How Much is a Fair Profit? Part III of V – Risk
A third factor in determining a fair profit percentage is risk. Risk is divided into two types. The first is insurable and the second is uninsurable risks. Insurable risks are mitigated and have very little to no effect on the profit formula due to transferring the risk to a third party known as the insurance underwriter. Uninsurable risks are non-transferable and therefore the profit must be adjusted to compensate for this type of risk.
Uninsurable business risks are categorized into internal and external risks. In general, internal risks are controllable and external risks are considered uncontrollable or are limited in the owner’s ability to manipulate the outcome. This article explains the two types and goes into detail about the two categories of uninsurable risks. In addition, a set of guidelines is provided to help the small business owner determine the amount of profit needed to offset these uninsurable risks.
A small business fair profit is between 9 and 37%.
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. This article covers the third factor of risk.
Every business has insurable risks. Property is the best example of an insurable risk. Insurance underwriters use actuarial science to calculate losses over a large group of insured customers to determine the average premium per customer. In effect the risk is shared by all the insured. In general, those losses that are random in nature (acts of God), financially measurable and not catastrophic (e.g. earthquakes, tsunamis, or volcanic eruptions) are considered insurable. Some risks are mandated by law to be covered by insurance, these include:
· Worker’s compensation
· Professional Liability (professionally licensed businesses)
· General Liability (accidents on the business property)
Other types of risk can be covered by insurance but are not required by law, these include:
· Life Insurance
· Health Insurance (law changes in January of 2014)
· Key Man
· Loss of Revenue (caused by flooding, fire, or vandalism)
In over 95% of all of the above situations, it is normal for the business to purchase the insurance and these costs are built into the price structure of the product or service rendered. In addition, competition succumbs to the same risk forces and they too purchase the same types of policies to reduce or eliminate the above risk factors. The cost of the insurance is built into their price structure too.
Overall, the cost of the insurance as a percentage of the price increase for the product or service is less than price increase needed to derive profit to cover these types of measurable losses without insurance. For most small businesses, a pool of funds needed to offset the associated costs from a loss could not be saved nor maintained in lieu of insurance. Insurance spreads this cost across many similar businesses and thus eliminates the need to pool funds.
Those risks that are immeasurable or not an act of God and exist for most small businesses are called uninsurable. In general, insurance companies will not cover these risks. It is this type of risk that profit must be adjusted to provide some form of funding to offset the likely occurrence in the future. Uninsurable risks fall into two categories. They are internal and generally controllable by the owner and external whereby the owner has limited or no control over these forces. The following sections describe in detail these two categories:
External Risks (Limited Control)
All external risks are considered uncontrollable or limited in control by the owner of a small business. These include regulatory issues such as changes in the law or in compliance requirements for your business. The following is a real life example of a regulatory change that affected over 95 employees for one of my clients.
In 2009 the state government changed the fee structure for a mental health service. The state mandated that it will only pay $60 for a unit of service (one hour) whereas in the past the state paid $70 for that same service. In addition to the rate reduction, the state increased the compliance element requiring more supervision for this service. My client had provided this service for over 9 years at the same rate (the state never increased the rate for the service in 12 years) and rendered over 30,000 hours of service per year. The client employed over 45 full time professionals and about 50 part time professionals to provide this service. It cost the company a little over $64 an hour to provide the service (labor costs, insurance, transportation reimbursements, and administrative compliance, licensing issues, training compliance, maintenance of patient charts, supervision and director). The state just sent a notice stating that on a certain date (10 days later) this service rate will be reduced 14.29% and regulatory compliance will increase. No warning, no surveys to providers of service, nothing. The client decided to terminate this form of service and over a course of 4 months laid off 95 employees. The risk associated with providing the service not to mention the daily stress of communications wasn’t worth the loss of $4 an hour and at 30,000 hours of service per year, you are talking about paying $120,000 per year to provide this service.
The above is an example of how our government works. Notice that the rate had not changed in over 12 years. Already the cost of inflation was eating away at the marginal value generated per hour of service. In addition the state didn’t discuss the issue, it didn’t have public input, and they just cut the rate arbitrarily. My advice to the client was that no matter how big you could get in rendering the service, there was no economy of scale to offset this price reduction and cost increase. To me, it was the state’s way of saying ‘we don’t want to provide this service anymore’. Guess what, you got what you wished for because many providers of the service have gone out of business. It is unknown how the lack of this service will affect those that needed the service because this just happened about 3 years ago.
