Everyone entrepreneur should be vigilant when it comes to managing profitability. However, many are not as clued up as they need to be when it comes to understanding profit and what factors impact profit both negatively and positively.
Let’s discuss some of the ways you may be unintentionally reducing your profit and how to avoid mistakes in future.
Bank balance accounting
As a business owner, you’ve heard the phrase “Cash Is King” so many times that it starts to feel like more cash means more profit. You then start to gauge the profitability of your business based on the bank balance. This is a common mistake I see so often. Here are 7 reasons why you might be making a loss in your business despite the cash in your bank account:
- You have not paid your suppliers or other creditors
- You have received advance cash from your customers
- Payroll expenses have not been reflected in the accounts
- You haven’t made adjustments for all expenses
- You have not taken any reasonable drawings or dividends
- The cash is from last year’s profits
- You are not paying yourself a reasonable salary
The above list is not exhaustive but covers the common areas where your cash will go. So, the next time your accountant presents you with accounts with less than expected profit figure, have a conversation and go through the above list together with other factors specific to your business.
Cost cutting in the wrong place
You realise the cash at bank is not yours and that you are not making profits. So panic sets in and you’re determined to cut costs to make profits. Here’s the thing though: Not all expenses will have a greater impact on your profits. A study by McKinsey and Co (global consulting firm) revealed that whilst a 1% reduction in fixed costs can have around 2% increase in profits, the same reduction in variable costs has a bigger 7% increase in profits. So instead of going for cost cutting at all cost (no pun intended here) conduct a cost benefit analysis and focus on variable or direct costs first.
Not understanding margins
This is an important indicator to profitability, but it’s vastly ignored or misunderstood among most entrepreneurs. The next time you get your accounts, take the direct costs of sales or direct expenses out from the revenue. Then divide that number by the revenue. That is your gross profit margin. Let’s say your revenue is £1,000 and your materials or direct labour or direct expenses cost you £700. The difference of £300 divided by £1,000 revenue gives you a margin of 30%. This means that for every £1 of sale, you are making 30p in gross profit. This tells you how profitable you are at the gross margin level. You can also compare this 30% to the industry average to gauge where you are at. If this margin is so low, then you’re unlikely to be making net profit because there won’t be enough to cover your overheads.
Losing profit margin
Having ascertained your profit margins of 30%, a common and huge mistake I see is as follows. You go to see a new project. You take your costs. Let’s say 1,000. What do you do next? You apply 30% to the costs. You then quote £1,300 for the job. Sounds familiar? And it makes sense, right? Well not quite. If you take your £1,000 costs from the £1300 revenue (price) you get £300. Now divide that by £1,300. You now get 23%. You’ve just lost 7% profit margin without even blinking.
And this mistake will make its way down to the net profit figure causing you to be less profitable year after year.
Fearing prices increases
Having realised that you’ve been under quoting for jobs or that your costs have gone up, another classic mistake is to put off price increases for fear of losing customers. Yes, you will lose some customers but let’s do some maths. Let’s say you have 20 customers and your price is £1,300 per customer. (£26,000 revenue) If you put prices up by 10%, your new revenue will £28,600. If you lose 10% of your customers (2 customers x 1,300 = £2,600), your revenue will revert to £26,000 but with two fewer customers and less resources needed to service the remaining 18 customers. And depending on how you approach the price increase and how you communicate it, you might be pleasantly surprised that less than 10% of your customers will leave.
Avoiding even small increases
McKinsey studies also revealed that increasing pricing has a bigger influence over your profits than reducing costs or increasing sales volumes.
But here is what most entrepreneurs do not consider doing: Assessing the power of a mere 1% increase in price, 1% increase in sales, 1% decrease in variable costs and 1% decrease in fixed costs.
Next time you sit down with your accountant, ask him or her to run these numbers and show you the impact it will have on your profits. Would you lose a lot of customers due to a mere 1% increase in price?
Miscalculating the effect of discounting
You’ve quoted a price for the job. The customer says, “what can you do about the price” Do you get a knee jerk reaction and offer a price discounts to win the work? Let’s return to the above example (on margins) where you were making 30% margin on sales of 1000. Let’s then assume you offer a 10% discount. Your revenue drops to £900 but you’ve kept your costs the same. Your margins drop to 22% (£900 less £700 divided by £900) The 10% discount now means a 26.6% drop in your margins (the original 30% less the current 22% dividend by the original 30%. This is just the beginning because it gets worse if we look at the impact this will have on the bottom line (net profit margin), assuming you keep all your overheads the same. Were you intending to have a 26.6% drop in your margins by offering a 10% discount?
The point here is to be aware of the profit effect of price discounts and use it to negotiate a better win-win deal for all.
Lack of familiarity with key figures
One of the biggest mistakes is not knowing the profit numbers that matter in your business. Your gross profit margin, profit per staff, profit per client or project, net profit margin, breakeven number, your monthly costs and your prices are all important numbers to track and focus on. If you currently speak to your accountant once a year only to be told how much tax to pay with no access to your key numbers, then it is unlikely you will be able to improve on your results.
The good news is that with so many online accounting apps on the market, (FreeAgent, QuickBooks and Xero), entrepreneurs should no longer be flying blind in their businesses.
A final tip
In his book Profit First, Mike Michalowicz makes the case for opening another bank account and transferring your profits before you make payments to anyone. So, if you’ve worked out that your net profit on every sale is 10%, then a safe way to see and secure those profits is to transfer it straight away to your “profit bank account”. That way you are forced to make do with the remaining 90%.
Profit is as essential to business as oxygen is to human being. Your business cannot hold its breath for long without it! Make sure you understand how profit is generated and impacted in your particular business. You can do what is needed to make your business as profitable as possible.
ABOUT THE AUTHOR
Jonathan Amponsah CTA FCCA is an award winning chartered accountant and tax adviser who advises entrepreneurs on business and profit improvement. Jonathan is the founder and CEO of The Tax Guys.