Total Income is the top line revenue of a business. It represents all cumulative sales. Real Revenue is the Total Income minus the cost of materials and subcontractors.
A business should only adjust to Real Revenue for Profit First purpose if a significant portion of the operations requires materials and subcontractors (typically more than 20% of Total Income). The rule of thumb is if you are a service based business with full time and part time employees do the Profit First process based on Total Income.
If you are a manufacturer, retailer, restaurant or a service provider that delivers the significant portion of its services via subcontractors you need to do the Profit First Process based on Real Revenue.
Please note that Real Revenue is similar to Gross Profit, but is not the same.
Real Revenue is a term we use in Profit First to show an entrepreneur that their top line revenue (Total Income) is not truly representative of the size of the business.
For example, a home builder may have $10M in annual revenue
and to complete their projects require materials and subcontractors that cost $7M a year. That this means is that the company really has $3M of “real revenue” and manages another $7M of transactions (effectively moving money from the customer directly to the purchase of materials and the cost of subcontractors.This business needs to operate like a $3M company and not a $10M company.
The term Real Revenue is used to make it very clear that the entrepreneur really has a $3M business.
No. Gross Profit is the total revenue minus Cost of Goods Sold (COGs). COGs can include materials, subcontractors, employee labor, project costs (e.g. project related travel), and ancillary costs (e.g. shipping costs).
Real Revenue is a simpler calculation and less subjective. It is total revenue minus materials and subcontractors. Period.
You do not subtract any labor of full or part time employees or other costs.
If you are making a Real Revenue calculation, that means you have material costs and/or subcontractors. In this case you need to set up two additional bank accounts: 1. Materials & Subs; 2. Total Income.
All your deposits from sales go to Total Income. Next, you take out the normal percentage of your Mat & Subs and move the money to the Mat & Subs account. Then the remaining money in the Total Income account goes to your "Real Income" account (formally named the Income account) and then you allocate the Profit First percentages from that Real Income account.
The opportunity to improve your company’s profitability is now achieved in two ways: 1. Reducing the amount spent on Materials & Subcontractors, which will flow more money to Real Revenue. And reducing Operating Expenses which will free up more money for the Profit, Owner’s Pay and Tax accounts.
Let’s look at an electrical contractor.
For this example, let’s use simple round numbers and say the contractor has $100,000 in Total Income. He spends $30,000 in materials (cables, outlets, etc.), $25,000 on subcontractors (another electrician he hires for certain projects), $11,000 on an internal administrator, $9,000 on vehicle costs, $8,000 on rent, and has take home pay of $15,000,
has taxes of $2,000 and has never had a profit.
This means that 55% of the Total Income ($100,000) is being used for Materials & Subcontractors ($30,000 + $25,000).
So, when deposits come in they would go into the Total Income account. Then on the 10th and 25th, 55% of the Total Income money would be allocated to the Material & Subs account (that money would be used to purchase more materials and pay subcontractors). The remaining 45% would be allocated to the Real Revenue account.
Then the Profit First allocations of Profit, Owner’s Pay, Tax and Operating Expenses would be allocated from the Real Revenue account. For this example let’s say that the allocation percentages match the Target Allocation Percentages (TAPs) specified in Profit First for a business under $250,000 in Real Revenue. That means 5% goes to Profit, 50% to
Owner’s Pay, 15% to Tax and 30% to Operating Expenses.
Based on $45,000 in annual Real Revenue, the Profit allocation would be $2,250, Owner’s Pay would be $22,500, $6,750 reserved in the Tax account, and $13,500 to operating expenses.
With $11,000 going to an admin plus $9,000 to vehicle costs and $8,000 to rent (a total of $28,000) this business needs to clearly cut costs and run smarter. Costs need to be $13,500 annually.
The other opportunity to make more profit (and owner’s pay) is to reduce the Material & Sub costs. Cutting those costs will drip that additional money to Real Revenue and make more money available for Profit, Owner’s Pay, Tax and for Operating Expenses.