The most common external risk is the increase in competition. When competitors set up shop near your operation, it will affect your business. One of my Subway clients saw a significant decrease in his sales when a Wendy’s opened up about one block away. Sales decreased by over 18% in the first 4 months. You can imagine that with a 25% contribution margin, this turns into significant dollars in a short period of time. To this day, the client has an average decrease in sales of around 14%.
Another example of external risk is the change in technology. Technology sees a complete turnover in hardware every 18 months or so. Software is more frequent. As technology advances, some businesses are affected greatly by the change due to outdated hardware or the learning curve involved with implementing new software.
Internal Risks (Controllable)
Internal risks are considered controllable by the owner. Therefore, the risk factor can be greatly reduced with a program of identification, prioritizing and action. Action is customarily in the form of training or changing policies and procedures to reduce the associated risk. In general, internal risks are grouped into either financial or operational in nature.
Financial – financial risks range from having adequate capital to deal with the business dynamics to proper accounting and reporting of financial performance. These risks can be easily controlled via proper funding to eliminate the capital issues and using well educated and trained staff to deal with the accounting and reporting requirements. The goal of financial accounting and reporting is reliance on the tenant of accounting which states: “Good information input maximizes the probability of good information output for the decision aspect of business operations”. In effect, it is difficult for the owner of a small business to make good decisions without the proper information. An owner can by accident make a good decision with poor information. It is highly unlikely but remotely possible.
Other financial risks include credit and the ability to have access to credit from vendors, suppliers and the bank. Without credit, most small businesses have little to no possibility of growth or continuity of operations.
Operational – operational risks include overproduction, low quality construction/manufacturing, or opportunities for fraud due to the culture of the operation. This usually stems from the lack of internal controls or measurement tools in the production cycle. Many small business owners are overly optimistic in nature and therefore this optimism creates an environment of invincibility. The owner needs to allow input from staff and outside consultants to monitor his enthusiasm and reduce the risk associated with optimistic beliefs. Other tools include internal operation reports. Read the following for more information as it relates to control reports: Operating Control Reports in Business.
Other types of operational risks include physical plant issues. These types of risk are safety related and can be reduced or eliminated by a program of identification and taking action to alleviate potential physical harm.
The following are more examples of operational risks and methods to reduce or eliminate these risks:
Key Man – when a company relies on one or two individuals to provide the knowledge or source of information, this is known as the key man. It is not uncommon in many really small businesses for the owner to be the key man. As the company grows it is imperative to allow more individuals to have this knowledge. The fear for a small business owner is that by providing this knowledge to a non-owner is that this person will obtain the information and leave the company to create competition or worse publicize the information. To reduce or eliminate this issue, small businesses should use employee agreements, non-disclosure agreements, and binding contracts with employees that penalize the individual when personal gain is achieved from this knowledge.
Harassment – when employees use bullying or sexual advances towards other employees to manipulate or control them, the owner is susceptible to repercussions from the affected employee. This alters production, the working environment and overall company-wide culture. I’m a big believer in the Barney Fife (The Andy Griffith Show) saying “You gotta nip it in the bud, Ange”. This means, no tolerance and immediate dismissal for the employee exercising this manipulative method. No other way around this issue. To let the employees know your concern, there should be no less than an annual awareness training for all employees about the definition and reporting methods concerning harassment within the company. It should be in the employee handbook and notices should be posted throughout the company. Management should be trained in dealing with the leading signs of possible harassment and how to address the issue and “… nip it in the bud”.
Misinformation – as a small business grows and more employees come onboard, many employees don’t fully understand how the company works or how it is doing. For employees, security is an issue. They have families and their day to day life decisions on spending for large ticket items relate to confidence in their job. It is important for the owner to communicate information about the company’s performance and the employee’s performance. When employees are secure in their job, their performance and loyalty increases and the company creates a better overall product and/or service for the customer. Monthly or quarterly newsletters, regular posting of notices to employees, and training provide reassurance to staff that the company cares and is doing well. One of the three primary goals of all for profit companies is providing security to employees, see Introduction to Non-Profit Organizations – A Comparison to Profit Driven Businesses for identification of the primary goals of profit based operations.
