Profit vs Revenue

“Revenue is the reason so many salespeople start businesses.  It is also why I ask my clients if they are in business to sell a bunch of stuff or if they are in business to make money.”

Recently, I have been having discussions with various people about what really matters in business: profitability.  And thus, the striking differences between profit and revenue have come to the top of my desk. High revenues are not the same as high profits—and what matters in a small business is profitability. Small business owners should always be asking: How much money does it cost to generate one dollar of revenue?

Revenue, quite simply, is income generated from normal business operations. (For purposes of this post, keeping accounting simple works best—so I am not going to get into the differences between cash accounting and accrual accounting when calculating revenue for taxation purposes.)

In product sales, for example, a simple formula works:

Revenue =  Number of Units Sold  x Sales Price  

As it does in calculating revenue from service industries:

Revenue = Number of Hours Billed  x Rate Per Hour

Whereas calculating revenue is fairly straightforward, defining profit poses some distinct challenges.  

According to Generally Accepted Accounting Principles (GAAP), a business’s gross profit is the difference between revenues and cost of goods sold.  Gross profit is calculated by adding the revenue from all operating activities and then subtracting from that number the costs incurred or associated with generating those revenues.  

Finding the actual Cost of Goods Sold number is far from simple. Rather, it forces us into a much more complex analysis, to drill deeply into the inner workings of the business.   To calculate a company’s real earnings requires us to subtract out the expenses for the Cost of Goods Sold—expenses like salaries, insurance, general administrative costs, etc.   

The first thing I do when a distressed business that is having significant and immediate financial constraints comes to me for help is look at cash flow which has its bases in revenue.  Initially, I am not concerned with profit. I suspect that many of you are thinking to yourselves, what good is a restructuring guy if he doesn’t work to make the company profitable? Don’t worry, when creating a long-term restructuring plan profitability is key. I partner with numerous professionals down the line to help get the company profitable and I formulate an overall plan with sustained viability as the ultimate goal.  But initially we have to look at ninety-day cash flow and determine which banks, vendors, and contracts have to be paid and which client obligations must be fulfilled in order to keep revenue flowing and critical bills paid.  

I want to protect cash-generating assets and equity.  Without revenue, a company cannot work its way out its problems.  Without revenue--along with a significant number of other things like assets, market share and growth potential--a distressed company cannot attract the financing it needs to address disgruntled lenders.  So, I protect the revenue to keep the company alive while we start to dive into operations.  

If revenue is so important at the outset of helping a distressed company, does that mean that the small business owner should focus on increasing revenue to the exclusion of immediate profits?   This topic has been debated until the revenues are blue in the face and profits are green with envy.  

Economic professor William Jack Baumol from New York University and Princeton posits that oligopoly firms generally focus on sales objectives rather than profit maximization with the idea that ultimately, substantial and increased revenue will generate profit sufficient to maintain substantial market share and therefore profits. Although this is an overly simplified one-line summary of the research he presents in Business Behavior, Value and Growth, it is interesting because many of the lower mid-market companies I work with have the same mindset.  

My experience with lower- to mid-market companies is that the vast majority are chasing revenue and ignoring profit.  Typically, I hear the following statements: “I am on track to increase my market share by 2.5% this year to . . .” or “Our goal is to double our contracts this sales season to. . . .”  Rarely can a client tell me how much each dollar of revenue costs to generate. 

Revenue is the reason so many salespeople start businesses.  It is also why I ask my clients if they are in business to sell a bunch of stuff or if they are in business to make money.   

A business owner must know how much it costs to generate each dollar.  Knowing how much it costs to generate each dollar enables a small business to budget and plan for its revenue growth.  Knowing the cost of each dollar generated means the business can forecast how much each new dollar of revenue is going to cost in general overhead.  The business can then assign a cost to each dollar of revenue, or customer, acquired. As a byproduct, the business will learn its current capacity and the capital improvement expenses that will be required to move to the next level of revenue generation.   A plan to temporarily decrease profit by reinvesting profit in the company in order to grow can then be created and should have a basis in the overall expected profit number down the road. It is impossible to estimate a return on investment if a business does not know how much each dollar of revenue costs today.  

In a distressed situation, immediate revenue generation is key, but when looking at long-term growth and sustainability of a small company, profit is the driving force.  A healthy balance sheet with a strong profit will open doors to financing, equity investment, and an ultimate sale.