Tuesday, 28 January 2014

Predicting Profits: The Power of the Profit Equation





  
Are you ready for this? This is probably one of the most important and insightful business guides I’ve ever written – a guide that will show you how to predict your business profits with uncanny accuracy using the powerful profit equation.

Economic modeling is an area of expertise for me, and one of the major things I do as a business data analyst. Analysts try to develop algorithms (systems of equations) that explain or predict the behavior of markets and profits. 

Don’t get spooked – analysts simplify findings in a way that is useful to the end-user, so read on with confidence. No technical mumbo-jumbo here, just stuff you can use directly and apply to your business.

OK, let’s get started.

The Profit Equation

Your business is a mathematical system that processes input (the factors of production) and generates output (sales and profits). In effect, your business can be modeled using a series of business equations.

[Related Article: Modelling Important Business Decisions with Game Theory]

For this article specifically, we will be looking at the Profit Equation – a model that explains business profits, and why they fluctuate. Please see the equation below.


Again, don’t panic! There is nothing technical about the profit equation above, and I will explain everything. Don’t forget that this is the equation that determines how much profit your business actually makes, so you might want to get familiar with it.

The first thing you notice is that the equation has two parts: the gain section and the loss section.

The loss section is time-dependent, while the gain section may be time-dependent or product-dependent (you lose money hourly while running a business, but you can either make money hourly or per head of goods sold).

How Profits Behave (and How to Control Them)

Profits are not random – far from it. Profits fluctuate, but usually because of changes in the gain section:

·         Changes in demand (and resulting fluctuation of daily sales volume)

·         Changes in consumer buying behavior (and resulting fluctuation in the actual distribution of goods bought per time – the sales ratio)

The loss section is mostly fixed – and far more controllable. You can increase profits by:

·         Reducing work hours per day

·         Increasing actual work days (consider working on weekends and maybe some holidays)

·         Lowering wages

·         Minimizing equipment and space rentals (consider purchasing your own equipment and getting your own facility)

·         Moving to an area with cheap utility costs (cheap water, power, gas, and transportation)

Now that you understand how profits behave and how you can control your profit, let’s take a closer look at the profit equation to show you how you can always accurately predict your business profit.

First off, WHY is it Important to be Able to Predict Business Profits?

Sometimes, you need to have an idea of how profitable a business will be BEFORE you get started with it. 

Imagine using your pension or life savings to invest in a business idea that fails to get off the ground? It can be a devastating experience – so it’s always better to know where you’re going to land before you actually jump.

For those of you already in business, it can’t hurt to see WHY you’re making profit in a particular range – and what you can do to improve your business performance.

OK, now for the analysis.

I’m going to use a fictitious company called ABELHAMMER SUPPLIES as a case study to show you how the profit equation can be used to accurately predict your business profits.

Tip: By the end of the article, you would have fully understood how to use the profit equation to accurately predict your business profits. I invite you to apply what you learn here to your own business and see if it tallies – promise me you’ll send your feedback to let me know how it goes!

Case Study: Predicting Business Profits

Let’s start by building a company profile for ABELHAMMER SUPPLIES:

TYPES OF PRODUCT SOLD: 3

PRODUCT DETAILS: Cables, Power Tools, and Plumbing Fittings.

SALES RATIO (POPULARITY OR DEMAND): Cables (20%), Power Tools (30%), Plumbing Fittings (50%) – total 100%

PRODUCT PRICE: Cables – per pack ($3.50), Power Tools – per set ($1,500), Plumbing Fittings – per box ($250)

AVERAGE SALES TRANSACTIONS PER DAY: 20

WORKING DAYS IN A MONTH: 20

WORKING HOURS PER DAY: 8

WAGES PER HOUR (SENIOR STAFF): $20

NUMBER OF SENIOR STAFF: 4

WAGES PER HOUR (JUNIOR STAFF): $12

NUMBER OF JUNIOR STAFF: 10

TOTAL SPACE & EQUIPMENT RENTAL COST PER HOUR: $200

TOTAL UTILITIES COST PER HOUR: $30

We’re now ready to start. Launch your calculator app or grab a handy one.

1. Gain Section – ABELHAMMER

Recall the gain section is given as follows:


That was simple enough.  Now for the loss section.

2. Loss Section – ABELHAMMER 

This is the tally of operational costs per day and is obtained as follows:


3. Monthly Profit – ABELHAMMER

We’re now ready to predict monthly profit for ABELHAMMER supplies:


Business must be very good for ABELHAMMER!

We have successfully calculated monthly profits for this case study. I invite you to use the equation and check out your profits! Meanwhile, enjoy the following bonus topics.

Bonus #1: Effect of Increasing Consumer Confidence on Profits

When consumer confidence in your products rises, your profits will rise as well. You should invest in improving the quality of your products, workplace, or facility to raise consumer confidence. See the illustration below:


Bonus #2: Effect of Lowering Work Hours per Day on Profits

This might not sound right to you, but actually LOWERING your daily work hours improves your profits dramatically. See the illustration below:


Wow – that was some good stuff, wasn’t it? Please try this for your business and let me know how it goes! Post your comments if you have any questions, and I’ll get right back to you!
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