Many of the operational related internal risks can be limited or reduced through programs of identification, prioritizing importance and taking action. Action is in the form of training or adherence to the policies and procedures in place to reduce and ultimately minimize risk. However, this is not going to completely eliminate the risk. As the company hires new employees and expands facilities, these risks are constantly there and have potential to rise up. A small business owner needs to adjust the revenue price to generate a profit to offset the cost associated with these risks. How does an owner calculate the financial impact from the above risks? The next section describes how to monetize the above risks and adjust the sales price associated with the product or service to generate the amount of profit needed to create a pool of funds to be used in the future to pay for these risks.
How to Monetize Risks and Adjust the Profit Percentage
The above two types of risks are going to cost a small business owner money over time. The insurable risks can be eliminated via insurance. It is important to understand that the competition is generally doing the same thing in minimizing these types of risks. They too have to comply with the law and purchase workman’s compensation insurance, provide professional liability insurance and in many banking relationship situations have to provide liability coverage for property, plant, and equipment including vehicles. Many of the other types of covered risks such as tenant insurance, life insurance, and key man insurance can be easily paid for by adjusting the price of the product or service by about 1 -3% depending on your industry. In general, it is not very expensive to obtain this type of coverage.
Only health insurance is a significant monetary issue for the small business operation. Currently the new health insurance law does not require those businesses with less than 50 employees to purchase this insurance. But many small businesses purchase this insurance in order to provide insurance to the owner and the owner’s family. In general this type of insurance costs around $600 to $900 per month per employee. Assuming an average payout per employee of $40,000 per year, health insurance can cost an employer around 18% of the average gross payroll. This can be offset via a sharing plan with the employees. Most small businesses use a 50-50 sharing of this cost. In general, an employer is looking at 9 to 10% of the gross payroll as the company’s cost for health insurance. In a pure service related business operation, the payroll is about 60% of the total service revenue. Therefore, health insurance under a shared cost plan is going to run about 5 to 6% of the total revenue. The profit related to the service should be adjusted this amount to provide the necessary funds to pay for health insurance. For product driven operations, the profit should be adjusted 3 to 4% to create the necessary funds to address health insurance.
In addressing and calculating the amount of profit adjustment to deal with uninsurable risks the owner of the small business must first rank the most likely risk that will unfold. Divide the group into the external and internal types.
The EXTERNAL types of risk have the greatest impact on the profit percentage because of the limited control factor. The most likely external risk is competition. The key is to understand the marginal contribution element of the sale. This marginal contribution is different in value for a restaurant than for a manufacturer of widgets. If the threshold of investment to get into your field of business is low, there is a likelihood of competition in the near future. A good example of this is a tree cutting business. One only needs to be physically fit and own a good chainsaw and ropes. Here the threshold to get in is very low. Whereas for the small manufacturer it is a different ballgame; let’s use a small brewery as an example. The still equipment and bottling process along with the necessary facilities will run more than $500,000 to get involved and this does eliminate a very large portion of the population from brewing distillates.
To determine the contribution margin is relatively easy. With proper accounting the owner can calculate the contribution margin per sale. If the contribution margin is more than 50%, then the owner will require a higher profit percentage to offset the contribution losses in the future from competition. As the contribution margin decreases, the profit percentage needed to pool funds to offset the losses from competition decreases in almost a linear fashion. The goal is to offset about 18 months of potential losses associated with competition. Eighteen months is used as the time duration it customarily takes an existing business to regain market share associated with the entrance of new competition. The contribution margin is used to offset overhead and administrative expenses. For most small businesses it takes 10 months of contribution margin to pay for the entire year of overhead and administrative costs. Therefore, 2 months of contribution margin generates the profit for the company. Mathematically, 17 percent of the contribution margin is the amount needed to offset competition costs. The profit adjustment is 17% of the contribution margin to offset new competition. Therefore, if your contribution margin is 18%, then the profit adjustment associated with competition is 3.06% (18% contribution margin * 17% of the contribution margin for the two months of profit). Other types of external risk should have an adjustment less than the competition adjustment. For most small businesses, the external types of uninsurable risks add about 4 to 7% to the profit requirement.
INTERNAL types of uninsurable risks are more likely to happen but the cost can be minimized via prevention methods (identification of the issues, prioritizing, and taking action). Below are examples of different types of businesses and the reality an entrepreneur faces.
