What You Can Do To
Improve The Profitability Of
WHAT IS PROFIT?
Profit is what's left over
after you've paid all your expenses. The
important thing to note is that profit is "what's left over". In other words, profit is a residual.
To answer this question it is helpful to understand that there are only four specific factors which determine your profit. These are:
1. The price you charge for the products and/or services you sell.
2. The quantity (or volume) of products and/or services you sell.
3. The costs you incur directly in producing or buying the products and services you sell. We call these variable costs because they increase or decrease as your sales increase or decrease.
4. Those costs you incur whether you make any sales or not. These are best described as fixed costs because they do not change with changes in sales volume, at least not on a day-today basis.
Let's put these four things together and for simplicity we'll assume you have only a single product but the conclusions we come to will apply whether you have 1 or 1000 products.
Suppose you sell a thing called a widget. It costs you $60 and you sell it for $100. What you sell the widget for is the price. What you pay for it is a variable cost. So if you sell 100 widgets your total variable costs will be $6000 where as if you sell 50 widgets the total variable cost is only $3000. It varies directly with your sales volume.
Now, if you sell a widget for $100 and it costs you $60 then you've made a profit of $40 on each sale. We call this, the gross profit or gross margin. We use this term to remind us that we still have to meet our fixed costs before we end up with a net profit.
If you sell 100 widgets and make a gross margin on each one of $40 then your total gross margin is $4000 and if your fixed costs for such things as rent, leases, wages, insurance etc amount to $3000 then you end up with a "net profit" of $1000. On the other hand, if your fixed costs are more than $4000 then you'll incur a loss.
HOW TO INCREASE PROFIT
If you're looking for ways to increase your profitability then you have to focus your attention on the four profit determining factors: price, volume, variable costs and fixed costs.
Let's look at each of these four factors under three headings - what factor, what possible action you could take and what conditions would have to occur. It’s important to note that profitability can be increased by either taking action to increase or decrease any of the four factors, as long as the required conditions are met.
The interesting thing to notice about the above summary is that no single factor can be considered in isolation without considering its impact on, or the impact from each of the other three factors.
The second thing to remember is that a profit improvement strategy may involve either an increase or a decrease in each of the four factors. There is no standard success formula; it depends entirely on specific circumstances and the relative strengths and weaknesses of your business.
The third thing to notice is that a favourable change in price and/or your variable costs will improve your gross margin per dollar of sales. Whereas a favourable change in your sales volume and/or your fixed costs indicates greater productivity. That is, the overheads you incur in running your business are lower per dollar of sales.
In other words any profit improvement strategy must focus on either or both of two things:
1. achieving a higher gross margin per dollar of sales by increasing price and/or reducing variable costs.
2. achieving greater sales per dollar of fixed costs by increasing the productivity of those things which have a fixed cost.
So that we can put everything into some sort of perspective let's consider the profit improvement potential that would arise from a modest improvement in each of the four factors. We'll use the previous example as a base and assume a 5% improvement in each of the four factors:
It can be seen that a 5% favourable change in each of the four factors without a consequential unfavourable impact on each of the other three would more than double your profit from $1,000 to $2,190. This is a 119% improvement.
You may want to take issue with the assumption that there are no consequential impacts. The model also ignores macro economic influences outside our control having a co incidental unfavourable impact on each of the other three factors.
However, it is a fact that small improvements made to each of the four factors that determine your profit will combine to give a staggering overall impact.
And of course, the reverse is also true. If you discount your price, allow your sales volume to fall, fail to control your overhead costs and let your variable costs get away from you then you can destroy a potentially profitable business. This can happen very quickly.
You see it's all to do with leverage and this is what brings so many people unstuck. If you get all the little things right, the big picture looks after itself. But if you get all the little things wrong you're going to be in real trouble and it’s likely, you'll never know why.
