When you’ve got your head down running your business, it can be really challenging to get some perspective on how things are going—even something as straightforward as how much money you should be making.
Unless you happen to have a finance or accounting background, digging into your financial numbers likely isn’t one of your favorite things to do. However, it’s critical that you have a basic understanding of how your business actually runs. You’ve got to understand how (or if) you actually make money.
One of these key financial ideas that comes up frequently is the question of how much money should a business owner make, both in terms of salary and profits. Unfortunately, the most accurate answer is “it depends.” Every industry is different in terms of profit margins and market based wages, and there can also be a huge difference in individual businesses within an industry, based on things like their maturity, competition, geography or other factors.
Despite all of that, how much you should make is still an important question and definitely worth thinking about. Luckily, author and speaker Mike Michalowicz has clearly thought about this topic a lot. In fact, in his book, “Profit First,” he does a great job of digging into this very idea. He has created what he calls an Instant Assessment (you can find it on his website under “Resources”) that helps you calculate a ballpark approximation of what your profit, owner’s pay, taxes and operating expenses should work out to, based on your revenues.
The engine behind his assessment process is the following table—Target Allocation Percentages, with Revenue Ranges across the top and the various categories down the side. So as an example, a company doing $2 million in real revenue (I’ll explain below) should target a profit of 10 percent of that $2 million, owner’s pay of 10 percent, taxes of 15 percent and operating expenses of 65 percent.
Take a couple of seconds to study the chart. There are several interesting things that stand out about it:
What is Real Revenue?
Michalowicz defines Real Revenue as your top-line revenue less what you paid for subcontractors or materials. So if you’re a $10 million general contracting company, and you pay out $8 million to subcontractors, your real revenue is $2 million, not $10 million.
Profits are hard to come by – The profit line ranges from 5 percent for a startup to 20 percent for a mature, established $10 million-plus business. This is a ballpark approximation for general small business, weighted towards service-related businesses since that’s the majority of what’s out there. You will hear stories of companies that make huge profits (30 percent, maybe even 50 percent or higher) but you have to realize a few things. For starters, you can’t believe everything you hear, and if someone IS making that kind of profit, then you can bet that others are going to be getting into that business soon and competing, which will drive that profit margin down quickly.
Finally, there are some industries (i.e. manufacturing) that would love to make 10 percent profit some day. If you’re in a highly competitive, nondifferentiated industry, you just aren’t going to have great profit margins.
Black Hole at $1 Million to $5 Million
Most businesses experience a very challenging growth period between $1 million and $5 million, mostly because that’s when you have to really start investing in overhead (larger management team, equipment, automation, etc.) if you want to grow. That investment costs money and makes you less profitable.
Owners Don’t Make Anything at $10 Million?
If you look closely, the owner’s pay drops to 0 percent at $10 million. That doesn’t imply that an owner doesn’t get to make any money at that point, it’s more of a recognition that the profits at that level end up being a lot of money and the owner can (and maybe should?) consider hiring a CEO and promoting themselves to the chairman of the board role instead, where you don’t take a salary and instead just take profit distributions.
It’s important to note that the Target Allocation Percentage table is a high-level estimating tool, more of a rule-of-thumb-type of guide. There are big spikes because it’s a simple table. If you’re around the $1 million mark in revenue, then there’s a huge jump in expenses as you cross to the next range. Obviously, that’s not how it works in the real world, but the table can still give you a reasonable ballpark to work with.
How Much Money Should You Be Making in Your Business?
Based on the “Profit First” assessment, how are you doing? If you’re like a lot of business owners, the information in the assessment process will be a wake-up call. It’s common for business owners to be short of those numbers. That doesn’t mean your business (or you) are broken beyond repair, it just means that there’s room for improvement. With focus and consistent effort, you can start steering towards a much healthier outlook over time.
I'm an expert in business management and finance, and I'll provide you with insights into the concepts mentioned in the article. To demonstrate my expertise, I'll begin by discussing the key financial ideas and concepts in the article.
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Understanding Your Financial Numbers: This is a fundamental concept for any business owner. It's crucial to have a basic understanding of your company's financial performance, including revenues, expenses, profits, and cash flow. Without this understanding, it's challenging to make informed decisions and ensure the sustainability of your business.
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Profitability and Owner's Compensation: The article discusses the question of how much money a business owner should make in terms of both salary and profits. Profitability is a critical measure of a business's success. Profit represents the amount of money left over after covering all expenses. Business owners typically aim to generate a reasonable profit to compensate themselves for their efforts and investments.
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Industry Variations: The article emphasizes that the answer to how much a business owner should make depends on the industry. Different industries have varying profit margins and market-based wage standards. Understanding industry-specific benchmarks is essential for setting realistic financial goals.
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Profit First by Mike Michalowicz: The article mentions Mike Michalowicz's book, "Profit First," which offers a unique approach to managing business finances. The book introduces the concept of allocating revenue into different categories, such as profit, owner's pay, taxes, and operating expenses, to ensure financial stability and growth.
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Target Allocation Percentages: The core of the Profit First system is the use of target allocation percentages. These percentages guide business owners in allocating their revenue to different financial priorities. For example, a company with $2 million in real revenue might allocate 10 percent to profit, 10 percent to owner's pay, 15 percent to taxes, and 65 percent to operating expenses.
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Real Revenue: Real revenue is defined as the top-line revenue minus expenses related to subcontractors or materials. This concept helps business owners understand their true financial performance by considering direct costs that reduce revenue.
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Profitability Levels: The article mentions that profitability levels can vary significantly based on the stage of a business's growth. Startups might aim for a lower profit margin (e.g., 5 percent) due to initial investments and uncertainties, while more established businesses may target higher margins (e.g., 20 percent).
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Challenges in the $1 Million to $5 Million Range: The article highlights the challenges businesses often face in the $1 million to $5 million revenue range. During this growth phase, businesses typically need to invest in overhead, which can reduce profitability temporarily.
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Owner's Compensation at $10 Million: The article notes that owner's pay drops to 0 percent at the $10 million revenue mark. This doesn't mean owners don't make money; rather, it suggests that at this level, owners might consider hiring a CEO and taking profit distributions instead of a salary.
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High-Level Estimation Tool: The Target Allocation Percentage table is described as a high-level estimating tool or rule of thumb. While it provides guidance, real-world financial management involves more complexity and nuances, but the table offers a starting point for financial planning.
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Continuous Improvement: The article encourages business owners to use the Profit First assessment as a wake-up call. Many business owners may find themselves falling short of the recommended financial targets, indicating room for improvement. With focus and consistent effort, businesses can work towards achieving healthier financial outlooks over time.
In summary, understanding your business's financial performance, industry-specific benchmarks, and strategic allocation of revenue are crucial concepts for business owners. The Profit First methodology, as outlined by Mike Michalowicz, provides a structured approach to managing finances and optimizing profitability.