- When an operation employs many young adults across both genders (ages 18 to 30) you should be greatly concerned about sexual issues. If you think it’s not going to happen, you are greatly mistaken. It is important to focus resources on training and identifying potential relationship issues. You almost need to broadcast that sexual harassment or activity is grounds for immediate termination.
- If your company is equipment intensive and this equipment poses life threatening harm, such as high speed cutting devices (saws, blades, chopping devices, chippers etc.) then there is never enough training. Make sure there is adequate safety equipment for all personnel. The equipment itself is well maintained and inspected regularly. Use the Department of Labor’s guidelines for compliance for safety (OSHA).
- For professional based operations (engineering, accounting, law, medical, and mental health), background checks and confirmation of credentials are essential to prevent potential liabilities from low quality product or service.
The key to internal risk management is to identify the most likely uninsurable risk and take action to reduce or mitigate its outcome. From there, determine the financial impact from these types of risks and rank them in order of final cost.
For the financial types of uninsurable risks, a good accounting and reporting function for any business operation is around 2% of the total revenue. If your costs are currently running 1.25% of the total revenue, then adjust your profit up about .75% and use these funds in the future to purchase better software or technology. Use can use the funds to hire more qualified staff to produce better information for decisions.
As it relates to operational risks, good legal documents, enforceable contracts and self-awareness (the owner’s optimism) reduce this risk to a negligible dollar amount. It doesn’t eliminate the risk, but it does reduce the financial impact significantly.
To attach a dollar value and ultimately a profit percentage for operational related internal risks, determine the top three issues in your business. For most small businesses, it will be equipment safety and personnel training. If a company utilizes good practices, then insurance will cover any litigation outcomes from human errors. Still there will be costs associated with legal counsel and lost time to deal with this unforeseen litigation or loss production time. In general, you will want to cover about 2 to 3 % of lost time and another 1% for legal counsel per year. Profits will need to be adjusted depending on production numbers per year. If production is 200 days per year and you anticipate 4 to 5 days of lost time per year related to production, then adjust your profit about 3% to cover the associated costs for uninsurable internal operational risks.
Overall, both financial and operational internal risks will cost the small business operation about 4 to 5% in profit to generate adequate funding over time to offset the expected losses associated with this type of internal risk.
Summary – Risk
The aggregated profit adjustment for risk is illustrated below based on the two categories and the types of uninsurable risks:
Additional Insurance (Fidelity, Revenue, Key Man) 1.75 %
Add Health Insurance 3.5
Sub-Total Insurable Risks 5.25%
Governmental Regulation & Compliance 1.00
Sub-Total Uninsurable External Risks 5.00%
Financial in Nature .75%
Operational (Lost Time) 3.50
Sub-Total Uninsurable Internal Risks 4.25
Sub-Total External & Internal Uninsurable Risks 9.25%
Total Insurable and Uninsurable Risks 14.50%
Without Health Insurance 11.00%
As a small business owner, adding 14.5% to the fee for services or products to the customers reduces the volume of sales. Competition is keen and therefore this type of an adjustment impacts the final price charged to the customer. If your operation is extremely small, say 1 -5 employees, this type of profit adjustment is not necessary. Good internal operations can reduce this cost dramatically and your own participation can reduce this number significantly. Overall, as your business grows and prospers, the profit percentage should adjust towards this final adjustment over time. Initially, I would tend to think that a 4-5% adjustment with less than 5 employees is appropriate. As you gain employees and exceed 15 employees, I would think that the fees for products and services should get adjusted in accordance with the schedule above.
Again, the idea behind the profit calculation is to adjust the price charged to the customer to offset the potential risks associated with your business operation. At first, reduce risk by purchasing insurance for the insurable risks items. For the uninsurable risk issues, be proactive in reducing or mitigating those risks.
To date I have identified owner compensation, the economic cycle and risk as the basic elements of calculating a fair profit to charge the customer. So far, owner compensation adjusts the profit about 7 to 15%, the economic cycle affects profit 1 to 3% and risk can range from 5 to 15% depending on insurance issues. Overall, risk has the second greatest bearing on the profit formula after owner compensation. The next article articulates the amount of profit needed to adjust for the cost of capital. The final in this series ties all four factors together to determine the final fair profit calculation. Act on Knowledge.
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