DEVELOPING A PROFIT IMPROVEMENT STRATEGY
You'll recall that we said earlier that to improve your profitability you must either make a larger gross margin on each dollar of sales or sell more without increasing your fixed costs. It goes without saying that the biggest improvement will occur if you can achieve both simultaneously.
Improving your gross margin
Remember your gross margin is the difference between the price of your product and what it costs you to buy or make it. Therefore, the only way to increase your gross margin is to sell at a higher price or buy at a lower price.
In most instances (but not all!) you will have limited scope to buy at a lower price. For this reason your selling price is the critical variable.
Without doubt, the biggest single barrier preventing small business managers from making an acceptable profit is their refusal to charge a price which will enable them to achieve this. You are not in business to match the price your competitors set; you are there to service your customers.
In fact, studies of the factors people regard as important influences on their decision to deal with a particular business indicate that product and price are relevant in only 15% of cases but we'll say more about that in the discussion on sales productivity.
Trying to hold or win market share on the basis of price discounting is the lazy manager's competitive strategy. It is relevant and applicable in only one situation and that is where you have a definite cost advantage (either variable or fixed) over your competitors and your product or service is one where customers are very price sensitive.
DISCOUNT PRICING POLICY
The following table indicates the increase in sales that are required to compensate for a price discounting policy. For example, if your gross margin is 30% and you reduce price by 10% you need sales volume to increase by 50% to maintain your profit. Rarely has such a strategy worked in the past and it's unlikely that it will work in the future.
If your present margin is
PREMIUM PRICING POLICY
On the other hand, if you adopt a premium pricing strategy the following table shows the amount by which your sales would have to decline following a price increase before your gross profit is reduced below its present level. For example, at a 40% margin a 10% increase in price could sustain a 20% reduction in sales volume.
If your present margin is
If you're like those many small business people who regard price as the only factor influencing the buying decision of their customers you will undoubtedly reject the proposition that a high price strategy (and by implication, high value) will work. You may accept that perhaps it's right for some businesses but it sure doesn't apply to your business. There is no business that does not have the potential to command a premium price for its products or services if, and this is the crunch, it is able to market those products or services in such a way that the customer perceives added value.
If all of your marketing effort, all of your advertising and all of your sales dialogues focus on price then you will be beaten on price every time a competitor comes along with a lower one. In other words, if you make price the critical factor, it will be the critical factor.
The only way to get out of the price trap is to promote other features and benefits that you can offer your customers. For example, better quality, longer warranty, satisfaction guarantee, 24 hour accessibility, more convenient location, greater resale value etc, etc. It might be that your competitors offer all of these things but unless they also emphasise this in their marketing, how will the customer ever know. Think about this for a moment. Your job as a marketer is to create the perception of value and then to back up what you sell with superb service. The thing to remember is that price is only important when all other things are equal.
Some customers only think in terms of price. They are better left to your competitors. What you should be doing is working with those people who are happy to pay for value. This means two things. First, you have to deliver value (embody service) and secondly, you have to educate your customers to be aware that they are receiving value. One without the other will leave you exposed.
A man named John Ruskin once said...
"It's unwise to pay too much, but it's worse to pay too little. When you pay too much, you lose a little money, that's all When you pay too little, you sometimes lose everything, because the thing you bought was incapable of doing the thing it was bought to do. The common law of business balance prohibits paying a little and getting a lot - it can't be done. If you deal with the lowest bidder, it is well to add something for the risk you run, and if you do that you will have enough to pay for something better.”
This is all about getting more sales per dollar of fixed costs. It can be achieved by either or both increasing your sales at a faster rate than your fixed costs increase or reducing your fixed costs without affecting your sales.
The critical thing with each fixed cost is to ask yourself the following questions: What service does this cost provide to my business? Can I obtain the same service from another source at a lower cost? If so, is it practically feasible to switch to another supplier of that service? If I did switch to another supplier would I get equivalent quality and would this effect the quality of my product or service? If I were to spend more on this service would it generate a gross profit that exceeds the additional cost?
