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This is a semantics issue, and it is bit of a pet peeve for me. I realize it bothers me more than other people, and I hope I don't offend anyone with my comments.

A common statement regarding a luthier's "profit" is that it refers to how much you make after you pay yourself a reasonable wage. Respectfully, I disagree. I fully understand the concept people are targeting with that statement, and the concept is a legitimate one. But in the interest of giving words their proper meaning, this is not how you define "profit," and there are other words that more accurately convey the meaning people are suggesting.

There are two definitions of profit, and Wikipedia breaks them down well. The first is an economic definition, and the second is an accounting definition.

The economic definition is the extent to which "revenue exceeds the total opportunity cost of inputs." Certainly, the total opportunity cost of making a guitar includes the opportunity cost of your time. However, the opportunity cost of your time is not a "reasonable wage," but whatever you could be making if you were putting your time to its highest and best economic use. So, for me, I am an attorney by day. I bill my attorney time at $400/hour. If I spend 75 hours building a guitar, my opportunity cost is the cost of materials, some amount for overhead, plus $30,000 worth of my time. Sadly, no matter how good I get at building guitars, I have no hope of ever making an economic profit. I suspect no one else here does either. So to use the economic definition of profit is not helpful to luthiers, because I suspect none of us will ever earn an economic profit from lutherie no matter how good we get.

The second definition of profit is an accounting definition: "The sales of the firm less costs like as wages, rent, fuel, raw materials, interest on loans and depreciation." Dave can correct me if I'm wrong, but my understanding is that, from an accounting perspective, the cost of wages is referring to the cost of wages ACTUALLY paid, not some fictional notion of a reasonable wage that you are not really paying to anyone. So, if any of you have set up your lutherie business as a corporation that sends money to a payroll service every two weeks, and if you get a check from that, then that is wages. Or if you pay yourself a salary, then that's wages and it goes against your accounting profit. But if you do like most luthiers here, and you just take home whatever's left over after you pay the hard costs --- which may be nothing, depending on the month --- then the entire amount you are taking home is your business' accounting profit, not wages.

That does not mean you should ignore the reasonable value of your time when you examine your profits. Obviously, that's important. But the correct way to describe it is that you want to earn a profit on each guitar that warrants the effort you put into each guitar.

But then again, maybe not. There are probably plenty of people here who don't worry too much about the time they invest in their guitars because they enjoy it --- enjoy it so much that they would be spending that same time building guitars even if they did nothing more than recoup their marginal costs of building an instrument. Those people don't need to earn a profit that warrants the amount of time they invest in the guitar.

So, if you invest 100 hours building a guitar, and you sell it for only $200 more than the money you spent to build it, then you have a $200 profit. You may or may not be happy about making $200 profit on a 100 hour project, but that's a different issue.

Kelby,
I am not offended but I do have to disagree if we are looking at a ledgers bottom line. If you do not account for consumables such as electric, gas, and your labor you are fooling your self. This has nothing to do with the money you put in your pocket and if you are happy with it. It has to do with making the books balance for both you and the IRS. You do have to pay tax on the earned income derived thus not counting labor as an expense is like throwing hundred dollar bills down a disposal.

This is my formula

material overhead + shop operating overhead + labor overhead + shipping overhead = total actual cost

total actual cost + profit margin = sales price

sales price - total actual cost = profit

Anything less is not a true profit economically. I do see your point but what you describe in the last scenario is derived cash flow not profit. Even if you don't pay a payroll your labor is an overhead expence. Not counting it is like not counting 75% of the material based at 100hrs @ just $5.00/hr.


MichaelP38945.607962963

Michael, I appreciate your thoughts. Let me approach it from a different perspective and see if we can resolve the impasse.

You talk about "a ledger's bottom line." All right, let's look at the ledger's bottom line. I can tell you absolutely, unequivocally, with 100% certainty that time invested by a business' owner that is not compensated through wages or salary (the item you describe as "labor overhead") does not show up on a business' ledger or any other financial statement when prepared by a real accountant. ;)

Here's my evidence. My law firm has roughly 50 attorneys (the number seems to change monthly). Of those attorneys, 13 of us are partners (owners), and the remaining 40 or so are employees. The employee attorneys are paid a salary bi-monthly. The partners are not; we take home whatever money is left over after we pay the bills.

Every year, we spend a small fortune having our accountants put together ledgers, financial statements, and numerous other documents that tell us how well we are doing financially. Those financial statements are extremely detailed, and they ultimately tell us how profitable the firm is each year. The only item on those financial statements for anything like "labor overhead" is the money actually paid to the firm's employees as wages or salary.

Now, 13 partners (owners) each invest 2000+ hours per year in our business. None of us get a wage or a salary. Each month, we do what most luthiers do --- we look at how much we have left (if any) in our bank account after paying the month's expenses, and we take it home. NONE of our thousands of hours of effort is accounted for in the financial statements. Or to be more precise, the financial statements show the REVENUE generated by those hours, but they do not attribute any COST to those hours. When our accountants calculate our firm's profit every year, they do not deduct "labor overhead" for the time the owners have invested, because we were not actually paid wages or salary.

Bottom line, it is important to think about your time investment when you evaluate how your business is doing. But the fact that it's important to think about your time does not mean your time will be deducted from the accountant's calculation of "profit."

