This guide contains the following topics:
Profit is residual
The important thing to note is that profit is ‘what’s left over’. In other words, profit is 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. Profit is what’s left over after you’ve paid all your expenses.
Four specific factors
If you’re 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 and decrease as your sales increase or decrease.
- Those costs you incur whether you make any sales or not. They are best described as fixed costs because they do not change in sales volume, at least not on a day-to-day 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.
Four profit determining factors
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.
|Factor||Possible action||Required conditions|
|Price||Increase||Either no change in sales volume or if sales volume declines, the decline is more than offset by the increase in price so that the total revenue is still increased.|
|Decrease||Sales volume increases sufficiently to compensate for the decline in price and/or new customers are won who will be retained in the future as and when price is increased to normal.|
|Variable costs||Increase||No change in product or service quality which could have a consequential effect on sales.|
|Decrease||Improvement in product or service quality allows a higher price to be charged which is both accepted by the market and which is sufficient to offset the higher variable cost.|
|Sales volume||Increase||Price remains constant so the increase in volume translates into higher gross profit.|
|Decrease||A saving in fixed costs is achieved by reducing the size of the business and the saving is greater than the reduction in gross profit.|
|Fixed costs||Increase||Sales remain unchanged or if they decline the fall in gross profit is less than the decline in fixed costs.|
|Decrease||Sales increase through better service delivery by an amount which is sufficient to compensate for the increase in fixed costs.|
Profit improvement strategy
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 or 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 indicated 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 and/or
- Achieving greater sales per dollar of fixed costs by increasing the productivity of those things which have a fixed cost.
Get the little things right
You may want to take issue with the assumption that there are no 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 Remember the old saying ‘Look after the cents and the dollars will look after themselves’. 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.
You’ll recall that we said earlier that to improve your profitability you make either 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 that 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 a 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
You are not in business to match the price your competitors set — you are there to service your customers.
Should you be discounting your price?
The following table indicates the increase in sales 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 gross profit rate is:
|And you reduce your price by:||To produce the same profit your sales must increase by:|
Should you be increasing your prices?
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 gross profit rate is:
|And you reduce your price by:||To produce the same profit your sales must increase by:|
Create the perception of value
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 than 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 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 let 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.
Let’s start by looking at your fixed costs. These costs must be incurred for you to remain in business. In the short-run they do not change as your volume of sales changes. Examples include rent, wages, advertising (to a large extent), interest, lease costs and so on. Some of these costs are discretionary in the sense that you can take a decision to reduce them simply by cutting back. Others, however, are committed and you can’t avoid them.
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?
- 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 affect 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 costs?
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 it should be considered carefully. More often than not, the appropriate strategy is to invest more into staff training to show your staff how to improve customer service and how to sell more to your customers.
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 is 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 the 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.
- TARGET your customers — never try to appeal to everyone. Focus specifically on those people who you know will benefit from your product/services. How to word your headline will be the major factor in accurately targeting your offer.
- Make your OFFER compelling and relevant to the market you target. Don’t be cute or clever. Say it exactly as it is.
- 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.
- 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 offers||will give||300% response increase|
|accurate target||will give||1000% response increase|
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.
Absolutely superb service
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 business because of perceived indifference. When you yourself deal with various businesses aren’t you inclined to want to deal again 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 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 revenue each year.
Ask your customer to buy
Another thing that 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 and 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 ‘Would you like to make a selection from our new dessert menu, can I offer you a beautiful platter of Australian and New Zealand cheeses or would you prefer to try the…’ or ‘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 following. It shows the effect on total sales revenue of a relatively small improvement in critical variables: customer attrition rate, new customer attraction rate, frequency of customer purchasing and the average value of each sale.
Plan of attack
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 it 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 can help you re-engineer your business so that it runs like a well oiled machined and once that is achieved, to help you keep it there. That is if you want it!