You'll notice that all of these questions are directed towards what you're getting for what you're spending. They are not simply concerned with whether or not you can eliminate or reduce the cost.
Take wages for example. In difficult times people will often think of dismissing staff. This may be an appropriate course of action but if should be considered carefully. More often than not, the appropriate strategy is to invest more in staff training to show them how to improve customer service and how to sell more to your customers.
Improving Productivity contd.
What about advertising? There is a standing joke in the industry that 50% of your advertising is wasted. The problem is to identify which 50%. In fact the 50% estimate is being generous. It's probably closer to 100% that's wasted - at least you know which 100% it is - yours!
In a Business Review Weekly article a manager of a major supermarket chain said that ... 91% of readers took very little notice of price and item ads - only 9% looked at them for shopping purposes. If that's a fact, why do the major supermarkets still persist with this type of advertising? Because the product suppliers pay for the ads and the supermarket gets to (1) promote its name and (2) create consumer perception that it's a price competitive retailer.
The only organisation to benefit whether your advertising works or not is the media company you use. They're always ready to invite you to participate in special deals and supplements and they're pleased to give advice on how to structure your ads "to get results". But ask them to do a deal where you pay an amount per inquiry and you'll be met with stony silence. How many times have you been contacted by a newspaper or radio rep and asked how your ad worked?
This does not deny the value of advertising. On the contrary, it is one of the best ways to explode your sales. What is folly is spending on advertising that does not work. You can learn how to create advertising that does work and you can test the results. When we talk about productivity, therefore, we're talking about how to get most out of your advertising dollar. This is unquestionably one of your major untapped areas of potential profit growth.
Effective advertising is clearly one way to create new customers. This is a specialised area in itself but there are four absolutely critical things to get right:
1. Target your customers - never try to appeal to everyone. Focus specifically on those people who you know will benefit from your product/services. How you word your headline will be the major factor in accurately targeting your offer.
2. Make your offer compelling and relevant to the market you target. Don't be cute or clever. Say it exactly as it is.
3. Graphics and layout will make your ad readable and noticeable. Don't try to make your ad look like an ad. Make it look like something worth reading.
4. Write your copy in terms that your readers can clearly understand. It must be specific and believable. Remember that if you have a clearly defined target market and your offer is compelling and well stated your copy can be poor and you'll still get a good response. That is, good copy writing will not sell a poor concept/offer.
Dick Potter one of America's leading advertising specialists has used split‑run tests to evaluate the relative performance of each of these things. He concluded:
great copy will give 50% response increase
good graphics will give 150% response increase
good offer will give 300% response increase
accurate target will give 1000% response increase
EFFECTIVE ADVERTISING CONTD.
In other words, a specific focused target (i.e. people in the market who are predisposed to buy) will be 20 times more powerful than how you express your message. If you know' exactly who will be interested in what you've got to offer and you make an offer that is compelling you will find that you don't have to be a brilliant copywriter to get a cost effective response from your ads.
The only sure way to get customers to come back and indeed, to act as advocates for your business, is to give them absolutely superb service. They need to feel that you really care about them and that your goal in business is to delight them with the way you look after them. All of us probably fall short of this ideal but it is an objective well worth striving for.
Almost 70%, or seven out of ten customers cease to patronise a business because of Perceived Indifference. When you yourself deal with various businesses aren't you inclined to want to again deal with those who take the trouble to show they care about you. Do you 'shop around' when you're already delighted with the service you get?
It is sobering to note that most businesses spend 6 times more trying to attract new customers than they do looking after the ones they've already got. They have to do this because their existing customers keep falling off the back and new customers are needed to replace the old ones. It's a merry-go-round (perhaps sad-go-round would be more accurate).
Bain and Company, a leading Australian stock broking and financial planning company following a study on client satisfaction reported, that just a 5% increase in customer retention will produce a 25% to 100% improvement in profit. In other words, it pays to look after your customers.
