What Is Profit
Posted on 23 Jan 2006
by Martin Burns (MartinB)
Rated 3.74 (Ratings: 1)
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profit? I've had many conversations with colleagues, clients and friends along the lines of:
So, you're selling this widget. It costs you £15 and you're selling it for £20. That's £5 pure profit.Which usually means
You're trousering the fiver, so you can move a bit on your selling price/commission rate.Something very similar applies to project costings. The same clients, employees, colleagues and friends tend to think that you subtract the cost of things bought for the project (say software licensing, hosting and so on), and the rest is
pure profit.But is that so? What does profit mean, and how do we make sure we're making any (let alone enough)? Let's take a look.
What is ProfitProfit is simply the final amount of money that the business makes, once all the costs are paid from income (aka Revenue). But Revenue and Cost have to go a long, long way before what's left makes its way into your trousers. What you're more interested in at a project level is Gross Profit. That's Revenue, less all the things you had to do to earn it. On a software/development project, the largest item is likely to be Labour — the amount the business or subcontractors charges the project for use of people. But it'll also include:
- any software you license for the project/client's use
- any hardware you buy for the project/client's use
- any custom development the project requires
- any hosting/connectivity the project requires
- all costs associated with enabling the people to work on the project, so all travel/accommodation expenses for the project. Be careful about which expenses are allocated to your project, and don't get confused that the term Expenses is also somewhat interchangeable with Indirect Costs (see below).
Measuring Project SuccessIn many organisations, a PM's primary target is hitting the required level of GP, and often, this is fixed on a company or client level as a percentage of Revenue. Hit (or exceed) the desired GP, and you're a hero. Miss the target, even if you deliver some GP, and you're not.
Beware - Fixed Costs Lurking
But I hear you say
What's the problem? I delivered 25% GP. I know my target was 30% GP, but I still brought in Profit, right? So I still did well.Well, not necessarily. Why do you think the target was set at 30%? Was it just corporate avarice and a desire to stick it to the customer? Possible, but unlikely. The reason for what might seem high targets is that the project's GP has to pay for a whole load of other costs, which are incurred no matter what the size of the job, or whether you even do it at all.
Quick Costs QuizWho pays for the following:
- Time spent selling
- Your company's offices (premises, heating, phone, equipment)
- Your site hosting
- Staff salaries that aren't client chargeable
- Interest on Bank Loans
- Travel that's not client chargeable
- Staff Holiday Time
- Developing new products and services
Death and..?Yes, you guessed it, Taxes. What you're left with at this point is a Pre-Tax Income (PTI) aka Net Earnings Before Taxes (NEBT). PTI is like your company's salary. The Taxman has to have his slice before it goes near anyone's trousers. Depending on where you work, this will a be combination of any number of national and local taxes (NB for UK people, this might not include VAT, as depending on how your accountant wants to handle it, it may be considered a Direct Cost to the project). Once the business has paid tax on what's left of the Revenue you brought in, then – only then – can you look at the pittance that's left and call it
Pricing for ProfitSo that tidy nestegg of GP that you delivered to the company gets chopped up many ways to pay the project and company's costs before it can be considered Profit. This might be visible to you, so at the end of the year or project, your (on-target, right?) GP takes a big charge for Indirect Costs (this is called Accruals). Or it might be invisible - so you just deliver your GP to the company, and it all happens behind the scenes. Either way, you are contributing to those costs, so your initial pricing had better reflect those costs. At the start of this article, you may have thought something like
30% Pure Profit? That's extortionate!Hopefully now, you'll see it as something more realistic. When you set your target GP for a project, you need to have an understanding of all the Direct and Indirect Costs that the project will need to bear. Once you understand the true costs, you're in a much better place to set a realistic price that leave the company ahead of the game at the end. But I hear you say:
But my clients won't pay prices that include such a high GP.Might I respectfully suggest that you're working with clients who either don't understand or (worse) don't care that you make enough to stay in business? Hopefully the above will give you ammunition for your negotiations. If you're doing small numbers of large projects, chances are that you're sharing the Indirect Costs around more thinly, reduce the proportion of non-chargeable staff time and take less management overhead than large numbers of small jobs. So it's reasonable that larger projects attract a lower percentage charge for Expenses, and therefore require lower GP targets.
DefinitionsTo recap all those definitions (and a few more you might hear):
- The final amount remaining after all costs have been paid from Revenue. Very difficult to calculate on a project by project basis, so a project usually talks about Gross Profit.
- The money that you charge to customers for providing products or services.
- The total money it takes to deliver the product or service; not only the cost of producing the actual delivery, but also having an organisation in place to do it.
- Direct (aka Variable) Costs
- The actual costs you can directly associate with each item or project. These vary with the level of activity — sell/produce/deliver more and your costs go up. You add a requirement? You add developer time, and that's a direct cost. Need hosting for a client site? That's a direct cost.
- Gross Profit
- A project's GP is what many people think of as profit - it's the project Revenue, less Direct Costs. This is frequently expressed as a percentage of Revenue.
- Indirect (aka Fixed) Costs
- Costs you bear, whether you're delivering or not. Bank loans, admin staff, heating, lighting, marketing & sales; they're all indirect costs.
- An expense is what is spent to bring a product to market and sell it. This is an indirect cost, and shouldn't be confused with expenses that your team charge for travel, accommodation etc (these are direct project costs). The most common type of Expenses a Project Manager will have to bear are SG&A expenses - Selling, General and Administrative Expenses.
- Overhead is an expense that goes to maintain the organisation. This might be management and admin staff. It's also the cost of people who aren't directly billable, such as system quality assurance or the operational support staff. It's equipment purchase/lease and network connectivity. It's heating and lighting.
- Burden is those expenses associated with employees. This includes payroll taxes, benefits, and holiday. It also includes all the time that your staff are sitting around, not earning Revenue (which is why contractors are popular, although their rates will include an amount to cover their Burden).
- Year-end Accruals
- Projects are often charged their Expenses at the end of the year – they're all saved up (accrued) and dropped on the project in one go.
- PTI (aka NEBT)
- Once you've taken all your Indirect costs away from your GP, you're left with your Net Earnings Before Taxes (NEBT) aka Pre-Tax Income (PTI). Take off taxes from your company's total PTI and you have Profit - Pure Profit at last!