Profit

Definitions

Profit

A profit is necessary to provide a return on the capital invested in the practice, as well as to provide additional incentive for the partners (business owners). A profit can also fund the development of the practice, for example, the purchase of equipment and the reward of staff with bonuses (which, of course, become an expense of the practice).

The concept of profit depends for its existence on other concepts, conventions, practices and judgements that cause it to be an exceedingly complex and misunderstood financial measure. It is certainly not one that should be taken for granted without thought or definition. (Professor Tom Lee, Cash Flow Accounting, University of Edinburgh, Longman Cheshire, 1984.)

A common view of profit is that it is the surplus of income over expenditure incurred in earning that income, over a specified period, where income exceeds expenditure. That is a perfectly legitimate view of profit, though not the only one. Unfortunately, however, the excess of income over expenditure is also sometimes referred to as earnings, margin, net profit, net income or simply income, any one of which may be quite proper in a particular frame of reference.

Profit is usually expressed as a percentage above costs and the level of profit should reflect the risk involved, the complexity of the project or the experience that the practice has had with projects of the type being considered. As a guide a profit margin of over 20% above costs is advisable as a target. The actual margin must be determined by each practice considering such other matters as competition, reputation of the practice, the nature of the projects and other factors considered relevant by the practice. The target rate of profit may well vary from project to project, but the overall profit of the practice should achieve the planned rate.

When calculating fees, including a realistic profit margin above the projected costs is critical to the long term success of the practice.

Gross profit is sometimes used to describe the surplus of income over direct costs only. Net profit is the surplus of income over all costs. Gross profit may be a useful concept and measurement in sales of goods but in sales of services, net profit would probably be more common.

The notion that profit is the same as income, or that all income is profit, would hold good very rarely and only in the unusual case where the profit-maker or income-earner has no expenses, or overheads to pay for. In spite of that, there is a not uncommon misconception that some people's income is all profit and this is especially the case where income is in the form of professional fees. That misconception is at the centre of many disputes. It is also the basis of misunderstanding of 'scheduled fees' for medical practitioners. The expenses to be paid for out of the fee charged by the practitioner, as distinct from the so-called 'fee' scheduled by the government, are often ignored.

Profitability

The capacity of an enterprise to generate from its own activities a level of profit sufficient to enable it to have a meaningful surplus after paying for expenses. 'Profit' in this context may be defined loosely as financial gain.

Not all enterprises need profitability. Some rely for their life continuance on finance resulting from charity, taxation or the owners' own pockets. The degree to which profitability is a goal depends, of course, on the nature of the enterprise. Every privately owned business enterprise would be expected to be motivated to achieve and maintain profitability, although, as will be explained later, profitability is not the key to staying in business.

Government and government funded enterprises, on the other hand, do not need to be motivated by a striving for profitability, except perhaps in the case of government-created organisations that have been instructed to pay their own way. (It is not surprising, therefore, that in fee negotiations between public servants and privately practising consultants, the two parties do not always share a common perspective.)

Equity (or proprietorship)

The rights of an owner of something and, specifically in this context, the financial rights or interests of a person who owns or shares the ownership of a business. ('Owner's equity' is more proper that simply 'equity' because equity, though more common, can mean other things.)

The motivation to achieve profitability is often, very naturally, related to equity. In the case of the self-funding government body, where there is no owner or proprietor other than the general body of taxpayers, there is no substantive owner's equity or proprietorship and therefore no motivation based on such a concept.

In privately owned enterprises, on the other hand, there is always identifiable owners' equity. Where the owners of a business are also the managers and operators of it, then their owners' equity will always be a conscious motivator of their business conduct – and will always, rightly, influence their concept of profit.

The owner's equity in a business, by its nature, necessarily means that the owner and the business are separate entities. This may be obvious in the case of companies but it is not so obvious in the case of the sole trader who is the only owner. Yet it is necessary to grasp the fact that even in that case the owner and the business are separate accounting entities, if we are to have a true concept of profit. Legally, the business and its owner or owners are the same person, unless the business is incorporated.

Direct costs (or direct expenses)

The costs in production that can be identified as having been incurred by a particular project, product or job. In an architectural office, they would be the costs of working on each job where those costs have been attributed to that job. In nearly all cases in architectural production the direct costs would be the salaries or labour costs, which are easily attributable to identifiable projects by means of time sheets. (See Keeping time records.)

Theoretically, any costs generated by having to work on identifiable projects are direct costs. Every architectural project generates, for example, costs of printing, paper, stationary, software etc, but the cost of recording the separate expenses would be in most cases counterproductive and self-defeating. The commonsense convention in most architectural contexts is to confine 'direct costs' to labour costs. Even that convention, however, has its variations. 'Labour costs' may be salary costs alone, or may be all the costs of paying for labour, i.e., salaries plus payroll tax, workers' compensation, holiday loadings and other items generated by the payment of salaries in addition to the salaries themselves.

In this context, 'direct costs' are labour costs. It is immaterial whether those costs are salaries only or include salary-related costs. In any case, that choice would be the result of an office's management and accounting decision-making and would not affect the concept of profit being developed here.

Indirect costs (or indirect expenses)

All the costs incurred by a business other than those directly attributable to identifiable and saleable goods or services. In the architectural sense and in the context of this Note, they are all cost other than those defined above as direct costs. They are commonly known as 'overheads'.

The costs of engaging secondary consultants

These would be part of the 'direct costs' except where the consultancy fees are to be reimbursed by a client, in which case they would be treated as any other reimbursable expense or out-of-pocket expense to be repaid by someone. It is worth noting that the administration to process complex invoices should be charged to the client in this instance.

Project (or transaction)

A project is any activity which generates a fee payable in return for the service which results from the activity. Most commonly in architectural offices, the activity would be design, documentation and administration of a building project but there are many architectural 'projects' of other kinds, for example the giving of an opinion on the condition of a building.

Every profit-motivated enterprise of a continuing kind relies on 'transactions'. In many, if not most cases, the transactions are achieved through sales of goods. In the architectural enterprise, the transactions are achieved through sales of services. In all cases, the common factor in every transaction is 'selling', whether of goods, materials, services, advice, expertise or skills. That fact is as true of professional services as of any other kind of business. It needs to be grasped if a proper view of profit is to be obtained.

Many transactions are so small that there is no chance of keeping track of them separately and no sense in trying to do so, for example selling ice creams. As a general rule, those transactions are characterised by payments always being made at the point of sale. Conversely, where payments are always made some time after the point of sale, then there is an absolute necessity to keep track of the separate transactions. This is invariably the case in architectural transactions, ie in architectural 'projects'. It is a necessity for a variety of reasons, not the least of which would be to ensure proper billing.

Being able to determine a profit or a loss for each separate transaction, in many businesses would be costly, tedious and unproductive, especially in the case of payments at the point of sale. In architectural enterprises, being able to determine a profit or a loss for each 'transaction' does have a potential value and is not unworkable or impractical, provided that every separate fee-attracting 'project' accepted by the business is identified as an entity in itself, logged in and then treated as another transaction, which is what it is (except, of course, in the mind of the architect who does not see the practice of architecture as a business).

Liquidity (or solvency)

The ability of a business to pay debts as they fall due or produce cash for that purpose. It should not be confused with profitability or the ability to make profit. The key to the concept of liquidity is understanding that a business cannot survive if it cannot arrange for its debts to be paid.

Whether or not it is a profitable business is irrelevant to that concept.