It is hard to compare a law firm partnership to a small lutherie business. A limited partnership is far different. My point is that if I did not consider my hours as an expense then my bottom line goes up as perceived by the IRS and therefore I am taxed a greater percentage per instrument, and cuts my actual profit by as much as the basic material and consumable materials. I do get what you are saying but being a small business owner there is no way I could reasonably count my labor expense as part of my profit. As a Partner you are more like a shareholder as compared to a sole proprietor or independent contractor. You are right this other $500 goes into my pocket but if I do not cut this as an expense, then I am taxed on that much more on my personal taxes. You are right that this is semantic, but I did not write the tax requirements I just merely operate legitimately within the guidelines.

Not trying to be obstinate here. MichaelP38945.6307523148

Hi Michael. I know I'm the obstinate one here. For goodness sakes, anyone who starts a thread about the way other people use a word is by definition being obstinate.   

I didn't completely follow your last post in terms of the IRS, but it sounds like you are treating your time as an expense for purposes of calculating your taxable income. If that's correct, I'm not a tax lawyer, but you may want to consult with your accountant about that one.

There is nothing that says an owner can't also be an employee. I get a paycheck just like everyone else.

AND... in this situation. The wages I pay myself are cost and are deducted against the revenue of the business. I pay taxes through payroll deduction just like every other employee, and at the end of the year I get a K-1 for the profit or loss of the business.

Kelby.. no offense... I see your point, but your wages are not considered profit.Brock Poling38945.6367361111

_________________
Brock Poling
Columbus, Ohio
http://www.polingguitars.com

Following your model: If I charged $2K for a guitar and my material,consumable and shipping cost were 50% of that $2K then my profit margin is 100% or $1k

Gee im making a killing MichaelP38945.6352893518

[QUOTE=Brock Poling]
There is nothing that says an owner can't also be an employee. I get a paycheck just like everyone else.

[/QUOTE]

I have I am totally legit as I sell a product not a service. I could actually deduct my work clothes and many other items if I got nit picky, not even thinking about tool and equipment depreciation. which I don't do because I do this as an independent contractor vs an incorporated business. Besides at 5 instruments a year it really would not be much.MichaelP38945.6409722222

Brock, you are absolutely right. If you are actually cutting a paycheck for wages or salary --- whether to yourself or someone else --- that is clearly an expense that cuts against the business' profit.

Bottom line, there's profit, and there's wages. Those are two different things. One you receive because you did work, and the other you receive because you own the business. If you are paying someone wages (even yourself), then that reduces the profit. If you are not paying wages, then that increases the profit. It turns on what was actually paid --- if you actually paid wages, then that reduces profit, but if you didn't actually pay wages, then profit doesn't go down just because you probably should have.

The real question is this: When I take money from my lutherie business, how much of it is because I worked for wages, and how much of it is because I took profits as an owner? Well, tax issues aside, the answer is fairly simple. If you have decided to pay yourself a set amount --- whether a set wage or a set salary --- and if you pay yourself that amount for your work regardless of how much the business is making, that sounds like wages to me. But if you are taking whatever is left at the end of the month, regardless of how hard you worked, that sounds more like you are exercising your privilege as an owner to distribute the company's profits.

Brock, it looks like you edited your post while I was writing mine.

Based on the additional information you have provided, I would absolutely consider your paycheck to yourself wages actually paid, which do cut against profits as I previously noted.

I suspect there are a lot of part-time builders who do not operate the way you do. And for those who do not actually cut a check for wages, I don't agree that you can pretend you did for purposes of calculating your business' profits.

The accounting definition is all that matters...
...but since I do that all day long, I'm a little biased.

There's also a difference between salaried and hourly wages, legally. A salaried person is going to get their pay regardless of working 40 hours or 100 hours. There is also a difference between exempt and non-exempt for salaried positions in paying overtime. Hourly employees get payed for however many hours they work. Period, plus overtime for hours worked over 40 in a week.

For a guitar builder, unless you have a constant stream of revenue from the business, you can't pay yourself a salary. So you can really only pay yourself an hourly wage - at best, if monies come in. And then wages can be payed out, taxes paid etc.

The partners in the law firm are not payed a salary, because they share the profits by contract and agreement. If your law firm made no profit in a month due to your substandard hourly billing for services and since you're not technically a salaried employee, you would not get paid, I'm assuming.

So for Kelby's argument...
It is similar for the guitar builder, in that if they don't make sales, they don't get paid. The reality of a sole-proprietorship is that the IRS is going to charge taxes based upon what income you have minus your expenses (unless you pay yourself a salary and have taxes taken out). After that, you can figure out whether you made $50/hr or $0.50/hr. More than likely the latter. How you define the costs on your books plays into all that. Pay yourself a salary or an hourly wage, or it's revenue vs expenses and you're keeping the profit.

Dave may have a different take on it....

_________________
"I want to know what kind of pickups Vince Gill uses in his Tele, because if I had those, as good of a player as I am, I'm sure I could make it sound like that.
Only badly."

[QUOTE=Kelby] Brock, it looks like you edited your post while I was writing mine.

Based on the additional information you have provided, I would absolutely consider your paycheck to yourself wages actually paid, which do cut against profits as I previously noted.

I suspect there are a lot of part-time builders who do not operate the way you do. And for those who do not actually cut a check for wages, I don't agree that you can pretend you did for purposes of calculating your business' profits.[/QUOTE]


Yeah, you are right. You certainly can't do it for tax purposes.... but for figuring out where you should be pricing your product it is probably a good exercise.

As I read more of your posts, I don't think we are disagreeing...

_________________
Brock Poling
Columbus, Ohio
http://www.polingguitars.com