Let’s put some numbers on this. Suppose you have 1,000 customers who spend an average of $250 per year with you. Suppose that you have a customer loss rate of just 10% each year and that a customer who stays with you would deal with you for an average of 10 years. Forgetting about inflation, each customer has a lifetime value to you of $2,500 and a 10% attrition rate is costing you $250,000 in potential future revenue each year.
Another thing which is overlooked by most businesses is the simple act of asking the customer to buy. It's no accident that McDonalds is one of the largest and most profitable businesses in the world. The reason for this certainly cannot be found by looking at the uniqueness of their product. It's the fact that they leave nothing to chance. Everything is done according to a plan including the question " . . . and will you be having fries and a drink with your meal today?" About 30% of the time people will say yes even though it may not have been in their mind - effect, 30% increase in sales of fries or drinks and over 100% increase in profit contribution from those lines
And a client in the restaurant business used to ask guests at the end of the main course (without really thinking) "Would you like anything else?" - frequent answer, "No, just some coffee thanks". He changed this to ". . . Now, can I offer you a beautiful platter of Australian and New Zealand cheeses or would you prefer to make a selection from our new dessert menu, the . . . are absolutely delightful" - result, he instantly tripled dessert and cheese platter sales and still got to make the coffee sale. It's all in what you say and how you say it.
Word of mouth referral is the best means of creating new customers. But satisfied customers do not become advocates for your business - Delighted customers do!
Most people don't fully appreciate the powerful dynamics of customer retention and frequency of contact. This is reflected in the table below. It shows the effect on total sales revenue of a relatively small improvement in the critical variables: customer attrition rate, new customer attraction rate, frequency of customer purchasing and the average value of each sale.
Perhaps the best kept secret in the business world is that it is very simple to improve the profitability of a business but there's a catch. What to do is the easy part, being willing to do it is the stumbling block.
In every case, business success stories have been associated with people who have had the courage to change their way of doing business. In the case of the failures it has been a refusal to try something different. Have you ever said "That sounds okay in theory but it won't work in my business. "
There are no special tricks to make a business more profitable. Those of us who make a living helping people in business can't pull rabbits out of hats. However, there is one over-riding consideration that must be accepted:
If what you're doing now isn't working then you must do something different.
In every industry and irrespective of the state of the economy there are some businesses that consistently out-perform others in their industry, not by small amounts but by staggering amounts. This is called the margin of excellence. They have got it right and the others have got it wrong. It's as simple as that.
Close enough is NEVER good enough. Improved business performance comes from a willingness to do something different and then getting the detail right. If you get all the little things right.... the big picture looks after itself.
The following example is an actual case in point. The result in the first year was a satisfactory 58% increase in profitability. The business itself increased in value by more than $75,000.
Today the business is generating well over $100,000 in net profit. It's a bigger business today than it was but it is also much more profitable in terms of Return on Capital Employed and in absolute dollars earned for the owner.
Before After % Change Note
Sales $242,750 $279,462 15.1% 1
Gross Profit Margin 36% 39% 8.3% 2
Fixed Overheads $61,358 $67,886 10.6% 3
Capital Employed $194,885 $201,179 3.2% 4
Net Profit $26,032 $41,104 57.9% 5
Return on Capital Employed 13.4% 20.4% 52.2%
Analysis of the Profit Improvement
volume and prices
More effective advertising - budget was established, market was segmented and targeted, analysis of advertising effectiveness was undertaken and ads that pulled more were developed;
Attention to team training with respect of both product knowledge, selling skills and customer courtesy;
Performance standards and targets were established and closely monitored.
15.1% increase in dollar value of sales, some of which was due to selective price increases on key products.
