Episode 59: Where Do Profits Come From?

As we’ve been imagining what it might be like to get our shot to pitch the investors on Shark Tank, we’ve had to ask ourselves what the equity of our creative practice might be worth—since equity—a percentage of ownership—is what investors essentially buy with their money. Equity is ultimately established through calculating the retained earnings of a company—its revenues less all the costs that were expended to produce those revenues. Investors are interested in a company’s total sales, but what they really want to know is their profit margin. This week we’ll evaluate the profit margins of a typical creative practice.

Are you ready to take the struggle out of finding new clients?

Every successful business must generate profits. The only alternatives are to loose money, which puts companies out of business, or to break even, which makes them extremely fragile and vulnerable to every downturn in the economy. Sadly, most creative service businesses do operate at close to a break even basis—which is why so many come and go.

Creative practices, like any other business, must generate profits—and the only way to do this is to sell your services for more than it costs you to generate them—including the costs of your own labor. So many creatives consider the revenue that they take home as their profit. It’s not, it’s an expense to the company. It’s only what’s left over after you pay all your bills, and pay yourself that counts toward your profit margin, and which builds up the value of your equity.

Let’s consider the typical margins of other kinds of companies. In the restaurant business, for example, a general rule of thumb is that one third of your revenue goes toward food costs, one third toward other overhead: rent, utilities and payroll—and one third should be left over for profit. For companies that sell products the margins are calculated by subtracting the landed costs of manufacturing from its sale price. Products whose costs are more than 50% of their sale price are rarely attractive to an investor.

But what about creative services? As with most professional services, the main input on your costs is your time. Sure you might have some hard costs in your overhead such as software licenses, and rent if you don’t work out of your home, but your time is by far your biggest cost center. And since your time is the main ingredient of your costs, calculating your margins presents some difficulties. Hard goods have material and production costs that can be measured to the penny. But your time, what’s that worth? Measuring the costs of your primary ingredient are much softer than calculating food costs.

Most creatives establish an hourly rate for themselves, whether they bill by the hour, or just use it as a basis for providing project quotes to their clients. So theoretically you could use that rate as a basis for determining your margins. Just add up all the work hours available to you in a year, multiply by that rate, and then subtract out all of your expenses—including your compensation—and you would have a margin that could be stated as a percentage. If you work 2,000 hours per year, and you charge $100 per hour, you might project $200,000 in revenue. If you also project $150,000 in expenses that would leave you with $50,000—which would equate to a 25% profit margin.

Without a doubt, the biggest problem with this kind of calculation is the failure to realistically reduce your overall “inventory” of work hours to account for non-billable activities needed to run your business. In the real world, at least 40% of those hours will not be billable. Rerunning our margin calculations with that factor means that we really only have 1,200 billable hours, which at our rate would produce $120,000 in revenue giving us a loss of $30,000—or a negative 25% profit margin.

When we fail to properly calculate our margins inevitable losses occur. Most creatives compensate by just paying themself less—effectively lowering their hourly rate to reduce expenses to stem the losses. Sadly, they also tend to blame the problem on a lack of volume of business, rather than the reality that their margins are just way too low.

As we pour ourselves into our creative practices, we need to set ourselves up for success by establishing rates that will actually provide real profits. As we continue our Shark Tank fantasy we’ll consider other questions that will reveal problems, but also begin to suggest solutions.

Until next week: don’t let the business of creativity overwhelm your creative business.