Profit alone is not a good metric for tracking your innovation services company’s performance. Profit is of course what you can spend or re-invest in your business, so it matters a great deal, but it doesn’t measure your success in running the business.
Consider these three possible ways of generating $500,000 of profit:
- $10M revenue with 5% profit margin
- $5M revenue with 10% profit margin
- $2.5M revenue with 20% profit margin
Each company generates the same $500,000 profit, so the results look identical by that measure. But if you look at profit margin, or the ratio of profit to revenue, the smaller company is more successful. When you consider some critical business measures, the 20% profit margin indicates stronger performance than the results shown by the larger companies.
One aspect of innovation services firms is their revenue is linear relative to the number of their employees. This reality has implications for profit sharing. In the example above, if the companies are in a position to distribute earnings, then the total profit to be distributed to owners would be the same. If, however, employees are included in the profit sharing scheme, then the $500,000 of earnings in the $10M firm will be much more thinly spread, both for employees and owners, than in the $2.5M firm, since there are likely four times as many employees in the company with the larger revenue.
In addition, the company with the 20% margin is in a much better position when times get tough. Profit margin is the first line of defense in your financial buffer.
Profit alone doesn’t tell you as much as profit margin.
I see profit margin as the single best metric to gauge a company’s overall performance. To have a high margin requires you:
- can generate a large amount of revenue per employee
- don’t need to pay higher than market rates for employees
- can properly manage fixed costs
These factors correspond directly to the top-level elements of a profit and loss statement (revenue, cost of people, expenses). What makes profit margin such a useful measure is how it rolls up all the factors critical to your business into one single, powerful metric. To achieve high margins, you need to:
- have a compelling value proposition
- be able to charge market rates
- keep your makers busy
- effectively market your services
- have a good reputation
- produce a quality product without a lot of rework
- have a high ratio of people producing to people supporting
- have a company which attracts and keeps the best people
- not pay more for rent, utilities, services, etc, than is necessary
- efficiently execute your business processes
Profit margin combines a lot of important elements into a single metric — it’s a simple way for everyone to keep track of how well the company is doing. Of course if profit margin tells you the company is not doing well, then you need to dig deeper to understand why, since profit margin is a composite metric.
I periodically offer a short course on the economics of Atomic Object for our employees and interns. The “lecture” part of the course covers basic financial terms and concepts. The “lab assignments” involve playing what-if games with a P&L model of the company.
In addition to the course, I always review what I call the fundamental financial equation of our business at each quarterly company meeting. (Actually, I skipped it once and several long-time atoms pointed it out to me as a mistake.) The fundamental equation of our business relates profit to revenue and costs. You can get into complicated accounting concepts pretty easily when you start talking about how to measure profits, which sort of profit, etc. I don’t think any of that’s necessary for basic understanding of company economics.
The simple relationship I use is nothing more than the top-level components of a Profit & Loss statement:
profit = revenue – cost of people – expenses
Though simple, it’s important to review when talking about profit sharing, as it shows the inputs to our profit sharing calculation. I also describe how profit margin is a vital metric we watch closely.
I believe the company runs more smoothly, harmoniously, and profitably if everyone understands the financial dynamics of our business.
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- Succeeding with outside leadership hires - March 31, 2017