How Much is a Fair Profit? Part II of V – The Economic Cycle
A small business fair profit is between 9 and 37%.
To me, 100% is a fair profit. The customer hands me their money and I do nothing in return. The problem with that scenario is that the customer will never come back. If I go to the other extreme, and I lose money on each transaction, then it would be cheaper for me to pay the potential customer to stay away. I’ll get plenty of those types of customers. Somewhere between a loss and a 100% profit lays the answer.
There are many factors used to determine the fair profit for your business. They are grouped into four major factors. The first factor has the greatest impact on the final profit calculation and that is the compensation package afforded the owner. The second factor affecting profit is the economic cycle of the industry the small business operates within. The third factor with significant impact is risk and finally the fourth factor group is return on the capital investment. The fifth in this series provides a master example of how a small business owner calculates a fair profit.
The Economic Cycle
One of the primary purposes of a profit is to provide funds during downturns in the business cycle. Often referred to as the economic cycle, there are two types of cycles. The first is industry related. The second is broader in scope and is economy wide. The following sections describe each type of cycle and illustrate how an owner of a small business calculates the appropriate profit to compensate for the cyclical periods.
Industry Economic Cycle
The McIlhenry Co. of Louisiana makes the famous TABASCO Sauce. It takes almost three years for the red peppers to age in white oak barrels to achieve full flavor. For them, their economic cycle is an industry cycle of almost three years. From the time they start to the time they get the product to the distributors is three years. That is a long time. Most economic cycles are recorded in calendar years. But in reality, it depends on the product produced and how long from the time the natural resource is purchased to the day the product is sold to the distributors is the true economic cycle. The following are some examples:
Newspapers – 1 Day
Raising chickens for slaughter – less than four months
Whiskey – 6 months to 12 years
Many Fruits and Vegetables – Seasonal
Baseball – 8 months Late Feb – Early October
Gold Mining in Alaska – 5 months
Farming – Spring to Fall
The key to calculating the profit for the business relates to the timing of the cycle(s) for the accounting period (generally recognized as one year). For the newspaper business, they’ll get 365 days of cycles in the accounting period. Whereas the guy involved in baseball, well, he can’t because it is seasonal in nature. He needs to make a profit to cover overhead during the four months of the year there is no income at all. He has to calculate the overhead costs for the down periods and add that to the normal operating costs during the regular season to determine total overhead costs for the entire calendar accounting period. This requires a higher profit margin on the products/tickets/royalties etc. to cover those periods of time where there is no revenue.
Think of the Santa’s in the cartoon, if you only get one gig per year to earn money, well, you had better charge a lot for your time. You need the profit to address the down period of time which is pretty extended.
But for the McIlhenry Company it is a little different. Although the cycle is every three years, a cycle is completed each calendar year for the peppers grown three years ago. The economic cycle is long and if there any issues associated with the peppers, than alternatives can be utilized to minimize the economic cycle. If a crop is destroyed, the company can resort to substitute peppers with a similar heat rating. They could even mix some of the their crop with other peppers similar to how wineries or beer companies mix batches together to get a consistent flavor for their product. The key is that they have time on their side to recover from a catastrophic event.
In general, those with longer industry cycles have a better chance at alleviating many of the negative factors in that cycle. Those with shorter cycle times have little or no window of opportunity to rectify the financial impact associated with the industry cycle time. Therefore, the profit percentage calculation must be adjusted appropriately higher for those shorter cycle times. In principle, a 1% profit margin must be added for each month of exposure to an industry related cycle element. If your business operation has 9 months of the year with exposure (summer related business) and there are two significant industry cycle elements of exposure (fuel cost for travel and exposure to foul weather during the summer travel period). Then your profit should carry at least 18% (two factors time 9 units of time) additional profit to cover these industry related economic cycle elements.
Economy Wide Cycle
The economy wide cycle is the natural fluctuation of economic activity referred to as expansion of the Gross Domestic Product and downturns known as recession. Each industry responds differently to the economy wide cycle. From 2008 through 2012, the construction industry, specifically new home construction, took the brunt of the downturn in the economy. Very few new home starts existed and many new home contractors resorted to alternative forms of construction to get through the extended cycle time.
Other industries saw the exact opposite. As an example the McDonald’s Corporation actually saw an increase in sales associated with this economic downturn. After much discussion the conclusion was that the consumer switched his eating out habits from the more expensive sit down style restaurant to the more affordable fast food chain in order to fulfill the desire to eat out.
