The Relationship Between Profits, Income, and Pricing
Provided by Visa, Content Partner for the SME Toolkit
Having Cash isn't the Same as Having Profit
Many small businesses withdraw cash from the business under the mistaken impression that they are paying themselves with the profit. But there's a big difference between making a profit and having cash.
You can avoid this misunderstanding—and best determine your actual net profits—by generating and reviewing an income statement. An income statement identifies your gross profit (income minus direct cost of goods sold or “COGS”) and your net profit (your income minus all costs).
Pricing Your Products
How does this relate to profit? As you can see from the hypothetical, one of the benefits of distinguishing profits from income is that it allows you to revisit your pricing. If you see that you're barely profiting from one item or service, you may want to reconsider whether to re-price the item (or discontinue it entirely). In addition to competition, your pricing may be affected by elements such as value, demand, and costs.
A common mistake made by small business owners is pricing too low. Don't sell your product or service short. If you can deliver, charge accordingly.
Test yourself by reviewing the following case study:
Susan operates a surfboard shop and also offers surfing lessons. She's priced her surfing lessons lower than her competitors because she considers the lessons to be pure profit. After all, there are no direct costs except her time. Yet, for some reason, when she does her annual audit, her business never seems to make as much money as she expects.
Response to case study:
When Susan runs an income statement she sees that although there are no direct costs for her lessons, there are operating or fixed expenses associated with them—specifically insurance. She had been associating the insurance policy with the retail business but the biggest chunk of the insurance payment was actually attributable to liability insurance for the lessons. When she subtracted the annual liability insurance costs directly from the annual revenue from the lessons, she realized she needed to price them higher in order to justify the insurance expense.
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