s a fiduciary, meaning that they’re required by law to put your interests ahead of theirs—I think a business providing that to its employees would be tremendously valuable and not very expensive. So that’s something I’m thinking about.

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