2. Gross Profit Margin
Detailed analysis of the major profit contributors was undertaken having regard to both the product lines and customer segments;
Products which were not achieving required margins and/or which did not fit the business were dropped;
Staff were acquainted with the major profit contributors;
More selective purchasing was put in place and greater attention to quantity discounts;
Selective price increases improved margins and enabled better service to be delivered at the point of sale;
Advertising and selling was orientated to higher profit lines and targeted to properly qualified customers;
8.3% improvement in gross margin.
All costs were analysed as a percentage of sales over last 3 years using available information - the major cost areas were identified;
Each area of cost was examined on a cost/benefit basis to determine whether the same result could be achieved at a lower cost from an alternative source or whether it was appropriate to increase costs to deliver more customer orientated service value;
Detailed cost budgets were prepared on a cash flow basis;
Actual costs were monitored against budget monthly and detailed reviews undertaken quarterly.
Fixed costs increased by 10.6% which was in line with normal inflation at the time - basically, in real terms fixed costs remained constant even though sales increased by about 5% in real terms and 15% in nominal terms.
4. Capital Employed
A post sale credit control was put in place. Customers who failed to pay within the prescribed term were politely brought into line. Some customers left, that was an added bonus;
As part of gross margin analysis (see (2)) stock lines that were not achieving turnover targets were rationalised and some duplicate lines were dropped;
Tighter control over stock and in particular stock purchasing having regard to the lead time for orders to be filled;
Old slow moving stock was disposed of quickly. This released valuable space and increased cash flow.
Stock levels and debtors were reduced relative to the increase in sales. This released cash that was then used to reduce overdraft finance and creditors.
Relationships with bank and creditors improved significantly. Although actual capital employed increased by 3% the volume of sales it supported
increased by 15% in other words, a 3% increase in resources supported a 15% increase in sales volume.
5. Net Profit - The Final Result
Improved by $15,072 - a 58% increase over the previous year. This example illustrates graphically how small marginal changes, although modest in themselves, can together result in a huge difference. Profit turnarounds of this magnitude cannot be achieved year-in - year-out but every business has room for improvement. The choice is up the owner/manager.
It is worthy to note that on the basis of a capitalisation rate of 20% the improvement in the profit of this business increased the value of its goodwill as a going concern by $75,360 - not bad for a year's work and certainly worth the management consultancy fees that were charged. But there is a rider: The advice and assistance that was given would have been absolutely useless unless the client had been prepared to make a total commitment to the task in the final analysis, it's up to you!
HOW TO ESTIMATE YOUR PROFIT IMPROVEMENT POTENTIAL
It's quite amazing what effect relatively small changes can make to your bottom line. The following example shows how you can quantify the profit improvement potential of your business given modest changes in the key variables that make up sales, fixed costs and margins. After you've had a look at the example see what the result could be for your business.
A 20% increase would require a factor of
variable costs therefore the
change factor is 1.05.
Result - Net Profit increased to $61,760 - more than double the present profit.
Unless you are already the leader in your industry there will be scope to improve the profitability of your business. It is not always easy to achieve but it's certainly not impossible.
You need a plan of attack. Specifically, you need to find out exactly what your existing and potential customers want (it's not always the lowest price) - this will form the basis of your marketing plan.
Then you need to organise your business so that you can delight your customers - this forms the basis of your operations plan. This will require giving attention to your team members and equipping them with the resources and skills they need to excel in what they do - you must systematise your business.
And finally, you need a management control plan in place to make sure everything's working the way you designed to work. This will focus on the things you must get right to succeed. We call these things your Critical Success Factors and we measure how your business is performing in relation to them with the use of Key Performance Indicators.
The reason most businesses don't work is that the people who are supposed to be managing them are too busy working in them rather than working on them as Michael Gerber, author of the excellent book "The E-Myth" said. That is, they're doing the technical work. They're working with their hands rather than their head. There's a limit to what the hands can do but no limit to what the head can do.
We believe that as your consulting accountant our job is to help you re-engineer your business so that it runs like a well oiled machine and once that's achieved, to help you keep it there.