Entrepreneur: So how do I know what my business’s baseline number should be?

Greg: There are some

business performance basics that help you decide your target profitability level. And then you’ve got to
adjust salaries and all the other operating expenses to make sure that you hit those profitability levels.
In the next few chapters, we’ll touch on these business performance basics, and I’ll show you how to
build your business up from your baseline number. It’s not as complex as everybody likes to make it
seem. TWO CHALLENGES Are you underpaying yourself and bragging about your sales or your net
income? To make sure you are not just showing off your peacock feathers when you talk about your
financials, you need to face two challenges. Challenge #1: Be a More Demanding Employee Are you
making $30,000 a year when you’re really worth $100,000, or maybe even $150,000 or $200,000 a year?
If so, why are you willing to work for such a low salary? To answer this question, you need a long-term
goal that makes working for such a low salary worth your while, and you need a plan to pay yourself a
market-based salary after that goal is met—a real cash salary, not a distribution of profits. Challenge #2:
Be a Demandinman Aa Demandg Shareholder If you are accepting a below-market wage, you are
overstating the profits of your business. As a demanding shareholder, you would never stand for that. If
you’re a single-shareholder business and you can’t be demanding enough on your own, you may need to
have a one-on-one relationship with a key advisor. If your advisor is not really helping, it’s okay to end
the relationship. Find a different advisor who will talk straight and help you drive your business forward.
I’ve had clients who have used advisory boards, which were usually found largely ineffective. If you
chose to have an advisory board, make sure you aren’t listening to too many voices, and make sure the
voices you are listening to have something relevant to say. Keep your goal in mind: You don’t want your
numbers to lie to you. Inaccurate numbers will distort your financial information and cause other
problems as well. Chapter 1 Keys 1. Know what your market-based wage is for your role. If the business
cannot afford to pay you, keep track of the wages you are giving up. 2. If you are profitable and you pay
yourself wages that are too low, you run a high risk of an IRS audit. And no one wants an IRS audit. 3.
Value profitability over tax savings. Stop distorting your net income because of improper owner
compensation. 4. Use market-based wages for everyone in the business, including shareholders. 5. Pay
back your investors before you share profits, and create reasonable financial expectations for your
investors. 6. Consider working in a limited capacity at a lower wage as you transition out of active
management. CHAPTER 2 PROFIT: WHY 10 PERCENT IS THE NEW BREAKEVEN Profit is like oxygen—your
business can’t hold its breath very long without it. You know that you have to pay yourself a market-
based wage and get a return on what you own. If you’re not at the point where you can do this, then
you’re not profitable enough. Maybe you’re thinking, “I’m committed to my business, and I want to pay
myself a market-based wage for the things I do. But I’m not getting enough profit out of the business to
be able to do that.” How do you fix that problem? THE IMPORTANCE OF PRETAX PROFIT First you have
to understand the concept of profit. Profit is the lifeblood of every business. If your business isn’t
profitable, you’re taking business from others and you will eventually fade away. You either have to be
profitable or have an endless amount of capital to throw at yworapital our business. To keep it simple,
when I say profit, I’m talking about pretax profit. This is the profit you make after you take all your sales
minus all your costs, before you pay taxes. If you can’t pay yourself a market-based wage, the first thing
to focus on is getting your business profitable. Remember the cow analogy in chapter 1? You can keep
your cow healthy and milk it every day, or you can have one big barbecue dinner. Think of the milk as
profit. It eventually turns into cash flow, but you have to be profitable first. A lot of business books and
articles use the term EBITDA, which means earnings before interest, taxes, depreciation, and
amortization. There’s a game, largely played in the investment banking community, where they recast
earnings and say that interest, depreciation, and amortization aren’t real costs. But let’s face it. Unless
you’re building a twenty-year production plant that is going to last fifty years, depreciation is a real cost.
If you buy a truck for $50,000 and it wears out in five years, you’ll have to replace it. That’s a real cost.
Amortization is just a fancy term that spreads the cost of nonequipment over years just like
depreciation, but very few entrepreneurs deal with amortized costs that are significant. Technically,
interest is not an operating cost. Generally accepted accounting principles (GAAP) are great, but at the
end of the day, entrepreneurs need to be practical. When you write a check for interest, you have to pay
real money to cover that check. It takes cash out of your business and typically indicates your business is
undercapitalized. This is an important aspect of interest, and it’s the key reason I focus on pretax profit.
Pretax profit is your earnings before taxes. That is the revenue-generating activity that your business
produces for your benefit. In most of the businesses I work with, interest, depreciation, and
amortization are real numbers, so it’s important to understand that you should ignore EBITDA and focus
on your pretax profit. As I said in chapter 1, revenue is for show, and profit is for dough. I couldn’t care
less how much revenue you have. It’s an important number in terms of cash turnover, but we need to
focus primarily on your gross profit before we can fix your pretax profit. Gross profit is revenue less cost
of goods sold. Contrary to many other accountants, I recommend that you not include any labor costs in
getting to gross profit. By keeping labor out of the equation, my definition of gross profit gets you to the
number that is the true economic engine of the business. Cost of goods sold typically includes pass-
through costs like finished goods, materials, and subcontractors. These costs will vary dramatically
among businesses and industries. By focusing on gross profit instead of revenue, most businesses from
any industry can be compared side to side. For instance, I can take a service-based business and
compare it to a retailer, and then I can compare the retailer to a building contractor. I can compare the
building contractor to a government contractor because when I sell materials, I’m really selling the
services of the people who deliver the materials. If I have labor that I want to account for as direct labor
(that is, labor that is directly responsible for product or service delivery), I show it on a separate line
below gross profit. Gross profit minusand Qofit min your direct labor is then what I refer to as your
contribution margin before you pay for your general operating expenses. Don’t think of subcontractors
as your labor that you make money from. If I hire a subcontractor, I have to leave profit in the equation
for the subcontractor’s business since I am offloading my downtime risk to the subcontractor. Therefore,
I am just passing through some of my revenue to the subcontractor. You can show the world all the
expanded financials you want, but you have to come back to reality and filter out the cost of goods sold.
If a construction contractor has a $20 million business, that’s great. But by the time he subtracts what he
pays for subcontractors and materials, he probably has a $2 million or $3 million business that looks like
any other service-based business. That’s why your revenue doesn’t matter. Your gross profit matters
most, followed by how you get to pretax profit. Take a look at exhibit 2.1. It compares a construction
contractor with a services business. There is a dramatic difference in their revenue and cost of goods
sold, but starting with the gross profit line, they are exactly the same. The construction company
survives on less pretax profit as a percentage of revenue because they try to not pay their
subcontractors and material vendors until they get paid. It is as if they are a selling agent for the
materials and their subcontractors