How can my business be more profitable?
“We have a loss of $1.3M over the last 2 years, all coming from gross profit shortfall, more than overhead spending. I’m not sure how to solve this issue, I don’t even know where to start. It’s been a difficult two years for sales and profit. We need to boost the profit we’re making on jobs. How can we become more profitable?”
Boosting profit margin is all about working smarter, not harder.
It starts with understanding how to categorize costs and profits. Use every tool in your arsenal: sales, finance, marketing, operations, and human resources. Take a look at your mix of the business overall. Having a combination of prices and margins can be good for business. Figure out how much selling effort goes into getting a customer and what role low-margin work play in bringing in new customers.
Understanding what drives profitability is essential for any small business to be successful.
Small business owners regularly drive companies into the ground by chasing unprofitable opportunities or by spending too much to produce what they sell. Sometimes it’s better to say “no” and walk away from opportunity, as hard as that may seem, especially coming out of recession. And occasionally, it’s better to take on revenue and find a new way to provide the product or service.
Customers and expectations eat up the profit margin in a small business.
Employees and systems. Marketing and sales. Finance. These parts of the business impact revenue and profit – both good and bad. Margin is a measure of profitability, and margins have several layers. Knowing which margin to look at and for what purpose will help this owner stay on top of what’s happening.
Profitability in business functions relates to the income generated in the business.
Profit is rarely a fixed amount for each period. Different levels of profit fluctuate according to other variables, including:
- how much is sold
- how profitable are the items that are sold
- how much does carrying cost, or overhead, the company has to cover
- How well the company keeps customer prices in line with increases in materials and labor needed to produce the good(s) sold.
Before calculating profit, a company has to know its expenses.
There are two primary expense categories: cost of goods sold (COGS) and overhead expenses. Coding expenses in the correct section will help yield a clearer picture of what’s happening in the business.
What is the Cost of Goods Sold (COGS)?
The costs of goods sold are what you invest in making your product or delivering service. Direct expenses, also known as material or labor costs, represent the expenses involved in producing your product. Generally, the price of goods includes all expenses related to the good, such as manufacturing or selling supplies and products purchased for resale. It also may consist of raw materials, packaging, and direct labor spent on producing or selling the product. Overhead expenses include indirect costs, such as marketing, shipping, and packaging, which are not included in your price of goods calculation.
What is gross profit?
Gross Profit percent tells an owner how hard the business is working financially. A low percentage (under 50 percent) means the company has a lot to manage in COGS before it makes any money to put towards overhead expenses. A high gross profit (over 50 percent) means the business doesn’t have to work so hard to make money towards overhead costs.
How do you calculate gross profit?
To determine gross profit, overall or by-product, the company needs to know revenue (money coming in from sales to customers) and COGS (the money spent to produce the items or services just sold). Here’s the formula to calculate gross profit: (Revenue $) – (COGS $) = (Gross Profit $). Once you know Gross Profit $, you can calculate (Gross Profit percent) = (Gross Profit $) / (Revenue $).
Knowing the gross profit percent and the number of overhead expenses means the owner can calculate how much revenue (income from sales) the company needs to break even. Knowing what it takes to exceed break even is a good thing since missing that mark means the owner has to take money out of their pocket to keep the company going. Here’s the formula for calculating: (Break Even) = (Overhead $) / (Gross Profit %).
What’s the difference between gross profit and net profit?
Net profit is the amount left over after the company pays for overhead expenses. Net profit is calculated like this: (Gross Profit $) – (Overhead $) = (Net Profit $). This calculation tells the owner how much is left towards taxes, savings, and debt repayments.
It’s important to know the net profit percentage and the dollar amount. You can calculate that using this formula: (Net Profit %) = (Net Profit $) / Revenue $). A low net profit percent means the company has little room for error if any of its costs increase or sales drop. A high net profit means the company may have room to begin investing in other growth opportunities.
How do you calculate profit margin?
There are several ways to measure profitability—one of the best tools in the accounting system. Time and motion studies may be helpful too. Tracking a specific project and client on a sampling basis may indicate costs. Whatever you do, it will be essential to get people involved in separating the time they spend by projects, by the client, from downtime and internal assignments.
Work with your accounting personnel and anyone who inputs data into the accounting system. Explain the importance of identifying and segregating revenue and costs by service. Ask them to record information into suitable buckets carefully.
Review the results. Delete Cost of Goods Sold from revenue for each service bucket to establish gross profit by service. Divide gross profit by income for each bucket to obtain a gross profit % per service.
Frederick Taylor was the manufacturing world’s father of time and motion studies.
His goal was to get an accurate picture of how long it should take to manufacture a particular product. He took pictures and notes as people did their work. He was looking to understand the effort and cost of production and identify streamlined opportunities. It is possible to do the same with service-based activities.
Explain to people that you want to understand what goes into producing the best services, including standardizing and streamlining the actions taken. Watch how people conduct each stage of the work needed to provide the service.
Make notes. Take pictures. Set up work groups to review and discuss. Ask the people who are doing the work to make recommendations. Set the goal to develop a standard amount of labor – cost/ person and hours/person – that can be used as a benchmark.
Make sure that you get all employees involved in the project. Explain to employees that the company is looking to increase efficiency so that it can continue to grow profitably, ensuring everyone will have jobs in the future. Tell people it is vital to have a standard set of costs so the company knows how to price the services it sells, to ensure profits, and know if and when there’s a problem.
