Profit is what is left over after you have paid all your expenses. The important thing to note is that profit is “what’s left over”. In other words, profit is a residual. It is the consequence of what happens in and to your business. Some of these things are within your control and some of them are outside your control, if you are going to have any effect on your profit you have to focus on those things over which you have control. So what are they?
To answer this question it is helpful to understand that there are only four specific factors which determine your profit. These are:
- The price you charge for the products and/or services you sell.
- The quantity (or volume) of products and/or services you sell.
- 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.
- Those cost 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-to-day basis.
Let’s put those 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 1,000 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 $6,000 whereas if you sell 50 widgets the total variable cost is only $3,000. It varies directly with your sales volume.
Now, if you sell a widget for $100 and it costs you $60, then you 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 $4,000. If your fixed costs for such things as rent, leases, wages, insurance etc amount to $3,000 then you end up with a ‘net profit’ of $1,000. On the other hand, if your fixed costs are more than $4,000 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 the possible action you could take for each of these factors, and the conditions required for each action to be effective at increasing profitability.
|Profit Determining Factor||Possible Action||Required Conditions|
|Price||Increase||For a price increase to be effective, sales volume would either need to remain unchanged after the price increase, or if sales volume declines, the decrease in sales would need to be offset by the increase in price so that total revenue would still increase.|
|Decrease||For a price decrease to improve profits, sales volume needs to increase sufficiently to compensate for the decline in price and/or new customers need to be won and retained in the future as and when price is increased to normal.|
|Variable Costs||Decrease||Decreasing variable costs can be effective if the product or service quality is retained. If not, this could have a consequential effect on sales.|
|Increase||Improvement in product or service quality involves increasing variable costs but allows a higher price to be charged. This can improve profits if the price increase is both accepted by the market and sufficient to offset the higher variable cost.|
|Sales Volume||Increase||Increasing sales volume can be effective at improving profitability if your price remains constant. This means the increase in volume translates into higher gross profit.|
|Decrease||Decreasing sales volume can lead to higher profitability through reducing the size of the business, achieving a saving in fixed costs.
This may be effective if the saving is greater than the reduction in gross profit.
|Fixed Costs||Decrease||Decreasing fixed costs can lead to greater profitability if sales remain unchanged or if gross profit drops by less than the decline in fixed costs.|
|Increase||Increasing fixed costs can lead to greater profitability if sales increase through better service delivery by an amount which is sufficient to compensate for the increase in fixed costs.|
It’s important to note that, in the previous table, no single factor can be considered in isolation without considering its impact on, or the impact from, each of the other three factors.
Secondly, remember 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.
Finally, note that a favourable change in price and/or your variable costs will improve your gross margin per dollar of sales. On the other hand, 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:
- achieving a higher gross margin per dollar of sales by increasing price and/or reducing variable costs.
- 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 factor.
|Sales Volume||100||5% increase||105|
|Variable Costs ($60)||6,000||5% decrease ($57)||5,985|
|Fixed Costs||3,000||5% decrease|
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 not consequential impacts. 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 earlier we said 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 a 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.
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.
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
|And you reduce your price by||To produce the same profit, your sales volume must increase by:|
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 is a 10% increase in price could sustain a 20% reduction in sales volume.
If your present margin is
|And you increase your price by||To produce the same profit, your sales volume can reduce by:|
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 its 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. 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.
If you would like to discuss a profit improvement strategy for your firm contact FWO Chartered Accountants on 07 3833 3999 or firstname.lastname@example.org