The 12-Week MBA Chapter 2: Profitability - How Companies Actually Make Money

The concept of profit was once considered important enough that two superpowers pointed nuclear weapons at each other over it. The Cold War was basically an argument about whether the profit motive should organize our economy. You would think something that serious would be simple to define. It is not.

This is post 3 in my 12-Week MBA retelling series.

Where Profit Comes From

Let me start with something relatable. Imagine you want to have a fancy dinner with someone special. A Michelin-starred restaurant might charge you $200 for the meal. Sounds expensive, right? But think about what it would take to replicate that experience yourself. The finest ingredients, the professional equipment, and years of training to cook at that level. Compared to all that, the $200 is actually a deal.

That gap is where profit lives. It is the difference between what it would cost you to do something yourself and what you pay a business to do it for you. The business can do it cheaper and better because they specialize in it. And somewhere in that gap, there is a price where you are happy to pay and the business is happy to deliver.

Profitability is about making that gap as wide as possible. Either you lower your costs while keeping the customer happy, or you convince the customer that what you offer is worth paying more for. Those are really the only two moves.

The Grilled Cheese Food Truck

The authors use a food truck example to explain the profit and loss statement, and I think it is brilliant because it strips away all the complexity. So let me walk you through it the same way.

You decide to open a food truck that sells grilled cheese sandwiches. Simple enough.

Your customers value things like taste, convenience, and speed. They could make a sandwich at home, but your truck saves them time and your recipe is better. That is why they pay you.

Now let us look at your expenses.

Cost of sales is the first one. These are the ingredients, the labor, and the energy it takes to actually make the sandwiches. If you sell a grilled cheese meal for $10 and the bread, cheese, labor, and energy cost you $6, then you have $4 left. That $4 is your gross profit.

Gross profit is a big deal. It tells you whether your core business makes sense. If customers will not pay more than your ingredients cost, you do not have a viable business. Period.

But your expenses do not stop at ingredients. You also need people to know your food truck exists. Maybe you pay for a spot on Google Maps or print some flyers. These are your selling expenses. You also need someone to do the accounting because you are better at cooking than counting. That is an administrative expense. Together, selling and administrative costs get lumped into something called SG&A - selling, general, and administrative expenses.

Then there is R&D. Maybe you are experimenting with a vegan cheese substitute because you are losing vegan customers. You have not nailed the recipe yet, but you keep spending time and money trying. That is research and development.

And your equipment wears out. The cutting boards, the grill, the truck itself. They all lose value over time. Accountants call this depreciation for physical stuff and amortization for things like software licenses.

Add it all up - cost of sales, SG&A, R&D, depreciation - and you get your operating expenses. Subtract those from your sales and you get operating profit. This number tells you if your business can sustain itself. If your operating profit is consistently negative, your business is slowly dying.

But Wait, There Is More

Operating expenses are not everything. There are costs that exist because of how you funded the business, not because of how you run it.

See, before your cash register rings for the first time, you need money. You need to buy or lease the truck. You need ingredients. You need to advertise. All of this costs money before a single customer shows up. That money has to come from somewhere.

If someone lends you the money (that is called debt), you pay them back over time plus a fee called interest. Interest is an expense, but it is not an operating expense because you could have funded the business differently and your sandwiches would be exactly the same.

The other option is equity. An investor gives you money but instead of guaranteed payments, they get a claim on whatever is left after all other expenses are paid. No guaranteed return date. No guaranteed interest. Just the leftovers. Those leftovers are called net profit.

Oh, and taxes. You drive on public roads, park in a public square, and rely on police to make sure people do not grab your grilled cheese and run. The government pays for all that and they collect taxes from you in return.

So the full picture looks like this:

• Sales ($10,000)
• Minus cost of sales ($6,000) = Gross Profit ($4,000)
• Minus SG&A ($1,500), R&D ($1,500), depreciation ($200) = Operating Profit ($800)
• Minus interest ($300) and taxes ($100) = Net Profit ($400)

You started with $10,000 in sales and ended with $400 in net profit. That is 4 cents out of every dollar you brought in. Now you see why restaurants have thin margins.

