Truth: Recently I found 3 different sources that cited 49.7% of businesses fail within the first 5 years.
One major contributing factor is not understanding how to manage business revenue properly. Too often new business owners get so excited about the revenue coming in that they overlook the costs of doing business and think they’re rolling in profit.
My goal with this article is to highlight the right revenue mindset new entrepreneurs need to eliminate unnecessary struggle. If you have a business idea or are thinking of starting a new business, keep reading because I wrote this for you.
Revenue vs. Profit
New business owners must understand the difference between revenue and profit because the money you make from a sale isn’t the same amount of money you get to keep. As a business owner, you are responsible for paying all of your business expenses — materials, labor, rent, taxes, software licenses, office supplies, professional services, and more — and all of those costs are paid for out of your business revenue, which reduces what’s left for you.
New business owners must keep track of expenses and make sure they are earning enough revenue to cover those expenses and still make a profit. This is where profit margins come into play. Profit margins show the percentage of revenue that a business keeps after paying all of its expenses.
Definition of business revenue
Revenue is the total amount of money a business earns from the sales of goods or services before subtracting expenses. It is a key indicator of a company’s financial performance and overall success.
The higher the revenue, the more profitable the business — and a profitable business is one that enjoys increased investment opportunities, expansion, and growth. Revenue is used to pay for expenses, fund future projects, and keep the business moving forward. By monitoring and increasing revenue, and compensating for expenses businesses can ensure long-term financial stability and success.
How revenue is calculated
Revenue is calculated in a variety of ways depending on the type of business or organization. Here are a few examples:
- Retail businesses: Revenue is calculated by multiplying the number of units sold by the price of each unit. For example, if a store sells 100 shirts at $20 each, its revenue would be 100 X $20 = $2,000.
- Service businesses: Revenue is calculated by adding the total amount earned from services provided. For example, if a freelancer or consultant charges $100 per hour, and worked 100 hours in a month, their revenue for that month would be 100 X $100 = $10,000.
- Subscription-based businesses: Revenue is calculated by multiplying the number of subscribers by the monthly fee charged. For example, if a streaming service has 100 subscribers paying $10 per month, its revenue would be 100 X $10 = $1,000 per month.
Definition of business profit
You now know that revenue is the total amount of money generated by a business based on its sales. Profit is the amount of money left over after all expenses have been paid and subtracted from a business’ revenue. Profit is the amount of money a business keeps and has available to reinvest after all costs of doing business have been taken care of.
All Money Earned Is Not Profit
The most common mistake made by new business owners is thinking that their revenue is the same as their profit, which leads to not properly planning for expenses and various business costs. When revenue is treated like profit and money is spent before expenses are paid, business owners can find themselves in a dangerous situation — reaching into their personal bank accounts to keep their business afloat.
Businesses should be tracking their profits month to month, quarter to quarter so they can forecast sales, which is important because if there are slow periods when the revenue generated dips they’ll be able to plan for it with their marketing and still cover their expenses. If you’re aware of potential business slowdowns, you also can set more money aside from the good months and quarters to balance out the slow periods. A boost during the slow periods can make a difference to the end-of-the-year revenue goals.
Why profit margins matter
Profit margins are a key measure of a business’s financial success and show the percentage of revenue that a company keeps after accounting for all expenses.
Let’s say a pizza shop charges $3 per slice and sells 50 slices per day making roughly $4,500 per month. The cost of the ingredients and labor to make the pizza and serve the customers is $2,250. This means that the pizza shop has a profit of $2,250 ($4,500 revenue – $2,250 expenses).
So, in this case, the pizza shop’s profit margin is 50%. This means that for every $1 of revenue, the shop is making 50 cents in profit.
The profit margin can be used as a measure of the pizza shop’s success, as it shows the percentage of revenue that is being turned into profit. A high-profit margin is generally a good sign that the business is doing well and is efficiently managing its expenses.
On the flip side, there are businesses that overextend themselves taking on too many expenses with the hopes that the risk will lead to more sales.
Let’s say instead of the business increasing its expenses by opening its shop in a more expensive high-traffic location thinking it’ll be able to increase the number of sales per day/month but instead it stays at 50 slices per day. Their profit margin decreases and they look to be more of a risk to a potential investor or bank should they need a loan.
The business would have to look for ways to decrease its expenses without compromising the quality of its products.
The importance of profit margins should not be taken lightly, especially for businesses that may seek financial support or outside investments. Businesses that track profit margins can forecast sales and measure their success or lack thereof.
When you can effectively forecast profit margins, you can identify the slower periods in your business and figure out how to address them. You’ll be able to create a strategy to get out ahead of it before things slow down and track the results to monitor effectiveness.
Profit margins can highlight a business’s financial performance
- Assessment of pricing strategy: Profit margins can also provide insight into a company’s pricing for its products or services.
- The pizza shop can evaluate the profit margin and determine if it is charging the right price for its pizza.
- Monitor performance over time: By tracking profit margins, you can monitor its performance over time and make adjustments as needed to increase profitability.
- If the pizza shop knows that there are slower periods they can plan ahead to scale back on labor and increase their profit by lowering their expenses.
- Compare with industry standards: you can compare profit margins with industry standards to see how a business is performing against other businesses in the industry.
- The pizza shop will be able to compare its profits against industry standards and competitors to gauge its performance and make sound decisions. For example, if all the other pizza shops in the area increase their prices, the pizza shop could also raise their prices and increase profit margins without adding additional expenses.
Successful Businesses Separate Revenue And Profit
The importance of understanding the difference between revenue and profit lives in understanding the cost of doing business, the amount of money coming in, and tracking what’s left over after all bills are paid. Tracking your profitability allows you to not only gauge where you stand in your business but also your position in the market.