How I Calculate Profit

I ran a startup for a few years, then a dev agency, and now work as a consultant. In order for me to understand how the business is doing, the risk of going bust, whether I need to put in my personal money into the business, or whether any money can be taken out of the business to invest for my retirement, I’ll use a concept I’ll call Kartick’s Profit.

This is different from the definition of profit that a real accountant would use.

This is how I calculate:

Kartick’s Profit
= Income received in my bank account (excluding advances)
- Expenses (both incurred and committed)
- Tax (overestimated)

That was a lot, wasn’t it? Let’s unpack it:

Income

I recognise income only when I receive it in my bank account. Let’s say I sign a contract in Jan, and start working with a client in Feb. The fee for Feb is $1000, which I invoice on March 1, and the invoice is due in April, but the client pays late, in May. In this scenario, I recognise the $1000 as income only in May. Why do I do it this way? Because in India, contracts are not respected, and many businesspeople are untrustworthy. Besides, I work with early-stage startups, which often go bust. For these reasons, I count the chickens only when they hatch. This is different from accrual-based accounting, which recognises the $1000 as income in Feb, because the work was done in Feb, irrespective of when the money is paid. I find that too abstract and disconnected from the real-world demands of running a business.

Consider a second scenario where the client pays $500 in May and $500 in June. In this case, I recongise only $500 in each of these two months.

Consider a third scenario where the client disputes the invoice of $1000 and pays only $600. One asshole told me, “You can take this lower amount, or you can take nothing.” In this case, I recognise my income only as $600, even if the contract and the invoice were for $1000.

Consider a fourth scenario where the client refuses to pay at all. In this case, I don’t recognise any income at all.

Notice that advances are not counted as income. Let’s say I have the following agreement:

The fee for every month will be $10K, which I should receive in my bank account by the last date of the previous month. In other words, the fee for Feb should be received in my bank account by Jan 31. In case the agreement is terminated before the beginning of the month (on or before Jan 31), such an advance will be refunded, but not otherwise. On Feb 1, the entire amount is considered to be spent and is no longer refundable.

In this scenario, if the client pays the Feb fee on Jan 25th, I don’t consider it income till Feb 1, because it’s just an advance. I might have to give it back. It’s not my money; it’s the client’s money that he has just temporarily parked in my account.

Consider a different contract:

The fee will be $175 per hour. There will be an advance of $10K every month, and at the end of the month, we’ll settle the account by multiplying the hourly rate with the number of hours used. If this works out to more than the advance, the extra amount will be invoiced. If less, the leftover amount will be adjusted against next month’s fee, or refunded if the contract is terminated.

In this scenario, I don’t consider the $10K as income. At the end of the month, if the actual fee was $8K, only that is my income.

Consider another scenario where the actual fee was $18K. Then I’ll recognise the income for that month to be $10K, and I’ll recognise the remaining $8K as income only when that amount is actually paid.

If it’s a foreign transfer where the client pays $1000 but the bank steals $50, my income is only $950, not $1000. That’s why I’ve phrased it as income received in my bank account, not sent by the client.

Expenses

If I buy a laptop for ₹3 lakh, I recognise the entire expense at the time I’ve incurred it. This is different from accrual-based accounting, where if the laptop lasts 3 years, we consider the expense to be 1 lakh per year. But this is divorced from the reality on the ground. I recognise the entire 3 lakh expense in the month it’s incurred.

Committed expenses are also considered in their enterity. In other words, if in March, I buy an Adobe software for ₹500 per month but with a 1-year commitment, I’d recognise an expense of ₹6K in March. Since I have committed, I have to set the money aside.

This is asymmetrical with income — if a client commits to paying me some money every month for the next year, I’ll count the chickens only when they hatch. This asymmetry is by design — we have to be conservative with running a business. In other words, I’d rather be pleasantly surprised some months down the line than unpleasantly.

I don’t recognise planned expenses, since plans often change.

Tax

I count only post-tax income. If a client pays me ₹1 lakh, I recognise only ₹68,800 as my income. The 1 lakh number is only notional, a vanity metric. I won’t be able to spend 1 lakh on (say) a smartphone. The formula of .688 x gross income comes from 30% tax rate with a 4% cess.

This doesn’t consider tax slabs, because it’s hard to put that as a spreadsheet formula. In other words, it’s not realistic to calculate the tax accurately, because there are some many possibilities. We have to choose between either over- or under-estimating it.

In the spirit of being conservative, overestimate taxes and expenses, and underestimate income.

There’s also fixed taxes like professional tax, which I also consider. So the tax per month is .688 x the gross income received in the month + fixed taxes.