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“Where did my money go?” asked the owners of a $16 million design and animation company.
The previous year was the company’s highest-grossing year: more than $4 million above normal. The projects they produced had margins of 40 to 60 percent and the accountant’s P&L reports showed a profit of more than $1 million. But there wasn’t any money in the checking account. Even worse, the company was worried about making payments on its line of credit, including a $60,000 American Express balance and a $500,000 tax bill.
Sure, they had taken extra vacations and purchased new cars during the windfall year, but nothing extravagant was taken out of the business for anything other than projects. So, what could account for such a discrepancy?
Simply put, they had no idea where the money was spent.
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How Does This Happen?
Over my 10 years of consulting experience, I have run into this scenario repeatedly: Business owners experience colossal growth, but lacking financial health, they kill their company.
Worse, the owners of the company had followed the conventional wisdom and trusted the tried-and-true systems of accounting and production that have been around for many years. Despite these systems, these owners still have no idea where their money is being spent. Breaking even becomes a real challenge… and profitability is a pipe dream.
Your CPA Doesn’t Know Your Profit
If you are like most owners, you work as hard as you can to win sales and drive every dollar possible into your business. From those dollars you pay your freelancers, staff, rent, utilities, commission, insurance, business lunches… the list goes on. Then you pay your taxes. When all those costs are taken care of, hopefully there is money left over from which you pay yourself.
The reason you follow this pattern: accountants follow the Generally Accepted Accounting Principles, or GAAP, and apply them to your creative service business. Your accountant calculates your profits like this:
Revenue – Expenses = Profit
As owners, you believe this formula simply because it’s what you’ve been taught, and it’s all you know. You dream, risk, work long hours and carry the stress, hoping your efforts will someday be worth it.
But the GAAP system was established in the early 1900s for manufacturing. And GAAP doesn’t work well for creative service businesses. Although the formula is sound, it removes the reality of how your firm’s money is actually spent.
Your producers and accountants pull information from different sources at different times. Even though they all report a “profit,” realistically they are referring to different types of revenue and expenses; therefore, production profit is a distortion of the company’s real profit. The underlying need is a comprehensive view of all company revenue and expenses calculated in a such a way that profit seen on a project is equal to profit captured by the company; otherwise, money is spent blindly on a daily basis.
To manage money in a creative service company, owners must implement routines to capture real expenses and create systems which track real profit in their companies. Traditional approaches to capturing profit – such as charging market rates or adding markups – are not enough.
“The Splits”
At RevThink we call this system of capturing real profits “The Splits.” How it works: We split all company expenses into two categories, Direct Costs and Indirect Costs. As the name suggests, Direct Costs are those expenses which are directly related to the project. These include both freelance and staff employees, out-of-house costs, commissions, and even the owners’ salaries for their time spent working on projects. Indirect Costs are all the costs related to specifically running the business, including rent, utilities, a sales person, pitch expenses, travel, taxes and most importantly, a profit.
When you divide a firm’s expenses into these categories, the majority of the expenses are in the Direct category, which means they are dynamic. They fluctuate based your firm’s project flow. In contrast, Indirect Costs are mostly static: they are roughly the same from month to month.
Knowing this, we can estimate a firm’s total Indirect Costs for the year ahead. This estimate enables us to determine what percentage of the total revenue is needed to cover those Indirect Costs. The basic formula looks like this:
Indirect Costs / Total Revenue = The Splits %
Bulletproof Profits
As we then apply The Splits to our projects, we treat these company costs like an expense – which projects must pay for – before any other dollar is spent. We allocate revenue to protect that money from being haphazardly spent on projects. The result is that we always have enough to cover a firm’s Direct Costs — including profit — before we spend any money on project costs.
The formula looks like this:
Project Revenue x The Splits % = Direct Costs (Money Available for The Project)
Once you calculate Direct Costs, you know the total money available for the project. Using the Direct Costs as the real production budget, you can appropriately allocate resources — such as freelancers and staff — to formulate a production plan that meets the need within this budget.
That formula looks like this:
Direct Costs - Project Actual Costs = Real Profit
Then frequently update your costs to record expenses and projected remaining costs. Always make sure the total spent on the project is less than the Direct Costs allocated.
Boom!! Bulletproof Profits.
Creating Your Future
As a creative entrepreneur, it is within your power to create a business that is profitable and worthy of the effort you invest in it daily. As with any system, there will be struggles getting all your work to follow the formula and always be on-budget, but with good planning and tracking of expenses, you will discover that the mystery of profit will disappear. You will have visibility and control over spending to guarantee profit for your company and yourself.
So instead of asking, “Where did my money go?” you can instead manage your business future forward by asking a much more exciting question, “Where should my money go?”
But that’s an entirely different question. We look forward to answering that – plus many others questions around the topic of profit – at our upcoming one-day Creative Entrepreneurs conference at Terranea on October 27.
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