Your industry needs to determine the average length of the cycles and the impact upon your industry related to these changes. If the economic wide cycle is every seven years and two of those seven years are highly active, three are marginal and two are losses, then a profit formula should be developed so that during the highly active periods enough profit is generated to offset any marginal losses during the three marginal years and the anticipated losses during the two down years.
The following is an example of an industry’s performance related to the economy wide variations. The writer uses the extended 11 year cycle and uses a generic business operation that has no industry related economic cycles. The symbol X+1 identifies the base year plus one. The first column states the level of economic activity as a whole. The second column associates business activity related to the first column. The final column points out the profit change associated with the economic point in the first column.
YEAR ECONOMIC POINT ACTIVITY LEVEL PROFIT %
X Growth Positive 2.7
X+1 Growth Robust 3.9
X+2 Stable Robust 3.8
X+3 Stable Positive 2.5
X+4 Downturn Negative -1.2
X+5 Unstable/Negative Lean -7.4
X+6 Recession Lean -8.1
X+7 Stable Negative -4.2
X+8 Positive Outlook Negative -2.2
X+9 Growth Neutral -0.3
X+10 High Growth Positive 2.2
Notice that in this company’s situation, years X+10 through X+3 (four years of the 11 year cycle) allows the company to make a positive profit associated with normal business activity. Total profit correlated to the good years equals 15.1. The economic downturn and recession periods offset the good times with a 23.4 loss. Overall, if the owner does nothing, then the cycle will cost him 8.3% or about .75% for one year’s worth of sales. To cover this, the owner should adjust his profitability by .7545% (8.3/11 Years) on all sales to offset the economic wide cycle impact to his company.
How does a new owner of a small business interpret the impact to him associated with the economic wide cycle? Research! Yep, find out what is the economic wide cycle associated with this industry and then make adjustments. Be conservative in your approach and yield towards more profit on each transaction to cover the overall economic activity. Below are some industries and the impact an economic downturn has on that industry:
New Auto Sales Steep Loss
New Home Construction Slight Downturn as Long as Money is Available to Lend
Food Service Slight Downturn
Entertainment Slight Downturn
Alcohol Significant Increase
Overall, an owner of a small business has to use his industry knowledge and select the economic wide cycle (there are about ½ dozen of them) that best matches his industry. From there, evaluate the impact in a schedule similar to the one generated above. Once done, calculate the profit offset needed to minimize the impact during the lean or recession years.
Summary – Economic Cycle
The owner of a small business must add together the two adjustments, the first related to the industry economic cycle and the second from the economic wide cycle to determine the total additional profit needed to offset the economic cycle cost. This is just one of four factors that are used to determine the final profit needed to protect the owner and reward him for his business. Act on Knowledge.
Do you want to learn how to get returns like this?
Then learn about Value Investing. Value investing in the simplest of terms means to buy low and sell high. Value investing is defined as a systematic process of buying high quality stock at an undervalued market price quantified by intrinsic value and justified via financial analysis; then selling the stock in a timely manner upon market price recovery.
There are four key principles used with value investing. Each is required. They are:
- Risk Reduction – Buy only high quality stocks;
- Intrinsic Value – The underlying assets and operations are of good quality and performance;
- Financial Analysis – Use core financial information, business ratios and key performance indicators to create a high level of confidence that recovery is just a matter of time;
- Patience – Allow time to work for the investor.
If you are interested in learning more, go to the Membership Program page under Value Investing section in the header above.
Join the value investing club and learn about value investing and how you can easily acquire similar results with your investment fund. Upon joining, you’ll receive the book Value Investing with Business Ratios, a reference guide used with all the decision models you build. Each member goes through three distinct phases:
- Education – Introduction to value investing along with terminology used are explained. Key principles of value investing are covered via a series of lessons and tutorials.
- Development – Members are taught how pools of investments are developed by first learning about financial metrics and how to read financial statements. The member then uses existing models to grasp the core understanding of developing buy/sell triggers for high quality stocks.
- Sophistication – Most members reach this phase of understanding after about six months. Many members create their own pools of investments and share with others their knowledge. Members are introduced to more sophisticated types of investments and how to use them to reduce risk and improve, via leverage, overall returns for their value investment pools.
Each week, you receive an e-mail with a full update on the pools. Follow along as the Investment Fund grows. Start investing with confidence from what you learn. Create your own fund and over time, accumulate wealth. Joining entitles you to the following:
- Lessons about value investing and the principles involved;
- Free webinars from the author following up the lessons;
- Charts, graphs, tutorials, templates and resources to use when you create your own pool;
- Access to existing pools and their respective data models along with buy/sell triggers;
- Follow along with the investment fund and its weekly updates;
- White papers addressing financial principles and proper interpretation methods; AND
- Some simple good advice.