Margins: The Real Comparison Tool

Raw dollar amounts of profit are useful for paying rent. But if you want to understand how well your business is actually performing, you need to look at margins. Margins express profit as a percentage of sales.

In our food truck example:

• Gross margin: 40% (you keep 40 cents of every sales dollar after paying for ingredients and labor)
• Operating margin: 8% (after all operating costs, you keep 8 cents)
• Net margin: 4% (after everything, you keep 4 cents)

Why do margins matter more than raw numbers? Because they let you compare. You cannot compare your food truck’s $400 net profit to Burger King’s net profit. They are completely different scales. But you can compare your 4% net margin to Burger King’s margin. That tells you who is more efficient at turning sales into profit.

Margins also help you track your own performance over time. Maybe your sales doubled this year. Great. But if your margin dropped from 8% to 4%, you are actually getting worse at your job even though the total profit might look the same or even higher.

The Two Levers of Profitability

When the authors ask managers how to increase profitability, most people jump straight to cutting costs. That makes sense because everyone has been asked to do more with less at some point.

Here are some ways to lower costs:

• Negotiate with suppliers. Get better prices on ingredients and materials. This sounds simple but there is a whole art to it. Labor is often the biggest cost, and wage negotiations can get intense.
• Use fewer inputs or cheaper ones. Slice the cheese thinner. Use a less expensive brand of bread.
• Redesign your processes. Rearrange your cooking station so you can serve more customers during the lunch rush without hiring more people.

Nokia was actually amazing at this in their early days. They designed their phones specifically to be cheap to manufacture. Their R&D focused on making production efficient rather than adding features. It worked beautifully for years. Their cost of sales was low, so their gross profit was high.

But cost cutting always has trade-offs. Skimp on cheese and your sandwich tastes worse. Now you need to spend more on advertising because word of mouth is not working. Buy a used truck to save money and you might pay more in repairs later. Every cost decision ripples through the business.

The Other Lever: Getting Customers to Pay More

This is the lever most people underestimate. You do not have to just cut costs. You can also convince customers that what you offer is worth a higher price.

Improve quality. Use better ingredients, develop a better recipe, create a better experience. The trade-off is that this usually costs more. But if customers pay $14 instead of $10 and your costs only go up by $2, you win.

Bundle products together. This is what every fast food chain does. The burger is priced close to cost to get you in the door. The real profit is on the fries and soda, which cost almost nothing to make. When you buy the combo meal, you feel like you are getting a deal. They are actually making most of their money on the add-ons.

Focus on a specific group of customers. Maybe instead of competing during the lunch rush, you park outside an office building at 5 PM and sell to-go boxes for parents picking up kids from daycare. Add a little toy, charge 50% more. Those parents are happy to pay because you solved their specific problem at the exact right moment.

The point is that pricing is not just about picking a number. It is about understanding what your customer values and finding ways to deliver more of that, so they are willing to pay more.

The P&L Tells a Story About Everyone

Here is something the authors point out that I had never thought about before. The profit and loss statement is not just a scorecard for the business. It is actually a map of how value gets shared among everyone involved.

The sales line reflects value for customers - they paid because they got something they wanted. The expense lines reflect value for employees and suppliers - those expenses are their income. Taxes reflect value for the community through public services. Interest reflects value for lenders. And net profit reflects value for shareholders.

It is not a perfect picture. But it is a reminder that a business is not just a money machine for its owners. It is a system where lots of different people create and share value with each other.

Key Takeaway

Profitability is the foundation of business value. It comes from the gap between what customers pay and what it costs to deliver. You can make that gap wider from two directions: spend less or convince customers to pay more. Both involve trade-offs that ripple through the entire business. The profit and loss statement is the tool that tracks all of this, and understanding it at every level - gross, operating, and net - is one of the most useful skills you can have as a manager.

Next chapter, we look at growth - the different ways a business can expand and why not all growth is created equal.

Book: The 12-Week MBA by Nathan Kracklauer & Bjorn Billhardt | ISBN: 978-0-306-83236-9

Previous: Chapter 1 - Value

Next up: Chapter 3 - Growth - The different ways a business can grow.

Part of the 12-Week MBA retelling series