The paper below attempts to answer the question of what the profit "Should Be" given the risks associated with investment in a small or medium size business.
My opinion is that the risk involved in investing in such a business, is at least 3 times that of a safe investment or twice the borrowing rate, whichever is the higher. These two calculations are on a gross return before tax basis and often give a very similar result. This criterion can of course be varied to suit local opinion and circumstances.
Operating Profit measured on this basis is therefore before interest and tax but is after deducting a management salary for the owner(s) that reflect a fair reward for their management activity (including overtime at home).

The calculations below assume a safe investment return of 8% and a borrowing cost of 12.5%. Given these parameters the Operating Profit should be at least 25% of the Operational Investment in the Company. Operational investment being:-
Fixed Assets (ideally valued at replacement value) plus Net Current Assets, which is Stock, plus Debtors (excluding any finance or tax balances), less Creditors (excluding any finance or tax balances).
The calculations require that the accounts of the business can be analysed into fixed and variable expenses.
The calculations illustrate the sales activity required to achieve the "Should Be" Operating Profit, based on the actual profitability and efficiency historically achieved, or the level of price increase required, or the degree of savings in cost required. If a business' profitability falls short of the "Should Be" Operating Profit criteria, the actions a management can take to improve profitability are of course many and varied. They are likely to include a combination of these and other actions.

Rent Return:-
If it is considered relevant, the criteria can be varied for different categories of investment. To illustrate this, an amount is included for a rental charge for owned land and buildings, rather than the criteria multiplier.
Fixed Asset Replacement Adjustment:-
It is considered that the proprietor manager of a small to medium sized business, should be able to make a reasonable estimate of an adjustment factor to be applied to the cost of fixed assets. The factor should represent the difference between the cost and the estimated replacement value of fixed assets.
Proprietor Salary Adjustment:-
If the accounts do not include a salary for the proprietors, that represents a fair reward for their involvement in the management of the business, then an adjustment should be included.
Super Profit
Super Profit (my terminology) is the extent to which "Should Be" profit exceeds a safe return on the level of operating capital employed in the business.

The "Should Be" profit calculation could be applied to the financial data included in business plans and budgets. It can also be used in the setting of targets and objectives.

If a business is highly seasonal, resulting in significant variations in operating capital employed during the course of the year, then the calculation can be applied to averaged data

A spreadsheet template and example are available to download. You can replace the data, in the example, with your own, to automatically calculate a "Should Be" profit for your business

Three types of spreadsheet template are available:-

1. Microsoft Excel 97
2. Microsoft Works version 6
3. Lotus 123 Release 2.2 This is a DOS version and now somewhat old. It has the advantage that it can probably be read by many other spreadsheet programmes.

Download Microsoft Excel template.
Download Microsoft Works template.
Download Lotus 2.2 template
Warning: Always check downloaded files for viruses before opening them.

E-mail us your queries and comments.

Reproduced with Permission
Copyright Len Bainbridge (Unregistered)