Increasing profit in your business (part 1 of 2)

By
John Liston
,
Director | Adviser
February 7, 2019

Profitability is what drives a business.  It allows a business to grow and enables it to function properly by being able to pay wages, bills and the owner's salary.  As a business owner, profit is what really matters.  It represents the outcome of the risks and hard work it takes to start, grow and manage a business.  As the saying goes “revenue is vanity, profit is sanity.”    

Yet as business owners, we sometimes don’t fully comprehend what actually drives profit. It can still be a guessing game until we get the figures at the end of the financial year.

Sure, we know the basics of profit; it’s what is left over from sales after expenses have been subtracted.  But it’s surprising how little is known on what truly impacts profit. And how incremental changes to your business can have a life-changing impact on the end figure.      

The simplest way to understand what drives profit is to understand The Four Profit Levers.  

What are The Four Profit Levers?

Imagine you have four levers within your business.  Each of these levers represents a significant change you can make to your business, and in turn, will impact your profit margin differently. Understanding this tool will allow you to forecast the impact of changes - so you can identify which lever will have the desired effect.

Today I will talk you through the first two levers; sales volume and the price of your product/service. These two levers both fall under the category of Sales. In March I will share with you the remaining two levers which fall under the category of Costs.

KEY TERMS  

  • Revenue: the total amount of money that a company receives from its customers  
  • Direct Costs: the costs that can be attributed to the production of specific goods or services  
  • Gross profit: the amount a company makes after deducting the direct costs from revenue  
  • Operating expenses: the remainings costs of running the business (e.g. rent, software, equipment)  
  • Net profit: the actual profit after all costs

CLIENT EXAMPLE

Oliver runs an advertising agency in the CBD.  The business grew quickly after he started it seven years ago and now turns over $4m in annual sales.  In the last 18 months the growth has tapered off and so has the profit.  It’s still a very healthy business, but Oliver wants to dig deeper into his business financials to find out how we can improve profitability.      

Looking at the figures below, Oliver’s business has $2.5m in direct costs. Direct Costs or Cost of Goods Sold are expenses that are crucial to delivering revenue.  For Oliver, this is made up of staff wages as his staff are what create sales.  

This gives Oliver a Gross Profit (Revenue – Direct Costs) of $1.5m.  His operating expenses or overheads are $1m, leaving a net profit of $500k.      

*please zoom in on graphic*

LEVER 1: INCREASE SALES BY 10%

After looking over the figures, Oliver thinks he knows what to do.  He’s always been an aggressive and motivated type of guy and lived by the mantra “sales solve problems”. Oliver believes if he can just lift sales by 10% then profit will look after itself.      

While this is true in part, it’s enlightening to look at how this plays out on paper.  

Oliver hires two new sales managers and 12 months later sales have lifted by 10% or $400,000.  Revenue is now at $4.4m.  However, the two new sales managers each demanded a salary of $125,000 per annum, which has added $250,000 to direct costs.  

The result of $400,000 of increased sales volume is a $150,000 increase in net profit or 30% uplift.  Not a bad result.  

*please zoom in on graphic*

LEVER 2: INCREASE PRICE BY 10%

What if instead of rushing out to generate more sales, Oliver decides to pull the other lever and increases his prices by 10%?  

The result is deceptively large.

Revenue still increases by $400,000. However, there is no equivalent increase in Direct Costs.  The full $400,000 of increased revenue drops to the bottom line, and Oliver’s business increases profit by $400,000 or 80%.  

Oliver is amazed at the result; he has nearly doubled profit by raising prices by 10%.  

*please zoom in on graphic*

MY BUSINESS IS DIFFERENT!  

Often when we run these scenarios by clients, the first reaction is “that won’t work in my business”.  “My customers won’t pay that.”  This may be true for some of your clients; however, as a business owner, it's your role to continue to innovate and improve your service to justify a price increase.  It may be that a 10% price increase isn’t possible, but what about 7% or 5%?  And maybe a 10% increase in sales is too much of a stretch, but what about another 5% there also.    

When you combine incremental increases with each of the levers, that is when you start moving the needle on your profit.  Once you understand the levers of your business,  you get clarity on where to focus your time and energy as the owner.  If you can’t increase prices, you need to question why?  Is your product or service a commodity in the market?  Are you doing enough to differentiate yourself from your competitors so that price is not the only deciding factor for your customers?  As an owner, your energy should be spent on solving those problems.                  

Next month we will show you the remaining two levers which are around reducing costs within the business and how they affect the net profit.