We have all been to small business networking events where particular individuals like to tell everyone how much money they are making. “The business is going great! We’ve grown from a $500,000 business last year to a $5,000,000 business this year”. You leave the conversation wondering if they’re being completely honest with you because your business isn’t making anywhere near that much money! What they are giving you is their total sales figure which, in reality, means absolutely nothing. If your business turns over $5,000,000 a year but the goods you sell cost $4,750,000 to buy then what you really have is a $250,000 business. While that number doesn’t sound as impressive it is a far more honest representation of how much money the business is making. In the Profit First world we call that number your Real Revenue.

A fundamental part of implementing Profit First in your Australian business is determining what your ‘Real Revenue’ is. The allocation percentages in the Profit First system split Real Revenue between your Profit First bank accounts. Before you can put a single dollar in your Tax, Profit, Operating Expenses or Owner’s Pay accounts you need to determine what Real Revenue is for your business.

Calculating Real Revenue

Real Revenue = Total Sales – Materials – Subcontractors.

As such, we need to understand what amounts fall into materials and subcontractors so that we can arrive at Real Revenue.

Subcontractors

These are individuals or businesses that provide services you require to produce what ever it is your business sells. An easy example comes from the Building and Construction industry. If you are getting a house built you pay the builder a large sum of money for the project. The builder, in turn, utilises the services of Painters, Tilers, Plasterers etc to help produce the finished product. These tradesmen are not employees of the builder but rather independent business owners who supply a service (and materials in some cases) which forms part of the product or service being sold. Note – employees are not subcontractors.

Materials

In the materials category we are looking for items that are either sold directly to your customers or consumed in the process of making the product or service you sell.
– If your business sells custom timber furniture, the cost of the timber used to produce each item would sit in the materials category;
– If you own a car dealership then the purchase of motor vehicles, which are then on-sold to your customers, are materials.

Now, this sounds very simple at first but it’s very easy to make the whole system messy and almost unmanageable right here. Why? Because it’s so easy for business owners to find a way to classify almost every cost in the business as materials. Even in my own business I could treat the stamp I use to post a client’s tax return to them as a material cost. It forms part of the final product that my client receives.

To help simplify the process Profit First has the 20% rule.

The 20% rule

The 20% rule states that even if a cost could be classified as materials you exclude it unless the cost is greater than 20% of the total sales price of the item produced.

Let’s return to my somewhat sarcastic stamp example. If the client paid me $300 for their tax return, I can’t include the postage cost as materials because it is less than $60 (20% of $300).

Another example is a web developer who, while building a $5,000 website for a customer, needs to purchase a few WordPress plugins totalling $100. Again, the plugins cost less than 20% of the total sales price of the website so we don’t include the cost as materials.

Real Revenue v’s Gross Profit

Many people who read the Profit First book, especially accountants, try to use instead of Real Revenue. Gross Profit is a very common accounting term and we calculate it as: Sales Income – Cost of goods sold. However, there is a difference between the two figures.

• Gross Profit looks for all expenses that can be easily tracked to the items you produce and classifies them as ‘Cost of Goods Sold’. All of these costs are then subtracted from total sales and the remaining amount is Gross Profit.
• Real Revenue works in a similar fashion but we are only interested in costs that are either subcontractors or materials.

What’s the difference? A great way to show this is to look at your wages costs. If you have manufacturing or sales staff they are usually classified as Cost of Goods Sold. Their role in the organisation is to produce and sell inventory which makes them a direct cost. Real Revenue, on the other hand, classifies ALL wages as operating expenses. All of your staff, regardless of their role, are on your payroll (they are not external to the business).

Implementation

While looking for costs to cut it’s the perfect time to make note of items that are either materials or subcontractors. When you start the Profit First allocations these amounts need to be transferred to a different account. They must be kept separate from the funds you are using to pay your other operating expenses. This is particularly important for businesses that maintain large, expensive inventories.

My own experience

During the last couple of years I have delivered dozens of one-to-one Profit First implementation packages. When it comes to Real Revenue the biggest mistake I’ve seen business owners make is trying to shift Operating Expenses into Materials and Subcontractors. This meant that they didn’t have to try as hard. By hiding operating expenses in materials their business was already closer to their targets before they started.

If you’ve ever been on a diet you’ll know the feel of sneaking a snack when no one is looking. You’re not even sure why you are sneaking around because it’s your body and your diet…but you do it anyway! In these situations my mum used to say “the only person you are cheating is yourself”. She was right, no body else really cares if you eat rubbish. You are just hurting yourself.

I look at business owners trying to hide operating costs in the Materials account the same way. It’s your business and its your profit. The only person you’re cheating is yourself. You are preventing your own business from generating the level of profit it is truly capable of!

Further Information

Read our comprehensive review of Profit First here

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