What are the basics behind profitability?
Profitability is the holy grail of any Shopify business, and fortunately, there are steps you can take toward this goal.
How do you measure your business profitability? This blog post will explore the basics of being profitable and important related marketing metrics that, if improved, can have a positive impact on your profits.
We’re digging into:
- Return on investment (ROI)
- Lifetime value (LTV)
Ready? Let’s go.
Profit vs. profitability
In order to understand how to be profitable, we must first understand the difference between profit and being profitable.
Profit refers to an absolute amount you make by selling goods or services after factoring in the expenses of buying, operating, or producing your offerings.
Expenses are the costs associated with generating revenue for a business. Hence the popular saying “it costs money to make money.” These expenses include cost of goods sold (COGS), rent, wages, and utilities.
Profit is calculated as:
Here is an example:
Emily wants to know how much she's earned from her online jewelry business. To calculate her profit, she needs to know her total revenues and expenses.
Step 1, her total revenue is $10,000.
Step 2, calculating total expenses requires adding up her costs, as follows:
- Marketing costs: $1,750
- COGS: $1,295
- Shipping: $245
- Transaction fees: $210
Therefore, the total expenses are $3,500. Subtract that from her $10,000 revenue, and Emily is left with a $6,500 profit.
On the other hand, profitability is the measurement of profit. With this measurement, you can forecast if your business has enough profit to grow. Let’s dive in.
Profitability starts with tracking expenses and profits
The first step to being profitable is having a good handle on your profits and expenses.
Many businesses struggle to determine profitability because they don’t record their income and expenses properly. Business expenses can be tracked in a variety of ways, but to manage your business effectively and to keep track of spending, you will need an expense tracking system that works for you.
Accurate tracking is critical to evaluating overall performance and is essential to measuring your company’s profitability, both current and future.
Why? Let’s take a look at both.
Why track your expenses
#1 Improve cash flow management
The main reason businesses fail is because of lack of cash. More precisely, 82% of businesses fail due to cash flow problems.
Having a cash flow problem means that the cash outflow exceeds the cash inflow, resulting in a lack of liquidity. This makes it difficult to make payments to suppliers, pay bills, and ultimately run a business efficiently.
By tracking your business expenses daily, you can control your costs and determine, in real time, whether you’re over or under your monthly budget. With this financial awareness, you save money and free up cash to invest in other crucial departments.
#2 Gain insight into specific expenses
Online businesses incur numerous expenses, like shipping, production, inventory and marketing. It's easy to overlook unnecessary expenses without proper tracking. Using a profit calculator like BeProfit will help you get a full breakdown of all your costs in one place.
With the help of an accurate profit dashboard, you can get better financial reporting charts, and auto exchange rates for accurate profit calculations.
This will ultimately allow you to make data-driven decisions and optimize your Shopify store to become more profitable.
#3 Be prepared for tax season
By continually tracking and recording your expenses, you'll have everything ready by tax time. You won’t have to waste energy hunting for records of tax-deductible items, which typically include:
- Cell phone and internet expenses
- Business lunches and meetings
- Business-related travel expenses
- Office supplies
- Home-office expenses
Why track your profits
#1 Acquire a realistic view of your business health
When you know whether and how much net profit you're making, you get a clear picture of your business's profitability. By regularly tracking your profits, you can proactively work on balancing your expenses and income and increasing your profit margin.
#2 Find minor cost shifts
Knowing your yearly profit is important, but it isn't enough in order to track profitability. You might not be able to decipher where costs have increased when you combine all expenses and revenues.
Tracking your profit helps determine if your business is growing financially. With profit margin analysis, you can compare and contrast several areas of your business in order to identify areas where profits are being drained.
For example, if you operate several divisions, product lines, stores, or geographically dispersed facilities, you can calculate profit margin to assess each unit's performance and compare it with each other.
Making sense of ROI and LTV
In the world of ecommerce, there are a multitude of metrics to consider, but ultimately your return on investment (ROI) and lifetime value (LTV) are the most crucial. Regularly monitoring these numbers is vital to identifying adjustments that will boost your profits.
ROI refers to revenue generated from business investments. Using ROI, you can measure your business's profitability or return on costs.
For future campaigns, it is important to know how to measure the results of your marketing efforts. The ROI of previous campaigns will help you decide whether to stick with the same strategy or try something new.
ROI can be calculated by dividing the net income by the total investment cost. Then multiply the value by 100.
Note that in most cases, ROI is calculated in percentage form.
For example, if the income from Emily’s marketing campaign is $1,000 and her cost of investment is a total of $500, then her total ROI would be $1,000 / $500 x 100 = 200%. That means she doubled her investment!
If you're spending money on advertising, it's wise to comprehend ROAS (return on ad spend) and how to calculate it.
LTV measures how much a customer spends over their lifetime with your business.
Your LTV can be calculated by looking at your churn rate, which is how many customers cancel their subscriptions in a given month. Next, calculate your gross margin. This is the percentage of profit left over after expenses are paid.
Lastly, you'll want to know how much your average customer spends every month. To find your LTV, plug those amounts into the following formula:
Customers with a high lifetime value are VIPs because they spend the most time with you.
Calculate your business’ profitability to make better decisions
When you calculate your company’s expenses and profits on a regular basis, you’re empowering your company to take profitability to the next level. Gathering this data and examining it is crucial to making the right decisions for your business.
ROI and LTV are essential to measuring your company's success now and in the future. ROI serves as a benchmark for marketing strategies, while LTV can be used to predict the value of your customers. By combining these metrics, you'll determine whether your product meets the market's needs and be able to judge any future growth experiments more effectively.
Hili Jeffery is Head of Content at BeProfit, an all-in-one analytics dashboard that helps you track your expenses and perform precise profit analysis automatically.
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