I enjoy talking to entrepreneurs and business owners about how I can help them to increase profit.
One of the techniques that I use is to show how small changes in what they do can have such a big effect on their bottom line.
If you simplify business, there are only three ways in which you can improve your profit:
- You can sell more
- You can sell at a higher price
- You can reduce your costs
An Exciting Profit Improvement Example
Imagine you run a business with £1 million sales which makes £40k profit after paying you a fair salary for your time and effort. The average gross or contribution margin you make is 40% after covering your variable costs but your overheads reduce your final return on sales to 4% which is around the average level.
In this example this would mean that your business returns a £40,000 profit on the sales of £1 million.
Just changing each of the profit improvement factors by a 1% - price, volume and costs - creates a total of extra £23k more profit or an increase of 57.5%.
Let me take you through this profit improvement example step by step:
A 1% increase in sales prices with no reduction in volume will increase your profit by £10k (1% of 1,000k) with no changes in costs.
A 1% reduction in your costs will save you £9k (total costs are £960k so 1% is £9.6k which I rounded down).
A 1% increase in your sales volumes means your sales increase by £10k so the 40% gross margin means £4k extra profit.
The overall profit improvement = £10k + £9k + £4k = £23k
Do you think that you could do just 1% better in each of these areas?
Perhaps increase your leads by 1% or convert 1% more of your leads into orders?
This is an exciting way to look at profit improvement and shows that small changes can have big effects on your business.
A Scary Example When Profit Improvement Goes Into Reverse
Unfortunately the same logic works if these profit drivers get worse.
A 1% worsening of these three profit drivers will reduce profit by £23k, and that will more than halve the profit.
So my question to you is:
"Do you have the information systems in place to tell you if things are getting better by 1% or worse by 1%?"
If you don't, you can't correct problems in the early stages before they become entrenched and you can't take full advantage of unexpected opportunities.
So at what stage do you think your information systems start flagging up issues if not at the 1% level which could increase or decrease your profits by 50%.
At the 2% level which in my simple example could wipe out the profit or double it?
At the 5% level when your business is going through wild swings or even bigger than that?
Don't you think you should know if these factors are changing in your business?
My Purpose In Explaining These Business Dynamics
By explaining the drivers of profit improvement and how sensitive profit is to small changes which reinforce each other, I am not trying to promote a new information system or accountancy service.
You may want to talk to your accountant about designing key performance indicators or if you are a bigger business, consider appointing a part time Finance Director so that you can monitor these changes.
Instead I want you to understand why small changes in the economy and a concept called the product life cycle can have such a big effect on your business.
Both factors can have a direct and dramatic effect on these three drivers of profit - your selling prices, your sales volumes and costs.
Both will be the subjects of separate articles on the blog but talk continues about whether the UK and the US will have recessions (definitions differ).
If there is a recessions will it be V shaped with the economy recovering quickly or U shaped with a prolonged period of contraction?
I fear that the difficulties are only just starting since the economies are so unbalances. Either way you need to start thinking about the possible consequences on your business.
A good place to start is to identify your profit drivers and to then make sure that you can track changes. You may not be able to stop competitors forcing down prices but you can be informed of the consequences of matching their actions or letting them have the volume.
For more information about the part time finance directors please see my Part Time Finance Director Blog