Last time, we presented the concept of profitability as a measure of sustainability. So, how do you calculate the amount of profit needed to achieve sustainability? Keep in mind that in order for a company to be sustainable, annual profit must be enough to cover the three measuring points: Owner’s Compensation, Return on Investment, and Reward for Business Risk.
Compensation: What would you pay someone to perform the daily operational tasks that you perform? Operational tasks are:
- Functions that you should be delegating because they are recurring,
- Activities that are necessary to sell and/or deliver product, collect cash, pay workers, etc.
- Assignments that much larger organizations assign to Managers or Supervisors, or
- Actions that keep your business on track (as opposed to actions that create change)
Return on Investment
This is calculated by taking your total equity, subtracting the current net profit for the period, and multiplying that resulting amount by a percentage rate. The percentage rate is your estimate of what a potential investor would use to justify purchasing your company.
Reward for Business Risk
This is calculated by taking your total sales for the period and multiplying that amount by a percentage rate.
This is actually the most difficult calculation, because the better you design your company to be safe or to mitigate risks, the smaller the percentage rate that you will use. So, a chemical refinery may use a higher percentage rate than an accounting firm. The percentage rate is your estimate of what a potential investor would use to justify purchasing your company in your industry.
The difficulty is calculating the sustainability rate is that your growth does not impact the percentage rate over time. So, 15% of $500,000 is $75,000 and 15% of $5 million is $750,000, but both amounts represent a 15% reward for business risk. If you do not improve your safety as you grow, you cannot justify a smaller reward rate just because the number is larger at higher sales levels. As a result, sustainability becomes more difficult at higher sales levels unless you manage your resources more effectively.
How do you determine profitability in your company?