Understanding wages and profit

Cash in the Hand

Many small business owners do not really understand the difference between wages and profits. Even a sole trader needs both. The televisions shows that claim to show how to make money from restoring houses, cars and furniture also fail to make the distinction.

Businesses Need Wages, and Profit

Such shows total the cash costs and take them from the sale price and call the result profit. It is not; the real or opportunity cost of the work is rarely included and the so-called “profit” is not what is available to the business owner as drawings except as a one-off exercise. This article is about building a business with a long term future.

First a photographic business needs to provide its staff, including the working owners, with a wage. Secondly the business managers need to understand the real nature of profit and its importance to the long term health of a business.

Think as an Employee and Investor

Wages are the payment for an individual’s time and skill spent working in the business. Profit on the other hand is a return for the use of the money invested in the business and compensation for the financial risk. So wages and profit both need to be built into the cost calculation used to set prices.

Think about is as if an employee. You would want your wages, and ideally overtime, for all the work you do for your employer. That would usually be based on the time you spend working.

However, if you have savings you would want a return on them, perhaps as a modest interest rate on an essentially safe bank savings account. On the other hand, if the money is invested in shares or in someone else’s business you would want a higher return to compensate for the greater risk. If you invest in shares that return comes in two ways. First there is a dividend which is a distribution of profits to the shareholders. Then there is growth in value through, hopefully, share price increases. In part that reflects the increased assets in the business; that needs retained profits to fund the growth of the business.

The position should be no different if you own and run a small business. A business owner, even a sole trader, needs to build both profits and wages or salary into the price. If the business does as well as planned the business owner will be able to draw their wages. There should also be profit that can be retained to pay for business development, to provide a cushion in uncertain times or distributed as a dividend or as an occasional return to investors – the business owners. Ideally it should be all three.

Money as a Commodity, With a Cost

To further illustrate the point that money is a commodity with a cost that the business has to bear is that large projects in construction or computer systems often show a line for “Cost of Money” in the proposal. Suppliers negotiate with clients on deposits and stage payments to reduce the amount of money needed for working capital. On large government projects there is a trade-off; government can borrow money more cheaply than even large suppliers. By using less of the more expensive cash from the supplier the overall cost to the customer is reduced. On the other hand the client wants to keep the supplier hungry to ensure they provide service and stay focussed on provide good service and value; “to keep the supplier honest”.

While such an approach is not appropriate for photography businesses it should be noted; take smaller deposits or stage payments and more working capital will be needed putting more money at risk. So cost of money drives the profit needed to fund working capital and give investors a suitable return. Bear in mind that the return should reflect risk so should be significantly higher than interest paid on bank savings. A starting point could be bank overdraft rate; bear in mind the risk of investing in a small business (even your own) is high so credit card interest rates (typically 16-40%) may be more appropriate. Suddenly the importance of considering cost of money and profit in setting prices becomes very significant and explains why so many small businesses are always short of cash.

So separating profit and wages becomes critical. Even a modest owner-run photography business may have £30,000, or more, tied up in capital equipment (vehicle, equipment, computers depending on how they are treated in the accounts). There will also be working capital to cover expenses such as wages, sales and marketing or travel, materials, printing and money owed by customers. Say that is another £20,000.That £50,000 would have to come from the owners’ investment in the business or from borrowing, both of which have a cost. Most business owners will include overdraft and bank borrowing costs in the budget but how many include the cost of their own investment in the business? If cash needs are met without borrowing then the business faces another £5,000 of costs just to provide a modest (for the risk) return of 10% a year to the investor – around £2.50-5.00 per hour depending on how many chargeable hours per year are planned.

Reward Investors, Even Owner-Manager

But return for investor is only part of the profit story. Many, perhaps most, small business are chronically short of cash so is essential to retain profit to reduce cash flow risk and to fund future growth of the business. Retained profits are needed to finance internal investment within the business; in sales and marketing, new products and services, new equipment and the increasing cash needs of a growing business. A business that cannot generate and retain profit is on a downward spiral; eventually it will not be able to fund essential replacements. In my early days as a photographer I learnt this lesson the hard way; I could not afford to replace cameras as I wore them out.

Owners of any small business need realistic cost budgets based on an understanding of all the fixed and variable costs. They should include an appropriate level of wages so they and their families can be fed and clothed. On top they need a realistic profit target so they, as investors, get a proper return on their capital and the busines

This article originally appeared in Professional Photographer

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