Ask people to keep track of what work they do. Give them a way to track the time they spend doing specific actions. Find the balance between monitoring too few minutes and losing track of hours. Generally, tracking activities in 30-minute increments is a good start. As people build skills at tracking, tighten it up to 15-minute increments.
Keep reminding everyone why you’re doing this. It’s a competitive landscape. The company that best manages and insures profits, finding the right balance between optimal productivity and accurate pricing, is likely to win the day.
Ways a small business can increase gross profit margin:
Create a grid to analyze what’s going on with profit.
Create a grid of all products or services you sell, one for revenue, one for gross profit dollars, one for gross profit percentage, plus columns for the number of selling costs, new customers, total customers, and rate of total sales.
Use this grid to analyze what’s going on in quantity, price, and profit.
Carefully analyze all low-margin items to be sure you fully understand and have allocated all costs.
Be sure that even your least profitable items contribute to the bottom line.
Make sure that any low-margin work you decide to stick with is relatively easy to produce and has few variables. Control the margin by making this service or product “cookie-cutter” work — every item looks the same, is created the same way, and gets delivered the same way.
Build up profit margin by creating an up-charge for customization and special handling.
The same goes for rush jobs, items requested in smaller than typically offered quantities, alterations, and out-of-season orders. In other words, exceptions cost the buyer more and serve to drive more profits to your bottom line. Willingly and gladly supply the kid-glove special treatment that some customers desire, and make them pay extra for it.
Find creative ways to increase your profit margin.
Offer buyers combination packages by putting a low-margin item together with a high-margin. Consider slightly discounting the package price, if necessary, to attract the middle-of-the-road buyer. In the process, get your average buyer to increase the overall size of the order, purchasing more quantity because they got a “deal.”
Ways to make more profit and improve margins:
- Up-sell existing customers. Get them to buy something additional that doesn’t cost much to deliver.
- Add to the sales force people who can bring in new customers willing to buy existing products at higher prices.
- Find out what else customers are looking for. Figure out if you can make it at a higher than average margin.
- Compare results from one client to another – focus on serving and expanding the most profitable ones.
- Identify low-margin products or services and sell them to some other firm to produce for you. Or get rid of them and fill the void with something more profitable.
- Make sure that all accounts receivables are collectible. Ask for a credit card upfront before taking on risky business.
- Ask for deposits upfront to cover the cost of materials and lower borrowing costs.
- Offer financing terms to clients who need more time to pay. Charge interest to those whose payment is over 30 days.
- Look for a leasing firm to work with. Increase financing ability.
- Look for competitors. Direct or in allied fields. Who may want to get out of one or .all products/services they deliver. Buy them up, decrease competition.
- Figure out niches. Become unique to specific buyers. They can’t get it anywhere else.
- Set aside a budget to test out new product/service ideas that can lead to sales in the future.
- Look for better deals from vendors. Shop around, and consolidate volume. Negotiate better payment terms. Ask for free delivery.
- Get more products/services out the door faster by increasing productivity.
- Look at production labor. How could changing hours increase productivity? Work 4 x 10 hours instead of 5 days x 8 hours, and that’s one less day of stop and start. Put staff on part-time if they’re not needed full time.
- Reorganize workflow and get more efficient.
Make sure your customers know you have more options if someone asks for low-margin items.
When someone asks for or clicks on a low-margin item, show them something a bit more upscale and point out the enhancements of the higher-margin item. You never know when a customer will bite on something they perceive as a superior solution, even though they first contacted your company looking for a low-price option.
Be sure to include selling costs when calculating the relative profit of each product or service that your company offers.
The low-margin products, at a minimum, must cover their selling costs so that your company doesn’t take a loss. In some cases, owners have been surprised to find out that higher-margin services and products, with a demand for hand holding, don’t make much more than the lower-priced, lower-margin cookie-cutter items.
Look at your low-margin items’ role in bringing in new customers.
As they say, variety is the spice of life. As long as you’re making a profit on every item that you sell, low-margin work can fill one or more needs, from acting as a loss leader to bringing in new customers who want to test the waters to filling in revenue or profit holes, to keeping things busy in slow periods.
Tips if you’re struggling to make more sales:
- Get rid of customers on which you lose money. Talk to customers about margin and find out who’s willing to work with you. Sell the losing accounts to a firm that can do the work more profitably.
- Figure out who in your workforce is productive and who’s not – talk with the unproductive ones and give them 30 days to turn things around, or they’re gone.
- If a product line is no longer in high demand, send employees who work on that to training on how to sell and produce something more profitable.
- Ask employees to take a vacation in slow times.
- When overtime starts to build up, cut it back by bringing on part-time workers.
- Increase productivity by training employees and upgrading equipment.
- Talk with employees about the importance of increasing margins.
- Reduce overhead costs. Get rid of excess space, re-negotiate bank loans, and pay off loans. Shop for office supply discounts, and evaluate insurance costs. Ask insurance brokers for training classes designed to reduce risk premiums.
Improving profit margins is essential for businesses of all sizes to remain sustainable and profitable in the long run.
However, it’s not always easy to know where to start. Our team offers a free assessment to help business owners understand where they can improve their profitability. We have the tools and experience necessary to help your business succeed. Contact us today to get started!