Part II · Chapter 4 · Engine · lesson 2

Revenue is not profit

11 min

Builds on Assets, liabilities, and things that only look like assets

Two businesses both did a million in revenue last year. One of them distributed 290,000 to its owners. The other one closed in March.

Revenue is the most quoted number in business and the least informative. It is the top of a waterfall, and everything interesting happens on the way down.

Revenue is what arrived. Profit is what is left after everyone with a prior claim on it has been paid — suppliers, staff, landlords, lenders, the state.

The order matters as much as the amounts. Each of those claimants is paid before the owner, which is why an owner's income is the most volatile line in the whole document and an employee's is the least. Nobody explains that at the interview.

The waterfall

Money comes in at the top and four things take a bite on the way down. Each bite has a name, and each name answers a different question.

Cost of sales is what it cost to produce the thing you sold. It moves when sales move. Sell twice as much and you pay twice as much of it.

Operating costs are what it costs to be a company at all — the people, the premises, the software, the marketing. Mostly these do not move when sales move, at least not this quarter.

Interest is rent on borrowed money. It arrives whether the year was good or not, which is what makes debt different from every other claim.

Tax is charged on what is left, and only if what is left is positive.

Predict

A business has revenue of 1,000,000, cost of sales at 40 percent, and 500,000 of fixed operating costs. If revenue rises by 30 percent and no cost is added, roughly what happens to the profit before interest and tax?

It rises by about 30 percent, in line with revenueIt roughly doublesIt rises slightly — most of the extra revenue is eaten by costIt falls, because growth costs money

Drive it yourself

Below is the same waterfall as a set of controls. Everything except revenue is held still, so you can watch what one line does to the bottom of the document.

Margin waterfall

Hypothetical model, not a forecast

Walks one period of revenue down through cost of sales, operating costs, interest and tax.

It assumes

Cost of sales is a flat percentage of revenue and never negotiates.
The three operating cost lines are fixed for the period regardless of volume.
Interest is a fixed amount, because the loan does not care how the year went.
The tax bands belong to no country and are illustrative only.

It ignores

Loss carry-forward, credits, allowances and every real tax rule
The difference between profit and cash, which is where businesses die
Depreciation schedules and anything that is not a cash cost
Exceptional items, disposals and discontinued operations

Profit after tax starts at 65,000. Move revenue alone until profit after tax passes 195,000 — three times where it started — then walk it back down and find roughly where it stops being true.

Revenue1,000,000

Gross profit: 600,000
Gross margin: 60%
Operating profit: 100,000
Operating margin: 10%
Profit before tax: 80,000
Tax charged: 15,000
Profit after tax: 65,000
Net margin: 6.5%
Average rate actually paid: 18.75%

What is left

Five bars falling from revenue, through gross profit, operating profit and pre-tax profit, to profit after tax.
Stage	What is left
0	1M
1	600k
2	100k
3	80k
4	65k

Not there yet — keep moving the controls.

The crossing point is a shade under 1,290,000. Revenue up 29 percent; profit after tax up 200 percent. That gearing between a revenue move and a profit move is one of the most useful things you can know about a business, and it is printed nowhere. You have to derive it, and you can only derive it if you know which costs are fixed.

Not the same thing

Revenue

Everything that arrived from customers during the period.

Measured in: Amount per period
For example: A shop rings up 1,000,000 across the year.
Chase it alone and: Optimise it alone and you end up buying revenue at a loss, which is a thing you can do forever right up until you cannot.

Profit

What remains after every prior claim on that revenue has been settled.

Measured in: Amount per period, and as a share of revenue
For example: Of that 1,000,000, the owners keep 65,000.
Chase it alone and: Optimise it alone in the short run and you cut the marketing, the maintenance and the hiring that produce next year's revenue.

Which is which? Put each one on a side.

A discount code that triples orders and halves the price
Renegotiating a supplier contract down by four percent
The number a founder quotes at a party

Something people say

“It's a million-a-year business.”

Why it spreads: Revenue is one number, it is unambiguous, and it is the only figure most owners are willing to say out loud. Profit invites follow-up questions about salaries.
The part that is true: Revenue does tell you something real: that a million units of somebody else's money were willing to move towards this thing. That is not nothing, and a business with no revenue has not proved it.

A million in revenue can be 300,000 of profit or a slow, well-attended insolvency. The number that decides which is the gap between the price and what it costs to deliver, multiplied by how many times you can do it, minus the cost of existing. Ask about the second number and watch what happens.

Worth remembering

Revenue is the top of a waterfall; cost of sales, operating costs, interest and tax each take a bite before the owner is paid.
The owner is paid last, which is why an owner's income is the most volatile line in a business and an employee's is the least.
Operating leverage means a business with high fixed costs sees profit move much further than revenue, in both directions.
In the worked example, a revenue rise of roughly 29 percent tripled profit after tax, because the costs below gross profit did not move.
Cutting a supplier cost by a few percent can add more profit than a launch, because it arrives with no extra cost attached to it.